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The Big Fail

posted by Adam Levitin

Last week the US Bankruptcy Court for the District of New Jersey issued an opinion in a case captioned Kemp v. Countrywide Home Loans, Inc.  This case looks like the first piece of evidence in what might turn out to be the Securitization Fail or, in homage to Michael Lewis, The Big Fail.

Briefly, Countrywide as servicer filed a proof of claim for a mortgage in a bankruptcy case on behalf of Bank of New York as trustee for a securitization trust.  The bankruptcy court denied the claim because there was no evidence that Bank of New York ever owned the mortgage. The mortgage note had never been negotiated or delivered to Bank of New York, despite the requirement to do so in the Pooling and Servicing Agreement (PSA) that governed the securitization of the loan.  That meant that Bank of New York as trustee had no interest in the loan, so the proof of claim filed on its behalf was disallowed. 

This opinion could turn out to be incredibly important.  It provides a critical evidence for the argument that many securitization transactions simply failed to be effective because non-compliance with the terms of the transaction:  failure to properly transfer the mortgage meant that the mortgages were never actually securitized.  The rest of this post explains the chain of title issue in mortgage securitizations and how Kemp fits into the issue.  

Note and Mortgage Transfers in Securitizations

A residential mortgage securitization is a transaction that involves a series of transfers of two types of documents:  mortgage notes (the IOUs made by mortgage borrowers) and mortgages (the security instrument that says the lender may foreclose on the house if the borrower defaults on the note).   Ultimately, both the notes and mortgages need to be properly transferred to a trust that will pay for them by issuing securities (backed by the mortgages and notes, hence residential mortgage-backed securities or RMBS). If the notes and mortgages aren't properly transferred to the trust, then the securities that the trust issues aren't mortgage-backed and are worthless. 

So the critical issue here is whether the notes and mortgages were properly transferred to the securitization trusts.  To determine this, we need to figure out two things.  First, what is the proper method for transferring the notes and mortgages, and second, whether that method was followed. For this post, I'm going to focus solely on the notes. There are issues with the mortgages too, but that gets much, more complicated and doesn't directly connect with Kemp.

 1.  How Do You Transfer a Note? 

A. The American Securitization Forum's Argument

The American Securitization Forum (ASF) has a recent white paper that purports to explain how notes and mortgages are transferred in a securitization transaction.  The white paper explains that there are two methods for transfer and that either can suffice, although typically both are used. Those methods are a negotiation of the notes per Article 3 of the Uniform Commercial Code (UCC) and a sale of the notes per Article 9 of the UCC (take a look at the definitions of security interest, debtor, and secured party to understand how UCC 9-203 functions to effect a sale).   (The ASF argues that the mortgage follows the note, meaning that a transfer of the mortgage effects a transfer of the note.  I've got my doubts on this too, but that's for another time.) 

B. Trust Law and the UCC Permit Parties to Contract for a More Rigorous Method

The ASF white paper is correct to the extent that is explaining how notes could be transferred from, say, me to you or from Citi to Chase.  But that's not what happens with a securitization.  A securitization involves a transfer to a trust, and that complicates things.  

It's axiomatic that a trust's powers are limited to those set forth in the documents that create the trust.  In the case of RMBS, that document is the Pooling and Servicing Agreement (PSA).  Most PSAs are governed by NY law, which provides that a transaction beyond the authority of the trust documents is void, meaning it is ineffective.  

PSAs typically set forth a very specific method of transferring the notes (and mortgages) that goes beyond what is required by Articles 3 or 9.  This is perfectly fine under the UCC, which permits parties to deviate from its default rules by agreement (UCC 1-203), which can be inferred from the parties' conduct, including the PSA itself.  So what this means is that if a securitization transaction did not meet the requirements of the PSA, it is void, regardless of whether it complied with the transfer requirements of Article 3 or Article 9.  The private law of the PSA, not Article 3 or Article 9, is the relevant law governing the final transfer in a securitization transaction. 

