Buying a Cow and Selling Hamburgers- A Closer Look at Mortgage Securitization

Posted on April 2, 2010. Filed under: Banking, Foreclosure Defense, Mortgage Law, Securitization | Tags: , , , , , , |

Our legal system is extremely difficult to understand and maneuver by a non attorney, partly because there is no single source or authority for answering complicated legal questions. For example how do you know if your mortgage was eviscerated through the securitization process? Did securitization of the note and mortgage constitute conversion of the asset thereby rendering the mortgage unenforceable? This question has not been answered by a high court yet but there is no shortage of legal scholars and practitioners analyzing the securitization process and its impact on the housing market and the economy as a whole.

Most agree that securitization changes the traditional debtor creditor relationship and interferes with contractual rights derived from a mortgage transaction. When two parties enter in to a contract they normally have the right to modify the terms of their agreement as long as there is mutual assent. When a contractual relationship is ongoing, as is the case with a mortgage contract, it is not uncommon for the parties to amend their agreement as and when unforeseen events occur or circumstances change. The main reason for doing so is to mitigate losses when modification is in the best interest of both parties and no better alternative is available.

Securitization, because of its complex structure and infusion of additional parties into the mortgage transaction, militates to an entirely different and unique set of priorities, obligations and interests that often conflict and compete with one another. In many instances, although it may be economically feasible for both the borrower and note holder to modify the loan, the rules of the securitization agreement prohibit or limit change of loan terms, thereby forcing the servicer to foreclose rather than negotiate. Securitization interferes with the mortgagee’s and mortgagor’s rights to freely engage in loss mitigation negotiations in order to mitigate their own losses, without having to be concerned with losses that may be incurred by a third party, who was not a party to the original mortgage contract.

One practitioner, Richard Kessler Esq., has compared securitization to buying a cow and selling hamburgers – “The people who buy hamburgers have paid for and are legally entitled to the hamburger but do not thereby become owners of or acquire an ownership interest in the cow… It [securitization] renders the mortgage note used to generate income unenforceable by eliminating the status of note holder.”

More than 60% of all mortgages are securitized representing in excess of seven trillion dollars in outstanding mortgage debt. (Source: Wikepedia, Mortgage-Backed-Securities) Once a mortgage loan has been funded by the originating lender the loan (note and mortgage) is sold to a sponsor who forms a pool of hundreds of loans and transfers them to a pass-through/conduit trust (REMIC), which issues certificates backed by the cash flow generated from the mortgage notes. The certificates are simultaneously sold to a broker/underwriter who subsequently sells them to investors. Additionally a trustee is appointed to manage the trust, who in turn appoints a servicer for collecting payments from borrowers, managing the escrow accounts, forwarding the payments to investors and when necessary initiating and processing foreclosures.

In order to qualify for a REMIC status which allows the cash to flow to certificate holders without taxation at the trust/conduit level (investors will still pay income tax individually) Mr. Kessler states that all legal and beneficial interest in the mortgage loans must be transferred to certificate holders, rendering the trust effectively asset free. “Therefore, neither the trustee nor the servicing agent can have any legal or equitable interest in the mortgages”. The investors are the purported owners and holders of the notes but the terms of the pooling and servicing agreement (PSA) do not allow them to foreclose or participate in controlling the mortgage notes. “The certificate holders bear the losses but do not control the mortgages. As such the moral hazard is severed from command and control thereby restructuring the debtor creditor relationship created by the original note and mortgage”. Richard Kessler, MEMORANDUM OF POINTS AND AUTHORITIES IN SUPPORT OF DEFENDANTS MOTION TO DISMISS.

“The certificate holders, therefore, cannot be [note]holders because they lack the necessary rights and powers conferred by holding the note: the right to payment, the right to sell or transfer the note, the right to foreclose and the right to modify the terms and conditions of the note or mortgage with the consent of the mortgagor.” id

In the event of default ordinarily the trustee initiates foreclosure proceedings claiming the secured party is the conduit trust, but one can argue this is legally impossible since the trust, in order to qualify for a REMIC status, cannot own a legal or equitable interest in the mortgage loans. Further, the investors cannot appoint the trustee as their agent to foreclose on the mortgage since as demonstrated above they are not the holders of the note. A principal cannot convey rights to an agent which the principal lacks. The rights of certificate holders are created by and derive from contractual obligations granted by and pursuant to the PSA as opposed to those conferred to holders of the notes.

Some practitioners argue that because the pooling and servicing agreement restricts the mortgagee’s ability to modify the loan and since the mortgagor was never notified of or consented to such restrictions, this amounts to a unilateral and illegal modification of the mortgage contract, thereby rendering it null and void. I, however, don’t understand this theory, since modification is not an express right or obligation under the terms of the mortgage contract and thus restricting it cannot be considered a unilateral amendment and hence a breach of contract. Further, even if we assume arguendo that the mortgage has been illegally modified, I am not so sure voiding the contract will be the proper remedy.

Others proffer that securitization interferes with a mortgagors right of redemption since he/she is restricted from negotiating directly with the mortgagee who may have been willing to accept a reasonable settlement offer but cannot do so because such decisions are no longer made by the actual note holder and not predicated on the mutual interests of mortgagee and mortgagor. For example often the competing interests of junior and senior tranches within a securitized pool of mortgages makes it impossible to negotiate a loan modification that under normal circumstances would have been beneficial to both the debtor and creditor. One can also argue “this constitutes either a breach of contract or a tortious interference with a contract, or both.” George Beckus Esq, blog.floridaforeclosurelawyer.org

The only conclusion I can draw with any certainty from the above analysis is that securitization and its legal and economic implications are difficult to understand or measure and even harder to explain. Imagine trying to explain all this to a judge with the cow and hamburger analogy. Judges are not always as smart as they are proclaimed to be and they resist novel legal theories, specially when they can hurt the banks. At the end of the day, regardless of how persuasive a theory may sound or how passionately it is argued by its proponents, until it becomes law it is just a theory.

Dean Mostofi

National Loan Audits

301-867-3887

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2 Responses to “Buying a Cow and Selling Hamburgers- A Closer Look at Mortgage Securitization”

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I always find it interesting how much heavy lifting people do to make this situation sound plausible.

What ever happened to the good ole principles of the law of contract. Is anyone going to say that a consumer loan transaction is the same as an investment securities transaction? I don’t think so. Securitizing parties shoot themselves in both knees when they choose this route without allowing the borrower to participate in choosing, and contemplation of the consequences of choosing that particular method of funding.

So, if there was no meeting of the minds between parties to the contract, then there is no contract because there can be no consent without understanding. Let’s not forget (for those in California) parties must be able to be identified in obligations.

But since a note is negotiable the holder can sell it without the consent of the maker.


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