Posted on 08 July 2010.
Hat Tip to a viewer for writing this as a post submission…
By: DinSFLA 7/8/2010
The Mortgage Foreclosure Maze: Securitization with a Twist
The cases and commentary, the blogs and discussions tend to focus on the legal details. Lawyers without
substantial knowledge of the securitization process attempt to shoehorn the resultant obfuscations into
often-arcane statutes and even more antiquated case law. The result is a bewildering array of conflicting
and confusing case law. Defendants “cannot see the forest for the trees”. This is the intended outcome:
the securitization process practiced by the numerous now defunct fly-by-night originator-securitizers
created a complex maze of internally contradictory documents that only a finance MBA can unravel.
So let us step back and focus on the bigger policy perspective and attendant questions commonly
asked—never definitively answered.
Why do servicers resist loan modifications when the clear economic consequences in terms of net
present value to the “lender” would appear to yield much better results than a foreclosure sale in a
distressed market, less costs of administration? Many focus upon the latter as the driver: the servicers
generate substantial fees in the foreclosure process. The government programs fix upon this aspect and
attempt to sway the servicers’ economic decision by offering a few thousand dollars for modification to
offset the benefits of foreclosure-related fees. But this has not worked—not at all. The reason is clear if
we step back two more steps.
At the inception, the securitizations were mass-produced models of complexity. They are a bewildering
assembly of “boiler plate” common to financings plus special twists that make each one a little different
from the next. These little twists make calculation of the specific payouts across dozens of the trusts
uncommonly difficult. Imagine a servicer with “rights” to service dozens of different trusts with complex
internal ladders of senior/junior tranches that drive re-allocation of payments from one group of
investor payees to another. These are often referred to as “waterfalls”. These waterfalls are driven by
“designed to fail” mortgage loans that go into default. The effect was intended, the triggers to default
were combinations of negative amortization, illusory teaser interest rates and last but not least a very
steep “cliff” that homeowners face when the current payment amounts hit a rest calculation 3-5 years after loan origination. Again the question arises as to why an originator would intentionally create a predictably defective loan. Again the answer lies buried among the boilerplate paragraphs in the seldom-read twists.
In the beginning, the trusts were constructed of ladders of “groups” of mortgage loans [promissory
notes] associated with “classes” of so-called mortgage-backed securities [“MBS”]. The various Classes
are commonly referred to as tranches—using finance terminology that usually referred to different
maturity classes in a conventional securitization pool. For example, a pool of “Group I” mortgage loans
were associated with a pool of “Class I” MBS. The two were theoretically matched: payments in from
homeowners were pooled and paid out to MBS investors. However, these “senior” Class I MBS payouts
were further “supported” by current payments received from mortgage loans associated with junior
classes of MBS. Some refer to this as “over-collateralization”. The investors themselves bought “notes”
issued by the special purpose vehicles [“SPVs”], which could either be affiliates of the originator/securitizer or the so-called trusts. The senior Class I MBS “notes” are payable as ARM investments with periodic payments set to match the full life of the associated mortgage loans. As noted above, the senior Class I MBS investors actually looked to forecast interest rates and the prospect of future payments out of all of the mortgage loans associated with the entire trust—all classes. In other words the senior investors’ returns are virtually guaranteed by all the payments of all the homeowners. There was little risk. These investors paid a premium for these senior classes to refect lack of risk due to over-collateralization, combined with an apparent solid expectation of rising interest rates. The underwriters set up these structures with a view to marketing. The underwriter could approach an investor and tout the safety of seniority and upside of interest rates. A guaranteed “IOU”. Although there were associated mortgage loans, these investors’ due diligence did not require investigation of the quality of the loans in the associated Group I mortgage loans. These investors looked to over-collateralization for payment. The MBS were marketed in this way. Nobody felt a need to look at the quality of these Group loans. That is why the worst loans, the predatory loans, the “air” loans [eg. falsified loans on non-existent condos located above the top story of a high rise] were concealed in the group I loan pool. The concealment was furthered by fairly consistent patterns of failure to file
“mortgage loan schedules” typically required by the securitization documents. These documents—
usually the Indenture—expressly provided for the filings of loan lists detailing aspects of the loans with
both Securities Exchange Commission [“SEC”] and (usually) the Delaware Secretary of State UCC
“financing statement” records. The failures to file loan lists—“missing loan schedules” are observable
from the docket of the SEC for every trust, in tandem with identification of the provision in the
Indentures where a “manually filed” exhibit is referenced. Any losses suffered by owners of these MBS
in 2007-2008 were due to unknowing panic sales or sales that were forced to meet margin requirements
elsewhere. There was no investor fraud associated with these senior classes.
Conversely, some investors in more junior classes received a different marketing pitch and product. For
argument’s sake, let’s say that the trust also included a pool of “Group III” mortgage loans. The Group III
loans are “salt of the earth” loans. These loans are straightforward 30 year fixed rate plain vanilla
conventional loans with no bells and whistles, good documentation, etc. [please note this is a premise
not necessarily a fact]. These Group III loans were superficially associated with junior Class III MBS. The
class III prospective buyers were directed by marketers to look to the associated “safe” mortgage loans
for recovery of investment—and interest. These investors either ignored, overlooked or were misdirected.
