Background. The residential loan market experienced tremendous growth between 2004 and 2007. Lenders were able to accommodate millions of borrowers, because they quickly sold the loans they made into the secondary mortgage market, thus “recycling” their funds for further loans. Initially, the secondary mortgage market was dominated by two major players, Fannie Mae and Freddie Mac. Upon receipt of the loans they purchased from the banks, Fannie and Freddie, in turn, bundled them into pools, and sold them as securities to pension funds and other large investors.
The vehicle of choice for these mortgage-backed securities (“MBS”) was the REMIC. The term stands for “Real Estate Mortgage Investment Conduit.” In short, a REMIC is a trust into which pools of promissory notes (debt instruments – like an IOU) and mortgages or trust deeds (the security instruments which permit foreclosure if the notes are not paid).
These loan pools range in risk from the highest quality down the credit chain to the lowest quality. The loans are, figuratively speaking, sliced and diced into many “tranches” (French for “slice”), each one varying in degrees of risk of default. At this point, the loans lose their identity as individual notes and mortgages, and consist only of blended pieces of loans. The tranches are investment graded by their contents. Some tranches are rated safer than others, depending upon the loan mix each contains. The riskier the tranche, the better the yield. Although the safer tranches have lower yields, their investors receive returns before those holding the higher-yielding, but riskier tranches.
However, these two Government Sponsored Enterprises (“GSEs”) placed limitations on the types of loans they would buy. These were called “conforming loans.” But Wall Street investment banks and the lending industry soon realized that with the increasing demand for homes and home loans, they could develop a “private label” market, i.e. a non-GSE secondary market for loans without the quality-of-loan constraints imposed by Fannie and Freddie. It was this “private label” market that fueled the credit boom for many of the more innovative and riskier loan products, such as no-doc loans, stated income loans, Alt-A and Alt- B loans.
In 2006, the GSE’s issuance of residential mortgage-backed securities was 44% ($899 Billion), while the private-label market was at 64% ($1.146 Trillion). This, according to Inside Mortgage Finance. However, today, following the collapse of the credit and real estate markets, there is no meaningful private-label secondary mortgage market. (There are still riskier loan products available for borrowers with lower credit scores, through FHA. Sort of a “subprime light” if you will.)
REMICs 101. So, what is a REMIC? If properly formed and operated, the REMIC entity is not taxed on its earnings, since the investors, i.e. the bondholders, are “passive ” – that is, they have no control over the operations of the trust. Taxation occurs only at the investor level, upon distribution of the REMIC earnings. However, in order to comply with the strict IRS tax rules governing them, REMICs are limited in the type of investments they may hold. Generally, they consist of certain permitted investments and “qualified mortgages,” i.e. those that (a) are principally secured by interests in real property and (b) transferred into the REMIC within three months of its startup (or closing) date. With only certain exceptions, transfers of mortgages into a REMIC after expiration of the three month period (usually defined as the “Cut-Off Date”) is a “prohibited transaction” and result in a tax being imposed upon the REMIC that is equal to 100 percent of the net income derived from the prohibited transaction.
The Pooling and Servicing Agreement (“PSA”). The rules for the operation of a REMIC are contained in a voluminous document called a Pooling and Servicing Agreement, or “PSA.” The PSA addresses many issues, but some of the most important provisions define the duties and responsibilities of the major participants. Here is the “Readers Digest” version:
- First, there is the Sponsor of the REMIC. The Sponsor is usually a large lending bank. It may or may not have actually made the loans, but acquired them from the loan originator (i.e. the bank actually funding individual loans directly to the borrowers). The Sponsor is largely responsible for indirectly or directly transferring the mortgage pool into the REMIC.
- Next, is the Servicer, who may be a subsidiary of the Sponsor. The Servicer’s role is to manage, collect and distribute the funds generated by the pool. The Servicers’ entire responsibilities are set forth in the PSA. The PSA also dictates the Servicer’s ability to waive, consent or modify terms of any mortgages in the pool. In the event of default, a loan is normally transferred to a “Special Servicer.”
- Lastly, there is the Trustee, who is frequently another bank, but not the same as the Servicer. The Trustee’s duties and responsibilities are also strictly governed by the PSA. The Trustee’s main responsibility is to take possession of the loan documents (the promissory notes, mortgages and trust deeds. The Trustee is also responsible for the distribution of payments to the investors.
When yields in the REMIC trust decline, the investors in the safer tranches have priority in payment over those holding certificates in the riskier tranches. Metaphorically, the arrangement is akin to issuing life rafts to a cruise ship’s first-class passengers, life preservers to those in second-class, and inflatable water wings to those in steerage.
Failure to observe the PSA rules, can jeopardize a REMIC’s tax immunity, thus resulting in significant liability at the entity level – i.e. the REMIC itself. In such event, the result is a form of double taxation, that is, for both the REMIC and the investor. Such an occurrence can destroy the investment quality of the REMIC.
What is perhaps most important about the PSA is that while the Internal Revenue Code and other regulatory rules may set certain de minimus requirements for a REMIC’s governance and operation, it is ultimately the PSA that governs what may and may not be done inside the REMIC. Thus, even though the IRS may set certain standards, if the PSA establishes a higher or more rigorous rule, the PSA controls.
What Does the PSA Say About the Pooled Loans? According to the terms of the PSAs, upon creation of the REMIC, all of the promissory notes and mortgages and trust deeds (depending on the state law where the secured property is located) are required to be physically deposited with the Trustee or an appointed “Custodian.”
- The Promissory Notes. Typically the PSA provides that the original promissory notes are to be endorsed in blank to the Trustee, or the Trust. If there are any “intervening endorsements” (e.g. any pre-REMIC entities that may have owned the paper [including those involved in making the loans, funding the loans, and converting them into securities], they must all appear in a continuous unbroken chain from the maker of the loan (the “Originator”) through the last endorser of the promissory note.
