The improper transfer of the promissory note - the borrower's promise to pay - to the securitization trust can create havoc in the process. However, the resolution of this problem could serve to re-start the private-label RMBS market. Are the note transfer contrarians MBS reformers or charlatans?

Recent testimony at Congressional hearings has highlighted issues that if proven true and acted upon by investors could severely impact some sponsors of MBS. However, resolving the issues might be necessary for the private MBS market's long-term viability.

Perhaps the most damaging issue centers on the promissory note - essentially the loan, or IOU, containing the borrower's promise to pay the money loaned - and whether that note was transferred properly in the securitization process. A witness's testimony in a recent bankruptcy case, In re Kemp, noted the failure of Countrywide to transfer such a note to its mortgage deal's trustee, the Bank of New York.

As a result, Bank of America, which agreed to a fire-sale purchase of Countrywide in January 2008, might find those mortgages less bankruptcy remote than it might have anticipated and back on its balance sheet.

"If this witness's testimony is true, Bank of America could have a monstrous problem on its hands," said Kurt Eggert, a professor of law at the Chapman University School of Law, before the U.S. Senate Committee on Banking, Housing and Urban Affairs on Dec. 1, 2010.

Eggert and Adam J. Levitin, an associate professor of law at Georgetown University, have expressed concerns about the legality of mortgage transfers by sponsors - who originate or purchase loans to put in a pool to securitize - during the mortgage boom years. Their arguments have, in turn, raised a ruckus in the ABS industry, especially among sell-side firms and their attorneys, because of their potential consequences.

For one, problematic transfers raise questions about a party's standing to foreclose on the mortgages - a securitization trust that never received the note may lack that standing. And some sponsors could potentially find that the asset transfers they accounted for as true sales were not sales at all, requiring them to bring those assets back on to their balance sheets and reimburse investors for their troubles.

Industry's Counterargument

The ABS industry, consequently, has in force come up with counter arguments.

Tom Deutsch, executive director of the America Securitization Forum (ASF), rebutted Levitin's arguments in testimony before the Senate committee on Dec. 1. And major law firms specializing in ABS, including Mayer Brown, Orrick, Herrington & Sutcliffe, and Sidley Austin, were signatories to a 27-page white paper the ASF issued Nov.16 that also aimed to counter the academics' arguments.

So far, said Josh Rosner, a managing director and mortgage analyst at research firm Graham Fisher & Co. and a former mortgage executive at Lehman Brothers and Oppenheimer, there's been little enthusiasm from institutional investors he's spoken with to exploit the note-transfer issue in their efforts to push sponsors to buy back toxic MBS. Nevertheless, Rosner said, it's a "real issue," despite many in the ABS industry's denunciations of the professors' arguments.

"The other side is you need a plaintiff who would be willing to actually bring such a suit," said Rosner, adding that whether there's a legal basis or not, there's a concern among investors and others that "no judge in the world would be willing to potentially blow up the securitization market. There's the law, and then there's reality."

Rosner said part of that unwillingness stems from the hazy nature of the issue, for which there's little direct precedent. He added that his discussions with potential plaintiff attorneys suggest that any rulings would likely be discreet and apply to very specific pools of assets issued by specific sponsors.

Chris Katopis, president of the Association of Mortgage Investors (AMI), launched in early 2010 to represent mostly state pension funds and other institutions investing public money, agreed there's little interest among AMI's members to pursue such litigation. Instead, "The AMI and its members look forward to more standardization of pooling and service agreements (PSAs) and believe this is an important step toward reviving securitization in America," Katopis said. " We think the current system has evolved over the last 60 years in an ad hoc manner according to varying state contract laws."

The Core Issue: PSAs

In fact, PSAs and their widely varying language are at the heart of the MBS legality issues, since during the frenetic years of the mortgage boom little attention was paid to the different terms and conditions set out in the PSAs of MBS offerings. And now the chickens are coming home to roost.

"This [variation in PSA language] requires investors to spend tremendous amounts of time analyzing the differences between different transactions' legal terms and subjectively weighing the economic meaning of those terms before coming to investment decisions - or alternatively to ignore these differences of legal terms in the interest of time, to the peril of investors when problems develop in the market," said the AMI in a white paper published in March about reforming the ABS market.

That creates opacity in the market and reduces liquidity, especially during turbulent periods such as the recent credit crisis.

"You have hundreds of different [PSA] agreements. As a result, investors don't have a standard to understand the rules governing securitization," Rosner said, noting that he started warning the industry of resulting confusion that could arise, especially during periods of market stress, in 2005.

PSAs provide the rules by which notes are transferred to the various parties involved in a securitization. In an MBS offering, a financial institution acting as the sponsor collects a pool of mortgage loans, either by originating them or buying them in the secondary market from another institution. It then sells that loan pool to a special-purpose subsidiary, also known as the "depositor," to segregate the loans from the sponsor's assets and liabilities. The depositor, in turn, sells the loans to a passive, single purpose corporate trust, which issues securities to raise funds to pay the depositor for the loans.

Deutsche testified before the Senate banking committee on Dec. 1 that PSAs usually include a section requiring legal documents for each pool of mortgage loans to be delivered to the trustee, or to a custodian on behalf of the trustee. He further noted that the PSA language typically requires either an endorsement in blank or an endorsement to the trustee, as well as a complete or unbroken chain of endorsements from the originator or named payee to the person signing the endorsement in blank or to the trustee.

