Erika Morphy is co-editor of Debt and Equity Journal, from which this article is excerpted.

Cleveland—A ruling in federal court here could have a potentially destabilizing effect on RMBS pools containing homes that have gone into foreclosure. Federal District Court Judge Christopher A. Boyko dismissed 14 foreclosure cases brought to court by special servicer Deutsche Bank National Trust Co. on the grounds that Deutsche Bank, as the trustee, had failed to prove it actually owned the properties.

Even after receiving three weeks to produce the necessary documentation, such as loan assignments that proved the lender was the legal owner of the properties, Deutsche Bank was unable to do so. The judge ruled in favor of the defendants.

To be sure, this is a federal case and there are no signs yet the judge will request for it to be recorded in Westlaw–a necessary step if other judges are to use this decision as a precedent. Also, it appears as though the mortgage holders and the trustee are guilty of sloppy paperwork, something that can be remedied. There are rumblings, though, that the case could have a deeper impact in the capital markets than merely pointing out the need to adjust back office processes.

For starters, news of the decision is gaining exposure in the media. At the very least, other attorneys for homeowners whose mortgages have gone into default will use similar arguments, some likely successfully. “This case sends a strong message to the securitization community that paperwork has to be checked to make sure mortgages are properly assigned and recorded, and those who want to foreclose on a property should have all their ducks in a row,” says Pillsbury Winthrop Shaw Pittman LLP bankruptcy partner Rick Antonoff.

But this decision has the potential to be even more damaging to lenders because it could erode market confidence in these pools. “The consequence of such rulings will be particularly felt by the companies that insure mortgage-backed securities because the inability or extended delay in completing foreclosures could lead to defaults on the payment of the securities and the bondholders will look to the insurers to make them whole,” Antonoff says. “The insurers, in turn, will look to the parties that put the transaction together to find out why the assignments and recording of mortgage loans weren’t done properly.”

More specifically, the system’s faith in the servicer’s ability to perform could take a hit, says Steve Stapleton, a partner with Cowles & Thompson, which represents servicers. “It is the way the securitization industry has been set up–the servicers may not have the proper documentation or evidence of a claim, even though they are the ones servicing it.” The servicer’s role as intermediary could possibly compromise a lender’s position in a bankruptcy, he adds.

Peter Davidson, a partner with MDFS Law, in contrast, does not think poor record keeping is endemic in the servicer industry. “Deals that get repooled a couple of times, yes, can be problematic. But not all transactions are like that,” he says.

David Seror, also a partner at MDFS Law, agrees this decision will have a limited impact, even in scenarios where the servicer might not be able to prove it has the legal right to close on the house. “Really, it depends on the equity the home owner has in the house,” he explains. “If there is enough, the debtor will want to protect it. But if there isn’t, why even bother?”

As legal experts grapple with the meaning of the case, they also wonder if it will go further in the court system, thus complicating these arguments even further. The case’s ultimate destination is still uncertain. “The judge thus dismissed the complaints without prejudice, meaning that the plaintiff can bring the case in state court, as opposed to federal court, or can re-file in district court with the right paperwork to show that the trustee is the owner and holder of the mortgages and notes,” Antonoff notes.

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