Five years after the meltdown of the subprime mortgage market left investors in residential mortgage backed securities (RMBS) with billions of dollars in losses, participants are still trying to clarify the responsibilities of trustees, servicers, and various other constituents in these deals.

Some clarity may eventually emerge from a slew of lawsuits that are slowly working their way through the legal system, most notably Bank of America’s $8.5 billion settlement with 22 of the nation’s largest institutional investors, which is being contested by numerous other investors.

Market participants aren’t waiting on the courts, however. Sponsors of private label deals that have come to market since the financial crisis are more carefully defining the roles of the servicer and trustee. Congress is also starting to look at these roles.

In the BofA settlement, 65 institutions, including AIG subsidiaries, and the home loan banks of Boston, Indianapolis and Chicago opposed the settlement, saying losses to the 530 securitization trusts could exceed $100 billion and an award of eight cents on the dollar was insufficient.

BNY Mellon, the trustee for the trusts holding the securities, had asked the court to approve the settlement and declare it binding on all investors. Objectors petitioned to intervene and have since sought to overturn it, resulting in the trial that started in early June. The objecting investors argue BNY Mellon failed to adequately pursue claims that Bank of America’s Countrywide unit made false representations and warranties (R&Ws) regarding the securitized loans sold to investors, and it inadequately represented them in the settlement negotiations, alerting them to the initiative only after it was announced.

Creating the Right Incentives

“A big concern for investors is to what extent do trustees or some other transaction parties have incentives and/or obligations to enforce reps and warranties,” said Tom Deutsch, executive director of the American Securitization Forum.

The Bank of New York’s decision to pursue an Article 77 filing, postponing consummation of the settlement until judicial approval of its reasonableness is obtained, is highly particular. Nevertheless, it’s likely to produce some of the early legal decisions that will aid in clarifying the role of participants in RMBS deals, especially trustees. Several dozen other legal suits are in progress, in which investors are suing trustees and, more recently, trustees are pursuing actions against servicers.

The federal government has so far focused its efforts on modifying mortgages and otherwise reducing the burden on borrowers, typically by requiring concessions from mortgage servicers. Members of Congress are now mulling language to clarify the responsibilities of the various parties in RMBS transactions.

Congressional efforts are a part of much broader legislation aimed at reforming the mortgage market and reducing the role of the home loan banks and government conservators Fannie Mae and Freddie Mac, which currently guarantee the vast majority of mortgages. Reforming those entitities has been the primary focus, arguably putting the cart before the horse.  

“Frankly, it’s backwards. Fixing the private-label mortgage market would allow for the rational reformation of the GSEs,” said Josh Rosner, managing director of independent research firm Graham Fisher & Co.

Redwood Trust Leads the Way

The private RMBS market has had only one regular issuer, Redwood Trust, and more recently Wall Street firms including Credit Suisse and J.P. Morgan have entered the market with privately placed RMBS transactions. Those sponsors, in fact, have laid the first marks for what a vibrant private-label RMBS market—capable of replacing much if not all the mortgage volume guaranteed by the federal government—may someday look like.

Redwood introduced its structure in 2010 and has used it in all of its deals since, including the eight transactions it has done so far this year. The structure creates a new entity referred to as a “controlling holder” that is tasked with hiring a third-party to analyze loans after they become delinquent to determine whether there were violations of R&Ws.

In much of the current litigation, still in its early stages, investors are suing trustees, claiming the trustees were in breach of contract because they did not actively analyze loans for those violations and later obstructed investors from pursuing claims against servicers.

Redwood’s transaction structure in some cases removes that responsibility from trustees entirely until it is determined that an R&W violation occurred, restricting them to their reporting and payments role. The trustee only takes responsibility if Redwood is the party marking the R&W or there is no controlling holder.

Trustees traditionally have been paid relatively small fees—approximately $5,000 for a $400 million deal—and in addition to the work involved to determine whether violations occurred, such determinations can draw lawsuits. Consequently, trustees take on liability and must be prepared to defend themselves against potential lawsuits, for not much compensation.

The controlling holder in Redwood Trust deals is the subordinated investor with the largest position, and that has been the Mill Valley, CA-based real estate investment trust. In the first-loss position, Redwood is therefore highly incented to monitor the loan pool for problems and ferret out rep and warranty violations and other breaches.