There is some variation among PSAs, but typically a PSA will have two relevant transfer provisions. First, it will have a recital stating that the notes (and mortgages) are "hereby" transferred to the trust.  This language basically tracks the requirements of an Article 9 sale.  Second, it will have a provision stating that in connection with that transfer, there will be delivered to the trust the original notes, each containing a complete chain of endorsements that show the ownership history of the loan and a final endorsement in blank.  The endorsement requirement invokes an Article 3 transfer, but it imposes requirements (the complete chain of endorsements and the form of the final endorsement) that are not contained in Article 3.  

There is a very good business reason for having the full chain of title in the endorsements:  it is evidence of the transfers needed to ensure the bankruptcy remoteness of the trusts' assets. Bankruptcy remoteness means that the RMBS investors are assuming only the credit risk on the mortgages, not the credit risk of the originators and/or securitizers of the mortgages, and RMBS are priced based on this expectation.  

It is also clear that historically the method of transfer for RMBS securitizations was endorsement, not recital of sale. The promissory note sales provisions of Article 9 only went into effect in 2001 (in 49 states).  Pre-2001 PSAs contain the sale language, however, as post-2001 PSAs. This indicates that the "hereby" language is really carryover boilerplate; in 2001, it was ineffective to transfer a note under Article 9 of the UCC. While that language might have been sufficient for a common law sale, it wouldn't work for a transfer to a trust under NY law. When assets are transferred to a NY trust, there has to be actual delivery in as perfect a manner as possible; a "mere recital" doesn't cut it (and frankly, endorsements in blank might not suffice either because there is nothing that indicates that something endorsed in blank is trust property, rather than the trustee's or someone else's).  

2.  Was There Compliance with the Trust Documents?

So to tie this all back to Kemp:  the note in Kemp lacked the endorsements required in the PSA.  That means, as the Bankruptcy Court concluded, that the note was never transferred to the trust at the time the bankruptcy claim was filed.  The Bankruptcy Court did not need to opine beyond that point, but it is a small step to recognizing that if the loan wasn't transferred to the trust in the first place, it cannot be transferred now.  PSAs contain numerous timeliness provisions about loan transfers, often related to ensuring favorable tax status for the trust. PSAs also require the transferred loans be performing (not in default). That means that for the securitization trust, the Kemp note is like caffeine in 7-up:  never had it, never will. The securitization of the Kemp note failed.

Now here's the real kicker: there's no reason to think that the Kemp note was a unique, one-off problem. All evidence from actual foreclosure cases points to the lack of a chain of endorsements on the Kemp note being not the exception, but the rule, and not just for Countrywide, but industry-wide.  Certainly on the non-delivery point (separate from the non-endorsement problem), Countrywide admitted that non-delivery was "customary."  If either of these issues, non-delivery or non-endorsement is widespread, then I think we've got a massive problem in our financial system.

3.  Implications for Various Parties

Below I briefly review the implications for several types of parties.  

Bank Regulators

Federal bank regulators should be all over this; there is monstrous systemic risk potential.  The new Financial Stability Oversight Counsel, as well as the OCC and the Fed and FDIC should all be doing very targeted examinations of the large trustee banks' collateral files to grasp the scope of the problem.  I don't know what they're actually doing, but I'm afraid that they aren't undertaking the proper investigation.  Fortunately, this particular issue is easily within the expertise of bank regulators: just go to the collateral files and start looking at a large sample of notes. See how many are missing complete chains of endorsement or lack signatures altogether. That will be a very quick way to tell if there is a problem. 

I'm also very concerned that some banks might decide to start filing in chains of endorsement and backdating. But that's fraudulent, you protest!  Surely no bank would ever engage in fraud! Of course backdating signatures is fraudulent, but if the signatures aren't there, the banks are dead, so there's really no downside in having some underlings fill in their signatures. If caught there likelihood of jail time is low. Why not bet the farm? Bank regulators should be very sensitive to this potential problem. They should insist on being the ones who actually select the collateral files to be reviewed and that they are the ones who pull the actual note out of the file. The examiners should be making digital images of all notes that they review and keeping those for potential examination against the actual notes if those notes are produced in future foreclosure cases.  

