Chairman and Chief Investment Officer, Cumberland Advisors, shares his thoughts on the foreclosure mess

David R. Kotok, Chairman and Chief Investment Officer of Cumberland Advisors, has shared the thoughts from a source in the financial services industry on the foreclosure situation.

“Homeowners can only be foreclosed and evicted from their homes by the person or institution who actually has the loan paper—only the note-holder has legal standing to ask a court to foreclose and evict. Not the mortgage, the note, which is the actual IOU that people sign, promising to pay back the mortgage loan

Before mortgage-backed securities, most mortgage loans were issued by the local savings & loan. So the note usually didn’t go anywhere: it stayed in the offices of the S&L down the street.

But once mortgage loan securitization happened, things got sloppy—they got sloppy by the very nature of mortgage-backed securities.

The whole purpose of MBSs was for different investors to have their different risk appetites satiated with different bonds. Some bond customers wanted super-safe bonds with low returns, some others wanted riskier bonds with correspondingly higher rates of return.

Therefore, as everyone knows, the loans were “bundled” into REMIC’s (Real-Estate Mortgage Investment Conduits, a special vehicle designed to hold the loans for tax purposes), and then “sliced & diced”—split up and put into tranches, according to their likelihood of default, their interest rates, and other characteristics.

This slicing and dicing created “senior tranches,” where the loans would likely be paid in full, if the past history of mortgage loan statistics was to be believed. And it also created “junior tranches,” where the loans might well default, again according to past history and statistics. (A whole range of tranches was created, of course, but for the purposes of this discussion we can ignore all those countless other variations.)

These various tranches were sold to different investors, according to their risk appetite. That’s why some of the MBS bonds were rated as safe as Treasury bonds, and others were rated by the ratings agencies as risky as junk bonds.

But here’s the key issue: When an MBS was first created, all the mortgages were pristine—none had defaulted yet, because they were all brand-new loans. Statistically, some would default and some others would be paid back in full—but which ones specifically would default? No one knew, of course. If I toss a coin 1,000 times, statistically, 500 tosses the coin will land heads—but what will the result be of, say, the 723rd toss? No one knows.

Same with mortgages.

So in fact, it wasn’t that the riskier loans were in junior tranches and the safer ones were in senior tranches: rather, all the loans were in the REMIC, and if and when a mortgage in a given bundle of mortgages defaulted, the junior tranche holders would take the losses first, and the senior tranche holder last.

But who were the owners of the junior-tranche bond and the senior-tranche bonds? Two different people. Therefore, the mortgage note was not actually signed over to the bond holder. In fact, it couldn’t be signed over. Because, again, since no one knew which mortgage would default first, it was impossible to assign a specific mortgage to a specific bond.

Therefore, how to make sure the safe mortgage loan stayed with the safe MBS tranche, and the risky and/or defaulting mortgage went to the riskier tranche?

Enter stage right the famed MERS—the Mortgage Electronic Registration System.

MERS was the repository of these digitized mortgage notes that the banks originated from the actual mortgage loans signed by homebuyers. MERS was jointly owned by Fannie Mae and Freddie Mac (yes, those two again —I know, I know: like the chlamydia and the gonorrhea of the financial world—you cure ‘em, but they just keep coming back).

The purpose of MERS was to help in the securitization process. Basically, MERS directed defaulting mortgages to the appropriate tranches of mortgage bonds. MERS was essentially where the digitized mortgage notes were sliced and diced and rearranged so as to create the mortgage-backed securities. Think of MERS as Dr. Frankenstein’s operating table, where the beast got put together.

However, legally—and this is the important part—MERS didn’t hold any mortgage notes: the true owner of the mortgage notes should have been the REMICs.

But the REMICs didn’t own the notes either, because of a fluke of the ratings agencies: the REMICs had to be “bankruptcy remote,” in order to get the precious ratings needed to peddle mortgage-backed Securities to institutional investors.

So somewhere between the REMICs and MERS, the chain of title was broken.

Now, what does “broken chain of title” mean? Simple: when a homebuyer signs a mortgage, the key document is the note. As I said before, it’s the actual IOU. In order for the mortgage note to be sold or transferred to someone else (and therefore turned into a mortgage-backed security), this document has to be physically endorsed to the next person. All of these signatures on the note are called the “chain of title.”

