Contributed by Kevin Chern, Total Attorneys, Inc.

Homeowners facing foreclosure are, understandably, looking for hope. News reports of homeowners successfully asserting the “produce the note” defense to stop foreclosure have sparked that hope in many. It seems only logical that a company commencing a foreclosure action should be required to demonstrate that it is the real party in interest before that action can move forward. But simply demanding that a mortgage servicer produce the note or establish itself as the real party in interest isn’t the magic bullet it sometimes appears in the popular press.

We know mortgage documentation is rife with errors, misrepresentations and missing links. Various studies have estimated the percentage of mortgage claims containing substantial errors between 57% and 80%. Katherine Porter’s 2007 study of mortgage proofs of claim in bankruptcy cases revealed that 52.77% of proofs of claim lacked at least one clearly-required document. What those errors mean for the homeowner depends not only on the nature of the error, but also on the state and jurisdiction in which the claims are prosecuted.

Success Stories

Attorneys in some states have had tremendous success with the defense. In September of 2008, the First District Court of Appeals in Ohio ruled on a case in which Wells Fargo Bank had commenced a foreclosure action based on a mortgage it did not own. (Wells Fargo Bank, N.A. v. Byrd, 178 Ohio App.3d 285, 2008-Ohio-4603.)

Although Wells Fargo subsequently acquired the mortgage by assignment, the trial court ruled that this later acquisition did not cure the jurisdictional defect and dismissed with prejudice. The trial court also ordered that the law firm filing the case on behalf of Wells Fargo submit proof that its client was the real party in interest in all future foreclosure actions filed by that firm.

Publicity surrounding Wells Fargo and a handful of other similar cases produced a flurry of real party in interest defenses and optimistic news coverage. A year later, the Ohio Supreme Court declined to review a similar case in Wells Fargo Bank, N.A. v. Jordan, leaving stand an Eighth District Court of Appeals ruling that “If plaintiff has offered no evidence that it owned the note and mortgage when the complaint was filed, it would not be entitled to judgment as a matter of law.”

At the same time, Florida legal aid attorney April Charney and a handful of others began challenging claims supported by affidavits of lost notes. It seemed that in the frenzy to slice, dice, flip and securitize the high-risk loans of the 1990s and early 2000s, many lenders and mortgage servicers had dropped the ball when it came to keeping accurate records. In many cases, the paper trail was broken, non-existent, or simply didn’t conform to legal requirements. Some plaintiffs in mortgage foreclosure cases found their claims dismissed outright for lack of documentation, and some homeowners found themselves in a better position than they’d ever imagined: enormous mortgage debt simply disappeared as it became clear that no proof of ownership of the debt could be produced.

It was heartening to see mortgage servicers taken to task and forced to follow the rules, but even in the oft-cited Byrd case, the real victory was scaled back considerably by the appellate court. While the dismissal was affirmed, the appellate court ruled that it should have been without prejudice; the order that the law firm submit additional documentation in subsequent cases was reversed. Those cases in which demanding the note and dissecting the paper trail resulted in a windfall for the homeowner were few and far between.

The State-by-State Difference

To a layperson, common sense dictates that a plaintiff would have to own the note and mortgage in order to file a complaint based on it; the big surprise is probably not the Ohio rulings above but the fact that the question ever arose. However, that question is far from settled in many states. Consumer attorneys in some states report that their courts are simply declining to entertain defenses like the one successfully raised in Byrd. The most likely explanation for this pattern is simple economy: a case dismissed without prejudice may be re-filed as soon as the defect has been cured, so many courts are apparently reluctant to go through the motions of dismissing a claim on procedural grounds only to have it filed as a new case soon after.

But disparate treatment of this issue by the courts isn’t the only—or even the most significant—difference from state to state. More than half of U.S. states allow for some form of non-judicial foreclosure. That means that the foreclosing party doesn’t have to file a court case in order to foreclose on the property. Non-judicial foreclosure doesn’t render true ownership of the mortgage irrelevant, but it does make it more difficult for the homeowner to pursue the issue.

While the defendant in a judicial foreclosure can simply raise the issue as a defense, the homeowner in a non-judicial foreclosure will typically have to file suit himself to get the issue of mortgage ownership and documentation before the court. That means not only filing fees and service of process, but also a host of procedural hoops unfamiliar to most homeowners. Few will be able to successfully prepare and argue such a claim without an attorney. That isn’t to say that the claim won’t succeed or isn’t worth pursuing in a non-judicial foreclosure state, but the process is far more complex, time-consuming and potentially expensive than the victory stories on television and in news reports might seem to suggest.

