The 16-page decision in the case of US Bank vs Ibanez does not make for easy reading. But itís a very important case: itís a solid precedent saying that if a bank doesnít own a mortgage, then it canít foreclose on a home. That was the decision of the lower court in Massachusetts, back in March 2009, and it has now been unanimously upheld on appeal to the Massachusetts supreme court.

After speaking to crack Reuters reporter Jonathan Stempel, Iím even more worried about this case than I was before.

The immediate effect of the ruling, which covers two separate cases, is that Mark and Tammy LaRace get to stay in their home, despite being foreclosed on in 2007. And Antonio Ibanez gets title to his home back, which means that the bank will either have to let him retake possession or else pay him for his deed.

Essentially, these homeowners bought their homes, defaulted on their mortgages, and then ó after a long legal struggle ó get to stay in their homes. Itís unclear whether they still owe money to any lender, and Massachusetts is a recourse state, which means that the bank could try to go after them personally, as it might had it lent them money on an unsecured basis. But in reality, if a bank does not have the ability to foreclose and the borrower is genuinely distressed and in default, thereís no point pursuing them for the balance of the loan.

The legal craziness that this decision sets in motion is going to be huge, Iím sure. Anybody who was foreclosed on in Massachusetts should now be phoning up their lawyer and trying to find out if the foreclosure was illegal. If it was ó if there was a break in the chain of title somewhere which meant that the bank didnít own the mortgage in question ó then the borrower should be able to get their deed, and their home, back from the bank. This decision is retroactive, and no one has a clue how many thousands of foreclosures it might cover.

Similarly, if you bought a Massachusetts home out of foreclosure, you should be very worried. You might not have proper title to your home, and you risk losing it to the original owner. It might be worth dusting off your title insurance: you could need it. And if you ever need to sell your home, well, good luck with that.

Going forwards, every homeowner being foreclosed upon will as a matter of course challenge the banks to prove that they own the mortgage in question. If the bank canít do that, then the foreclosure proceeding will be tossed out of court. This is likely to slow down foreclosures enormously, as banks ensure that all their legal ducks are in a row before they try to foreclose.

This decision wonít be appealed: the state law seems pretty cut-and-dried, every judge whoís looked at it has come to the same decision, and thereís no conceivable grounds for the US Supreme Court to take on the case.

Whatís more, courts in the other 49 states are likely to lean heavily on this decision when similar cases come before them. The precedent applies only in Massachusetts for now, but itís likely to spread, like some kind of bank-eating cancer.

If a similar decision comes down in California, which is a non-recourse state, the resulting chaos could be massive. People who are current on their mortgage and perfectly capable of paying it could simply make the strategic decision to default, if and when they find out or suspect that the chain of title is broken somewhere. They would take a ding to their credit rating, but millions of people will happily accept a lower credit rating if they get a free house as part of the bargain.

The big losers here are the banks ó of course ó as well as investors in mortgage-backed securities, including of course Fannie and Freddie, a/k/a the US taxpayer. No one knows how itís all going to play out: thereís certainly going to be a lot of litigation in every US state, and thereís a good chance that the federal government is going to feel the need to get involved as well. Not every jurist and legislator is going to see things the same way as the judges of Massachusetts, and thereís a case to be made that banks should have the ability to go back and cure their mistakes once theyíre pointed out, rather than just losing the house altogether, as they did in this case.

But of course the problem is that the banks canít cure their mistakes: in many cases the original mortgage is lost, at this point, if it ever properly existed in the first place.

The tail risk here is enormous, and thereís no easy solution to the problem. And this is over and above the problem of putbacks, or legal risk associated with the scandal of banks lying to investors in many mortgage-bond deals. And itís certainly yet another reason not to buy a house right now. You donít know if you really have title to what youíre buying, you donít know whether youíll be able to sell it if you have to, and thereís a good chance that as a result of all these problems shaking out, home prices could fall dramatically.

Maybe weíll muddle through this somehow ó thatís still probably the base-case scenario. But maybe we wonít. And if we donít, the downside here, to the banking system and to the economy as a whole, could hardly be larger.

Update: Adam Levitin emails with three other points, all important:

  • The ruling should (but surely wonít) led to a ratings downgrade of every securitization trust with MA properties in it. The documentation sloppiness in Ibanez was hardly unique.
  • Notice how MA rejected the ďmortgage follows the noteĒ argument and also the ďassignment of mortgage in blankĒ argument that ASF has argued is beyond reproach. There are (in my opinion) stronger arguments about the mortgage notes, but that wasnít raised in this case.
  • The MA Supreme Judicial Court is widely considered the best state court in the country. No one questions the quality of the jurists on the court (unlike in some other states). Itís one of the few state supreme courts that can routinely compete with federal appellate courts in recruiting top clerkship candidates and the only state court I know of that has had clerks go on to US Supreme Court clerkships.