Commentary: Mortgages Lost in the Cloud

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State and local governments could have invested in digital record-keeping systems for real estate to preserve every legally important feature of the paper method, but with the speed and accessibility of a Google or a Facebook. Why didn't they? William Raftery, a communications and research specialist at the National Center for State Courts in Williamsburg, Va., says three things got in the way: state laws, which no one bothered to amend; court precedents dating back hundreds of years that demand paper records; and inertia. Says Raftery: "Things of this nature only happen when circumstances demand it."

The private sector couldn't afford to wait for government to catch up. Hence the MERS database, a unit of MERSCorp in Reston, Va., which was founded by Fannie Mae (FNM), Freddie Mac (FRE), and the mortgage industry. The concept was to avoid the cost and delay of recording the passing of loans from one party to another by naming Mortgage Electronic Registration Systems as the mortgagee for the lifetime of the loan, regardless of how many times it changed hands and to whom.

Some judges accepted MERS' right to foreclose on a delinquent homeowner. Others didn't. Instead of untangling the confusion early on, MERS forged ahead. It's now the mortgagee for more than 60 percent of new mortgage loans.

A promissory note—i.e., a paper I.O.U.—is the only legal proof of creditorship that courts ordinarily accept. Incredibly, though, the Florida Bankers Assn. told the state Supreme Court that when its members converted to electronic records, "the physical document was deliberately eliminated to avoid confusion." Further angering judges, MERS deputized bank executives to handle foreclosures, making it unclear who the people appearing in court really worked for. In Brooklyn, state Supreme Court Justice Arthur Schack in 2009 rejected a foreclosure in which a Bank of New York executive identified herself as a MERS vice-president. He called her "a milliner's delight, by virtue of the number of hats she wears." Ally Financial said in September that it found a "technical" deficiency at its GMAC Mortgage unit that let employees sign foreclosure documents without a notary present or with information they didn't know was true.

If the transition from paper to terabytes were unprecedented, it would be easier to give lenders a pass. But the banks behaved more straightforwardly in 2003 when they sought permission to digitize paper checks—a similar legal leap, since electronic copies had long been considered unacceptable in court. The banks lobbied Congress, which in 2003 passed the Check Clearing for the 21st Century Act. Now your monthly bank statement contains images of your checks instead of the paper, saving time and money. Because the reform was done with the blessing of Congress, there have been few problems.

MERS executives say their system will overcome legal challenges. "We find it very ironic that we're being accused of all these different wrongdoings when in fact we brought a lot of clarity to not just the industry but homeowners," says Karmela Lejarde, a MERS spokeswoman. There's some truth in what Lejarde says. This year, MERS opened its system so homeowners can find out for free online who their loan's servicer is and (usually, but not always) who owns the loan.

The problem is that the data in the MERS system isn't verifiable or legally binding. That recalls de Soto's insight into what made the U.S. work so well in the first place. "What characterized the rise of capitalism was that you actually created facts—statements that can be tested for truth. Now you've got plenty of information, but you don't have facts that can be tested for truth. Can you have a prosperous market economy without knowledge of who owns what and how they're related?" We know the answer to that one.

With John Gittelsohn

Coy is Bloomberg Businessweek's Economics editor.

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