Securitization Process (Simple Model) Transfer by the Mortgagee: Assignment of Mortgage Loans

Securitization Process (Simple Model)

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Securitization Trust (SPV)

Note/ Mtge

Note/ Mtge

Borrower (x10,000±)

(Notes)

Warehouse Lender

Monthly P&I payments on Borrower’s mortgage (through Servicer)

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Investors P&I payments on Bonds/MBS

Originator Loan $$

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Note/Mtge

Secondary Market Buyer

Note/Mtge

Trustee

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Securitization Trust (SPV)

Note/ Mtge

Originator Loan $$

Note/ Mtge

Borrower (x10,000±)

Monthly P&I payments on Borrower’s mortgage (through Servicer)

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Investors P&I payments on Bonds/MBS

– 1) Outright sale of ownership (transferee takes on all risks and benefits associated with enforcing the note) – 2) Collateral assignment or “assignment for security” (transferee receives a lien on the right to collect payments due under the mortgage loan, as security for another debt)

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Note/Mtge

Note/Mtge

• Transfer/assignment of a mortgage loan can occur in one of two basic ways:

Secondary Market Buyer

Trustee

Securitization (Simplified) • Problem 1: Golden Sacks purchases many mortgage loans from Horizon (the original mortgagee) and transfers them to a “special purpose entity” (SPE) • The SPE issues bonds, which are sold to investors – The mortgage servicer collects monthly payments from the mortgagors (e.g., homeowners), as they come due – After its servicing fee, the servicer transmits these funds to the trustee for the SPE – The trustee then uses these funds to pay principal and interest payments due under the bonds – The pool of mortgage notes (secured by mortgages) serves as collateral for these bond repayments

• Why create a special purpose entity (SPE) to hold title to the pool of mortgages and issue the mortgage-backed securities to investors? [E.g., why doesn’t Golden Sacks just issue the bonds directly?] – “Bankruptcy remoteness”: placing mortgage loans into the SPE isolates them from other assets of the securitizing party (e.g., in Problem 1, Golden Sacks) – E.g., if Golden Sacks issued bonds directly and directly owned the mortgage loans, and it went bankrupt, the loans would become part of Golden Sacks’ bankruptcy estate (and bond repayments to investors would be stayed in bankruptcy)

Problem 1 • Horizon loans Mitchell $150,000, and Mitchell executes negotiable note payable to Horizon (secured by a mortgage of Mitchell’s house) • Suppose that Horizon sells the note to Golden Sacks (through a “Pooling and Servicing Agreement”), and Golden Sacks places the note into an SPE • But, Horizon does not indorse the note and deliver it to Golden Sacks; instead, it retains possession of the note as “servicer”

Transfer of a Mortgage Note • There are TWO key aspects to the transfer of a mortgage note, and it is important to distinguish them

– The first is ownership of the note (i.e., who owns the right to the proceeds of the note if it is paid off or collected?) – The second is the right to enforce the note (i.e., who has the right to bring an action against the maker of the note and to foreclose the mortgage, if the maker defaults?)

• These can reside in the same person, but do not have to

• In this way, Golden Sacks has separated ownership of the note (which is now in the SPE) from the right to enforce the note (which remains in Horizon, which is servicing the loan) – Conceptually, Horizon (as servicer) would collect the loan payments (and, if Mitchell defaults, would initiate collection efforts such as foreclosure), but as agent for the owner of the note (the SPE) – This separation creates potential confusion, however, given the underlying requirements of commercial law

Negotiable Instruments [§ 3-104(a)]

Relevant Commercial Law • UCC Art. 3: governs the right to enforce the obligation to pay a negotiable instrument (negotiable promissory note) • Common law of contracts: governs the right to enforce the obligation to pay a non-negotiable instrument (a nonnegotiable promissory note) • UCC Art. 9: governs the question of who owns a note (whether it is negotiable or non-negotiable) [Article 9 applies to “sales” of promissory notes, § 9-109(a)(3)]

Transfer of a Negotiable Note: Say Hello to PETE • If a note is negotiable, the right to enforce it can be transferred (whether in an outright sale or by a collateral assignment for security purposes) ONLY as required by UCC Article 3 – This typically occurs by indorsement of the note (i.e., the payee signs the back of the note) and delivery to the transferee – By this act, the transferee becomes the holder of the note and the PETE (the “Person Entitled to Enforce” the note) [§ 3-301]

• A promissory note is “negotiable” if

– It is an unconditional promise or order to pay a fixed amount of money (principal), either with or without interest – It is payable “to bearer” or “to order” of a specific person – It is payable on demand or at a definite time, and – It does not state any other undertaking to do any act in addition to the payment of money (other than an undertaking to provide or maintain collateral to secure repayment of the note)