My concern here is that the bank regulators so badly don't want for there to be a problem that they won't look at the notes in the hopes that this issue goes away. I hope that they are sensible enough to know that if there is a problem, they cannot prevent it, and would do best by gathering up all the information they can.  

SEC and Accountants

If the mortgages weren't properly transferred, there could be a variety of securities law violations, including servicers' regular Reg AB attestations. There could also be securities law violations on behalf of the banks--if the assets weren't properly transferred, they are still on the banks' balance sheets (as are the losses) and should be accounted for as such. 

Ratings Agencies

The ratings agencies should be all over this issue. It goes to the question of whether the collateral backing the MBS is there and whether the representations made to them about deals was in fact correct. I have heard, but cannot verify, that ratings agencies were themselves able to inspect the actual notes. If so, then there is a real conflict of interest on this point, as they should have caught this facially obvious problem. Unfortunately, the materials I've seen coming out of some of the ratings agencies make me concerned that they simply don't understand the legal issue involved and may not even understand the difference between the note and the mortgage.  

Banks (Securitization Sponsors)

The banks are in serious trouble if there are widespread securitization fails. If the loans weren't transferred to the securitization trusts, then they are on bank balance sheets, which means that (1) the losses on the loans are the banks (to be sorted out with the investors), and (2) the banks need to be holding capital against the loans that haven't gone into foreclosure.  Depending on the scale of the problem, the banks might not have enough capital to cover the securitization fails, which means we're in Dodd-Frank resolution territory. 

Investors

If the notes weren't properly transferred to the trusts, then investors have the mother of all putback claims.  Investors probably also have claims against securitization trustees and against the law firms that did diligence on the securitization deals. (Note that these same firms are the ones lining up to swear that there isn't a problem....). Of course, the danger for investors is that there is a huge problem, and the banks lack the money to fix it. 

Let's be clear that investor interests here are split. AAA investors who are still well in the money would prefer to simply be paid out on their RMBS at 100 cents on the dollar than mess with putbacks. But mezzanine (like CDOs) and junior investors have a lot of potential upside here. 

Monolines

This could be very awkward for the monolines. Generally they promise timely payment of principal and interest to investors. If that coverage obligation continues while the monolines make rescission claims, they might have to pay out of pocket first and then look to the banks for recovery. If so, they would be in a heck of a liquidity pickle. 

Homeowners

Chain of title doesn't affect whether homeowners are in default on their loans.  The loans' validity is not in question because of chain of title. But chain of title does affect who has the right to foreclose. At the very least, if there is a chain of title problem, it means lots of foreclosures cannot properly proceed because of lack of standing. On the other hand, if the loans weren't actually securitized, they are on banks' books, which might, just might, facilitate workouts. More generally, if there is a widespread securitization fail, it means that there will have to be a legislative solution to the problem, which might facilitate real loan modifications.

Comments

Agencies did NOT have access to notes. It was a consumer privacy issue.

I reread the decision and I don't see that the court relied upon the requirements in the PSA to disallow the claim, as your post implies. The decision sees to rely mostly upon the non-possession of the note by the party listed as the principal, and the particulars of the UCC that does not recognize an interest for a holder without possession.

Did I misread your post, or did I misread the opinion?

David,

My post wasn't perfectly clear on this. The court ruled on the basis of New Jersey's version of the UCC, which requires delivery. But on this point the UCC and the PSA are identical. Even if you go with the argument that the UCC governs, then there's still a problem of lack of delivery; absent delivery, the note, even if sold, isn't enforceable against the debtor by the buyer per UCC 3-203. UCC Article 9 only applies to the sale of the note, not its enforceability against the debtor.

To be fair the lawyering for CW in this case was all bollixed up (citing the wrong version of UCC 3-309, etc.) , but that's hardly unique--the lawyering for US Bank and Wells Fargo in the Ibanez case in Massachusetts was astonishingly poor too. They couldn't even get the critical documents into the record.

Professor, couple of quick things - don't let them get wrapped around your axle TOO tightly...

I'm guessing that you may have simply become a tad turned around in thought as it is easy enough to do when someone refers to a "mortgage" and a "mortgage note". I've always tried to stick with "mortgage and promissory note" simply for easier distinction. You wrote,"(The ASF argues that the mortgage follows the note, meaning that a transfer of the mortgage effects a transfer of the note. I've got my doubts on this too, but that's for another time.)"

