In defense of "free houses".

• Author: Wachspress, Megan
• Position: Res judicata where banks fail to prove foreclosure elements

Eight years after the start of America's housing crisis, state courts are increasingly confronting an unanticipated consequence: what happens when a bank brings a foreclosure suit and loses? Well-established legal principles seem to provide a clear answer: the homeowner keeps her house, and res judicata bars any future suit to foreclose on the home. Yet state courts around the country resist this outcome.

Banks have lost many foreclosure cases for two reasons, both resulting from recent changes in the mortgage market. First, securitization has created widespread errors in mortgage notes' chains of assignment, malting it difficult for banks to prove that they in fact own any particular mortgage. Second, securitization contracts incentivize banks to use "foreclosure mill" law firms to keep up with the flood of defaults, despite the fact that these firms are unable and sometimes unwilling to detect and rectify basic legal errors.

When addressing faulty foreclosures, courts are afraid to bar future attempts to foreclose--that is, afraid of giving borrowers "free houses." While courts rarely explain the reasoning behind this aversion, it seems to arise from a reflexive belief that such an outcome would be unjust. (1) Courts are therefore quick to sidestep well-established principles of res judicata in favor of ad hoc measures meant to protect banks against the specter of "free houses."

This Comment argues that this approach is misguided; courts should issue final judgments in favor of homeowners in cases where banks fail to prove the elements required for foreclosure. Furthermore, these judgments should have res judicata effect--thus giving homeowners "free houses." This approach has several benefits: it is consistent with longstanding res judicata principles in other forms of civil litigation, it provides a necessary market-correcting incentive to promote greater responsibility among foreclosure litigators, and it alleviates the tremendous costs of successive foreclosure proceedings.

This Comment proceeds as follows. Part I explains basic foreclosure and mortgage-acceleration law. Part II describes how systemic banking behaviors and market forces have resulted in banks increasingly losing foreclosure suits after the 2008 financial crisis. Part III then describes how state courts have struggled to develop their jurisprudence on "free houses," often ignoring these significant market problems. Finally, Part IV contends that the application of res judicata in foreclosure litigation is essential for two reasons: (1) it would uniformly apply civil rules of finality to foreclosure cases, and (2) it would have a much-needed positive behavioral effect on a mortgage-foreclosure market run amok.

1. THE FORECLOSURE LAW BACKDROP

Foreclosures begin with a mortgage note's "acceleration clause." Under a mortgage note, the homeowner is required to make a certain payment every month for a fixed period. (2) In judicial-foreclosure states, if the homeowner defaults on at least one payment for a specified amount of time, (3) the bank has a choice: it can bring suit to recover just the missed payments, (4) or it can exercise the acceleration clauses (5) in the note and bring the entire remaining loan balance due. (6) Under the mortgage contract, only acceleration allows the bank to foreclose on the mortgage. (7)

In a foreclosure suit, the bank must generally prove the following: (1) the homeowner has signed both the note (the underlying loan) and the mortgage assigning the house as collateral for that note; (2) the bank owns the note and mortgage; (3) the homeowner still owes a debt to the bank; (4) the homeowner is behind on that debt; and (5) the bank has accelerated that remaining debt in accordance with the terms of the note itself. (8) When a bank fails to prove these elements, a judge is legally required to rule in favor of the homeowner.

Recently, courts have been inundated with suits where homeowners question the bank's ability to prove the second element. Litigation over "proof-of-ownership" issues in foreclosures is a growing nationwide problem; sampling suggests a ten-fold increase between the periods immediately preceding and following the 2007 collapse of the housing market. (9) Cases addressing this kind of "failed foreclosure" have reached state supreme and appellate courts, including-recently-the Maine Supreme Court. (10) In certain states, including Florida, (11) New Jersey, (12) and New York, (13) courts have also been confronted with cases where, after accelerating the note and initiating a foreclosure proceeding, the bank abandons the proceeding and the statute of limitations on the accelerated debt expires, calling the third element into question. (14)

This massive increase in cases where banks' prima facie case is challenged or outright fails is not the product of novel foreclosure law or changes in its application. Rather, we argue, it is due to fundamental changes in how banks handle mortgages--the same changes that facilitated the financial crisis of 2008--and banks' unwillingness to invest in sufficient legal services to adapt to these underlying structural changes when pursuing foreclosures.