You can endorse the note as many times as you please—but you have to have a clear chain of title right on the actual note: I sold the note to Moe, who sold it to Larry, who sold it to Curly, and all our notarized signatures are actually, physically, on the note, one after the other.

If for whatever reason any of these signatures is skipped, then the chain of title is said to be broken. Therefore, legally, the mortgage note is no longer valid. That is, the person who took out the mortgage loan to pay for the house no longer owes the loan, because he no longer knows whom to pay.

To repeat: if the chain of title of the note is broken, then the borrower no longer owes any money on the loan.

Read that last sentence again, please. Don’t worry, I’ll wait.

You read it again? Good: Now you see the can of worms that’s opening up.

The broken chain of title might not have been an issue if there hadn’t been an unusual number of foreclosures. Before the housing bubble collapse, the people who defaulted on their mortgages wouldn’t have bothered to check to see that the paperwork was in order.

But as everyone knows, following the housing collapse of 2007-’10-and-counting, there has been a boatload of foreclosures—and foreclosures on a lot of people who weren’t sloppy bums who skipped out on their mortgage payments, but smart and cautious people who got squeezed by circumstances.

These people started contesting their foreclosures and evictions, and so started looking into the chain-of-title issue, and that’s when the paperwork became important. So the chain of title became crucial and the botched paperwork became a nontrivial issue.

Now, the banks had hired “foreclosure mills”—law firms that specialized in foreclosures—in order to handle the massive volume of foreclosures and evictions that occurred because of the housing crisis. The foreclosure mills, as one would expect, were the first to spot the broken chain of titles.

Well, what do you know, it turns out that these foreclosure mills might have faked and falsified documentation, so as to fraudulently repair the chain-of-title issue, thereby “proving” that the banks had judicial standing to foreclose on delinquent mortgages. These foreclosure mills might have even forged the loan note itself—

Wait, why am I hedging? The foreclosure mills did actually, deliberately, and categorically fake and falsify documents, in order to expedite these foreclosures and evictions. Yves Smith at Naked Capitalism, who has been all over this story, put up a price list for this “service” from a company called DocX—yes, a price list for forged documents. Talk about your one-stop shopping!

So in other words, a massive fraud was carried out, with the inevitable innocent bystanders getting caught up in the fraud: the guy who got foreclosed and evicted from his home in Florida, even though he didn’t actually have a mortgage, and in fact owned his house free –and clear. The family that was foreclosed and evicted, even though they had a perfect mortgage payment record. Et cetera, depressing et cetera.

Now, the reason this all came to light is not because too many people were getting screwed by the banks or the government or someone with some power saw what was going on and decided to put a stop to it—that would have been nice, to see a shining knight in armor, riding on a white horse.

But that’s not how America works nowadays.

No, alarm bells started going off when the title insurance companies started to refuse to insure the titles.

In every sale, a title insurance company insures that the title is free –and clear —that the prospective buyer is in fact buying a properly vetted house, with its title issues all in order. Title insurance companies stopped providing their service because—of course—they didn’t want to expose themselves to the risk that the chain –of title had been broken, and that the bank had illegally foreclosed on the previous owner.

That’s when things started getting interesting: that’s when the attorneys general of various states started snooping around and making noises (elections are coming up, after all).

The fact that Ally Financial (formerly GMAC), JP Morgan Chase, and now Bank of America have suspended foreclosures signals that this is a serious problem—obviously. Banks that size, with that much exposure to foreclosed properties, don’t suspend foreclosures just because they’re good corporate citizens who want to do the right thing, and who have all their paperwork in strict order—they’re halting their foreclosures for a reason.

The move by the United States Congress last week, to sneak by the Interstate Recognition of Notarizations Act? That was all the banking lobby. They wanted to shove down that law, so that their foreclosure mills’ forged and fraudulent documents would not be scrutinized by out-of-state judges. (The spineless cowards in the Senate carried out their master’s will by a voice vote—so that there would be no registry of who had voted for it, and therefore no accountability.)

And President Obama’s pocket veto of the measure? He had to veto it—if he’d signed it, there would have been political hell to pay, plus it would have been challenged almost immediately, and likely overturned as unconstitutional in short order. (But he didn’t have the gumption to come right out and veto it—he pocket vetoed it.)

