2005 – 2007: Big Bank Securitizations, Easy Credit, MERS, Housing, and the Foreclosure Crisis (Part One)

Introduction.  Well, it’s been nearly five years since the 3Q 2007 collapse of the credit and housing markets.  How time flies!  Are we having fun yet?  According to the Regional Multiple Listing Service (“RMLS™”) for the Portland Metro area, comparing January – April 2012 [the latest reporting period available at this time] with January – April 2011, closed sales increased 13.1%, pending sales were up by 17.5%, and total time on the market decreased 18.3%.  These are all good signs, as far as they go.

But there’s much more to the story; there are more troubling statistics that belie the cheerier numbers: April’s 2012 housing inventory was a dismal 4.7 months, compared to 7.2 in April, 2011.  In effect, there are fewer homeowners entering the market, and what’s available is being snapped up.  This is confirmed by the January – April, 2012 new listing numbers; they were down 9.7% compared the same period in 2011.  [Although I’ve not gone behind the housing inventory numbers, I suspect what’s happening is the lower priced homes, e.g. short sales and REO sales (i.e. bank inventory), are flying off the shelf, and higher-end properties and equity sales are languishing. – PCQ]

But the most sobering statistic is that over the same four month period, 2012 versus 2011, there is less than a 1% difference in both median sales price and average sales price.  At the peak of the Portland Metro market in August, 2007, the average home price was was $355,000.  Today it stands at $262,000.  From September 2007 to the present time, Portland Metro housing prices have been on a steady decline.  According to the RMLS™, annual average sale prices were as follows: 2007 – $342,900; 2008 – $330,300; 2009 – $289,900; 2010 – $282,100; 2011 – $263,300.  So for half a decade, Portland area housing, as measured by average price, has been in a dead calm, adrift and rudderless. Perhaps 2012 will yield better results. Time will tell.

So, lest no-one forget from whence we came, the following post connects the dots from the securitization frenzy of 2005 to where we are today.  You can call it Causal, Quixotic, or Karma.  But you can’t call it random.  The housing crash cannot be likened to a butterfly that gently moves its wings off the South American coast, causing ripples to the winds and currents that move up the Gulf Stream and result in an Atlantic hurricane.  No. Nada. Nyet. Like Newton’s Third Law, our present fix is a direct, unbroken and immutable consequence of Big Bank Greed.  Pride Before The Fall.

But the millions of folks who were assured by their banker or loan broker that there was a loan they could actually afford, and could qualify for – however risky the loan may now appear in retrospect – they are not to blame.  Remember, an “expert” sat on the other side of the table with them.  He or she was the one who encouraged them, and explained the low-risk nature of the transaction: “You can always refinance or re-sell if the payments become too burdensome.  But you have to act now!  Housing prices are going up!”

The Securitization Process. As the Big Banks began to securitize subprime loans into the private label secondary market [discussed below] they quickly figured out they could avoid responsibility for their poorly underwritten loans by selling them off to unwitting investors who actually believed that credit ratings meant something.  Of course, there were many political enablers, such as the Chris Dodd and Barney Franks, who willingly partook of the Big Bank’s largess, but now, having succumbed to political amnesia, are sanctimonious and self-righteous.  And since both are retiring, they have deigned to leave this country with a monolithic 2300+ page financial tome [bearing their names, of course] that is still not yet out of rulemaking, with some of the most contentious provisions pushed off until after this year’s election.  But, I digress….

Securitization is a process by which loans are pooled together, converted into securities, placed into trusts, and then sold to large investors, such as pension funds, who are issued certificates evidencing their ownership interest.  In addition to mortgages – which have received the most attention due to the credit and housing crisis – many other different forms of debt obligations and receivables have been securitized in the U.S., such as commercial loans, home equity loans, motor vehicle loans and leases, small business loans, student loans, etc.  For purposes of this outline, our focus will be on the securitization of residential loans.

The securitization process was used quite successfully in 1990 and thereafter by the Resolution Trust Corporation (“RTC”) in disposing of non-GSE conforming residential loans [discussed below] seized during the Savings and Loan Crisis of the 1980s.

The Secondary Mortgage Market.  This is the financial market that consists of pools of securitized mortgages from lenders.  Fannie Mae, Freddie Mac, and Ginnie Mae, are the primary participants in the GSE secondary mortgage market.  The term “GSE” stands for “government sponsored enterprise,” and they were initially called that because they began as quasi-private corporations [e.g. they issued stock to private investors] and had the “implicit guarantee” of the Federal Government.