• Most courts have concluded that the Fannie Mae/Freddie Mac Uniform Note is a “negotiable” instrument

Say Hello to PETE • UCC Article 3 provides that the obligation of the maker of a note is owed to the person entitled to enforce the note (or the PETE) • UCC § 3-301 — the PETE is: – The holder of the note (the original payee, or another person to whom the note was properly negotiated) – A nonholder in possession of the note with the rights of a holder (someone with possession of an unendorsed note) – In some cases, the owner of a “lost” note

• Suppose that Horizon sells the Mitchell note to Golden Sacks under a Pooling and Servicing Agreement, and Golden Sacks assigns it to an SPE

– Golden Sacks is going to have Wells Fargo service the loan, and Wells Fargo notifies Mitchell and directs him to make payments to Wells Fargo – However, the note was never actually indorsed to Golden Sacks or Wells Fargo or physically delivered into their possession (it is sitting in storage at Horizon)

• Do you see the problem?

Foreclosure of Securitized Mortgages • In judicial foreclosure, lender/servicer must show that:

– It had possession of note, properly indorsed, at the time that it

commenced the foreclosure action

– In cases where lender/servicer fails to make this showing, courts will dismiss the foreclosure action (without prejudice)

• In nonjudicial foreclosure states, nonjudicial foreclosure by someone other than the PETE may create question about the validity of the sale (more on this tomorrow)

• Here, even if Horizon transferred ownership of the note to the SPE, Horizon remains the “holder” of the note (which has not been properly negotiated to Golden Sacks or Wells Fargo) • As a result:

– Horizon is the PETE [§ 3-301] – Mitchell can only discharge his obligation on the note by paying the PETE (Horizon) [§ 3-602(a)], and – Wells Fargo (who is not a PETE) cannot legally enforce the note (or properly bring a foreclosure action)

Nonnegotiable Notes • But, if the note is nonnegotiable, transfer of the right to enforce it is governed by common law of Contracts • That law is more flexible – E.g., transfer could occur by a written agreement between Horizon and Golden Sacks, without indorsement of the note or delivery of physical possession

• Thus, if the note is nonnegotiable, Wells Fargo (as servicer for Horizon) COULD enforce the note vs. Mitchell

Problem 5: Payment/Discharge • Mitchell borrows $100K from Bowman and signs a negotiable note, secured by mortgage on Mitchell’s land

– Bowman later negotiates the note to Uphoff (by proper indorsement and delivery), but does not advise Mitchell – Mitchell tenders $100K prepayment to Bowman (who promptly disappears with the money)

• Can Uphoff enforce the note v. Mitchell, or can Mitchell argue that it has been paid/satisfied?

• Revised Art. 3 changed the “payment rule” [p. 569]

– Under revised § 3-602(b), Mitchell would be discharged b/c he paid Bowman before he received notice of the assignment (this is consistent with how UCC Article 9 treats the collection of accounts receivable) – Problem: Revised Article 3 has been adopted only in 11 states (MO and 38 other states have original Article 3)! – Under the “payment rule,” Mitchell is at risk of having to make double payment in this circumstance

• What should Mitchell have done?

• Problem: Mitchell did not pay the PETE (Uphoff, the then-holder of the note, is the PETE) • Thus, Mitchell’s obligation on the note was not discharged by his payment to Bowman [§ 3-602(a)] • Uphoff (the PETE) can enforce the note and collect from Mitchell! • Is this the appropriate result?

The “Payment Rule” • In a state with original Article 3, Mitchell is at risk of making sure that he is paying the right person (the PETE) – He could ask Bowman to “show him the note” to ensure Bowman is still the holder of it – He can ask for some other proof that Bowman is the PETE (or the agent of the PETE)

Problem 2: Defenses Payment Rule: Nonnegotiable Note • The same rule was applied to nonnegotiable notes, under the common law of contracts (although, as the Problem demonstrates, it makes little sense) • Restatement of Mortgages § 5.5 rejects the payment rule and instead provides that the maker of a nonnegotiable note should be able to pay the original mortgagee and discharge the obligation, until the maker receives notice of assignment of the note

Non-negotiable Promissory Note • If the note is not a negotiable instrument, its enforcement is governed by the common law of contracts (not UCC Article 3) – Under contract law, the assignee of a contract right to payment takes that right subject to all defenses of the counterparty to the contract (derivative rights doctrine) – Thus, if the note is non-negotiable, Lynch’s ability to collect the note from Mitchell is subject to Mitchell’s valid defenses

• August 1: Mitchell signs a note to pay Crouch $1,500, + interest @ 10% annual rate, on Sept. 1 • August 2: Lynch buys the note from Crouch for $1,475

– Crouch indorses the note to Lynch, who takes possession of it in good faith

• On September 1, Lynch presents the note to Mitchell and demands payment

– Mitchell says: “Crouch didn’t provide the services for which I agreed to sign the note, so I don’t have to pay.”