The Real Value of Demanding the Note / Questioning the Real Party in Interest

While demanding that the claimant produce the note / arguing that the claimant isn’t the real party in interest and doesn’t have standing to pursue a foreclosure action only occasionally results in a decision that effectively forgives the mortgage debt, the challenge can be a valuable tool for homeowners facing foreclosure. If a claim is dismissed and re-filed, that may buy the homeowner valuable time in which to negotiate or assemble funds to cure the default; the added procedural complications and the possibility that the mortgage servicer or alleged note holder may not be able to establish its claim provide an incentive for the claimant to compromise. Likewise, in a non-judicial foreclosure state, initiating a suit against the claimant may only rarely put an end to a foreclosure action altogether, but may still benefit the homeowner by slowing the proceedings and creating an incentive for the mortgage holder to negotiate a workable settlement.

– Kevin Chern
Total Attorneys, Inc.
25 East Washington Street, Suite 400
Chicago, IL 60602

The following post was contributed by Ken Andrews of the Doan Law Firm in California. Ken also runs a blog called “San Diego Predatory Lending”, where the original of this article is posted. The article discusses a bankruptcy defense based on existing law to dispense with second mortgages.

A lot has been written by me and others about How To Walk Away From Your Home. My blog has become more of a self-help guide to walking away in California. I get at least 25 calls and emails a week from people who want to get out from their underwater homes, but are scared they will be liable for the unpaid mortgage debt. As I previously explained, California homeowners who used 80/20 loans to purchase their homes and have not refinanced the second mortgage

But I also get many folks who have refinanced that second mortgage, or who want to keep their homes, but can’t pay for the adjusted payment on their mortgage, or don’t want to pay on a house that worth substantially less than they owe on it. They have tried to get the bank to work with them, but are frustrated because the bank won’t talk unless they are two payments behind and the only thing the bank will do is freeze their payments or add their arrears to their loan balance. Banks will not reduce the principal amount on loans to fair market value to save a borrower from foreclosure. They just won’t do it.

Once again it’s the 80/20 loan to the rescue. This beautiful piece of financial engineering genius (you really need to click on that link, it’s hilarious!) has found yet another way to help distressed home owners. And not just in California, this trick works all over the United States.

The trick is called a “Chapter 13 Lien Strip” but I like to call it the “Back Door Cram Down.” You may have read about the proposed mortgage “Cram Down” legislation that would allow Chapter 13 judges to reduce or “Cram Down” mortgages balances to fair market value in a Chapter 13 case. This legislation has zero chance of passing until a new election and Congress are seated next January.

Instead, we are “Cramming Down” second mortgages using the old Bankruptcy code section 1322 which states:

“Contents of plan

(b) The plan may–

(2) modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor’s principal residence, or of holders of unsecured claims, or leave unaffected the rights of holders of any class of claims.”

What’s not obvious about this code section is a loan is not “secured” by your personal residence if there is no value or equity in your home that would go to the lender if the home was sold. That means the loan can be converted to unsecured or the lien “stripped” from the house by “modifying the rights of holders of secured claims.” This turns it into unsecured debt, like credit card debt, which can be discharged!!!! This is why I call it a “Back Door” cram down because we are cramming down the second mortgage to unsecured status.

Here is an example. You bought your home in 2006 for $500k with 100% financing using an 80/20 loan. So your first mortgage is 80% or $400k and your second mortgage is 20% or $100k. The market is down more than 20% from its peak and your house is now only worth $375k. This means if the house was sold, the first mortgage would take all $375k and the second mortgage would get nothing. In this case the second mortgage is “wholly unsecured” and the second clause of section 1322(b) does not apply, so we can modify the rights of the second mortgage holder and turn it into unsecured debt.

What happens to the now unsecured stripped off second mortgage? It gets paid in your Chapter 13 plan but only after your other secured debts are paid. Secured debts are the first mortgage, your property taxes, and your car payments. And because a Chapter 13 plan lasts only 3-5 years (usually 5) a whole lot of that unsecured debt does not get paid. At the end of 5 years, most unsecured debts (not student loans, back income taxes, or family support payments) are discharged so you don’t have to repay them.

So at the end of 5 years, you are left with just your just mortgage payment on your house. Your cars and your back property taxes are paid off, your student loans and back income taxes are paid down, but your second mortgage and your credit card debt is gone! Beautiful isn’t it? God bless the 80/20! It just keeps on giving.

You can read more about Chapter 13 plans here so I’m not go into great detail on them other than to say they are like debt consolidation inside of a bankruptcy, they last 3 to 5 years (usually 5) and you also can included student loans and back income taxes.

So what is the downside? First off, you will have gone “Bankrupt.” Your creditors will report that for 7 years and it will appear as a public record for 10 years on your credit report. Creditors do not really distinguish between a Chapter 7 or a Chapter 13 bankruptcy so your credit will take a beating. But I like to point out to people that if they do nothing, their credit will likely take a beating anyway, so it’s not really any worse.

The other major downside is you must make every plan payment for 3 to 5 years. If you fail, everything goes back to the way it was. You owe all that debt, and the second lien is no longer stripped off. So I always tell my clients to make a budget that will work for 5 years, not just one that looks good to the Bankruptcy Court.