Countrywide, which is now part of Bank of America Corp., routinely didn't bother to transfer essential documents for loans sold to investors, an employee testified.
The testimony — which a New Jersey bankruptcy judge cited in dismissing a BofA claim against a debtor — could complicate attempts by the company to foreclose on soured loans that Countrywide originated and sold in better times.
The BofA employee's admission that the lender customarily held on to promissory notes could also undermine the industry's position that document transfers to securitization trusts are fundamentally sound.
O. Max Gardner, a North Carolina consumer bankruptcy lawyer who was not involved in the case, called the testimony "a major problem" for BofA, which acquired Countrywide, the country's largest servicer of residential mortgages, in 2008.
"These original notes were supposed to be transferred and delivered all the way up the line and for this witness to admit they were never transferred is pretty amazing," Gardner said.
"I've never see this admitted anywhere."
BofA did not immediately respond to requests for comment Friday.
Attorneys representing the borrower and BofA in the New Jersey case did not return calls seeking comment.
In a Nov. 17 ruling, Chief Judge Judith Wizmur of the U.S. Bankruptcy Court in New Jersey rejected Countrywide's claim that it had standing to foreclose on a borrower who owed $211,202.41 on a Haddon Heights, N.J., home.
Countrywide originated and serviced the loan.
It securitized the mortgage in 2006 but failed to endorse or deliver the note and other related mortgage documents to the bond trustee, Bank of New York Mellon, the court found. (BNY Mellon had no comment on Friday.)
Linda DeMartini, a supervisor and operational team leader in BofA's litigation management department, testified that "the original note never left the possession of Countrywide," and was instead transferred to the lender's foreclosure unit, as shown by internal FedEx tracking numbers, according to the ruling.
DeMartini "testified further that it was customary for Countrywide to maintain possession of the original note and related loan documents," Judge Wizmur wrote.
Attempts to reach DeMartini for comment were unsuccessful.
In private-label RMBS transactions, it was supposed to be standard practice for the sponsor of a securitized trust to physically deliver the original mortgage notes to the trustee or custodian at the closing of the securitization.
Typically, lenders endorse a mortgage note "in blank," similar to a bearer bond or a check made out to cash, giving the holder any ownership rights.
"Most significantly for purposes of this discussion, the note in question was never endorsed in blank or delivered to the Bank of New York," Judge Wizmur wrote.
Whether a servicer or investor has the standing to foreclose on a borrower has become a major issue since late September, when BofA, Ally Financial's GMAC Mortgage and JPMorgan Chase first admitted problems with robo-signers — employees who signed thousands of foreclosure affidavits without personal knowledge of the borrowers' debts and without signing in the presence of a notary.
Many defaulted borrowers and mortgage investors are now questioning whether mortgage documents were properly transferred, and whether servicers or third-party foreclosure attorneys may have fabricated documents in courts to prove underlying ownership of the debt.
Judge Wizmur wrote that, in a bizarre twist, Countrywide had filed a "lost note certificate" in 2007, claiming the original note had been "misplaced, lost or destroyed."
But two years later, in September 2009, it suddenly found the note and attorneys were unable "to explain the inconsistencies between the lost note certification, Ms. DeMartini's testimony and the 'rediscovery' of the note," the judge wrote.
Some investors in MBS claim that loan documents were not properly delivered to the trusts because of the rush to securitize residential mortgages during the heady days of the real estate bubble from 2005 to 2008.
Earlier this month, the Congressional Oversight Panel for the Troubled Asset Relief Program said in a report that document problems could potentially call into question the validity of millions of mortgages, and it called on the Treasury Department to investigate.
Adam Levitin, an associate law professor at Georgetown University, said in Congressional testimony Nov. 16 that many of the requirements set forth in securitization pooling and servicing agreements "were not followed."
"If the notes and mortgages were not transferred to the trust, then the trust lacks standing to foreclose," he said.
The American Securitization Forum, a trade group, has described the delivery of notes and mortgage documents as "standard practice."
But investors have argued that if documents were not delivered properly, the custodian would have been required to notify servicers in an "exception report," and the trust's sponsor would have to repurchase the loans.
However, failure to provide such notification may be tantamount to falsely certifying under the Sarbanes-Oxley Act that the documents had been delivered, investors and analysts have said.
The American Bankers Association published a paper this month claiming that the role of trustees is "ministerial in nature" and does not require that trustees "verify, investigate or monitor the actions of the seller or the servicer."
All appearances suggest that, up until now, industry attorneys have not seriously contemplated the possibility that securitization procedures could have failed on so basic a level.
"In our experience, we are not aware of material deviations from the general practice of delivering the physical mortgage notes to the trustee or its custodian," wrote Steven Kudenholdt and Stephen Ornstein, former attorneys for the securitization legal giant Thacher Proffitt who are now partners at SNR Denton.
In a subsequent interview with American Banker, the two lawyers — whose previous firm helped Countrywide securitize mortgages — argued that a widespread failure to complete the transfer was implausible.