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Lots of Smart People Couldn't Possibly F*%! Up, Could They?

posted by Adam Levitin

In relation to the chain of title argument on securitization, I have been repeatedly confronted (often unsolicited) with an argument that there's no way there were massive screw-ups because thousands of top Wall Street legal minds were working on securitization deals.  Yes, and there's no way the underwriting was lousy on the mortgages themselves because thousands were being done.  I tend to get this argument from people with a large financial stake in ensuring that securitizations don't fail. This is a really bad argument, so let me just debunk it now (and hopefully never hear it again):

  •  First, even smart people screw up sometimes.  We lesser folks tend to screw up even more. Anyone remember Long Term Capital Management?  Weren't those the "Smartest Guys in the Room?"
  • Second, this isn't generally a question of deal design, which is where the brain power in securitization was applied.  Chain of title is a question of deal execution.  The exception is the question of whether notes can be transferred in blank to a trust, but that's not an essential design question.    
  • Third, the best legal minds in the country weren't doing diligence on endorsements on securitization deals.  Those people who did the diligence faced lots of time and economic pressures militating against careful diligence.  As a general matter, the quality of legal diligence (and I'm guessing other diligence) on most deals, regardless of the quality of the law firm is shockingly bad--often diligence is conducted by associates who have no idea what a problem would look like and are under intense time pressures to get the diligence done in time for a closing date. I think the problem was likely worse in structured finance. Say there were 7,000 mortgages in a typical RMBS deal.  No one wanted to pay out partner bucks to have 7,000 sets of signatures examined.  If a partner reviewed around 50 notes an hour, it would take about two weeks to do the diligence just on this one point and at say $700/hr billing, that would be around $100k in added legal expense and would be time that the partner couldn't spend on other more important matters (like other deals).  If there's enough work to keep everyone busy as can be, as there was during the bubble, why not give the mindless diligence to the first year who is billed out at $200/hr? The point here isn't that $=quality (they don't), but that the mind-numbing diligence on the endorsements was likely done by inexperienced attorneys because of the economics. 
  • Fourth, it's pretty easy to imagine the way an error in the diligence process could occur, even with a diligent associate. Some deals do not require a full chain of endorsements, so there could be a path dependence problem where associates got diligence instructions based on that deal template and then mindlessly repeating the process on another deal that required the full chain of endorsements.  
  • Fifth, there was certainly no incentive for an associate to be overly diligent.  Everyone wanted the deals to happen, no one wanted to stand in the way.  Structured finance associates had no trouble meeting minimum billables during the bubble, so why spend extra time being careful and getting behind on your work and losing the sliver of non-work time that existed?  No one got paid more for finding mistakes in the endorsements. 
  • The ASF white paper says that a dozen or so top law firms reviewed it. If so, this to me is simply proof of the problem--if a bunch of top securitization firms reviewed the ASF white paper and didn't comment about the lack of discussion about trust law, there's a real concern about how well the attorneys involved really did understand the legal framework for securitization. (I would also note that these law firms probably have large exposure to this issue both from having conducted the diligence and from having written opinion letters about the assets being bankruptcy remote, although the "would" or "should" language in those opinions will give some cover as the letters assume compliance with the deal terms.) 
  • Finally, remember Y2K?  We got lucky with that, but we nearly had an example of lots of smart people screwing something basic up.  We'll have to see if this turns out to be a dud Y2K or the real deal.  Of course, if we think it might be the real deal, it might be best to act now, rather than later when there is a real crisis to try and fix things. 

This isn't to say that things are necessarily screwed up, but surely the presence of lots of smart people in designing securitization deals does not support an argument that the deals were properly executed.  


The Smartest Guys in the Room were Enron.

Just curious, but how many securitization deals have you worked on? You were a bankruptcy attorney, right?

Just want to know where all this presumed knowledge about how things "worked" in securitization deals comes from. Since I've seen you make some pretty jaw-dropping mistakes on *bankruptcy* law on this blog, I'm pretty skeptical that you really know what you're talking about.

Enron, LTCM; the both ended the same way; hopefully the principles in this ghastly mess will also end up either in prison or dead.

I doubt that lawyers of any level reviewed any of the individual residential loan docs for securitization of those loans.

In the commercial real estate securitization world where I worked lawyers looked over the docs for each loan.