The third party reports its findings to Redwood, which makes the initial determination whether a breach occurred. If Redwood believes a breach has occurred, it reports that violation to the trust and pursues remedies against the originator who made the R&W.

“Just the fact that Redwood is holding the subordinated piece, and the fact that it’s in a first loss position, means it will do everything in its power to avoid those losses,” said Isaac Gradman, an attorney at Perry Johnson Anderson Miller & Moskowitz and author of the www.subprimeshakeout.com blog.

If Redwood does not believe a breach occurred, then a majority of investors in the deal’s AAA-rated bonds can overrule Redwood and opt to have the trustee continue pursuing action. If they decide on that path, however, they must agree to indemnify the trustee and fund any costs the trust incurs in its pursuit.

Redwood securitizes very high quality, typically jumbo loans, and so far there have been no instances to test the mechanism and how to fund it.

“When it comes down to it, the trustee’s role is to protect bond investors, regardless of the rating of the bonds they own,” said Mike McMahon, managing director at Redwood.

McMahon said that in most RMBS deals the trustee has little financial incentive, ability or desire to act without direction. Redwood’s deals have addressed that problem by explicitly saying either the controlling holder pursues and pays or the AAA investors pursue and pay.

“It doesn’t make sense for the AAA investors to both overrule the controlling holder and then make it pay for the action,” McMahon said.

Credit Risk Manager

Back in the RMBS heydey, most deals were done by Wall Street bank sponsors, which typically sold the investment-grade as well as noninvestment-grade portion of the deals to investors. Given the capital required to hold onto subordinated portions, and the requirement to consolidate the entire deal onto their balance sheets if they also service the loans, banks will likely prefer selling most if not all the deals they underwrite.  

Consequently, they must take a different approach to protecting investors’ interests. J.P. Morgan approached the market in late May with a $510 million RMBS deal that includes a new participant in the securitization trust that’s generically been referred to as a “rep and warranty reviewer. Its precise duties vary among deals, but it essentially checks loans for origination flaws and works with the securities administrator to put back loans, leaving the trustee to focus on other administrative tasks.

J.P. Morgan tapped Pentalpha Surveillance, an independent capital market advisory and operations oversight firm, to test for rep and warranty violations and facilitate put-backs of loans that have been delinquent at least 120 days. Before the recent round of private-label RMBS deals, many investors believed the trustees were tasked with doing or overseeing the identification of troubled loans, obtaining necessary documents, analyzing the data, and effectuating put-backs when appropriate in the context of the securitization.

“I would say most trustees didn’t think they signed up for that,” said Jim Callahan, Pentalpha’s principal.

In the J.P. Morgan deal, there is a notably enhanced governance structure that combines the roles of Pentalpha, the securities administrator, and the trustee. They provide more “teeth” in making sure that the loans are originated according to the applicable underwriting rules. If the R&W provider does not agree to take back the loan, Pentalpha and the securities administrator will step aside and an arbitration process automatically begins that the trustee oversees. The arrangement seeks to resolve the compensation issue for the entity reviewing R&Ws by paying Pentalpha a fixed fee to stand by with systems and qualified personnel and a variable fee to examine delinquent loans as they arise.

Pentalpha has no stake in the deal, and neither did it participate in creating or securitizing loans in the J.P. Morgan deal. Pentalpha was named upfront in the deal’s documents, so investors and rating agencies could vet the firm, Callahan said, adding that investors also hold a termination option if they determine Pentalpha is not meeting expectations.

The Association of Mortgage Investors (AMI) has been promoting the notion of a CRM for at least three years, describing it in detail in its comment letter on the SEC’s Reg AB-II proposal.

“You can’t say there’s a functioning system where the trustee is allowed to fall down on the job, and when there’s a problem investors have to go kicking and screaming to receive compensation,” said Chris Katopis, executive director at the AMI. “But regrettably for RMBS investors that’s the system we live in.”

Gradman said trustees have tended to stand in the way of RMBS investors pursuing litigation against servicers in the years following the mortgage meltdown. They alone had legal authority to request loan files from banks, but they opted instead for tactics to delay exercising that authority.  

