Chain of Title (5 page)

Investment banks began to offer lightly regulated nonbank mortgage originators, who specialized in marketing to poor borrowers,
warehouse lines of credit, or defined funding for their mortgages. In exchange, the banks would purchase all the originator's loans and package them into private-label securities (PLS), separate from Fannie and Freddie's mortgage-backed securities on conforming loans. The originators knew what the big banks wanted: subprime mortgages, and lots of them.
Brokers were given “yield spread premiums,” bonus payments for every high-rate mortgage they sold.

Lenders perversely described exotic loans as “affordability products.” After a teaser period of one to two years, monthly payments would increase by thousands of dollars. If borrowers ever showed concern about this (and typically they didn't, as disclosures were written in such byzantine legalese that virtually no one could decipher it), brokers told them not to worry: they could always refinance again. Every refinance away from the payment shock added closing costs—profit for the lender—and built up unpaid balance on the loan. It was not uncommon for homeowners to refinance five or six times in a few years, taking on more debt each time.

Another industry creation was the cash-out refinance, giving borrowers with equity in their homes a new loan with a lower starting payment, along with some cash to cover other expenses. This was an attractive option for newly targeted low-income families of color. Since the 1930s African Americans and Hispanics were locked out of the housing market, with government maps
“redlining” designated tracts of land (indicating them as off-limits to nonwhite buyers) and banks shunning their business. Now old women in inner-city Detroit or Cleveland got knocks on their door from pitchmen promising to make their financial hardships disappear. It was redlining in reverse. For decades the problem had been that black people couldn't get loans; now the problem was that they could.

Nonbank lenders Option One, New Century, and First Alliance started in the mid-1990s, joining Countrywide and Long Beach Mortgage, which would eventually become Ameriquest.
Federal Reserve statistics show that subprime lending increased fourfold from 1994 to 2000, to 13.4 percent of all mortgages. Brokers were under significant strain to pump out subprime loans with high interest rates or else lose their warehouse lines of credit. So lending standards flew out the window. Practically no applicants were rejected.

That these loans were harmful concerned nobody.
The Clinton administration wanted to increase homeownership rates, which had fallen amid the S&L collapse. It wasn't likely to crack down on irresponsible lending practices if they served that goal. Anyway, the Federal Reserve held responsibility over consumer protection for mortgages, and Alan Greenspan viewed regulations the way an exterminator viewed termites.

Investment banks also got more sophisticated about the securities. Mathematicians fresh out of college—quantitative analysts, or “quants”—spent
their working hours converting risky subprime loans into something that could secure a coveted AAA rating, guaranteeing sale into the capital markets. For example, banks had no problem selling high-rated tranches of their mortgage-backed securities, but the lower-rated mezzanine and equity tranches were more of a puzzle. To solve this problem, they built something called a
collateralized debt obligation (CDO), using the same tranching mechanism, squeezing AAA ratings out of low-rated junk. Then they would make CDOs out of the unsold portions of CDOs, creating what was known as a “CDO-squared,” and so on. Investors knew they were buying securities backed by mortgages; they didn't know they were getting repackaged leftovers of the worst bits, julienned through financial alchemy into something “safe.”

CDO sales increased exponentially after market deregulation through the
Commodity Futures Modernization Act in December 2000, in one of President Clinton's last official acts. You didn't even have to own the mortgages to wager on whether they would go up or down.
“Synthetic” CDOs just tracked the price of certain mortgage securities, with investors taking up either side of the bet. This multiplied the amount of money on the line well beyond the value of the mortgages and turned the whole thing into gambling.

The securitization machine resembled the children's game of hot potato. Everyone stopped caring whether the borrower could pay back the loan, because everyone passed the default risk up the chain. The lenders didn't care because they sold the loans to Wall Street banks; the banks didn't care because they passed them on to investors; and the investors didn't care because Wall Street's financial wizards lied to them. Investors were assured that the loans were of high quality; furthermore, they were told that even if a few failed, slicing and dicing thousands of loans from all over the country into bonds would make up for the delinquencies and eliminate the risk. The geographic diversity of the bonds would insulate investors from a regional market collapse, and everyone knew that mortgage markets were regional; you never saw a broad-based price decline. The credit rating agencies, paid by banks to rate the securitizations, blessed the whole scheme, either out of ignorance or to make sure they grew their businesses.