2. WHY HOMEOWNERS WIN THEIR FORECLOSURE CASES: SECURITIZATION AND ITS MARKET FAILURES

   To successfully bring a foreclosure suit a bank must produce very little evidence. Why has this proven so difficult? The answer lies with banks' own practices. In the last twenty years, banks have significantly altered how they profit from mortgages; however, they failed to adequately adapt their record keeping and customer-service practices.

   In the 1990s, banks began to convert long-term mortgages, familiar to most Americans, into short-term financial commodities, a process called securitization. Rather than keep mortgages on the books, mortgagees (banks) sought to sell the mortgages immediately to financial entities that would transform thousands of individual mortgages into securities--financial instruments that entitled the bearer to homeowners' mortgage payments and that could be arbitrarily restructured or resold. (15) After securitization, although a homeowner would continue to make mortgage payments to the originating bank, that bank ceased to have a financial interest in receiving these payments. Instead, a variety of investors owned an interest in the pool of mortgage payments of which the homeowner's is a part. (16)

   Securitization gave rise to widespread errors in the documentation of mortgage ownership. To allow a variety of investors to own portions of a mortgage pool, originating banks entered into pooling and servicing agreements, which authorized "servicers"--sometimes large commercial banks, but often companies who were primarily or exclusively engaged in servicing to act as the diffuse investors' agents in receiving payments from and pursuing foreclosures against homeowners. Because actual ownership of the mortgage note became independent of servicing and the relationship with the mortgagor, a loan, or the right to receive part of the payments on that loan, might be sold several times while the homeowner still interacted with the same servicer. Conversely, the servicer might change while the loan remained part of the same investment pool. Throughout this reshuffling of title ownership and servicing, banks frequently made errors in how they documented and recorded their ownership of mortgages. (17)

   Common mortgage fee structures set up in pooling and servicing agreements also disincentivized servicers and their attorneys from devoting adequate resources to foreclosures. Each servicing agreement paid servicers a flat annual fee of around 0.25% of the loan's total value (for example, $500 per year on a $200,000 loan), but the cost of pursuing a single foreclosure cost servicers around $2,500. (18) When foreclosures began climbing precipitously in 2007, (19) servicers were unprepared to handle the sudden increase in volume and had no incentives to devote additional resources to prove their banks' ownership over each mortgage. (20) To demonstrate ownership without expending more resources than pooling and servicing agreements allotted, bank employees signed hundreds of thousands of affidavits asserting that they had seen and could attest to the contents of original documents demonstrating ownership of the underlying mortgage. Although such affidavits were a legally acceptable means of demonstrating such ownership, a significant number of them were actually fraudulent. (21)

   Similarly, servicers' attorneys also relied on sloppy paperwork--and, at times, on fraudulent and unethical practices in foreclosure proceedings. For example, one New Jersey foreclosure law firm operated without any method of contacting its mortgage-servicer clients. Instead, the firm received all work orders through a one-way computer system, along with a requested timeline and documents the servicer had determined were necessary. (22) This underresourcing and the resulting ethical transgressions have affected hundreds of thousands of foreclosures. (23)

   The result of securitization contracts' underresourcing of mortgage servicers and their attorneys has been a "factory-line approach to litigation," rife with abuses. (24) In many individual cases, these litigation strategies have been unsuccessful. Homeowners, their attorneys, and sometimes judges have successfully prevented foreclosure by demonstrating the falsity of an affidavit or simply by forcing the mortgagee to produce actual documentation that it owned the mortgage. (25) As an increasing number of foreclosure suits are lost on the merits for lack of documentation, or for failure to prosecute within the statute of limitations, courts face a new problem: what happens next?

3. THE COURTROOM SOLUTION: ANYTHING BUT "FREE HOUSES"

   In many states, longstanding principles of res judicata, when taken with the state law's treatment of acceleration clauses, require courts to grant homeowners...