The Massachusetts Supreme Judicial Court issued a ruling in a foreclosure case earlier this month that sent bank stocks down sharply.
Now, legal experts say the nation's largest banks may be facing yet another potential disaster: Millions of outstanding mortgages may have faulty paperwork.
Understanding The World Of Mortgages
If you've ever bought or sold a used car, you can better understand what's going on in the world of mortgages. There is a place to sign on the title to the car when you sell it called the "assignment of certificate of title by owner." This is very similar to what happens with mortgages.
Kevin Costello, an attorney in Boston who represents homeowners, says mortgages are like a car that gets sold properly once, and "then gets sold 10 more times, except that piece of paper never gets signed again."
In recent years, Costello says, more mortgages were packaged into securities on Wall Street. They were often sold to different parties again and again and in some cases the systems broke down for keeping the required legal paper trail. Now, banks that are trying to foreclose sometimes can't prove to a judge that they actually have the legal right to foreclose on a property.
"In order for that foreclosure to be appropriate, you have to show that the originator assigned the interest to entity A who then assigned the interest to entity B, all the way to whoever it is, entity Z, whoever it is who is showing up to foreclose on your house," Costello says.
If it turns out that there are legal questions surrounding the mortgages for millions of homes facing foreclosure, it could mean more trouble for the banks.
State Supreme Court Decision
Legal questions sent bank stocks down after the recent Ibanez decision by the Massachusetts Supreme Judicial Court.
The banks were basically arguing they should be able to foreclose anyway. But, Costello says, the judge not only disagreed, he disagreed strongly.
"The term that he uses is 'utter careless' with which banks documented the title to their assets," says Gary Klein, who heads the legal team that Costello is on. "The importance to me of Ibanez is that the courts are saying that banks are not above the law."
The legal team is seeking class action status on a related lawsuit on behalf of homeowners.
Wells Fargo, one of the banks involved in the Ibanez case, said it believes the court's ruling does not prevent foreclosures on loans in securitizations.
"The court simply set forth a standard legal process that mortgage servicers must follow in Massachusetts," the company said in a statement.
In many cases, the banks may be able to sort out the paperwork problems given time.
Klein says it's unclear how many mortgages are faulty.
"That's something that we don't know yet. I think there's reason to believe that this problem affects a lot of foreclosures," he says. "But not every foreclosure."
Some analysts think this faulty paperwork could also open up the banks to litigation from investors who lost money on securities backed by home loans that went bad.
Randall Wray, an economics professor at the University of Missouri, Kansas City, says "what we have been calling mortgage-backed securities aren't. They're not backed by mortgages."
Wray says if the paperwork wasn't done right, investors could argue they were sold faulty securities and demand their money back from the banks.
Wray's fellow professor in Kansas City, William Black, agrees. He's a lawyer, a criminologist and a former federal bank regulator.
Black says it used to be that banks were punctilious about mortgage paperwork.
"You had to get everything right. You had to have copies of all the documents. That was the very mark of a banker, that's what you were taught as a banker and now it's the equivalent of Girls Gone Wild, but now it's banks gone wild," he says.
What This Means For The Banks
Marty Regalia, chief economist with the U.S. Chamber of Commerce, says the legal problems "won't be as good as we hope [and] it won't be as bad as we fear." Regalia says more than likely we'll see something in the middle.
Other economists also believe the legal problems will likely slow down foreclosures, but not derail the whole banking system.
Klein says he hopes all this will give homeowners more leverage, and push banks to work out alternatives to keep more people in their homes.