In the late 1990s, amid the Asian financial crisis, Wall Street pulled back on warehouse funding for nonbank lenders. Subprime lending momentarily
stopped, and some lenders went out of business. But this was only a blip. Though consumer lawsuits exploded during this period, complaining of predatory practices, the Federal Reserve and other regulators showed no interest. When the smoke cleared, the remaining subprime lenders and their Wall Street funders started up the machines again. The
second wave of subprime mortgages dwarfed the first wave.

The entire industry was assembled on a mountain of fraud, starting from the first contact with a prospective home buyer. Many brokers over-inflated home appraisals to increase the loan balance. Some pushed borrowers into “no income, no asset, no job” (NINJA) loans by telling them they would get better deals if they falsely inflated their income. These were also called “liar's loans.” If loan officers demanded income verification, brokers would sometimes even use Wite-Out and replace the numbers on W-2 forms, or construct fake tax returns with a photocopier, to get them through underwriting. In his book
The Monster
, Michael W. Hudson describes one loan sent to underwriting that claimed
a man coordinating dances at a Mexican restaurant made well over $100,000 a year. The dance coordinator got the loan.

The typical borrower too easily fell prey to this routinized deceit. Some lenders took borrowers eligible for prime-rate loans—people with perfect credit, like Lisa Epstein—and gave them subprime ones. Others forged borrowers' signatures on disclosure forms that would have actually explained how much in interest and fees they were paying.
Some brokers used light-boards or even a bright Coke vending machine to trace signatures and enable the forgery.
Others presented borrowers with a loan at closing whose first few pages looked like a fixed-rate loan, masking the toxic mortgage underneath. When the borrower signed all the papers, the broker ripped those first pages off.

The fraud continued up the chain as well. The Financial Crisis Inquiry Commission found that a third-party firm called Clayton Holdings, brought in to reunderwrite samples of loans backing subprime mortgage securities for twenty major banks, consistently found defects in half the loans in the samples. Clayton relayed its findings to the banks, who promptly used them to negotiate after-the-fact discounts on the full loan pools from originators. Those discounts never got passed on to bond investors, who remained ignorant about the defects. In such cases, the securitizers knowingly sold
defective products to investors without disclosure, and took extra profits based on how defective they were.
It was clear securities fraud.

Many investment banks knew about, and indeed drove, the poor quality of the loans. Internal documents later uncovered in a lawsuit against Morgan Stanley, the largest buyer of mortgages from subprime lender New Century, showed the bank demanding that 85 percent of the loans they purchase consist of adjustable-rate mortgages. When a low-ranking due diligence official told his supervisor about the litany of problems associated with New Century loans, she responded,
“Good find on the fraud :). Unfortunately, I don't think we will be able to utilize you or any other third party individual in the valuation department any longer.” In other words, finding the fraud got people fired.

In September 2004 the FBI's Criminal Division formally warned of a mortgage fraud “epidemic,” with more than twelve thousand cases of suspicious activity.
“If fraudulent practices become systemic within the mortgage industry,” said Chris Swecker, assistant director of the FBI unit, “it will ultimately place financial institutions at risk and have adverse effects on the stock market.” Despite this awareness, almost no effort was put into stamping out the fraud. In fact,
when Georgia tried to protect borrowers with a strong anti-predatory lending law in 2002, every participant in the mortgage industry, public and private, bore down on them. Ameriquest pulled all business from the state. Two rating agencies, Moody's and Standard and Poor's, said they would not rate securities backed by loans from Georgia, cutting off the state from the primary mode of funding mortgages. And the Office of the Comptroller of the Currency, which regulated national banks, told the institutions that they were exempt from Georgia law. Georgia eventually backed down and replaced the regulations, rendered moot by an unholy alliance of the industry and the people who regulated them.

