Most people by now know the story of how speculation in mortgage-backed securities, along with a host of exotic derivatives built around them, created our banking crisis. The bursting of the housing bubble brought down some of our country’s largest financial institutions and plunged us into the Great Recession that began late in 2007. We have fought our way partly back, yet today the ongoing explosion of foreclosures—and the growing realization that many of these foreclosures have been initiated without the required legal documentation—has exposed the possibility of a new chapter in the crisis.

First, some background. Traditionally, most mortgages were issued by banks that hoped to make money on the interest they charged, and thus had good incentives to ensure that borrowers were creditworthy—and that the paperwork necessary in the event of a foreclosure was in order. In the 1980s, however, a secondary market in residential mortgages developed in which lenders (or “originators,” as they are known in that market) did not plan to make money from the interest on the loan, but instead sold them for a quick profit to bond issuers, who in turn repackaged them into mortgage-backed securities to sell to investors. This secondary market pumped a lot of new money into the mortgage market, making credit cheaper and more readily available to homebuyers. As long as the standards for issuing mortgage-backed securities were high, this was all for the better. But in the years before the housing crash, demand for these securities exploded, and issuers rushed to buy up more mortgages. The increased demand drove originators to take aggressive steps to generate enough loans to meet issuers’ needs, which in turn helped inflate the housing bubble.

It is well known now that the rise of the secondary mortgage market created serious conflicts of interest both for loan originators, who made their money by extending and selling loans fast (and were not likely to be around to suffer the consequences if the loans were bad), and for bond issuers, who also made quick money selling their securities. What is less well known is that the booming secondary market also put grievous pressure on the centuries-old title recording system. Typically operated by county governments, the system does a reasonably good job for loan originators who plan to hold on to mortgages and service them. Creating mortgage-backed securities, however, requires numerous transfers of the mortgage interest over very short periods of time. When county recording offices became overwhelmed with the volume of these transfers and delays ensued, the mortgage industry created the Mortgage Electronic Registration System (MERS). The idea behind MERS was to have a single entity registered as the mortgage holder in the county property records. MERS would then use a nimbler internal process to keep track of the actual mortgage and the note—in effect, the IOU promising to repay the loan with interest—as they rapidly changed hands in the secondary market.

In theory, this would allow participants in the secondary market to bypass county recording systems, supposedly without threatening the interests of borrowers. The practice, however, proved messier. As University of Utah law professor Christopher Peterson has observed, MERS itself exists as little more than an empty shell company. It has almost no employees of its own, but allows its clients to designate their own employees as officers of MERS for the purposes of initiating foreclosure proceedings. Unsurprisingly, then, homeowners who have tried to contact MERS to find out who actually holds the note for their loan have often been given the runaround.

MERS has not worked much better on the legal front. Mortgages designating MERS as the party of interest used terminology that was confusing and at times contradictory. Some lawyers in foreclosure proceedings have alleged that MERS’s own records of mortgage transfers are inadequate. As a result, it is not always clear what legal rights MERS or its customers have in a foreclosure action. Indeed, several state high courts have called into question the legal right of MERS to foreclose on mortgages held in its name—or otherwise to act on behalf of its clients.

An even more significant contributor to the current foreclosure crisis than these problems with MERS is the fact that participants in the secondary market were often inattentive to the requirements of the complex legal system that has grown up around mortgages and the foreclosure process over hundreds of years. That system was designed to avoid errors and to protect the important interests of both borrowers and lenders during a mortgage foreclosure. The same conflict of interest that encouraged originators to create risky loans also encouraged them to cut corners in completing and transferring paperwork that would be necessary in a foreclosure proceeding. If, for example, the originator failed to properly transfer the note to the bond issuer, the issuer would have no basis for claiming entitlement to loan payments. In some cases, those notes may no longer even exist. Yet without the note, banks servicing the mortgages may not be able to prove that a homeowner is in default—or to whom.

