Standing, Securitization, and “Show Me The Note”

By Matthew Hector

If you spend some time researching foreclosure defense, sooner or later, the "show me the note" defense will make its appearance. It's a perfectly valid means of defending against a foreclosure lawsuit, and is useful where even a traditional attack on a plaintiff's standing to sue is inappropriate. Simply demanding to see the original note is good practice, even if the plaintiff bank is the home owner's original lender. Without the original note, the plaintiff bank cannot demonstrate that it has the power to enforce the note. Does this mean that it lacks standing? If there is no evidence that the note was ever conveyed to a third party, maybe not. A lost note affidavit may provide enough evidence that a note existed to defeat the standing issue. Even in original-lender-as-plaintiff situations, demanding to view the original note makes good sense. You never know if it was negotiated to a third party.

During the real estate bubble, mortgages and their associated notes were sold and re-sold, then pooled into trusts. These trusts then sold bonds that entitled purchasers to a portion of the yield of the pooled mortgages. It turns out that many of the mortgages that were pooled were horribly underwritten - many did not even come close to conforming with the issuing bank's lending standards. It also turns out that many lenders did not follow basic rules for buying and selling all of these mortgages and notes. Although many attorneys think of secured transactions as something that bored them to death in law school, the law of secured transactions is very much alive in modern foreclosure defense.

For purposes of this discussion, how a note is negotiated from one party to another is the key to understanding "show me the note" arguments as well as standing. As stated above, only the holder of the original note may enforce that note against its maker. The maker is the home owner who signed the note. The note is a promise to repay a specific amount of money to a specific entity at specified times. If the note is indorsed, it becomes negotiable, which means that it can be freely transferred to other parties.

For instance, Bob decides to purchase a starter home for $170,000. He has $20,000 in savings as a down payment. His local bank issues him a loan for the remaining $150,000 that Bob needs to purchase the house. To commemorate this loan, Bob signs a note and a mortgage. The note designates Bob as the maker/borrower. Bob promises to repay the $150,000 over a term of 30 years at 5% interest. His monthly payment will be $500. [1] The bank keeps the original note in a secure location. Over time, Bob makes payments. Eventually the note is paid off and the bank releases the mortgage it holds on his house. This was how things worked before securitization really took off.

Securitization made it possible for banks to sell their loans to the secondary market. This freed up capital at the bank, allowing it to make another loan to someone else. At first, there were strict guidelines regarding securitization. Over time, those guidelines were loosened. Securitization boomed. Lenders couldn't originate loans fast enough to keep up with the demand. In order to meet that demand, many lenders loosened their lending standards. Thus began the rise of the sub-prime mortgage market. Many sub-prime loans were bundled together into the trusts that are the backbone of the mortgage-backed security market.

In a perfect scenario, National Bank, N.A. would issue the loan. It would then sell the loan to National Bank Holding, Inc. That sale would ideally be for the value of the loan and commemorated with physical documentation. Specifically, National Bank would indorse the note "Payable to National Bank Holding, Inc." National Bank Holding, Inc. would then sell the loan to National Bank Holding II, LLC. That sale would also be documented and the note indorsed over to National Bank Holding II, LLC. At that point, National Bank Holding II, LLC would deposit the loan into a trust. Once fully funded, the trust would then sell bonds to investors seeking a stable, long-term investment.

It turns out that there were very few perfect scenarios. Mortgage-backed trusts are established via documents called Pooling and Servicing Agreements. These PSAs govern the ins and outs of the transactions that are needed to establish the trust. More often than not, the original lender would retain the servicing rights to the loan. This means that although the lender no longer owned the loan, it had the right to collect payments, assess late penalties, foreclose, etc. It turns out that the original lenders frequently retained the physical loan documents themselves. No indorsements were made, and the documents never changed hands.

Why is this a problem? If the physical note was never negotiated down the chain and into the trust, then the trust never actually held the note. It also means that the original lender, who allegedly no longer owns the loan, still has documents that make it appear as if it still owns the loan. These defective transfers are at the heart of the current mortgage foreclosure fiasco. This is also why it is vital that home owners demand to see the original note when their lender seeks to foreclose.

Even if a loan was never sold into the secondary market, the lender needs to demonstrate that it is in possession of the original note in order to enforce the note against a home owner. If a loan was sold on the secondary market, and especially if the loan was securitized, proving that possession becomes orders of magnitude more difficult. If a loan was sold from A to B and B to C and C to D, it must bear indorsements that demonstrate those transfers. If there is a gap in that chain of ownership, the current holder of the note will have a difficult time proving that it has the authority to foreclose upon the mortgage.

No matter what the facts of your foreclosure case may be, it is imperative that you always demand to see the original note. It could be the difference between losing a home and securing a loan modification or other settlement.


[1] This may not be an accurate number based on loan value and APR, but this is an example, not an amortization exercise.