- The Mortgages/Trust Deeds. With respect to the Mortgages/Trust Deeds, each is to be recorded before being delivered to the REMIC Trustee or Custodian. Recording refers to the requirement that the mortgage/trust deed be physically delivered to the recording officer in the county where the property is located. The recording officer notes the actually date and time of the document’s delivery and assigns it a number to uniquely identify and locate it. Once the original document is date and time stamped and assigned the recording number, it is returned to the person or entity identified in the body of the recorded document. Most, if not all states, require that only original documents containing one or more notarized signatures, may be delivered to the county recording officer for recording. In this fashion, any member of the public may inspect the public record at the county courthouse, to view the entire chain of ownership of the mortgage or trust deed. This “chain” should reflect the entire unbroken ownership history of the mortgage or trust deed, from its creation between bank and borrower, on through all successive assignments of the security instrument up to the present time. It is this requirement of an unbroken chain that lends validity to the claim that the person or entity last holding the title – or security interest in the title – is the true owner or holder. [Oregon law requires as a pre-condition to foreclosure that all assignments of the trust deed must be recorded. See, ORS 86.735(1). Promissory notes are not required to be recorded in Oregon or most other trust deed states. – PCQ]
Empty REMICs? Today, what one is likely to see shortly before the formal foreclosure process begins, is the execution and recording of an assignment document from the original lender (or it’s “nominee” in the case of MERS) to another lender that purports to be the actual owner of the note and mortgage/trust deed. What this means – on its face – is an admission that the original loan documents, together with all successive off-record transfers, occurred and remained outside of the REMIC. Moreover, since the originating bank that made the actual loan immediately assigned its rights to a third party as a part of establishing the REMIC, that lending bank has nothing to now assign. Yet it is done every day with impunity. None of the off-record assignments of the note and mortgage or trust deed are accounted for prior to the foreclosure. [The only exception would be those lenders who retained their loans to hold for servicing (and/or later assignment) as a part of their own inventory. – PCQ] Thus, the unpleasant reality is that in most cases where their loan was ostensibly transferred into a REMIC trust, the borrower being foreclosed has no way to know if the entity foreclosing them is actually the true and current owner of the note and mortgage/trust deed. What’s more, if the loan was actually inside of the REMIC as it should have been, only the REMIC, through its Trustee or Servicer, would have the power to foreclose. Thus, any foreclosure of a REMIC-owned loan, should most properly be foreclosed by the REMIC through its Trustee or Servicer.
But the issue of missing mortgages and trust deeds is not the end of the story. Lately, there have been reports of lenders being unable to produce the promissory notes at the time of foreclosure. Although promissory notes are not normally recorded, one would think they could easily be located through the REMIC’s Trustee or Custodian. However, over the last few years, there have been an inordinate number of “lost note” affidavits by lenders seeking to foreclose. Yet how could this be? If the notes and mortgages/trust deeds and all their successive endorsement and assignments were securely tucked away in a Trustee’s vault to protect the REMIC investors, why would there be any difficulty in locating them before commencing a foreclosure? The startling answer appears to be that in many, many cases, these documents may never have found their way into REMICs in the first place. Whether this was due to negligence, sloppiness, inadvertence, or intelligent design, remains to be seen.
If it true, the implications are staggering. It would suggest that many investors are holding certificates for non-mortgage backed securities, in violation of the REMICs’ prospectus, the PSAs, and federal tax law. And in the words of Dezi Arnez, the REMIC Sponsors, Servicers and Trustees may have some “splaining to do.”
For lenders and default processing companies acting on their behalf, the foreclosure implications are significant, as well. Unfortunately, it appears that over the last few years, the industry had already developed a “work-around.” Rather than track down the errant original promissory notes, mortgages and trust deeds that should have been in the possession of the REMIC Trustees or Custodians, lenders and default processors simply began creating “assignment” documents – courtesy of their “robo-signers” i.e. low level staff employees who have been signing thousands of bogus documents, including assignments of mortgages and trust deeds, to fill gaps in the chain of off-record transfers of the mortgages/trust deeds leading up to foreclosure. The press has covered several stories of Lenders, “foreclosure mill” law firms, and default servicing companies, creating legal documents with blank spaces for the robo-signers to execute, using fictitious titles, such as “Vice President, Assistant” “Vice President” (or “AVP”) and “Assistant Secretary.” (See, here, here, and here.)
Remarkably, many in the lending, legal, and title industries, fully know, understand, and appreciate the implications of what has been going on – but most have said little or nothing. And when it is discussed, the conversation is imbedded in a larger discussion of the lending industry as a whole – almost as a distraction rather than a train wreck waiting to happen. Moreover, there can be no question but that the Washington DC regulators and politicians with knowledge of the industry, know as well. It most certainly was a topic of discussion when TARP was being created, since it was in part, this excess bank risk that demanded greater capital requirements.
However, it now appears that this not-so-secret-secret is slowly bubbling to the surface of the public’s consciousness. Besides being the “topic de jour” on various websites for months, the issue is finding its way into litigation court records, and thus being picked up by the mainstream media. At least one major class action lawsuit has been filed that alludes to the problem.
Sooner or later, lending industry spokespersons will have to revise their public pronouncements that these revelations about defective or bogus assignments are “merely technical” snafus. If the evidence that is starting to appear is true – and the jury is still deliberating – some of those private label REMICs created over the last several years, may not contain the loans they were supposed to contain – if any. This may not bode well for the balance sheet (and stock price) of many of our nation’s largest lenders.