As for Fannie Mae and Freddie Mac, we have now seen that “implicit guarantee” become an “explicit guarantee.”  On September 6, 2008, they were placed into conservatorship under the Federal Housing Finance Agency or “FHFA”.  Ever since the 1970s the GSEs have engaged in securitizing the loans they purchase in the “secondary mortgage market” i.e., the market that purchases loans from lender banks, thus permitting those banks to re-lend their money.

Today, when a bank makes a residential loan that “conforms” to the GSEs’ underwriting requirements, loan limits, and credit criteria, it is sold to one of the GSEs who pool and sell them as securities to investors.  A “conforming loan” only refers to loans conforming to GSE requirements – not those conforming to Federal Housing Administration (“FHA”), Department of Veterans Affairs (“DVA”), or U.S Department of Agriculture (“USDA”) loan guidelines.

Private Label Securitizations.  The “private-label” secondary market for securitized mortgages came into existence so that banks could sell their loans that did not conform to the GSEs’ underwriting and credit requirements.  According to the Wall Street Journal, in 2005 and 2006 the non-GSE [aka “non-Agency”] or “private label” secondary market accounted for over a trillion dollars of mortgage backed securities, nearly half of the GSEs’.  The loan products that were created, often with lax underwriting, were then sold into the private label secondary market.  These loan products represent a sort of “Rogues Gallery” of infamous nicknames: “Subprime loans”; “Alt-A loans”; “No-doc loans” sometimes collectively referred to as “Liar Loans”, because the lax underwriting invited such abuses.  Negatively amortizing or “neg-am” loans” made their appearance during the easy credit years of 2005-2007. They had the insidious characteristic of permitting borrowers to pay less than the applicable rate of interest, thus adding the deferred interest to the principal balance, resulting in balances going up, rather than down, over time.[1]

Since these private label securitized loans did not have the “implicit” guarantee of the government, they needed another source of validation for large investors to become interested. Enter, the ratings agencies, S&P, Moodys and Fitch, who issued [later discredited ] “investment grade” ratings that encouraged large investors to purchase these riskier, but higher yielding securities.  However, so far, the ratings agencies seem to have avoided significant liability.   In May, 2011, the U.S. Court of Appeals for the Second Circuit issued a unanimous 3-judge ruling[2] holding the rating agencies were only issuing an “opinion”, and under their Commercial Free Speech rights, could do so without liability.  This ruling, along with several others in the Federal District Courts, has tended to affirm the “Commercial Free Speech” defense.

Advantages of Securitization.  Banks that package and sell their loans into the secondary market do not have to carry them on their own books. Rather, the loans are quickly placed into large pools, securitized, and sold to specially created trust entities, known as “REMICs”, discussed below.  This results in lenders receiving repayment for the loans when the securities are sold to investors. Thus, the lenders funding these loans are able to continuously “recycle” their money to make more and more loans.

Disadvantages of Securitization.  As the credit and housing crises have proven, banks began making loans solely for the purpose of pooling and securitizing them.  Since many banks did not carry the loans on their own books, they cared little about whether they were made to credit-worthy borrowers.  The result was that prudent underwriting criteria virtually disappeared.  During the easy credit years of 2005 – 2007, almost anyone could qualify for a home loan.  With easy credit availability, housing demand skyrocketed, pushing up prices.  Both borrowers and lenders believed that with rapidly appreciating home values, if a loan later proved imprudent or unaffordable, the homeowner would either refinance it or sell the home; in either case avoiding serious default. And if the bank had to foreclose, the assumption was that it would receive back a home of greater value than when the loan was first made.  [This calculation proved wrong as credit dried up – preventing refinancings – and home values plummeted, – preventing re-sales at prices sufficient to pay off the home loans. – PCQ]

Participants in the Securitization Process [See Flow Chart, here].

• First, there is the Originator. This is the bank that makes the loans directly to the individual customers.
• Next is the Seller, the bank that buys the loans from Originator, forms the loan pool, and sells it to the Depositor.  The seller may provide some form of guarantee and/or “credit enhancement” [e.g. creditor-placed mortgage insurance] to add value to the bonds. The Seller may provide certain representations and warranties related to quality of the mortgage collateral.
• The Depositor creates the REMIC trust into which the loans [notes and trust deeds or mortgages] are placed.
• The Underwriter is usually a large investment bank. They sell the pass-through certificates to investors and collect the proceeds from the public offering.
• The REMIC Trust holds the pool of loans for servicing.

Real Estate Investment Trusts (“REMICs”).  A REMIC is a highly complex and sophisticated vehicle used to hold a pool of mortgages secured by real estate.  If properly created and operated, REMICs are not taxed on the income generated.  [This is what is meant when it is said that REMICs are not taxed at the “entity level.” Therefore, they act as a “conduit” or “pass-through vehicle”.]  Only the investors are taxed when the REMIC distributes dividends.  REMICs are governed by Sections 860A through 860G of the Internal Revenue Code.