But I would bet that in the residential loan securitization world the lawyers created standard documents and clerical level people working for the originators filled them in and handled the alleged "assignments" without lawyers reviewing any of them.

Just my two cents. The originators would not have wanted to pay the lawyers to look at even a sampling. The reason this seems likely to me is that hte originators were willing to ignore state laws on recording assignments of mortgages to save $50 to $500 per loan. I'm betting they didn't pay lawyers to look at any of the docs for any of the individual loans.

Many years ago I was retained to give a local counsel opinion on a major secured financing ($x00 million). Enforceability, perfection, and priority. I'm in a smallish state, but the borrowers' principle place of business was in our state. As those things went, I was working almost exclusively with associates in the lender's "white shoe" New York law firm. It was Friday. They wanted to close on Monday. They couldn't close without my opinion. I wouldn't give an opinion until I had read all of the documents. This was before email, so there was lots of faxing going on.

Around 4:30 on Friday, I was reviewing one of around 30 guaranty agreements. When I got to the "action words" (i.e., the words of guaranty) it became very clear that something was very wrong. There was no verb in the alleged sentence. The guaranty wasn't a guaranty. I checked several of the other guaranties, and they all had the same problem. I quickly got on the phone with the senior person with whom I had dealt. I had to insist that they pull him out of a meeting. He didn't believe me at first. He said something like "It can't be wrong. It's the form we use for all of [one of the world's biggest bank]'s deals." Then he read it. He got really quiet and said he would call me back.

I never heard from that fellow. A very senior partner called me a couple of hours later to thank me. Apparently nobody else had caught the error. He suggested that I add some serious money to my bill. Of course, I couldn't really do that, because my client was the borrower, not the lender.

I've always wondered how many deals needed to be reworked because of the bad form. And how many people suffered adverse employment consequences.

The moral: Big firms can really screw up. Even on big deals.

Hank--are you disputing anything in my post or just engaging in ad hominem attack?

Let's consider your ad hominem line. If you think I've made "jaw-dropping mistakes on *bankruptcy* law on this blog," I'd sure like to know what what they were. I'm not aware of anything that rises to that level. There have been commentators who have argued against my assertions on credit card interchange, in particular, but I don't recall anyone telling me I don't know what I'm talking about in the bankruptcy area. If you've got any evidence to back up your claim, please lay it out. Otherwise, I can only conclude that your skepticism is due to your ideological priors.

I'm not sure what assertions in this post you are actually questioning. There are very few factual assertions in this post. As far as I can tell they are mainly in the 3rd bullet point. I know the number of loans in a typical RMBS deal from databases; I know what partners and associates bill from having prepared billing statements in bankruptcy cases; and I know the incentives of law firm associates because I was one, I am friends with many of them, and was married to one.

There's nothing particularly unique about the economics or dynamics of diligence on a securitization deal. I worked on some securitization true sale opinion letters and have done diligence on corporate deals, but I haven't had the pleasure of sorting through thousands of endorsements in an RMBS diligence. (If so, I'd be one of the ones responsible for the screw ups...) I have, however, spoken to people who have spent more hours than they ever wanted doing structured finance diligence, and I have no reason to doubt what they tell me. Again, if you dispute anything asserted in the post, please state so.

RegReader: I think you're probably right. It'd sure be interesting to know how many hours were billed for diligence on RMBS deals. I'm sure the number was far too low for there to have been anything but a sampling. I am told that in the good old days attorneys were much more careful, but that was when these were more bespoke, high profile deals, instead of the factory production of the bubble.

Commercial mortgage securitization is quite different (and I've written about that). There are many fewer properties (about 150 on average) in a deal and a screw up on a single on is very costly. Goof on a commercial property, and that's several million. Goof on a resi mortgage and that's maybe $150K. There is better diligence on commercial deals, not least because the junior tranche holder gets to do a special round of diligence.

Phil: you're right of course. Enron had the smartest guys in the room, and the LTCM guys just had some Nobel laureates working for them (perhaps not in the room). Both are great examples of intelligence not being a guarantee of success.


I posted this at Mike Konczal's Rortybomb a few hours ago, but I think it's also worth adding it here - it's taken from the late Tanta at Calculated Risk in 2007:


On the one hand, mistakes just do get made, in any business. On the other hand, the mortgage industry’s back room got incredibly sloppy during the boom. You had experienced closing and post-closing staff laid off and replaced by temps who don’t know an endorsement from a box of Wheaties, you had loans being sold by brand-new entrants into the business with no experience in these legal transactions, you had gigantic pressures to move loans through the pipeline into a security as fast as possible and paperwork be damned, you had a business too comfortable working on reps and warranties and indemnifications–on a promise to make it good if it ever blows up rather than fixing it now. You had regulators of big depositories that were sound asleep when it came to such operational “trivia.”

