«DECONSTRUCTING THE BLACK MAGIC OF SECURITIZED TRUSTS: HOW THE MORTGAGE-BACKED SECURITIZATION PROCESS IS HURTING THE BANKING INDUSTRY’S ABILITY TO ...»
18. BITNER, supra note 10, at 23. Prior to AMPTA, banks were limited to traditional fixed-rate loans, making it easy for borrowers to know exactly how much their payment was going to be, and how long it was going to take to pay off their traditional mortgage. Birger, supra note 14. With the passing of AMPTA, new loans which made the true nature of the debt owed confusing and unclear greatly increased the chance of default by unsuspecting borrowers. Id. The newly allowed loans included adjustable rate mortgages, balloon-payment mortgages, interest-only mortgages, and the option-ARM. Id. As McCoy points out, the greatest danger came not from the deregulation itself, but from the failure to create any kind of new regulations to prevent these new practices from becoming exploitative. Id.
19. Roger Lowenstein, Who Needs the Mortgage-Interest Deduction, N.Y. TIMES, March 5, 2006. The Tax Reform Act of 1986 made the mortgage deduction more important by ending the deductibility of interest on credit card and other consumer loans. Id. President Regan in his address the National Association of Realtors in 1984 made clear that the goal of the Act plan was to increase homeownership, stating “I want you to know that we will preserve the part of the American dream which the home-mortgage-interest deduction symbolizes.” Id.
However, as noted by Roger Lowenstein, “[h]e didn’t mention that it also symbolized the American love affair with debt; after all, it encourages people to pay for their homes with a mortgage instead of with equity.” Id.
20. Birger, supra note 14.
21. The Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. 108-27 (May 28, 2003).
by encouraging speculative investment in real estate due to the disparity in tax rates on regular income versus capital gains from real estate investment.22 Further, significant changes within the mortgage industry itself were creating a system ripe for making high-risk loans because the potential payoff to the bank justified the high rate of default for such loans.23 First, interest rates began climbing, making it more difficult for people to get traditional mortgage loans.24 Second, mortgages were bundled and sold as mortgagebacked securities (“MBS”).25 As securitization took off on Wall Street, for the first time lenders could make loans and then sell them off in packages, maximizing their gains while allocating various levels of risk to investors.26 At a lightning fast rate mortgage loans went from being illiquid to liquid assets, and for the first time mortgage brokers began making a premium for selling or disposing of the loans upon origination instead of only the up-front fee they charged to borrowers.27 There are several players within the subprime mortgage industry that contributed to the current crisis.28 In Confessions of a Subprime Lender, former industry insider Richard Bitner documents what he called the “mortgage industry ‘food chain’” which sets forth the position and importance of various players who are involved in creating, packaging, and selling subprime mortgages as mortgage-backed securities.29 The base of the food chain, like all good food chains, begins with the small animals that are building blocks for the larger predatory animals. In this food chain, the small animals include borrowers, mortgage brokers, and small time lenders.30 The larger animals include big lenders and investors, government agencies such as Fannie Mae and Freddie Mac, investment banks, rating agencies and financial institutions.31 And of course Congress, at the very top of this chain, gouges itself on the largess from these institutions that lavish significant
22. Id.; Tax Foundation, History of the Income Tax in the United States. Further, since the tax on capital gains made from buying and selling real estate was capped at 15%, it encouraged investment in real estate as income tax rates on regular income were capped at 30%, twice the rate of capital gains. This disparity made it more than worth the risk of real estate investing as the tax on any investment return was significantly lower than that paid for hard labor.