REMIC Terminology. There are a few terms associated with REMICs that are necessary to know in order to understand what created the foreclosure crisis.

• Special Purpose Vehicle (“SPV”).  A special purpose vehicle or special purpose entity is an “off-balance sheet” subsidiary entity, say of a large bank that is created in order to shield the parent bank from exposure to debt. As such, under the Federal Accounting Standards Board (“FASB”) SPVs must be “bankruptcy remote,” meaning that the investors must be absolutely shielded from any adverse consequences if the parent company should go bankrupt [and vice versa].  A SPV can have no purpose other than the transaction for which it was created.  SPVs may take the form of limited partnerships, limited liability companies, trusts, or corporations.  REMICs are one type of SPV used for the securitization of pools of real estate mortgages.
• The True Sale Requirement. In the case of REMICs, the bank disposing of a pool of loans must structure the transaction so that it retains no effective control over the SPV entity.  The failure to do so can be disastrous, since the transaction could then be treated as a “secured loan” by the issuing bank [the “Originator”] would be deemed to have made a “loan” to the REMIC, thus permitting the Originator’s creditors to reach the assets of the REMIC before the investors. This cannot happen if the transfer of the loans into the pool are “true sales”, since the Originator does not retain any control over the activities of the REMIC.
• Tranche. – This is French for “slice”.  It refers to the “tiers” in the REMIC that are sliced up for purchase by investors with differing cash-flow needs, time-to-maturity horizons and appetites for risk. The loans transferred into the REMIC are not physically arranged in specific tranches – just the cash flow is allocated or arranged [e.g. cash flow for short or long periods of time] and risk [e.g. sub-prime vs. prime loans]. The greater the risk of default of certain loans, the greater the return for the investors holding shares of the tranches. When mortgage defaults occur within a REMIC, the investors’ rights of payment on their investment are prioritized by the terms of the Pooling and Service Agreement [described below].  Investors holding higher risk shares or “pass-through certificates” get paid only afterthe investors holding the lower risk shares are fully paid.
• Pooling and Service Agreement (“PSA”). – This document, consisting of hundreds of pages, is the “rule book” for REMICs. Each REMIC operates by the terms of its own PSA. The PSA defines the roles of all the participants.  It also describes how the REMIC is to operate.
• Cut-Off Date.  According to Internal Revenue Bulletin 2012-3,  an SPV qualifies as a REMIC “…only if, among other things, as of the close of the third month beginning after the startup day and at all times thereafter, substantially all of its assets consist of qualified mortgages and permitted investments. In general, the term “qualified mortgage” means an obligation that is principally secured by an interest in real property. See section 860G(a)(3)(A). That is, an obligation secured by an “interest in real property” is not a qualified mortgage unless the obligation is “principally secured” by such an interest.”  [The Bulletin goes on to define the meaning of “principally secured.”] This 90-day cut-off date is specified in the PSA of every REMIC.  This means that, subject to limited exceptions,   mortgage loans may not be placed into the REMIC after 90 days.

Participants in the Securitization Process (See Flow Chart).  Below are the players:

• Seller. This is the owner of the mortgage loans sold to the REMIC trust.
• Beneficiary. The investors. [Note: Trustee’s fiduciary duty is to REMIC, not the investors.]
• Servicer. The servicer performs the traditional functions of a mortgage servicer, including the collection of borrower’s payments and dealing with delinquent loans. The servicer prepares reports for the Trustee and forwards it the monthly collections for payment to the investors.  Under the PSA, the servicer must advance its own funds to cover borrowers’ delinquent mortgage payments.
• Trustee. Represents the interests of the investors (i.e., the “certificate holders”) acting as an administrator for the trust. The trustee calculates and distributes the stream of income to the investors. The trustee also is normally responsible for the preparation and filing of the trust’s income tax return and informational filings. In the event the servicer is unable to do so, the trustee must advance its funds to cover borrowers’ delinquent payments.
• Custodian. Occasionally the Trustee may designate a Custodian to physically hold the promissory notes and mortgages/trust deeds that have ostensibly been transferred into the REMIC as a part of the securitization process.
• Underwriters.  They sell the pass-through certificates to investors and collect the offering proceeds.
• Investors. They purchase mortgage backed securities; are given certificates evidencing their ownership of the security, and receive the stream of income sent to them by the Trustee.

[To be continued.]

[1] Negatively amortizing loans are not “illegal” in Oregon, but under ORS 86A.195, a loan originator may not make such a loan “…without regard to the borrowers repayment ability at the time the loan is made, including the borrowers current and reasonably expected income, employment, assets other than the collateral, current obligations and mortgage related obligations.”