“There was a sort of Catch-22 for bondholders, because they initially came to trustees with complaints, but before trustees acted they asked investors to show specific evidence of problems, which most bondholders could only get through the trustee asking for loan files,” Gradman said.

The tide began to turn in early 2011, when news emerged about Wells Fargo, as securitization trustee, suing EMC Mortgage over loan files. Since then, said Gradman, trustees have been noticeably more cooperative.

Nevertheless, that cooperation hasn’t been across the board, and there’s no writing in stone to ensure more cooperative trustees remain so. The legal process takes time, and suits that may have been filed a few years ago are still in their early stages. BNY Mellon’s suit in relation to the Bank of America settlement is the first of its kind.

Test Case

“It’s not the perfect case to test what the role of trustee is because of its unique circumstances, but there will be certainly be interesting rulings and clarifications to come out of it that may help guide trustees going forward,” Gradman said. He added that another suit that went to trial, AGO vs. Flagstar, was brought against a bank by a bond insurer, which was awarded 100% of its losses.

For example, he said, the court has found the objectors have a plausible claim the trustee did not act in a reasonable manner vis a vis all the investors, and that it had acted under a conflict of interests, given BNY Mellon gets more than 60% of its trustee business from Bank of America. “So it certainly has incentive to keep Bank of America happy while at the same time it’s indemnified for any liability from not pursuing put backs,” he said.

Gradman said the court allowed objectors to the settlement to obtain certain privileged communications between BNY Melon and its counsel, to better understand how the settlement came about.

“It’s pretty unusual for the court to rule that the defendant has waived attorney-client privilege, given its actions, and it’s necessary to disclose those communications,” Gradman said.
Strong legal precedents could serve to establish guidelines for the responsibilities of participants in RMBS, but that’s likely a ways off. Rosner said the biggest challenge now—and it must be resolved sooner rather than later if the private-label market is to return in sufficient volume—is simply a lack of leadership.

“The SEC has every ability to make it clear that in every RMBS issued, the trustee has its primary obligation to investors … Congress could also define this as a fiduciary relationship,” Rosner said.

So far, however, there’s been nary a peep about this issue from the SEC, although presumably something could appear in the regulator’s long-awaited Reg AB II proposal, which was first issued in 2010, reissued in part the next year, and place on the back burner ever since until rules stemming from the Dodd-Frank Act subside.

Possible Legislation

Congress is the other initiator of industry standards, and there are rumbles on Capitol Hill about possible legislation that could clarify the responsibilities of RMBS participants toward investors.
Senators Bob Corker (R-TN) and Mark Warner (D-VA) proposed legislation June 12, called the Secondary Mortgage Market Reform and Taxpayer Protection Act of 2013, whose main goal is to create the Federal Mortgage Insurance Company (FMIC) to replace Fannie Mae and Freddie Mac. It would require private market participants to take the first loss portion of a security and insure the rest, and as part of the bill, the FMIC is required to develop uniform securitization agreements for the covered securities.

PSAs, or pooling and service agreements, are entered into before the initial funding of an RMBS deal or the transfer of assets to the trusts, and they represent the agreement between the trustee and the third-part servicer that actually performs the collection of income from the pooled loans.

“That standardization would be an immensely powerful and productive approach and could be implemented by industry or government,” said Gradman. “There should be some standardization of guarantees that investors are protected, because I don’t think they have the ability to vet and do the due diligence on every deal, and nor should they.”

The staff of Senator Sherrod Brown (D-OH) is instead working on legislation called the Foreclosure, Fraud and Homeowner Abuse Prevention Act. It’s aim is to address the private-label market and clarify the duties of the trustees and servicers in RMBS by amending The Securities and Exchange Act and the TIA, according to Lauren Kulik, a spokesman for Senator Brown.

The legislation would extend the TIA to MBS by placing more fiduciary duties on the servicer, rather than the trustee, and it would permit 50% investors to remove the trustee. That provision first appeared in 2011 legislation that was worked on by Senator Brown and former Congressman Brad Miller (D-N.C.), and Senator Brown is now in the process of reintroducing the legislation and discussing with various stakeholders how to improve, perhaps by lower than the 50% threshold.

“We want this to be a part of the conversation,” Kulik said, adding, “When we start doing housing finance reform, we want these ideas to be out there and considered.”

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