There's a lot more in Tanta's archive, from someone who could see all the screwed up interior workings of the beast, but wouldn't live to see it all unravel.


I'm curious. Do you think that the opinion means that the debt represented by the note no longer exists, and that the mortgage is therefore unenforceable? Or is it an issue of getting the note and mortgage legally into the same set of hands?

I agree with you that the implications of this for B of A (by way of Countrywide) and others who originated and "sort of" sold these loans are ominous, because the syndication trusts have, as you say, the ultimate "put." But the bottom line remains that the debtors received the loan proceeds and mortgaged their real estate to secure their obligations. Even if their personal obligations on the loans are discharged, I would think that somebody will ultimately be able to foreclose on the property.

tww--the note still exists and is valid and the mortgage should be enforceable, absent other defects. The only issue is who can enforce it. The holder of the note can definitely enforce the note, and the mortgagee can foreclose if there is a default on the note. There's an interesting question about whether someone with the mortgage, but not the note can foreclose. That's sort of the issue presented by foreclosures in MERS name, as MERS doesn't have the note (excluding e-notes), but there at least MERS can claim that it is acting as a nominee for the noteholder. If you take away the nominee angle, I think it's a trickier question.

For the homeowner, then, the bottom line is that there's a temporary stay of execution and maybe a greater possibility of a workout. But from RMBS investors' standpoint, a securitization fail has critical consequences because the loss on the mortgage is actually the bank's, not theirs.

Thanks, Adam:

I agree with you (I'm sure that helps your self-esteem). When I started reading the opinion, I thought we were headed down the MERS highway. I was pleasantly surprised where we ended up.

I had a case back in the '80s representing the FDIC where the note had been properly negotiated through the "chain of title," but the mortgage had not been assigned, either of record or otherwise. A bankruptcy trustee objected to our claim. We prevailed based on the doctrine that the lien follows the obligation. The lien was of record, so no subsequent "purchaser" could trump it. This negated the trustee's rights under sec. 544. No reported decision, unfortunately.

Keep up the good work. While I often don't agree with you, I always enjoy reading your posts.

tww--are you worried about my self-esteem?

I've previously heard that FDIC and RTC had a number of cases with documentation problems. If anyone knows more about those issues, I'm all ears.

I'm not the least bit worried about your self-esteem. I was trying to be ironic.

As I recall, one of the big problems had to do with transitioning loan documents from FDIC as receiver to corporate FDIC. FDIC was always very careful to maintain the distinction, but the distinction could rise up and bite it (them?) if the niceties weren't observed.

"this isn't generally a question of deal design, which is where the brain power in securitization was applied. Chain of title is a question of deal execution."

Deal designs that don't take problems with deal execution into account *are* poor deal designs. I worked on a deal in 1991 that involved a bunch of us lawyers sitting around a room, drafting a complicated payment provision that I sensed was getting pretty disconnected from that portion of the universe that resided outside of the room. At one point, I snuck out of the room and faxed it to a guy in my client's payables department named S______, an eminently sensible and intelligent person, and asked him to read it and tell me if he would know how to pay it. He said "No." So I went back up to the drafting room and said, "We flunked the S______ Test. Let's start over." In the ensuing 19 years, I have had frequent occasion to invoke the S_______ Test.

The vast majority of the smart people at the top of the food chain have done just fine, thank you.

May years ago, I was in aircraft structured finance, one night, when waiting for some documents during a closing, a bunch of us (structurer and lawyers) were sitting around in NY law firm conference room. Out of boredom a junior associate started doing the maths for a termination payment in the Japanese leveraged lease structure we were closing (ok we were very bored), within 20 minutes he became very quiet, took me aside and told me he though there was an error in this (very simple -- but long) equation, since the payment amount was rising the wrong way (as maturity neared payment amount should fall).

Once alerted, I took aside the senior partner (big NY law firm) and I told him that we should revise the equation so that its right (Despite the fact that the documents had already been negotiated), the words didn't match the equation...