As soon as the White House announced the pocket veto—the very next day!—Bank of America halted all foreclosures, nationwide.

Why do you think that happened? Because the banks are in trouble—again. Over the same thing as last time—the damned mortgage-backed securities!

The reason the banks are in the tank again is, if they’ve been foreclosing on people they didn’t have the legal right to foreclose on, then those people have the right to get their houses back. And the people who bought those foreclosed houses from the bank might not actually own the houses they paid for.

And it won’t matter if a particular case—or even most cases—were on the up –and up: It won’t matter if most of the foreclosures and evictions were truly due to the homeowner failing to pay his mortgage. The fraud committed by the foreclosure mills casts enough doubt that, now, all foreclosures come into question. Not only that, all mortgages come into question.

People still haven’t figured out what all this means. But I’ll tell you: if enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loans and keep their houses, scott-free? That’s basically a license to halt payments right now, thank you. That’s basically a license to tell the banks to take a hike.

What are the banks going to do—try to foreclose and then evict you? Show me the paper, Mr. Banker, will be all you need to say.

This is a major, major crisis. The Lehman bankruptcy could be a spring rain compared to this hurricane. And if this isn’t handled right—and handled right quick, in the next couple of weeks at the outside—this crisis could also spell the end of the mortgage business altogether. Of banking altogether. Hell, of civil society. What do you think happens in a country when the citizens realize they don’t need to pay their debts?”

Apollo Valuation Overdiscount Regulatory Risk

A San Francisco presenter likes Apollo Group (NASDAQ: APOL, $50.45) at this level. The current valuation overdiscounts the regulatory uncertainty in the for-profit education space. Apollo's student and program mix mitigate any potential hit to enrollment numbers and revenues from the DOE ruling expected in November. The new orientation program will curb dropouts and loan defaults. The company has solid global expansion opportunities through its joint venture with the Carlyle Group. The downside is very limited at this point and the steady case scenario of $5+ eps can translate into a 60-100% upside.

Roulston smart grid roundtable in San Francisco

Aaron Lehmann has partnered with Roulston Research to review our consultant Roundtables and to add a 40 plus year investor perspective on the experts’ industry comments. The opinions and points below are from his experience. Roulston delivers his thoughts to give our clients a summary of the event and a market insight of possible investment actions that might parallel the conclusions that the experts delivered. Let us know your thoughts, or if you would like to talk to Mr Lehmann directly, we encourage further dialogue.

Aaron Lehmann has since 1968 been engaged in the investment industry as a securities analyst, director of investment research, portfolio manager, and investment banker. His previous employers include Bank of America, Goldman Sachs, Hartford Insurance, Westinghouse Pension Investment Corp., Chase Investors, Steinhardt Partners and several investment boutiques. Mr. Lehmann has performed consulting services for corporations and investment firms. Although retired, he is actively involved in the investment markets and may periodically perform consulting services.

Roulston Conference September 14.2010
Smart Grid: Key Trends, Outlook and Winners/Losers

Sterling Lapinski, President, Genscape, CEO, GLO Ventures, who has impressive credentials, made a very academic type presentation. He focused on wind generation, the storage of the wind gusts and metering issues confronting the alternative energy industry, in particular, as well as the traditional providers of energy. His major concerns are:
1. How do you offload all the different energy sources- wind, solar, LNG, gas, and nuclear and store it for peak levels and what do you do with it in off-peak hours?
2. Can you change users habits to use energy when there is normally lower demand?
3. Can we create better metering to obtain more accurate measures of usage and to adjust the outputs to conform to demand?
4. Can alternative energy systems be made more efficient so that the utilities can get a better ROI?
Mr. Lapinski did not really provide any serious answers to these questions but did say the most likely players will be existing companies that are already in that space, such as: Siemens, IBM, Samsung, GE, as well as all the “chip” manufactures. He also felt that on the industrial metering side Honeywell and Johnson Controls would be dominant. He also raised concerns with the security of the power grid and the risk of cyber attacks.


Aaron Lehmann’s Comments

It was clear that Mr. Lapinski is highly knowledgeable in this field but unfortunately offers no real solutions for some very obvious and serious issues. One would have great difficulty in coming away with an investment thesis from his presentation. Nothing was said about the difficulty of building wind generating systems without some very rare earth materials necessary in building them and the fact that the Chinese now control the rare earth materials. No comment was made about the greater usage of nuclear around the world while the United States lags significantly. After a significant correction, uranium prices have begun to rise sharply based on a very positive long term outlook.

