When I originally came across this story, it was just a glitch in foreclosures. Cleveland federal judge Christopher Boyko tossed 14 foreclosures without prejudice, because the plaintiffs could not show that they owned the loans.

Basically, the title on the loans was never changed, they just put it in the transfer contract.

I figured, this isn’t a big deal…It just means that before foreclosing, the banks have to do some paperwork, so amidst a sea of financial ice-bergs, this is a spring rain.

Well, once again, I am wrong.

It appears that the methods used to pool loans into CDOs and similar instruments may also mean that the organizations holding the CDOs are legally liable for any unethical or illegal tactics used whenever the loans were first made.

The problem stems from a shortcut that many players in the fast-moving securitization business have used in recent years. Normally, when a loan is sold, a simple document is prepared showing that the debt and any collateral attached to it has been transferred to the purchaser. That piece of paper is called an assignment. But in buying up thousands of mortgages at a time, Wall Street commonly skips this step, which requires separate paperwork for each loan. Instead, the industry customarily relies on a lengthy contract, known as a pooling-and-servicing agreement (PSA) to spell out arrangements for all of the loans in a pool. But, as some recent court rulings indicate, a PSA may not be good enough when it comes time to foreclose.

…

There also could be a more troubling consequence for investors, says Kathleen C. Engel, a professor at Cleveland-Marshall College of Law. Players in the secondary market for mortgages rely on an obscure but critical legal theory–known as the “holder in due course” doctrine–to insulate themselves from problems with the underlying loans.

Under the doctrine, a homeowner who believes that a lender deceived him about the terms of a loan can’t press such claims against the purchaser of a mortgage, such as a mortgage-backed securities trust. The holder-in-due-course doctrine protects pension funds and the like from having to worry about any misbehavior by home lenders–and thereby greases the wheels for the whole mortgage-securities market. But it’s a different story if, as appears to be common practice, the trust waits to complete paperwork transferring a loan until after it goes into default. In that case, the holder-in-due-course protection evaporates, and anybody who tries to foreclose could face defenses from the borrower that he or she was lied to when seeking a loan.

Ouch!