At p4 graph 1, The ASF White Paper states, "When a mortgage note is transferred in accordance with common mortgage loan securitization processes, the mortgage is also automatically transferred to the mortgage note transferee pursuant to the general common law rule that “the mortgage follows the note.”

Just so I'm clear, does that not simply state that the transfer of a note automatically effects the transfer the mortgage and NOT that the transfer of a mortgage automatically effects the transfer of a note??

More importantly, while there may never be a way to verify this, if I'm not mistaken, the reason for the sheer volume of Lost Note Affidavits floating in every county registry may not simply because notes were "lost" but because the trustee and/or servicers realized early on that the notes were never properly indorsed and "disappeared" the physical piece of paper and any allonges thereby eliminating any evidence contrary to the trust's ownership of the notes.

That said, despite Article 3 upholding "lost note affidavits", it simply seems counter-intuitive to me that something as legally non-descript as a "lost note affidavit" actually holds water in a court with regard to ownership. Simply by it's very creation, a "lost note affidavit" is an admission of lack of possession of the physical note on ANYONE'S part thereby eliminating, at least in my mind, any arguments of agency, etc.

Obviously, if someone - ANYONE - knows the location of a particular promissory note it is not "lost". And if the location is known, "possession" and/or "ownership" can then be argued. How is it possible to legally argue ownership of ANYTHING once you have admitted, in writing and recordation no less, that the thing in question is, in fact, lost? "We don't have it, we can't produce it, we don't know who has it or where it is, but we still OWN it." seems to go hand in hand with childhood cops and robbers "Bang, I shot you!" "No, you missed!!!" arguments....

Or maybe I'm oversimplifying the whole thing....

For those lawyers who do offer the service, it is now more expensive for their clients because it takes more of their time. This means that you will pay more for bankruptcy under the redesigned bankruptcy laws. For example, bankruptcy lawyers now have to personally attest to the accuracy of the information provided by their clients in the bankruptcy courts. This means that they have to take the time to personally research all of the information provided by their clients. The more time a lawyer spends with a client's case, the more that case will cost.


"The Bankruptcy Court did not need to opine beyond that point, but it is a small step to recognizing that if the loan wasn't transferred to the trust in the first place, it cannot be transferred now. "

This case was about whether the note could be enforced; the court acknowledges that the trustee could own the notes. Assuming the trustee does have legal title, then it would seem they could ship the notes to the trustee's place of business at anytime. (as long as they do it prior to trying to enforce the notes, that is)

Great post. Two comments:

1. The court states that "the purpose of the possession requirement in Article 3 is to protect the debtor to multiple enforcement claims to the same note." That's also why we make people record deeds and mortgages. With all this laxity in "chain of title" on both the note side and the mortgage side, and given that humans seem endlessly resourceful about such things, it seems like somebody out there might have noticed that laxity and taken advantage of it. Is there any evidence out there yet of servicers selling the same note to more than one ultimate "holder?" I imagine that it would be difficult to pull off this kind of fraud if the ultimate "holder" (or agent or servicer acting on the holder's behalf) did the tiniest bit of diligence, such as checking whether the mortgage had been assigned to anyone else of record (in the Kemp case, there *was* a recorded assignment of mortgage).

2. If there *isn't* a widespread problem of "multiple enforcement claims on the same note" (and maybe even if there is), aren't the Bank of Americas of the world simply going to use their political pull to get Congress and/or state legislatures to "cure" all of these errors ex post facto?

Totally creepy that the note in question relates to a house on a neighboring street.

I would love to hear a similar discussion regarding the transfer of mortgages.

Could somebody explain the economics of the "note owner with power to enforce" getting a relief from stay? Most discharges or dismissals happen relatively quickly in legal time. Doesn't it make more sense to wait? Or, is the willingness to go on offense too important for the "enforcers" not to seek relief, at least occasionally? Use it or lose it?