Banks issued $1 trillion in nonprime mortgage bonds every year during the bubble's peak.
Subprime mortgages made up nearly half of all loan originations in America in 2006.
Total mortgage debt in America doubled from 1999 to 2007. There was so much money in mortgages that
loan brokers right out of college made $400,000 a year. Traders on Wall Street made even more.

Home prices appreciated rather slowly for fifty years, but between 2002 and 2007 they shot up in a straight line.
In several states,
annual
price increases
hit 25 percent. Since this boosted property values, boosted the economy, and made the industry more profitable, few politicians or regulators raised alarms.
Even Fannie Mae and Freddie Mac, locked into buying “conforming loans” for their securities, lowered their standards and bought subprime loans once they started to lose market share to the private sector. Everyone mimicked industry claims that the market transformation was good for homeowners, and for a little while it was:
even amid rising prices, homeownership rates rose over this period to an all-time high of 69.2 percent. Nobody wanted to stop the merry-go-round while the song was still playing.

At the end of 2006 the song stopped, and homeowners used to refinancing out of trouble were stuck. Even before this point, you could see warning signs in
skyrocketing early payment defaults—people missing their very first mortgage payment.
Foreclosures started to occur in large enough numbers—they nearly doubled in 2007, and again in 2008—that mortgage-backed securities, even the senior tranches that were supposed to be infallible, took losses. Investors tried to dump the securities, and banks stopped issuing new ones. Brokers suddenly had no money to make new loans; by 2008, all of them were either out of business or, in the case of Countrywide, sold to Bank of America. The entire system, which soared along with home prices, crashed when those prices dropped. And because the system had been replicated multiple times, in CDOs and other credit derivatives, failures cascaded through Wall Street investments and led to a catastrophic financial crisis.

Lisa read about all this and internalized it; after a couple of weeks of intense study, she could cite chapter and verse on previously unknown financial industry machinations. She started to daydream while working, her mind filled with theories about mortgage-backed securities and what caused the crash. At work or at home, it became hard for Lisa to concentrate on anything else.

Of all the websites she sought out, none deconstructed securitization and Wall Street malfeasance like
Living Lies
. Neil Garfield went much deeper than the surface layer of fraud in the subprime scam. He viewed the originators as straw lenders, because they immediately sold the loan and did not care about its quality. To Garfield, this violated modest federal
mortgage laws such as the Truth in Lending Act.
Garfield called such originators “pretender lenders” and thought the fact that they relinquished their interest in the loan by having investors pay it off in full could form the basis of a legal challenge.

More interesting to Lisa were Garfield's contentions about promissory notes, mortgage assignments, and pooling and servicing agreements.
“The reality is that nearly all securitized mortgage loans are worthless and unenforceable,” Garfield wrote in one post.
“The ONLY parties seeking foreclosures . . . do not possess ANY financial interest in the loan nor any authority to foreclose, collect, modify or do anything else,” he wrote in another. He quoted a bankruptcy attorney in Missouri, who added,
“Democracy is not supposed to be efficient—because in the tangle of inefficient rules lies the safety and security of popular rights. The judge is not there to clear the sand from the gears of the machine—the judge is the sand.” Lisa didn't understand Garfield's line of argument at first, but a lot of
Living Lies
commenters were agitated about it, talking about document fraud and broken chain of title. And the discussion refreshed Lisa's memory about something in her court summons.

Count II in the complaint was entitled “Re-establishment of Lost Note.” Lisa needed more information about what that actually meant—what was the difference between the note and the mortgage?—but it surprised her that the plaintiff admitted that it lost a key document and was trying to reestablish it in some manner. Others at
Living Lies
had note problems; for example, Andrew “Ace” Delany's lender could never supply the note, although he asked for it every week. What was with this epidemic of lost notes? Where did they go? And how did that impact foreclosure cases?