How the Mortgage Market Lost Its Paperwork—and Why It Affects Us All

There is an old adage that "possession is nine-tenths of the law." While that's not strictly true from a legal standpoint, it reinforces the idea that it's much easier to prove ownership of something if you have possession of it. This idea has come back to haunt the U.S. mortgage securities market, and it has a big effect on individual homeowners facing foreclosure-and the entire housing market.

The problem is that in the 1990s, financial companies that held mortgages throughout the country began to bypass existing regulations and legal precedent that required the companies to hold the actual paper documentation for that mortgage. Financial institutions instead sold the mortgages they originated or owned with electronic documentation, through a company called MERS (Mortgage Electronic Registration Systems).

This electronic process for recording mortgage transfers enabled financial companies to bundle multiple mortgages together and sell them as mortgage-backed securities to other financial institutions. By the end of the real estate boom in 2006, about 70 percent of the roughly $6.1 trillion in U.S. mortgages had been bundled and sold as bonds. This meant that the banks who originated the loans were able to sell them off quickly and thus had more money to make new loans, which helped to facilitate the real estate boom. In theory, this was a good thing.

But when the market tanked, the investors who had bought the loans in the form of bonds did not have the actual paper documentation to prove they owned the mortgages in question, nor did the homeowners always have a clear idea of who owned their mortgage. To re-establish ownership, a company would have to demonstrate the "chain of title"-records showing all the ownership transfers from beginning to end. But after the recent market upheaval, some of the companies in the chain of title no longer existed, making records hard to find.

Not only is this a problem for homeowners (who don't know who truly owns their mortgage) and banks (who are sometimes unable to get their money back through foreclosure because they can't demonstrate they have chain of title), but it's also a problem for the country as a whole. For the real estate sector to get back on its feet, there needs to be a robust secondary market for home loans-in other words, investors willing to buy mortgages from banks so that the banks have money to make more loans.

Today Government-Sponsored Enterprises (GSEs) like Fannie Mae and Freddie Mac are the only game in town, backing 90 percent of new mortgages, when in 2005 they accounted for roughly only a third of the market. Until the secondary market for new home loans returns-and cleans up its paperwork problem-the real estate market will continue to be a drag on the economy.