The Mortgage Loan Foreclosure Mess: Yves Smith on the Banks’ Gluttony; Problems with MERS and Sloppy Securitizations
by Linda Beale
Edited noon 11/1/10 to clarify discussion of certificates as qualified mortgages in a REMIC.
crossposted with Ataxingmatter
Yves Smith has an op-ed in the Oct. 31, 2010 New York Times on the mortgage mess. See Naked Capitalism, here, for full op-ed.
As noted, the mortgage crisis goes much deeper than just bank use of robo-signers for documents. When the securitization process took off in the early 2000s, banks became sloppy. Loan product was needed, so niceties like documentation became an expendible. Subprime loans were more grist for the mill–the faster mortgage lenders could process them, banks could buy and securitize them, the more money they could all make. Since they were selling off the mortgage loans, they didn’t care how good they were. And since they were often selling them via securitizations that they “sponsored”, they didn’t want to have to do all that legal busywork that location-specific transfers of mortgages and notes required, including payment of recording taxes in the county where the land was located every single time a loan was moved from one owner to another, though they still wanted to collect all kinds of fees from servicing the mortgage loans that they “sold” via securitization.
Just a little aside on the way these REMIC securitizations worked (edited noon 11/1). Often, original mortgages and notes were put in a trust and pass-through certificates were issued by the trust–this is the case in particular when Ginnie, Freddie, or Fannie aggregated a pool of mortgage loans and issued certificates representing ownership interests in that pool of loans which are treated as obligations secured by interests in real property under Treas. Reg. 1.860G-2(a)(5).
Certificate holders were “beneficial owners” of the mortgage assets of the trust for tax purposes, though the Trust, or the trustee on behalf of the trust, would hold legal title to the mortgage loans. The certificates, representing interests in mortgages, could then be contributed to a REMIC, or mortage loans could be contributed directly into a REMIC trust. REMIC regular interests are also treated as qualified mortgages under Section 860G(a)(3)(C), and they could therefore be contributed to another higher-tier REMIC, resulting in “re-REMICing”. The state law entity status for a REMIC doesn’t matter–trust, partnership or mere segregated pool of assets (no state law entity at all) could all elect REMIC treatment for mortgage loans under the Federal income tax rules for REMIC securitizations, if they satisfied the federal tax code requirements.
The requirements generally were that the REMIC had to hold only certain assets consisting of “qualified mortgages” and “permitted investments” (covering certain cash flow investments, qualified reserves, and foreclosure properties); it had to issue only permitted REMIC interests consisting of “regular interests” that were treated as debt for tax purposes under the tax code and one class of “residual interest” that was treated as the owner of the REMIC under the tax code (special tax rules applied to require the holders of the residual interest to report certain amounts of income with respect to the REMIC on their tax returns ); and it had to satisfy an “arrangements” test to ensure that the residual interest was not held by inappropriate organizations and that appropriate information was provided. Qualified mortgages had to satisfy a loan to value ratio and had to be contributed to the REMIC either at startup or within 90 days under a fixed-price contract OR be substituted for defective loans within 2 years of startup. If a loan were discovered to be defective after that, it would need to be sold out of the REMIC within 90 days, or the REMIC would hold a “bad” asset that could cause the REMIC to lose its qualification as a REMIC. (There is a de minimis rule that lets a REMIC hold an insignificant amount of bad assets, but that generally would not cover a REMIC with lots of mortgages that fail to qualify.) If a REMIC is disqualified, it is almost certainly a “taxable mortgage pool” under section 7701(i) of the Code that is subject to corporate taxation without the ability to be consolidated with other members of the same affiliated group.
Earlier private REMIC securitizations–the ones that were done in the late 1990s, for example–were careful to include detailed representations in the pooling and servicing agreement that the Depositor/Sponsor would assign the mortgage loans to the trustee for the benefit of the certificate holders–including the original note endorsed to the Trustee, the original mortgage, assignments of the mortgage, original assignment of leases and rents (for commercial properties), and original lender’s title insurance policy. The trustee was to hold such documents in trust for the certificate holders. The following is an illustrative sample of representations that would have been included in a commercial REMIC pooling and servicing agreement regarding the transfer of mortgage loans from a current owner to the depositor/sponsor who would transfer them to the trust.