His first comment was, your guy made a mistake, when we showed him our spreadsheet, he started yelling at one of his junior for being a dumb-ass at copying the equation.

The junior came back and said, its exactly the same equation that we used in a previous week's closing -- it came form the law firm's document database.

We got everyone in the room and told them, immediately the law firm pulled documents for the last 3 years -- and the wrong equation was used in every single transaction.

Errors creep up easily, eventually more than 90 transaction had to be revised -- don't know if they were (not my problem).

This is an empirical question. All that's necessary is to open up some of these trusts and review them. Was the note transferred within 90 days? If not, then the trust is screwed; it loses its tax-exempt status and the originator buys it back.

Why debate a question that can (and must) be answered factually?

I am following this discussion closely. Please take into account:

1. The systemic failure of homelosers to get timely and good faith access to "best practice" default loan servicing to avoid foreclosure that we all pay for up front in our mortgages. There are many reasons for this industry-wide failure including the tunnel vision and lack of supervision/control of the conflicted servicers to comply. There is a related issue of what to do now that the default servicing failures have become the reason for the huge and lengthly payment defaults and nationwide lack of hazard insurance now replaced with force placed debt insurance.

2. The "best practice" servicing that is required by every psa and every mtg contract (and never given)found online at the single family loan servicing guideline at www.fanniemae.com where you find detailed protocols for intensive and customized default loan servicing starting at 45 days from first payment default.

3. The control fraud problems in the rmbs industry (and other consumer debt driven securitizations) brought on largely by the wholesale/collusive abdication of governmental regulatory enforcement and by the practical need to feed the securitization beast with loans taken out by America's base of income-sensitive borrowers.

4. The failure to do any of the underlying transfer paperwork required by every psa and mlpa (and the SEC and the IRS) as evidenced by the failure to show a single complete timely transfer in all the land.

5. The systemic inflated appraisals and the overwhelming failure to meet origination underwriting that resulted from the need to feed the securitization beast.

6. The PSA obligatory disconnect between origination and risk and the attendant (and necessary?) lack of due diligence.

7. The PSA obligatory disconnect between investment and servicer interests that generated a separate industry-wide practice of credator servicing (force place debt insurance replacing hazard insurance, bpos, drive by appraisals, suspense (sweep) accounts, etc.

I can't help but wonder if "Hank" is the same "HankDennemann" (Attorney?) from Richard Zombeck's recent "Homeowner Activists: We Told You So" piece - http://www.huffingtonpost.com/richard-zombeck/homeowner-activists-we-to_b_784610.html.

Thank you, again, Professor for helping to drag this conversation to the forefront (finally?) where it (hopefully) can no longer be ignored. I'm sure that Attorney Charney can easily attest to the fact that it is overdue by much longer than the previous decade that I have been hoping that it would take place.

Attorney Charney, since you mention force placed insurance, you may find Exhibits T-V of my GAO Review request to be of interest. http://www.getdshirtz.com/gaoreview.htm

I think David Larsson's comment totally has it right. In any industry or organization, the best and the brightest don't work on the details or at the retail level. It's all back office stuff t the best and the brightest. But that level is where the mistakes are made. It's an incredibly important part of risk management to remember what David Larsson wrote, that no design that generates such alarge amount of errors is a good design. What I have learned in 30 years in finance is that the sectors of biggest growth are where the biggest problems are building up. Risk management practices at financial institutions should be designed on that principle.

I finally got to Pat Randolph's snark about your written Congressional comments that he posted on the UMKC Dirt listserv yesterday. Over four years of discussions of structural problems with MERS, and he still won't admit any of them. I sometimes wonder if MERS doesn't fund his chair.

Knute, Professor Randolph's firm has done work for MERS.

I have said before and will say again that most consumers, debtor and creditor attorneys, Courts, and lender employees did not understand the mortgage securitization process. Even Congress still doesn't understand and the regulators were and are ill prepared to control. All combined equals an absolute mess and while trying to fix part of the securitization problem the correct part is tanking as well.
The post and comments are well taken and lend some insight to why the mess occurred. Now what?

"Lots of Smart People Couldn't Possibly F*%! Up, Could They?", If the INCENTIVES actively REWARDED f**cking up then it becomes THE RULE not the exception. After all if you can shift the liability and pocket the loot WHAT incentive to you have to get it right?. Cutting corners is faster and cheaper, as for those you disadvantage - MEH.

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