How the mortgage clearinghouse MERS became a villain in the foreclosure mess

By Ariana Eunjung Cha and Steven Mufson
Washington Post Staff Writers
Thursday, December 30, 2010; 3:16 PM

In the early 1990s, the biggest names in the mortgage industry hatched a plan for a new electronic clearinghouse that would transform the home loan business - and unlock billions of dollars of new investments and profits.

At the time, mortgage documents were moved almost exclusively by hand and mail, a throwback to an era in which people kept stock certificates, too. That made it hard for banks to bundle home loans and sell them to investors. By contrast, a central electronic clearinghouse would allow the companies to transfer thousands of mortgages instantaneously, greasing the wheels of a system in which loans could be bought and sold repeatedly and quickly.

"Assignments are creatures of 17th-century real property law; they do not coexist easily with high-volume, late 20th-century secondary mortgage market transactions," Phyllis K. Slesinger, then senior director of investor relations for the Mortgage Bankers Association, wrote in paper explaining the system.

On March 4, 1994, the MBA unveiled its plan to county recorders who were charged with keeping track of titles signifying the ownership of land. Not everyone was sold on the idea.

"There needs to be some outside control or oversight," one recorder said, according to a transcript of the meeting.

Another said that if errors were put into the electronic system, "they're really hard to track further down the road."

Sixteen years down the road, the mortgage business is a mess. The electronic clearinghouse has become a reality; Virginia-based Mortgage Electronic Registration Systems, a registry with 67 million mortgages on file, has become part of the industry's standard operating procedure.

Critics say promises to increase transparency and iron out wrinkles in recordkeeping haven't panned out. The firm, which tracks more than 60 percent of the country's residential mortgages but whose parent company employs just 45 people in a Reston office building, is now on the firing line.

MERS is facing lawsuits from across the country seeking unpaid county recording fees. Several state courts have rejected attempts by MERS to act on behalf of banks seeking to foreclose on delinquent mortgages. And Congress is weighing legislation that would bar home loan giant Fannie Mae from buying any mortgage listed in MERS, potentially a death knell for the registry.

Merscorp, the registry's parent company, argues that it helps borrowers. Spokeswoman Karmela Lejarde said MERS has kept costs low, reduced the risk of recordkeeping errors and made it easier to keep track of loans.

"MERS plays an important role in building and sustaining confidence in the mortgage process," Lejarde said.

But in the recent uproar over improperly prepared foreclosure paperwork, MERS has become the central villain.

"They've tried to turn the mortgage business into . . . a production line," banking lobbyist Rick Hohlt said. "But in reality you're dealing with humans. You're not building cars or widgets."

The blueprint

The impetus for a nationwide electronic database of mortgages originally came from the biggest players in the mortgage business - the MBA, Fannie Mae, Freddie Mac and Ginnie Mae - in the early 1990s.

"The original thought was that the process was one of the most manual, labor-intensive, town-hall-to-town-hall processes, and there was a kind of broad industry effort to improve on that," said Daniel Mudd, former Fannie Mae chief executive and now chief executive of Fortress Capital, a private equity firm.

The savings and loan crisis had just passed and the mortgage business was picking up again. At the time, an unconventional entrepreneur named Angelo Mozilo was on the MBA board. Mozilo would eventually pay a $67.5 million to settle Securities and Exchange Commission allegations of fraud and insider trading. But back then Mozilo was one of the industry's most admired executives, known for his inventiveness and technology investments at his firm Countrywide Financial, which in 1992 catapulted to first place among the nation's mortgage originators.

Mozilo could not be reached for comment.

Mozilo began brainstorming with a young MBA technology expert, Brian Hershkowitz, about ways to computerize and centralize the way the industry did business.

"Angelo Mozilo loved to think about that," Hershkowitz said, calling Mozilo "the inspiration" for what would eventually become MERS.

In the fall of 1993, the MBA began circulating a white paper, "a blueprint for the future" that Hershkowitz wrote outlining a new central registry for mortgages.

Hershkowitz, who would later join Mozilo at Countrywide, modeled the new system on a clearinghouse for stocks called the Depository Trust Co. That company not only kept track of the stock ownership but kept the physical certificates in a vault. Before the DTC had been created, brokers hired thousands of messengers to ferry certificates across New York City - a process that grew prohibitively expensive and inefficient as the volume of stock trades skyrocketed.

The mortgage industry was facing a similar problem. As interest rates sank, the number of new mortgages and refinancings soared. County recorders' offices, which at that time were not automated, were having trouble keeping up.