X is the sole owner and holder of the Mortgage Loan and will have, on the Closing Date, good and marketable title to the Mortgage Loan;
X has full right and authority to sell, assign and transfer the Mortgage Loan as contemplated by the Mortgage Loan Purchasing Agreement; all of the obligations of X with respect to the Mortgage Loans are legal, valid and binding and enforceable against X except as may be limited by bankruptcy, insolvency or reorganization (or other similar laws affecting the enforcement of creditors’ rights, generally) and by general principles of equity; the execution and delivery of the documents contemplated by the Mortgage Loan Purchase Agreement has been duly authorized and such execution and delivery….will not constitute a violation of any federal, state or local law or the rules of any regulatory authority.
As of the cut-off date, the information pertaining to the Mortgage Loan set fortyh in the Mortgage Loan Schedule is true and correct in all material respects; X is in possession of a file on each Mortgage Loan containing, among other things and to the extent applicable, the note, loan agreement, mortgage or deed of trust, and all amendments, allonges or the like thereto, records of payments, correspondence, and borrower’s address and each such file will be transferred to the Trustee, and X has not withheld any material information with respect to such Mortgage Loan…
The assignment of the related Mortgage to the Trustee constitutes the legal, valid and binding assignment of such Mortgage…
But when the banks got greedy in the early 2000s, they applied that brand of “financial innovation” that was bragged about as bringing us the nirvana of a service-oriented, financial transaction-dominated economy that would grow and grow and grow. (Of course, it did at first, making lots of money for the financial institutions and particularly for investment banks. But then it crashed, costing taxpayers while banks continued to make money out of cheap (taxpayer-made-possible) credit coupled with low interest to depositors and high fees for anything and everything.) Two things began to happen.
1. For convenience, the assignment/allonge was “indorsed in blank”–meaning that the sponsor wouldn’t actually complete the document that transferred the mortgage loan to the trustee because it was “not practical to record mortgages in the name of the trustee” so the sponsor “retains record ownership subject to an obligation to transfer it to the trustee upon its request.” James Peaslee & David Nirenberg, Federal Income Taxation of Securitization Transactions (3d Ed. 2001) at 86 n.64 (concluding that this would be done only when the sponsor was “creditworthy” and so the fact that legal title wasn’t conveyed should “not be very significant”).
Of course, the boom in mortgage lending, securitization glut, and ultimate bankruptcy of key sponsoring banks such as Lehman and Bear Stearns suggest that this “practical” issue had substantial consequences, at least for the legal proceedings even if not for the IRS tax status of entities (where legal title is not necessarily determinative of tax beneficial ownership). The danger, of course, is that bankrupt sponsors that retain legal title might be treated as owning the mortgage loans and the securitization vehicles to which the loans were purportedly transferred would be left with nothing, with the result that there would be questions whether the securitizations were legitimate (and if a REMIC, whether it had been disqualified from REMIC status because it had too many defective assets and therefore owed corporate taxes).
2. The reason it was “not practical” to record the mortgage in the name of the trustee was that there are almost always local law mortgage recording taxes to be paid every time a transfer is made. And of course, recording such taxes would be costly for a securitization–lawyer fees, servicer fees, the recording taxes themselves, document delivery and verification, etc. That would cut into the profits from the securitization for the sponsor (who might well also be the servicer). By keeping the legal title with the original sponsor, in spite of the pooling of the mortgages in a securitization, there would be no transfers until it was time to put the documents in somebody’s hands for foreclosing. That led to another financial innovation–the Mortgage Electronic Registry System (MERS), invented and owned by Chase, CitiMortgage, Bank of America, HSBC, Mortgage Bankers Association, Fannie, Freddie, various mortgage companies and title insurance companies.
MERS apparently exists primarily to permit banks to avoid multiple transfers and multiple mortgage recording taxes in local jurisdictions where the property is located with each purported assignment of the mortgage. MERS claims that it serves to provide a consistent database that reduces errors caused by frequent assignments and reassignments of mortgage loans. See MERS fact sheet (pdf available at home page). But it seems to do the opposite–eliminate the actual assignment even though securitization has moved the mortgage loan from originator to bank sponsor to servicer or whatever, and avoid the ability of anyone to know who actually owns the mortgage loan from looking at county property records. MERS indicates that it records the mortgage (in its name) and that it can foreclose on mortgage loans as the “nominee for all parties” –or the bank that claims to “own” the loans can foreclose on them. See MERS statement about JP Morgan Chase (Oct. 13, 2010).