23. BITNER, supra note 10, at 23–24.
2011] THE SECURITIZATION CRISIS 7 campaign contributions on individual congressional members.32 It is all of these players working together that created the “gunslinging process of subprime lending” and as a by-product, mortgage-backed securities.33 That Old Black Magic: Traditional Mortgage Loans Before the Subprime Lending Crisis, and the Securitization Takeover Traditional mortgage loans before the subprime mortgage lending crisis were created and serviced by the same lender.34 Thus, the lender had a vested interest in making sure that the borrower to whom it was making a loan could support the monthly payments and would not default on the loan obligations.35 These lenders are called portfolio lenders and are now a dying breed.36 However, after subprime lending took over, portfolio lending became the exception rather than the rule in the mortgage lending industry and lenders lost incentives to keep loans in-house and on track.37 As Professor Adam Levitin, an Associate Professor of Law at Georgetown University and
an expert on mortgage securitization explains:
[s]ecuritization is a financing method involving the issuance of securities against a dedicated cashflow stream, such as mortgage payments, that is isolated from other creditors’ claims. Securitization links consumer borrowers with capital market financing, potentially lowering the cost of mortgage capital. It also allows financing institutions to avoid the credit risk, interest-rate risk, and liquidity risk associated with holding the mortgages on their own books.38 It is of course the very nature of securitization that made it so appealing to mortgage lenders.39 As larger financial institutions figured out how to securitize mortgages to allocate the risk to different investors by selling securities based on different levels of risk, called tranches, they began purchasing sub-prime loans from small mortgage lenders.40 Mortgage brokers, “the street hustlers of the lending world” would find borrowers and get paid a
32. See GRETCHEN MORGENSON AND JOSHUA ROSNER, RECKLESS ENDANGERMENT (2011).
33. BITNER, supra note 10, at 23–24.
34. Id.; Adam Levitin and Tara Twomey, Mortgage Servicing, YALE J. ON REG. 11 (2011).
35. Id.; Levitin and Twomey, supra note 34, at 11.
36. Id.; Levitin and Twomey, supra note 34, at 11.
37. Id.; Levitin and Twomey, supra note 34, at 11.
39. Atlas and Drier, supra note 7; Levitin and Twomey, supra note 34, at 11.
40. Atlas and Drier, supra note 7.
premium for creating sub-prime loans, “seduc[ing] millions of people into signing on the dotted line.”41 Then, instead of holding onto the loans as traditional lending practices had called for before, sub-prime lenders sold the loans, and the very high risk of default that goes with them, to investors who were looking to buy these types of loans, investors such as pension funds and 401k plans.42 As noted by John Atlas and Peter Drier in their article The
Conservative Origins of the Sub-Prime Mortgage Crisis:
[t]he whole scheme worked as long as borrowers made their monthly mortgage payments. When borrowers couldn’t or wouldn’t keep up the payments on these high-interest loans, what looked like a bonanza for everyone turned into a national foreclosure crisis and an international credit crisis. For millions of families, the American Dream of ownership has become a nightmare.43
SELLING THE AUDIENCE: SO WHAT IS “SECURITIZATION?”
Perhaps the most confusing issue when dealing with securitized trusts and what those trusts mean with regards to foreclosure standing is understanding what “securitization” is.44 While there are many explanations, some lengthy while others brief, understanding the process of securitization and the repercussions from a defensive perspective can truly allow for a crucial offensive strategy. Further, it is essential for any lawyer or judge involved in the foreclosures to understand the process of securitization, the key components, deadlines, contractual obligations of a trustee and a servicer, and how the failure of certain procedures or parties can lead to a nightmare for a foreclosing trust, and potential salvation for homeowners trying to get out of a financial nightmare.
A simple definition of securitization is “a process where thousands of mortgage loans are bundled together into financial products called mortgagebacked securities.”45 However, this is an over-simplified definition that does not give true credit to the structural complexities of MBS.
44. Although ‘securitization” is one process, the ramifications and intricacies are different depending on whether you are addressing it from a foreclosure defense standpoint, tax standpoint, or seeking loss mitigation alternatives as a borrower. For a detailed explanation of securitization as it relates to problems with loss mitigation, see Adam Levitin, Mortgage Servicing, supra note 34.