Although the bankers touted the registry as a way to make mortgage processing more efficient, thus benefiting borrowers, they weren't shy about admitting their main goal: more profits. They estimated that the cost of preparing, recording and mailing 11.1 million loan documents totaled about $210 million in the previous year alone.

In addition, the mortgage bankers had greater ambitions of hyper-charging the market for mortgage-backed securities. Invented in the late 1970s by a trader at Salomon Brothers, these investment packages pooled together thousands of mortgages. They were then sold not only to banks but to pensions, insurance companies and other big investors.

The only thing holding back wider securitization, they believed, was the time-consuming and costly chore of recording and re-recording ownership of the individual mortgages.

In the years to come, the growth of MERS and securitization went hand in hand.

Countrywide, which had become a pioneer in securitization, saw its profits soar from $60.2 million in 1992 when MERS was still just an idea to $2.67 billion by 2006 at the peak of the boom.

By 2007, MERS had more than 60 million mortgages on file and said that it had saved the banking business $1 billion in recording fees and other costs. Meanwhile, the volume of securitized mortgages soared, making them the nation's largest asset class and contributing to a $12 trillion bubble in the real estate market - before it all broke down.

The doubters

From the beginning, the clearinghouse idea had its doubters.

At the March 1994 meeting between mortgage giants and the county recorders, the recorders ran through their list of concerns: whether consumers would be able to get access to their own information; how data errors would be corrected; whether the registry was consistent with state laws; whether the chain of title would be broken if documents weren't recorded properly; and whether too much power would be concentrated in the hands of those who would manage and own the clearinghouse.

"This one group of people, the investors, the people that benefit, are in total control," one county recorder warned, according to minutes of the meeting.

Another commented that "it seems to me it creates a whole new system - different than anything that has been before."

The bankers brushed off such questions.

The chairman of the industry's legal team, Edmond R. Browne Jr., said the system would comply with the land recording laws in all 50 states.

"I don't think it can really hurt as long as things are handled effectively," he said. "It doesn't take anything away from the existing system . . . but it's an additional layer that has some economies of scale and some efficiencies."

But somewhere along the way MERS became a stripped-down version of the original idea. The first thing to go was the vault for keeping documents. MERS instead became a giant electronic card catalogue that tracked who was managing a particular loan as it was sold and resold, but it left the companies responsible for guarding the mortgage (or deed of trust) and the promissory note (or IOU) - the two critical pieces of paper that prove who owns a loan.

Next to go, critics say, was transparency.

When a home loan is securitized, at least a half-dozen parties are typically involved. The loan might be originated by a mortgage finance firm, then sold to a company that aggregates them into a pool and sells them to an investor such as a pension fund. A different "servicer," often a major bank such as Bank of America or Wells Fargo, is usually responsible for collecting payments. Most loans are bought and sold several times, and the servicer can change, too.

The mortgage bankers decided that to simplify recordkeeping, MERS would be listed as a "nominee" for the mortgage holder in local land records offices. When the loans changed hands, the new owner or servicer would register the transaction electronically in the MERS system without having to re-record the transaction across the country.

Mark Monacelli, a county recorder in Duluth, Minn., who was the lead negotiator for the association representing recorders from most of the nation's 3,600 counties, said that practice makes it difficult for homeowners to trace the chain of ownership of their loan.

"MERS turned out to be something completely different than what we originally thought," Monacelli said.

MERS insists that it has not kept information from the public.

"The MERS System actually fills an information void in the county land records system," said Lejarde, the spokeswoman. She said that although county land records list information about only the owner of loans, MERS tracks both the owner and the servicer.

Lejarde acknowledged, however, that some borrowers don't have access to all that information. MERS gives investors the right to withhold their names from being displayed in the database, and about 3 percent do so.

In the mid-1990s, some of the recorders lobbied states and Congress for legislation to block the creation of MERS but failed. By 1999, just two years after MERS went live, the number of loans in the MERS system hit the 1 million milestone and Lehman Brothers issued the first "AAA"-rated security with MERS-registered loans.

The roof falls in

The collapse of the housing market over the past three years has drawn back the curtains on MERS.

As millions of homes fell into foreclosure, MERS found itself in a tricky legal position because its name was listed as the mortgage holder in local land records. Because the law allows only the mortgagee to foreclose, MERS had to either file court papers in its own name or transfer the mortgage back to the real owner. Both scenarios require huge amounts of paperwork.