The fact sheet further indicates that MERS expects its standing to foreclose as the agent for the noteholder to be upheld in litigation and reiterates that MERS holds legal title (which is the reason that only one recording tax has to be paid, if MERS is held valid) and that it will transfer the legal title to the servicer/sponsor bank for foreclosing if requested. (This transfer usually takes place, by the way, by the servicer bank personnel signing the indorsement from MERS to the servicer bank as an officer of MERS–another kind of robo-signing that the industry has perfected.) This does mean that many Servicers/Sponsors may have interacted with borrowers as though they held legal title when they did not.
As Yves Smith notes, “While a standardized, centralized database was a good idea in theory, MERS has been widely accused of sloppy practices and is increasingly facing legal challenges.” On the website, I see that MERS claims that it always has possession of the full documentation and that its arrangements for bank personnel to act as personnel of MERS are perfectly legitimate.
Yet I can’t help wondering, if MERS always has possession of full documentation, why are there groups that advertise their ability to create documents, as Yves Smith also notes regarding “Lender Processing Services”? Further, the idea of letting anyone represent themselves as an employee of MERS when they actually are an employee of a party that might have a reason for commiting fraud by inappropriately claiming to own a mortgage seems at least a questionable practice and one that should not be tolerated when it compromises the integrity of the mortgage system. If I were a judge dealing with one of these foreclosure cases, I would have serious qualms about accepting such a document as “proof” that a particular bank had a right to foreclose.
As noted, under the rules before MERS, the trust established with original mortgage loans would hold legal title, and the trust would be entitled to act on the mortgage loans on behalf of the REMIC as beneficial owner. That’s especially important, since pooled trust certificates may not be held in a single REMIC vehicle–in fact, they are often scattered in various REMICS, and in REMICs of REMICs (REMICs squared and cubed, which may themselves be “re-REMICed” in the same deal or in later deals). But if the trust doesn’t actually hold legal title–because legal title is left with MERS from the first, in spite of the documents tracing a transfer from the sponsor to depositor to trust–that means that the trust actually holds in trust no mortgage loan but only its rights under the various documents and agreements it has entered into with MERS (and that borrowers have, probably unknowingly, signed off on in borrowing to buy property from a lender that is securitizing through MERS) to be able to acquire legal title if needed and then assign it, possibly, to the Servicer who will act on the foreclosure on the trust’s behalf.
Do each of those assignments get appropriately recorded (and taxes paid)? Does this electronic database satisfy the state and securities law requirements? If not, the important tax question is whether this limited actual legal right supports a REMIC’s claim to “hold” qualified mortgages (aside from the question of whether these mortgages were “qualified” in the first place, in cases where appraisals were rigged and borrowers’ ability to pay was unexamined)? It seems that the legal title should not be determinative for REMIC status. If the loans are defective and do not qualify as “qualified mortgages” for REMIC status, however, it is possible that some REMICs would have “bad” assets that would disqualify the REMIC if the loan is not sold within 90 days of discovery of the defective loan problem.
Moreover, if a bankruptcy court were to determine that a sponsor or other entity actually owned (not just as legal title, but as beneficial owner in the tax sense) mortgage loans that had been thought to be included in the REMIC pool (and thus the court order allocated all funds connected with that loan, or foreclosure rights and sales proceeds, to parties other than the REMIC investors), it would appear that the decision removing the loan from the pool would create a loss to REMIC investors but would not in itself jeopardize REMIC status. If the problem of non-existent documents and unverified loan quality was substantial, however, is there some possibility that the sham transaction doctrine could be applied to the REMIC to cause it to lose REMIC status ?
That’s a hard call but seems unlikely given the highly “constructed” nature of the REMIC as a special tax entity under the Code–any entity or even a non-entity can be given REMIC status if it meets the requirements, regular interests are treated as debt even if they wouldn’t independently be considered debt under general tax principles, residual interests are treated as equity even though they may have no entitlement to proceeds and primarily represent a liability to includes certain “phantom income” amounts in income, the sponsor may continue as servicer and continue to hold the mortgage loans (in a segregated pool) even when they are REMICed, tiering of REMICs results in a final allocation of mortgage payments that may differ considerably from the initial allocation in the first-tier REMIC, servicer and trustee actions are taken under the pooling and servicing agreement with respect to the mortgage loans according to whatever the documents permit or require (such as servicer advances to which it has reimbursement rights), etc.