I am confused about 'ownership' of the note in the securitization process: The securities themselves were broken down into 'tranches' -- with investors buying different tranches based upon return and risk.

Were these tranches assigned specific notes, or were the tranches merely assigned payment priority based upon their tranche position in the securitization?

If they were never sold specific notes, but only a income stream, did the investors ever actually buy any notes at all -- even it all assignments were done by the book?

If each tranche is assigned specific notes, then shouldn't the chain of title lead directly to the correct tranche.

This may be a basic question, but I would appreciate clarification. Thanks.

Adam, I have a loan that is in foreclosure that wasn't transferred into a Trust (GSR 2007 OA1) until 3 YEARS later when they wanted to file the NOD. So I am very interested in this topic. But my question is if the foreclosure goes through (a non-judicial in CA) who gets the money from the sale? And does that leave me (and many others in this situation)with a potential for an issue many years from now when they figure out the law and find the wrong party was paid? What are the issues for the homeowners in all of this mess?

The intentional selling of notes to investors more than once that the banks knew would not be paid in full, explains:
(1) why a bank would give or buy a mortgage to a person very likely not to be able to pay,
(2) the alleged sloppy paper work, and
(3) the attempted cover up with robo signers.

The banks (by selling a bad note more than once)were simply short selling the bad mortgages (as was Goldman and Paulson)and hoping to make a lot of money on each foreclosure with a deficiency.

Neither the large banks nor their NY attorneys are stupid. Thus, intentional fraud and not negligence best explains the facts coming out.

Mduclos:

The trust owns the notes.

The securities that CDO invetors own, the tranches, are a claim on the income of the trust. The prospectii are quite specific as to how the tranches get paid. But the individual tranches don't own anything themselves.

There are very good articles out there on how this works.

by a strange twist of fate perhaps the 2nds that were never securitized or sold (assuming proper recordation)could now become first while the original first becomes unsecured. maybe this is why all of the big banks still carry them at par as they know their true priority.

If the note is valid but not securitized can't the holder of the note sue on it and be compensated from the note signer's estate whatever it encompasses including his house?

Archie-

Most note signers estates are underwater. There is nothing to get but the house and all the subsidized government guaranteed goodies that come from foreclosing

the rights from securitization are the only scraps left....Thats one of many reasons a "note holder" (banks? trustee? anyone?) wouldnt do that

Having established that the trust can't foreclose... how would an investor go about the process of establishing clear title to a home whose title wasn't passed correctly to a trust?

You state: "So what this means is that if a securitization transaction did not meet the requirements of the PSA, it is void, regardless of whether it complied with the transfer requirements of Article 3 or Article 9."

First off, what constitutes a "securitization transaction". Presumably, any and all transactions by or for the benefit of the Trust?
Presumably, the "after the fact" endorsments to assign the note to the Trust?

Assuming such transactions would include the endorsements necessary to "after the fact" transfer the note to the Truste, what do I gain by arguing in Bankruptcy Court that all transfers of the note "after the fact" are "void"? If the transfers are void, there may be serious implications as between the original lender and the Trust, but I don't see how that finding helps me in my representation of the homeowner. That is, if the transfers are fatally "void", that would simply mean that the note is still held by the original lender. In such an chess match, what keeps the original lender from getting to checkmate by simply assigning the note to whatever entity it wants, including the Trust?

For example, what keeps the original lender from "gifting" the note to the Trust "after the fact" if only to mitigate damages as between the original lender and the Trust? Can such a Trust accept a gift?

Or did you mean that the Trust itself is "void", in which case there is no legal entity to serve as donee or transferree?

Even if the Trust itself is "void", I am still back to the same problem, am I not? In this scenario, even if the Trust is void, the original lender is owner of the note and, as owner, it can simply assign it(or gift it) to whatever entity it wants. Right? And then the foreclosure proceeds anyway, right?

Adam --

I am a bankruptcy lawyer and am familiar with the Commercial Code. Reading the opinion, the Court disregarded as irrelevant that Countrywide, the transferor/servicer, had actual possession of the note, because the proof of claim was filed in the name of BNY. Is that at all logical to you? What possible policy interest is advanced by having the servicers assert claims/relief from stay motions/foreclosure actions in their own names as opposed to in their capacity as servicers, simply because the transferor/servicers retained possession of the note? There is absolutely no risk to the borrower of double payment. In fact, there is no practical consequence to the borrower at all. I just don't get it.