But with only a handful of employees - most of them computer technicians - MERS was in no position to do so. So MERS authorized employees at mortgage servicers, debt collectors and foreclosure law firms - 22,000 in the most recent count - to identify themselves in records or court papers as "vice president" or "assistant secretary" of MERS.

Distressed homeowners have bombarded MERS with hate mail. And thousands of borrowers have challenged the right of MERS and these agents to act on behalf of lenders or service firms, effectively calling into question the company's business model.

"MERS is both a cause and a symptom of cavalier documentation practices in the mortgage industry," said University of Utah professor Christopher L. Peterson. "It goes back to a slogan of theirs: 'Process loans not paperwork.' " He said MERS created the "illusion of recordkeeping."

In a recent paper, Peterson wrote, "As a practical matter, the incoherence of MERS' legal position is exacerbated by a corporate structure that is so unorthodox as to arguably be considered fraudulent."

Some state courts agree. The Missouri Court of Appeals said in June 2009 that MERS lacked the authority to assign a mortgage from one service company to another. Because the transfer by MERS "had no force," the court ruled, the owner of the loan lacked "a legally cognizable interest" and could not pursue the delinquent borrower.

The Kansas Supreme Court ruled in August 2009 that MERS did not have any interest in the underlying property of a bankrupt borrower whose home was auctioned - even though MERS was listed as the mortgagee. Moreover, the court said that the MERS transfer of the mortgage was invalid because the owner, Sovereign, had never recorded its interest in Ford County, Kan.

In October, a federal judge in Oregon issued an injunction preventing Bank of America from foreclosing on a home, because of the use of MERS.

In testimony before Congress, Merscorp president R.K. Arnold said he believes MERS "is based on sound legal principles" and that its role in such cases will be upheld on appeal.

More than half a century ago, the uniform commercial code ensured that commercial transactions didn't need to comply with countless state rules. But real estate transactions remained protected.

Now, in the wake of the foreclosure wave, states are asserting themselves in ways that undercut efforts to make MERS a tool for unifying the mortgage business. A key bone of contention is whether MERS can be listed as the mortgage holder without actually owning the loan.

In the District, Attorney General Peter Nickles in October said that all transfers of mortgages should be inscribed in the land records within 30 days and that listing MERS does not meet this requirement. In Massachusetts, a county recorder has called on the attorney general to investigate whether MERS failed to pay the proper recording fees.

MERS says it believes it is in compliance with District law and that in Massachusetts "no fee is due, because there is nothing to record."

Virginia Del. Bob Marshall, who has proposed tighter recording requirements, said that "the practice of MERS is going to destroy 400 years of guarantees that American law has sought to give people."

Problem or 'solution'?

MERS was a key component in a machine that was tearing up the traditional mortgage business. It both furthered and embodied the growing automation and anonymity of the booming home loan industry.

Whether MERS was a flawed concept or whether it was simply poorly constructed remains a matter of dispute.

"Perhaps the vision I had might have been better if it had been fully seen through," said Hershkowitz, author of the original white paper.

He said that foreclosures were far from the minds of mortgage industry officials in the early 1990s - they were simply trying to boost the volume of mortgages they could handle.

Kurt Pfotenhauer, chief executive of the American Land Title Association, said MERS is an "elegant solution" to the inefficiencies of paperwork. Although he would welcome more regulatory oversight, he said title companies have found the database to be accurate and that its main flaw is that it doesn't contain every mortgage in America.

"I think if you didn't have MERS you'd have to invent it today," he said.

William E. Kelvie is a former chief information officer for Fannie Mae who was a founding board member of MERS in 1997 and is now chief executive of Overture, a software company for the mortgage industry. He said the real problem is not that the industry automated too fast; it's that it went too slowly. If every component of a mortgage were digitized then there would be no paperwork controversy, because there wouldn't be any paperwork in the first place.

Others have the opposite view.

"In theory it's a good idea because it saves everyone a lot of money," said Howard A. Lax, a real estate expert at the law firm of Lipson, Neilson, Cole, Seltzer & Garin. But in practice, he added, MERS "relies on all these people from different financial institutions to give them accurate information.

"Nobody at MERS is responsible for due diligence, to go back and question whether the information they're getting is accurate. It's just like a computer program. If you're going to put garbage in, you're going to get garbage out."

Phyllis K. Walters, a recorder from Illinois who led the opposition to MERS in the 1990s, said that in her district the chain of title for a parcel of land goes back to 1839 - and that never was broken until banks started recording, and foreclosing, in the name of MERS.

"If things had been recorded in our offices," she said, "we wouldn't be in this mess."

View all comments that have been posted about this article.

© 2010 The Washington Post Company