They did not take into account the impact of the over-collateralization benefits granted to the
senior Class I MBS holders. These investors needed to examine the quality of the toxic Group I loans that
purportedly supported the senior Class I holders. They did not. They did not even perform the due
diligence necessary to make the simplest of determinations—that in most cases the loan lists were
never filed with the government agencies that the SEC filings represented. These investors were the
teachers and other pension funds. The extent of the fraud on these investor managers was matched
only by their negligence/assumption of risk.
The foregoing sets the stage for the events 2007-8. The original toxic trusts began to really blossom in
2004. They took off. Massive outreach programs were launched to train mortgage loan broker personnel
how to aggressively market the Group I toxic and other loans to “anybody with a pulse”. They needed to
produce loans rapidly to feed the securitization and earn the tax-free SPV premiums. This is well-known.
By 2007, the earliest toxic loans were hitting the “cliff”—facing unsustainable dramatically higher
payment resets. Now the rest of the structure begins to kick in and the motivations of the then creators
and today’s servicers comes into focus.
The Group I loans that go into default cease current payments to the trust. However, the Class I MBS
investors MUST BE PAID. The waterfall kicks in. Current payments by Group III mortgage loan payers are,
in effect, diverted from paying Class III MBS teachers pensions to paying the holders of the Class I MBS
preferred “in the know” underwriter customers. The senior status of the Class I investors went into
effect. As the 2007-2008 debacle gains momentum, more group I mortgages fail and more current
payments are diverted from the Class III investors to Class I investors. Panic sets in and the entire MBS
structure comes under a cloud. In the know bottom feeders buy up Class I MBS for a fraction of their still
solid NPV. Class III investors are coming up short with worse times to come. These MBS sell for pennies.
These investors look to government buyout programs, insurance—anything to recoup.
The disintegration of the group I mortgages accelerates as all approach reset and the economy tanks.
Homeowners lose long-held jobs and must relocate to find new jobs. Their homes are now well below
water, no matter what the original loan to value ratio. They abandon homes to the foreclosure mills.
This is a well known scenario. But the unanswered question remains: What happens to the growing
volumes of incoming foreclosure proceeds? Who gets these monies?
The answer to this seeming imponderable is found in the servicing agreements. The servicer deposits all
receipts from current payments and foreclosure proceeds into a “collection account”. Payments are
made as per the terms of the MBS to the MBS investors from this account. However, the twist is that the
payments to the junior MBS classes, such as the Class III MBS, can be sourced exclusively from current
mortgage loan payments after the re-allocation of payments to the senior Class I MBS. By EOY 2008,
70% of the early 2004 Group I loans have defaulted—no current payments made. This 70% shortfall in
receipts available to the Class I holders is “made up” by shifted funds from Class III holders. At the same
time as the servicer is short-paying the Class III holders, the servicer is literally swamped with incoming
proceeds of foreclosure from all Groups—worst being toxic Group I mortgage loans. The terms of the
trust do not allow the servicer to distribute the foreclosure proceeds. The foreclosure proceeds instead
cause the servicer’s “collection account” balance to grow exponentially. The terms of the servicing
agreement, not surprisingly, contemplate this easily foreseeable eventuality.
Under older less aggressive securitizations and escrow arrangements a common benefit to servicers and
banks alike was the ability to retain the income from investment of the collection account balance. In
the “old days” this balance typically arose from timing differences between escrowed insurance and real
estate tax receipts versus payments to insurers and county governments. However, the same rules were
applied to these trusts. The balance of the entire trust’s loan amounts outstanding was and is shrinking.
Simultaneously the servicer’s related “collection account” is burgeoning with foreclosure proceeds.
Theoretically these proceeds must be held intact until the amounts are called upon to make distributions in the distant future to the Class I senior MBS holders. So after the Class III salt of the earth payers have themselves failed or refinanced, the proceeds might be needed. The servicer is stuck with large cash surpluses in the collection account. Once again by careful forethought the servicing agreement provides that the servicer may invest the proceeds of the surplus [foreclosure proceeds] in some worthwhile investment of several types typically set out in the servicing agreement. But there is no oversight and only in years’ far in the future will failed or fraudulent investments be felt by the Class I investors for whose purported benefit these sums are maintained. However, the servicer is expressly entitled to retain the entire income stream from this collapsed structure.
This series of events explains why servicers are REALLY anxious to foreclose—even if the decision
appears from the outside to make no sense. It explains why servicers have paid large sums for the
“servicing rights”—which most unknowing souls believe relates primarily to skimming fees. The true
incentive for the servicer is control over the ever-growing pool of foreclosure proceeds—similar to a life
estate. This is the last step on a long trail of American tears. It appears superficially to be legal but for
the original deceptions. That is why the worst trusts were made by fly by nights and they conveniently
file for bankruptcy. By connecting the servicers today to the original trust structure planning, the
servicers be deprived of their ill gotten gains and justice be done. This cycle will repeat itself absent
intercession by government.
© 2010 FORECLOSURE FRAUD | by DinSFLA
© 2010-13 FORECLOSURE FRAUD | by DinSFLA. All rights reserved.