When confronted with gaps in the paperwork, some of these servicers—including some of the largest banks in America—have knowingly or recklessly generated documents that do not actually satisfy the legal requirements for foreclosure. And some courts have turned a blind eye toward this practice. But that paperwork is not a mere formality. In foreclosure it is necessary to prove that the homeowner is actually in default, and that the foreclosing party is truly entitled to force a sale of the property. Failure to attend adequately to the formalities of foreclosure have led to homeowners being mistakenly foreclosed. Some homeowners who are current on their loan payments—and some who did not even have a mortgage—have found the locks on their doors changed and their personal belongings removed from the house.

At least some courts are starting to wake up to the problem, and in a number of cases have begun to scrutinize foreclosure documents to ensure their legitimacy. The Supreme Judicial Court of Massachusetts recently invalidated a pair of foreclosures because the foreclosing banks, which claimed to be holding the mortgages in trust on behalf of the owners of mortgage-backed securities, had not properly documented the assignment of the mortgage to them by the loan originators. In a concurring opinion, one of the justices lamented “the utter carelessness with which the plaintiff banks documented the titles to their assets.” The New Jersey Supreme Court is currently considering a statewide freeze on foreclosures filed by the worst-offending servicers. Explaining the court’s actions, Chief Justice Stuart Rabner pointed to “evidence of flaws in the foreclosure process.” “For judges to sign an order foreclosing on a person’s home,” Rabner said, “they must first be able to rely on the accuracy of documents submitted by lenders. That step is critical to the integrity of the judicial process.”

These developments may have grave consequences. If more courts were simply to follow to the letter the existing laws governing foreclosure, the ability of issuers to foreclose on millions of Americans would be thrown into doubt. That, in turn, would have serious implications for the housing market and for the value of mortgage-backed securities—and could even lead to another banking crisis, with drastic results for our economy.

That does not need to happen. In fact, this new round of the foreclosure crisis gives policymakers something like a second chance. In particular, it gives them an opportunity to relieve homeowners of some of the debt burdens created by the housing bubble. Of course, borrowers share responsibility for these debts, particularly those who used their homes as ATMs during the bubble, taking out large home-equity loans on the complacent assumption that the value of their house would continue to rise forever. But many of those facing foreclosure today are simply people who bought their homes at the wrong time and at prices artificially boosted by the bubble that the bankers’ greed helped inflate. These borrowers are now underwater, struggling to pay their bills amid the high unemployment brought on by the bursting of that bubble.

It is important to emphasize that the current stage in the crisis is due in no small part to sloppy lending practices driven by short-term greed. Despite their share in the blame, however, bankers have enjoyed the benefit of a series of bailouts, while homeowners facing foreclosure have largely been left to fend for themselves. A recent bill to reduce the standards for notarization of documents—which sailed through both houses of Congress but was pocket-vetoed by President Barack Obama—was yet another attempt to help the banks rather than the homeowners.

A fairer approach would balance a legitimate concern for the health of the banking system with a due regard for home-owners. Borrowers should not be allowed simply to walk away from their obligations—but neither should bankers be allowed to rewrite retroactively the rules of foreclosure to cover up for their own carelessness. Congress should therefore couple any effort to help banks shore up gaps in their paperwork with efforts to help homeowners escape foreclosure altogether. One way to do this would be to revive an earlier proposal empowering bankruptcy courts to force banks to restructure loans so that they share some of the pain, without letting defaulting homeowners completely off the hook. Rather than simply streamlining the foreclosure process, which would constitute yet another one-sided giveaway to the banking industry, this time around Congress should craft a solution that will spread the burden more equitably. By doing so, our representatives would make it clear that we refuse to let banks trample on the rights of homeowners and avoid their share of the blame for creating the current crisis.

Related: The Wall Street Meltdown, by John W. Weiser
After the Meltdown, by Charles R. Morris
Taking Stock, by the Editors

Eduardo M. Peñalver is the Allan R. Tessler Dean of the Cornell Law School. The views expressed in the piece are his own, and should not be attributed to Cornell University or Cornell Law School.

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