45. BITNER, supra note 10, at 107.
2011] THE SECURITIZATION CRISIS 9 The complex definition of the securitization process requires an explanation of the key steps, and how they interact with one another. The first stage occurs when a “sponsor” financial institution bundles mortgage loans together.46 This bundle is created from loans either originated by the sponsor, or purchased from third party originators such as small lenders or mortgage brokers.47 The next step involves a sale of the bundled mortgages to a subsidiary created specifically for this purpose, known as a “depositor.”48 The depositor is created for this purpose because it has no assets or liabilities other than this single bundle of mortgages, and this step is very important because it ensures bankruptcy protection for the sponsor.49 The third step occurs when the intermediary depositor sells the loans to a passive entity50, in the case of residential mortgages a “trust” which is designed to hold the mortgages and to issue securities which are repaid from the mortgage payments made on the loans.51 The initial purchase of securities provides the capital to pay the depositor and sponsor for the loans.52 The trust can issue securities one of two ways, either directly to the depositor as payment for the loans who is then responsible for reselling the securities, or to investors directly, using the funds from the direct sale to pay the depositor.53 The Congressional Oversight Report published in November 2010 notes that for proper securitization, “[t]here are at least three points at which the mortgage
46. Levitin and Twomey, supra note 34, at 11.
49. See Levitin and Twomey, supra note 34, at 11 n.34 for an explanation as to why bankruptcy remoteness is a key component to this process; Adam Levitin, Written Testimony Before the House Financial Services Committee Subcommittee on Housing and Community Opportunity, at 3, November 18, 2010 [hereinafter Written Testimony].
50. The passive entity component has extensive tax ramifications that are unrelated to the standing issues raised in this article. In general, the passive entity that the trust becomes for tax purposes is referred to a Real Estate Mortgage Investment Conduit (“REMIC”) pursuant to I.R.C. §§860A-G. Failure to maintain the passive status of a REMIC results in loss of entitylevel tax exemptions designed to promote these types of investments by a trust, as well as significant liability potential for both the trustee and the servicer of any loan that is improperly managed. “A variety of reasons-credit risk (bankruptcy remoteness), off-balance sheet accounting treatment, and pass-through tax status (typically as a real estate mortgage investment conduit (“REMIC”) or grantor trust) mandate that the SPV be passive, it is little more than a shell to hold the loans and put them beyond the reach of the creditors of the financial institution.” Levitin, Mortgage Servicing, supra note 34, at 15. In fact the IRS has taken notice and already initiated an investigation into the “active” activities of these trusts and the tax implications from them. Scot J. Paltrow, Exclusive: IRS Weighs tax penalties on mortgage securities, REUTERS, April 27, 2011.
51. Levitin and Twomey, supra note 34, at 11.
and the note must be transferred during the securitization process in order for the trust to have proper ownership of the mortgage and the note and thereby the authority to foreclose if necessary.”54 Credit Rating-Agencies: Making a Silk Purse Out of a Sow’s Ear The final stage of securitization involves the sale of the mortgagebacked securities based on the risks they presented.55 Each bundle of mortgages is divided into different levels, in what are commonly referred to in the finance industry as “tranches” and then rated based on their creditworthiness.56 Tranches are then assigned a different credit rating by a credit rating agency.57 Each tranche is a portion of the risk on the loan.58 Therefore, the higher rated portion, those given a Triple-A rating, down to an Equity rating.59 Those who receive a portion with the triple-A rating are repaid first, have the least risk of loss, but also the lowest possible return on their investment.60 The lower you go down in the ratings, the higher the rate of possible return, but the greater the risk.61 Once the securities are broken down into tranches, the rating agency has to try and judge the quality and value of the assets in each tranche.62 Bitner
uses the following analogy:
54. November Oversight Report, Examining the Consequences of Mortgage Irregularities for Financial Stability and Foreclosure Mitigation, Congressional Oversight Panel, November 16, 2010.
55. Levitin and Twomey, supra note 34, at 11.