A very brief reply to John Orcutt and David Shemano:

1. CW as servicer had the note, but the mortgage was to BONY. Without the mortgage, CW can't foreclose.

2. CW can't transfer the note to BONY and BONY can't transfer the mortgage to CW because of the way the trust is set up. The trust isn't generally allowed to take new assets after its closing date for tax reasons, and the trust documents specifically forbid the trust to take defaulted loans. So no note to the trust. Similarly, the trustee has no authority to transfer a mortgage from the trust to the servicer so that the servicer can foreclose, and even if the trust could, the trust lacks authority to accept a pile of cash from the servicer.

3. Here's the payoff: if the note wasn't transferred properly, the trust can't foreclose. Someone else (the sponsor? the originator?) might be able to foreclose, but that's a problem for another day whenever they can finally get the paperwork in order, and the costly delay in foreclosure increases the incentive for the banks to do workouts, not least to avoid a world of pain from investor suits. And, at the very least, it gives your client some time.

4. If you're in bankruptcy and a proper claim hasn't been filed by the bar date, you might be able to get the debt discharged and/or the lien stripped. It occurs to me now that one might try a 363(f) sale of the house to the debtor individually for a new, market price note. The lien would be on the proceeds of the note, not on the house. The lender's credit bid (potentially restrictable) would be the biggest problem, I think. Let me be clear that I haven't looked if there is any case law on this in a Ch. 13 context (is this sub rosa redemption? is that a problem or not in light of _Chrysler_?), so this might be a non-starter, but I thought I'd throw it out there as an idea.

On your #4 Adam if you don't know who owns the Note how can you serve them with a summons/Notice and if the the real "Slim Shady" "stands up" like... later on maybe post-discharge, how do you get around the pass-through lien and Anti-Mod? Latches on the 363(f) sale? I think maybe Espinosa might give a bit of help on the "finality" of Plans Res Judicata and all that jazz but you still have a Notice problem especially if nobody knows who has the paper.. I guess as I think through it the lien holder on file at County/Parish(La) Deed Records might give you your due diligence?

For the monolines, its not clear your conclusion is correct. If the securitization wasn't properly constructed (due to a lack of transfer of title to the trust), then the insurance contract would also be invalid. The "mother of putback claims" would greatly benefit the solvency of the monoline insurers.

Adam --

In #1, you appear to be arguing that a mortgage can be separately assigned from the note, and if it is, the holder of the note has no rights against the collateral. Do you have any authority for that proposition? Is not the mortgage a mere incident of the debt that cannot be separately assigned and simply follows the note?

Furthermore, the court in Countrywide, didn't simply hold that Countrywide could not assert a secured claim -- it held it could not assert even an unsecured claim (in its capacity as servicer).

With respect to #3, again, what conceivable policy reason is advanced by denying the holder of the note permission to foreclose because of confusion of rights between the holder and holder's assignee, provided no risk of double-payment? Isn't that the exact opposite of policy underpinning negotiable instruments?

With respect to #4, under what section of 363(f) could the debtor sell free and clear? Bona fide dispute? But there is no bona fide dispute concerning the validity of the debt (as opposed to the identity of the debt holder). And how could the debtor sell to the debtor?

Kudos (with emphasis) to Counsel who argued for Mr.Kemp in this case, Bruce Levitt.

Mr. Levitt has been a pioneer in bringing these issues to the forefront in both the state and federal courts throughout NJ, more often than not without much success until now, although, he has been offering logical and stright forward evidence to many Judges in many cases who in more instances than not have taken the tact of: borrower took the money,therefore, owes the money, end of story.

Disclaimer- Mr. Levitt currently represents me in a pending foreclosure case in NJ, even though biased, I see first hand his understanding, dedication and patience in trying to argue these complex legal issues in front of Judges that for the most part do not understand or care, and for us lamen, almost impossible to understand.

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