• Can Lynch enforce the note against Mitchell, or can Mitchell raise a defense to payment?

Negotiable Promissory Note • If the note is a “negotiable instrument,” it is governed by Article 3, including Article 3’s “holder in due course” (HIDC) rule • A HIDC of a negotiable instrument takes it free of the maker’s personal defenses (e.g., failure of consideration) [UCC § 3305(b)] • Thus, if note is a negotiable instrument and Lynch is a HIDC, he can collect the note from Mitchell, even if Mitchell’s failure of consideration defense would’ve been valid against Crouch!

“Real” and “Personal” Defenses

Holder in Due Course [§ 3-302] • To be a HIDC of a negotiable instrument, Lynch must: – – – –

Be a “holder” (i.e., indorsement + delivery) Pay value to acquire the instrument Take the instrument in “good faith,” and Take the instrument “without notice” that it is/has been (a) overdue or dishonored, (b) forged or altered, (c) subject to claim of another party, or (d) subject to defenses

Fraud in Mortgage Loans • Going back to Problem 1: Assume that Mitchell’s loan was supposed to bear a 6% fixed interest rate

– Instead, the note Mitchell signed bore a variable rate that is now scheduled to adjust upward to 12% – Mitchell refuses to pay more than the payment that would’ve been due on a 6% fixed loan, claiming fraud by Horizon

• Can Wells Fargo (as servicer for the SPE) accelerate the loan and start foreclosure?

• Real defenses (even a HIDC takes subject to them) – – – – – –

Infancy Lack of capacity Duress Forgery Fraud in the factum Bankruptcy discharge

• Personal defenses (HIDC takes free of personal defenses)

– Any general contract defense (breach of warranty, failure of consideration) – Fraud in the inducement

• If the note is non-negotiable, Mitchell’s fraud defense (if proved) would give him a defense to payment of anything more than the payment that would’ve been due under the agreed terms • If the note is negotiable, however, and Wells Fargo is a HIDC, then Wells Fargo can enforce the note against Mitchell as written (despite the fraud) – If Mitchell doesn’t pay, Wells Fargo can accelerate the mortgage debt and institute a foreclosure action

Questions • Should HIDC rule apply in the modern mortgage market? • Does it create the appropriate incentives for those involved in the process of making and securitizing mortgage loans?

Holder in Due Course • Note that the holder in due course doctrine has been largely abolished in the consumer credit context (introductions of the Uniform Consumer Credit Code, the FTC rule, state “lemon laws” and other state consumer protection laws) – This abolition was based, in part, on the perception of substantial abuses/frauds in the making and transfer of consumer loans

Rationale for HIDC Rule? • Promotes commercial activity by facilitating the availability of credit for business activity on more favorable terms – Policy argument: “Investors would be less likely to buy promissory notes (or lenders would be less likely to lend using notes as collateral) if the notes were subject to the maker’s defenses or third party claims. Without HIDC protection, investors or lenders would demand higher returns.”

UCCC § 3.404(1) • “With respect to a consumer credit sale or consumer lease, an assignee … is subject to all claims and defenses of the consumer against the seller or lessor arising from the sale or lease of property or services, notwithstanding that the assignee is a holder in due course of a negotiable instrument ....”

– E.g., assignee of retail installment sale contract for sale of a car would take subject to buyer’s warranty defenses

FTC Rule • Consumer credit contract for $25,000 or less must say: “NOTICE. ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED WITH THE PROCEEDS HEREOF.” – Legend prevents transferee from qualifying as HIDC – Not including the legend is an “unfair trade practice” (fines)

Transfer of the Mortgage • When a mortgage loan is assigned, a separate written assignment of the mortgage is not necessary to transfer the mortgage • Mortgage “follows the note” automatically [note 1, p. 533]; transfer of note transfers ownership of the mortgage by operation of law • Why might the purchaser of the loan want a written assignment of the mortgage anyway?

• A lender holding mortgage loans in its own portfolio has a strong incentive to maintain rigorous underwriting standards • “Loan-to-sell” lenders may have less incentive to maintain rigorous underwriting standards • In turn, HIDC rule creates less pressure for secondary market purchasers to “vet” and monitor loan originators – Abolition would give investors greater incentive to vet and monitor loan originators. Would the additional cost be justified?