However, the ASF interprets "a complete or unbroken" chain of endorsements to mean "only that there be no gaps in the chain of endorsements," and that the chain is "sufficient to effect a transfer to the trust under applicable law," requiring an endorsement only by the trustee.

Deutsch's testimony was in response to Levitin's argument that PSAs require endorsements from each of the entities involved in the securitization process. Under the Uniform Code of Conduct Article 3, Deutsche said, "If there's an endorsement in blank, the note may be transferred to numerous successive parties without any need for a separate endorsement to each purchaser."

On the blog, Levitin responded on Dec. 8 to the ASF by noting that some PSAs do, in fact, simply require a delivery of the note to the trustee. But others - and Levitin acknowledged that number is difficult to quantify - are very specific about requiring an endorsement from each link of the securitization chain.

He quoted from a 2005 MBS transaction's PSA, which provides that the depositor will deliver to the trust "the original mortgage note bearing all intervening endorsements showing a complete chain of endorsement from the originator to the last endorsee..."

"There can be no question that this language is calling for every endorsement from the originator to the trust, and cannot be satisfied with a single endorsement in blank," Levitin added.

In other cases, the notes were not delivered at all to the securitization trust - generally contrary to PSA requirements.

"While delivery of the note might seem a simple matter of compliance, experience during the past several years has shown that, probably in countless thousands of cases, promissory notes were never delivered to secondary market investors or securitizers, and, in many cases, cannot presently be located at all," Eggert said in his testimony.

Eggert said plenty of anecdotal evidence supported his claim. In one example, he referred to statements by foreclosure defense attorney April Charney, who estimated that 80% of the 300 foreclosures she defended in her Florida practice involved lost-note affidavits. Eggert then quoted Charney as saying, "Lost-note affidavits are pattern and practice in the industry. They are not exceptions. They are the rule."

In the In re Kemp bankruptcy case, the court found that the note in question was never endorsed in blank or delivered by Countrywide to the trustee, Bank of New York, as required by the PSA. The court ultimately ruled, Eggert noted, that the Bank of New York could not enforce the note through its servicer, in this case Countrywide, because it had never obtained possession of the note and so didn't qualify as the holder of the note.

The Greater Problem

If indeed widespread and judges are forced to rule, the failure to deliver notes could have a bigger impact than the endorsement issue, since it is in direct violation of most PSAs. That could leave securitization trust assets insufficiently segregated from the sponsor, which may then have to bring the mortgages back on to its own balance sheet.

Such an outcome could probably be avoided if PSAs are written to allow sponsors to hold the notes as agents of the trustee, making delivery of the note unnecessary. Rosner said that's often the case and a reason courts are likely to rule only on specific pools of MBS. Investors, however, are not privy to that PSA information about delivery except through litigation.

Another PSA-related issue, Rosner said, is that most of those trust agreements require the trustee, prior to the offering's closing date, to review the mortgage loan files to ensure that all material documents are included. PSAs then require trustees to send exceptions reports to the sponsors detailing any documents that are missing or incomplete. Sponsors typically have 90 days to correct any mistakes or ommissions, Rosner said, "If the sponsor fails to do so, then most PSAs require the sponsor to buy back those loans," he added.

The Kemp vs. Countrywide case - still awaiting a verdict - illustrates the complexities stemming from PSA language. A Countrywide witness testified that the mortgage lender never delivered the note to the trustee, Bank of New York. Rosner said that in most of the Countrywide PSAs he's read, the mortgage lender is not designated as the agent of the trustee.

Those PSAs, he added, require Countrywide to deliver "in blank" all the notes, mortgage loan files and endorsements to the trustee, which then must review them for missing or incomplete documents. So, if Countrywide was not the designated agent of the trustee by the PSA, then, as suggested by Kent, failure to deliver the note would put it in violation of the PSA.

"If Countrywide never delivered anything, how could the Bank of New York fulfill its obligations as trustee?" Rosner asked.

However, even if Countrywide was designated agent and could retain the note, according to the PSA, the trustee was still responsible for reviewing the loan files and alerting Countrywide of any missing or incomplete documents. So whether Countrywide failed to deliver the note or as agent retained it, failure by the trustee to carry out its responsibilities could bode poorly for it. "Did the trustee, as required, review the mortgage loan files and make sure everything was there? If it didn't, then it becomes more of a trustee failure," Rosner said.

Standard PSAs would give investors a clear understanding of the responsibilities of the various parties involved in an MBS offering. Rosner noted that the ASF has been hammering out standard PSA language for the past three years but has yet to issue a document. "I would argue that the Securities and Exchange Commission and the primary banking regulators, and certainly the Financial Stability Oversight Counsel, have the ability to do this," Rosner said.

Either way, standardizing PSAs appears to be a critical element of MBS reform.

"Standardizing legal documentation gives investors a common framework with which to evaluate their potential and actual holdings of asset-backed and structured finance securities based largely if not solely on collateral pool performance," the AMI noted in its whitepaper. "The asset-backed securities market as a whole would thereby become more homogenous and therefore more liquid."

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