Josh Rosner, a well respected bank analyst (he describes himself as “a recovering GSE analyst”) is circulating a client note and it takes the foreclosure crisis very seriously.

The critical part is his discussion of the conveyance chain. As we indicated before, the minimum chain for a recent mortgage securitization is is A (originator) => B (sponsor) => C (custodian) => D (trust). Older deals might only have three parties, but recent vintage typically had at least four, and some as many as seven or eight.

The reason for doing this is bankruptcy remoteness. You as the buyer of a mortgage backed security want certainty in what you purchased. If an originator goes bust (as ironically many did), you don’t want the creditors to say, “They were already toast by the time they set up that MBS, so the sale of the loans was a fraudulent conveyance, we are gonna take the loans back.”

The way to prevent that was to introduce intermediary parties between the originator and the trust. Each party had to be independent (which meant fit the legal definition of independence; the intermediary parties and even many originators were dependent on financing called warehouse lines from the investment bank packager/distributors). The note (the borrower IOU) had to be endorsed (like a check) to the next party in the chain, who then endorsed it over to the party after that, with the last party being the trust.

Rosner’s remarks are consistent with our prior posts, and he adds a couple of important additional observations:

We have a larger and more significant concern, which, if proved out, could call into question the validity of nearly all securitizations and raise material questions about whether “true sale” was achieved. Nearly all Pooling and Servicing Agreements require that “On the Closing Date, the Purchaser will assign to the Trustee pursuant to the Pooling and Servicing Agreement all of its right, title and interest in and to the Mortgage Loans and its rights under this Agreement (to the extent set forth in Section 15), and the Trustee shall succeed to such right, title and interest in and to the Mortgage Loans and the Purchaser’s rights under this Agreement (to the extent set forth in Section 15)”. Also, an Assignment of Mortgage must accompany each note and this almost never happen. We believe nearly every single loan transferred was transferred to the Trust in “blank” name. That is to say the actual loans were apparently not, as of either the cut-off or closing dates, assigned to the Trust as required by the PSA. Rather than continue to fight for the “put-back” of individual loans the investors may be able to sue for and argue that the “true sale” was never achieved. To think of it simply, if you go to sell your car and you endorse your title but neither you nor the party you are selling it to sign their name who owns the car? It appears you likely still do. While there may be a view that the government can intervene it appears that the private contract spelling out the terms was violated at the transfer point. The Trustee, who has responsibility to make sure all loans were properly assigned to the trust, may have liability. So too might the lawyers who issued the legal opinions.

Yves here. Let’s deal with this in reverse order. The attorneys are probably not liable; lawyers who have looked at typical opinions have advised us that the legal opinions provided on these deals were highly qualified (they took the form “if you took the steps you said you are going to, you have a true sale”).

However, the significant part of Rosner’s comment is his belief (and Rosner typically has very good contacts) that the notes were endorsed in blank. That means they were presumably endorsed only by the originator. This means, effectively, that none of the intermediary transfers took place. This is independent of verification of what we’ve been told. Per a post from late September:

One of my colleagues had a long conversation with the CEO of a major subprime lender that was later acquired by a larger bank that was a major residential mortgage player. This buddy went through his explanation of why he thought mortgage trusts were in trouble if more people wised up to how they had messed up with making sure they got the note. The former CEO was initially resistant, arguing that they had gotten opinions from top law firms. My contact was very familiar with those opinions, and told him how qualified they were, and did not cover the little problem of not complying with the terms of the pooling and servicing agreement. He also rebutted other objections of the CEO. They guy then laughed nervously and said, “Well, if you’re right, we’re fucked. We never transferred the paper. No one in the industry transferred the paper.” This creates a lot of problems. If the originator is bankrupt (New Century, IndyMac), the bankruptcy trustee is supposed to approve any assets leaving the BK’d estate. I’m told bankruptcy judges who have been asked were not happy to hear this sort of thing might be taking place, which strongly suggests this activity is going on without the requisite approvals. And who from the BK’d entity can endorse it over? It doesn’t have any more officers or employees. Similarly, a lot of the intermediary entities (the B and C in the A-B-C-D chain earlier) are long dead. How do you obtain their endorsements? Now you understand why everyone is resorting to fabricated documents and bogus affidavits. There is no simple way to fix this mess. The cure for the mortgage documents puts the loan out of eligibility for the trust. In order to cure, on a current basis, they have to argue that the loan goes retroactively back into the trust. This is the cure that the banks have been unwilling to do, because it is a big problem for the MBS.

Yves here. The next question is “what does this mean for MBS investors?” If you are a Fannie and Freddie investor, there will probably be no obvious consequences, even thought there ought to be. The government is not going to want to raise doubts about the integrity of such an important market. Servicers will continue to pay advances on delinquent accounts.

The bigger implications will be for the servicers and trusts of securitizations for so-called non-conforming mortgages, aka private label or non GSE paper. If Rosner is correct and no one endorsed the notes correctly, at best this is now effectively unsecured paper. I’ve had securitization lawyers argue that even though the trusts may have impaired rights to foreclose, a lower standard of rights applies to ongoing payment, so the trust may be OK as far as non -defaulted borrowers is concerned. But the New York trust experts (and all the trusts are governed by New York law, this was the standard choice for these deals) say if no notes got to the trust by closing, it was unfunded and does not exist.

Regardless, this mess looks likely to be an attorney full employment act. Stay tuned.