Gretchen Morgenson has written an uncharacteristically cautious piece, “One Mess That Can’t Be Papered Over,” which in a rather abstract manner, discusses the issue we’ve been harping on for over a month, that the trusts that were established to hold the promissory notes for residential real estate loans and the related liens (the mortgage) may in fact not have taken the steps necessary for them to have ownership.
The story only gives a rather hazy account of the issues, and also pulls its punches as to the implications. It does signal the problems could be serious for specific deals, but pointedly steers clear of suggesting they are widespread.
While it’s good to see a recognized writer acknowledge these issues, I’m puzzled as to the sketchy description and the pulled punches. It might simply have been vagaries of deadlines, however, that Morgenson couldn’t confirm as many details as she needed to to run a more definitive piece.
I wish the story line were clearer. The issue, as we’ve indicated, that some, and we have reason to believe many, residential backed mortgage securitizations failed to take the measures stipulated in the governing contract, the pooling and servicing agreement, for the trust to obtain the promissory notes. As we explained earlier:
The pooling and servicing agreement, which governs who does what when in a mortgage securitization, requires the note to be endorsed (just like a check, signed by one party over to the next), showing the full chain of title, and the minimum conveyance chain is A (originator) => B (sponsor) => C (depositor) => D (trust). The note, which is the borrower’s IOU, is the critical document in 45 states. The mortgage, which is the lien, is a mere accessory to the note and can be enforced only by the proper note holder (the legalese is “real party of interest”).
The wee problem is that this apparently never done (I’ve been told one person trying to track down a particular note found it, at Countrywide. The guy who wandered down the corridor to produce it from his files claimed that Countrywide kept all the notes on its deals, and would send them out on request when someone needed them in a foreclosure. If this is true, it indicates there are pervasive and not readily remedied problems. The required endorsements were never done).
Why is this serious? The cure for the mortgage documents puts the loan out of eligibility for the trust. In order to cure, on a current basis, they have to argue that the loan goes retroactively back into the trust. This is the cure that the banks have been unwilling to do, because it is a big problem for the MBS. So instead they forge and fabricate documents.
There are actually two impediments. The first is that the note had to go through parties specified in the pooling and servicing agreement, in recent deals, at least two between the originator and the trust. Why so many moving parts? Because the investors wanted to make sure no creditor of the originator could later come back and demand the loans back, in case the originator failed close to the date of a securitization. In other words, the investors sough “bankruptcy remoteness” and they also wanted no exposure to claims by the FDIC. So the parties in between the originator and the trustee had to be independent (this independence was often nominal; all it took was one independent director) for the sales to be deemed “true sales” (crucial to establishing bankruptcy remoteness).
A second issue was timing. All the notes were supposed to be conveyed to the trust by closing. However, it did have a period post closing for clean-up, which effectively extended the time frame for any particular note to 90 days after closing (for some deals, the post closing period was only 60 days). After that, the exceptions permitted were very limited. And these trust were almost always were governed by New York law. New York law was selected because it is very well settled, but the flip side is it is also particularly unforgiving. New York trusts can operate only as stipulated.
Some of these ideas are included in the Morgenson piece, but I’m not certain this is at all clear to someone who lacks the full picture.
The notes, as Morgenson indicates via a quote from a real estate lawyer, normally remedy breaks in the conveyance chain. But that presupposes we are only looking at real estate law considerations. When you look at the additional complications created by the mortgage securitization, messing up the conveyance chain creates problems that look insurmountable. She eventually gets to the real issue:
For example, the common practice of transferring a promissory note underlying a property to a trust without identifying it, known as an assignment in blank, may run afoul of rules governing the structure of the security.
“The danger here is that the note would not be considered a qualified mortgage,” said Robert Willens, an authority on tax law, “an obligation which is principally secured by an interest in real property and which is transferred to the Remic on the start-up day.” If, within three months, substantially all the assets of the entity do not consist of qualified mortgages and permitted investments, “the entity would not constitute,” he said…
What if a loan originator failed to provide documentation substantiating that what’s known as a “true sale” actually occurred when mortgages were transferred into trusts — documentation that is supposed to be provided no longer than 90 days after a trust is closed? Well, in that situation, a true sale may not have legally happened, and that doesn’t appear to be a problem that can be smoothed over by revisiting and revamping the paperwork.
“The issue of bad assignment has many implications,” said Christopher Whalen, editor of the Institutional Risk Analyst. “It does question whether the investor is secured by collateral.”
In other words, were the loans legally transferred into the trust, and, if not, do the trusts lack collateral for investors to claim?
A mortgage securitzation lawyer, via e-mail, went through some of the ways this might play out:
It’s clear the parties intended a transfer. But it appears that they did not document the transfer. Based on the agreement, they described how the transfer should take place and then didn’t do it, apparently. Unfortunately, while this might have been the intention of the parties, they can’t produce any real, documented evidence that this mortgage is owned by the trust. I’ve provided affidavits that state that the requirements for a mortgage to be part of the trust are clear in the documents, that mortgages can’t be added to the trust after start up (as servicers have tried to argue), and that I see no evidence that this trust owns this loan.
On one hand, the problem is easily cured – the party who is the documented owner of the loan could foreclose (the original lender). The problem with this is that the proceeds of the foreclosed property, including the recoveries intended to reimburse the servicer for advances, would have no mechanism for getting back into the trust.
If the original lender foreclosed, took title and liquidated the loan, accountants would have an issue with how the proceeds could possibly end up back with the trust. The result would be a total loss for the trust for that loan.
The servicer’s attorneys have no desire to go this route – it terrifies them.
The servicer’s attorney’s could argue for some sort of documentary exception – that a mistake was made and the intention was for the trust to own the mortgage – an appeal to equity or fairness. Unfortunately, in many cases, they already submitted an affidavit stating that they had proper title and full right to foreclose in the name of the trust. So going this route would expose them to perjury.
The appeal to equity or fairness, given the intent of the parties to the trust and the relatively minimal harm to the borrower, seems like a logical route – except that a number of judges would argue that fairness might dictate a fair outcome for the borrower, such as a real modification. And you still have the issue of the possible damages and legal expenses for a wrongful foreclosure action.
The big argument people make against this approach is that the borrower is just a deadbeat who has failed to pay their mortgage, so there’s no reason why the borrower should be entitled to some sort of gain or benefit. While this may be true, real estate law is pretty clear – the party holding title is the one who should foreclose. Otherwise, someone else could come along after the improper foreclosure and be the actual title holder and sue the borrower for foreclosure and loan repayment again. The borrower is entitled to protection against this.
Most people assume that the parties followed the terms of the trust agreement – it’s so basic and fundamental to all MBS. It is hard to grasp that they screwed this up. As a result, it takes some work to pull through everything and see what actually happened. Without the mortgage documents showing the current title, combined with the affidavits from the foreclosure attorney, I wouldn’t have believed it myself.
As we’ve been saying, this is going to be difficult to resolve. Yet the powers that be keep acting as if they keep up the “nothing to see here” talk, this problem will abate. That is as likely to succeed as putting a band-aid on a gunshot wound.