I don’t profess to have the answers to all of his concerns nor those that I pointed out here. What I believe is that while the companies mentioned by Mr. Lapinski may be participants because of their vast resources, I also feel that giants like Emerson Electric, LG, Mitsusbishi, Cisco, Oracle, as well as Badger Metering, and Ituran will be involved. However, I believe that over the next 10 to 20 years new companies will come onto the scene that may have serious solutions. Who would have believed that Intel (founded in the late 1960’s), or Apple (founded in the 1970’s) Microsoft (in the 1970’s), Cisco and Oracle (in the 1960’s), Google (in the 1990’s) and many others would have become the leading companies today. Likewise, there are many creative individuals all around the world looking for the opportunity of emerging as the next Google.
In conclusion, I can not suggest that an investor buys on the basis of a company possibly coming up with a solution to any of the aforementioned issues, since, with the exception of Badger and Ituran, they are very large companies and may only represent a small percentage of their respective business.


Opinions expressed herein are based upon presentations by participants at Roulston Research, LLC. sponsored Roundtables. The associated notes of such presentations summarized herein have not been independently verified for accuracy, truthfulness, or completeness. The report is in no way intended to be a recommendation by Roulston Research, LLC. to purchase or sell any security.

NWK: Benefitting from Transition to UC

A San Francisco presenter recommends Network Equipment Technologies (NASDAQ: NWK, $3.04) as a play on the global transition of enterprises to the unified communications (UC) platform. The company is at the forefront of this paradigm shift, which is finally accelerating to the next level. Large companies are beginning to move from pilot UC projects and installations limited to just HQ locations to much broader rollouts. With the release of Microsoft's new UC server this week and the pending introduction of NWK's new single-box solution, the company is poised to become a major player in the market projected to grow to $15 billion by 2015.

Roulston’s Technology Community Chair’s thoughts on Intel

Bart Perkins, Founder, Leverage Partners, and Roulston Research’s Community Chair shares his thoughts on Intel.

Intel has a Broader Vision.

Intel’s recent purchase of software security maker McAfee along with the wireless chip unit of Infineon have been the basis for a lot of speculation over the last few weeks. Investors and analysts have not been quite sure where Intel is headed.

That changed at today’s (9/12/10) Intel Developer Forum. Paul Otellini announced that Intel will build a 22-nanometer processor in 2011. Otellini stated. "At Intel, our vision is to create a continuum [with] consistency and interoperability between devices." Later he said, “we're trying to deliver a full computing solution stack. … We'll deliver and develop more complete hardware and software solutions (emphasis added) than ever in the past."

Later Otellini expanded on the theme, observing computing needs internet connectivity, security, and energy efficiency. All this means that Intel is expanding well beyond its roots as a chip maker. Today Intel is positioned to offer virtually all components of a mobile device. They can provide the processor, security, and operating system.

Intel is not limiting themselves to mobile devices. They are positioned to expand into a much wider set of products. In the Sept. 13 issue of Forbes Magazine, Otellini said “Everything is getting connected; everything is getting smarter; TVs, phones, cars, retail displays. The microprocessor is the driving factor for this. We believe our architecture is best suited for these tasks.”

Update on Alamo Group

Recommended late last year by Texas presenter the company is tied to farm income with mature products in mature markets. A reminder that they sell specialty mowers and products to farmers and governments for road and field maintenance. Their concept is to tuck in multiple brands so that when giovernment asks for 2-3 bids they are multiple bidders with multiple brands in niche markets. Their other focus is expansion internationally adding brands and products to offer all products to all markets. Their replacement cycle is 5-7 years in the government side and 7-9 years in the Ag side. With farmer income strong and commodity prices rising, business is good. Government municipal purchases have slowed but still holding to past cycle. Presenter still likes the story.

Listening to Kansas City Southern talk Economy

There is a $200/container savings crossing the border by shippers switching from the 1.9 million trucks to rail. Look for more to happen. Cross border traffic for KSU is up 55% year over year now equal to 25% of their total business. Hurricane Alex really hurt 2010 but other growth has been with train length up 10% year over year. Pricing is increasing and carloads are up 24%. No recession here.