Putting “trust” back in American housing finance
News reports suggest that New York prosecutors are preparing fraud charges against a number of large investment banks for defrauding insurance companies with respect to mortgage loans. These allegations and many civil claims with precisely similar predicates illustrate one of the most important aspects of the subprime financial crisis, namely the construction and collapse of the non-bank financial sector.
Thousands of trusts based on a variety of different assets were created to sell bonds to investors, and some of these trusts carried private mortgage insurance. Most of the trusts used to fuel the subprime debt debacle were filled with residential mortgage loans, but other types of loans and commercial paper also were used as collateral. Roughly a third of the US financial markets were financed by the non-bank sector, which has largely disappeared. Thus deflation abounds.
The subprime investment vehicles of 2007 were almost precise copies of the trusts employed in the years leading up to the Great Crash of 1929. The investment trusts of the early 1900s were often fraudulent vehicles used by Wall Street to enrich the sponsors and stiff investors — like many private deals done during the past decade. Railroad trusts and other seemingly reputable issuers of debentures were highly unpredictable and the assets underlying a trust were always opaque. There was no SEC and no public disclosure standards to provide even minimal information to investors about the assets inside a trust. And the Robber Barons owned the courts, too.
In 1925, during the laissez faire presidency of Calvin Coolidge, the progressive
Chief Justice of the Supreme Court, Louis Brandeis, laid down the law on the assignment of all collateral, from commercial receivables to mortgage notes. We wrote about this important Supreme Court decision in a previous piece on Reuters.com. The key paragraph in the Brandeis decision in Benedict v. Ratner follows:
But it is [268 U.S. 353, 363] not true that the rule stated above and invoked by the receiver is either based upon or delimited by the doctrine of ostensible ownership. It rests not upon seeming ownership because of possession retained, but upon a lack of ownership because of dominion reserved. It does not raise a presumption of fraud. It imputes fraud conclusively because of the reservation of dominion inconsistent with the effective disposition of title and creation of a lien.
The Brandeis decision struck down the practice of making a simple, often verbal common law pledge of receivables. The claims supposedly held by Ratner, the creditor of a defunct company over which Benedict was the receiver, was eventually rejected by Brandeis in a decision that shook the ground of American finance and began a seven-decade long debate over the proper construction of secured financial transactions in the US. It led to the adoption of Article 9 of the Uniform Commercial Code, which even today governs the methods used to create most commercial security interests in collateral.
In plain terms, the above paragraph means that an assignment of collateral is deficient without “the effective disposition of title and creation of a lien.” A financial transaction involving security that lacks these features “imputes fraud conclusively,” wrote Brandeis. Indeed, by that measure, many mortgage backed securities (MBS) created over the past few decades are fraudulent as a matter of law.
While the Benedict decision was good for investors, it also arguably encouraged the 1929 crash. The strict requirements set by Brandeis for delivering collateral to the trustee effectively brought the Wall Street sausage factory to a halt for more than a decade — a situation not unlike what we see today in the evaporation of private mortgage finance since Lehman Brothers failed. This same systemic breakdown in the non-bank, non-GSE finance sector since 2007 is why housing prices remain weak now four years since the subprime crisis started. As I told Tom Keene on Bloomberg Television, there will be no economic recovery until we fix the non-bank financial sector.
The Trust Indenture Act of 1939 began the rebuilding process for secured transactions in the private sector. It required an independent trustee to act on behalf of bondholders. The Act also mandated that bond indentures conform to certain standards set forth by the SEC and the Act itself, and that issuers must report financial information periodically. It was not until the 1970s, though, that Wall Street lawyers were able to convince regulators that pledges of mortgage notes to a trust as collateral could be accomplished consistent with Benedict v. Ratner.
In those days, the way to make private MBS compliant with the law was to physically deliver each properly-endorsed mortgage note to the trustee. That is how documents for MBS deals done under the laws of the State of New York read even today. But do investment bankers and other professionals always do what the documents say and Benedict requires? Of course not.
Unfortunately, members of the bar in the US began to attack Benedict and to go so far as to suggest that common law pledges of collateral were OK. Some even said that Benedict need not be interpreted strictly. In “Rethinking Benedict v. Ratner” Edward Janger wrote:
To the extent that commercial law professors mention Brandeis’s role in the case, it is to point out with a certain self-aggrandizing satisfaction that the great Brandeis even got the law wrong.
Such new thinking was common in the 1990s and allowed the private mortgage finance industry to compete with government sponsored entities like Fannie Mae and Freddie Mac — for a while, anyway. From the start, Wall Street firms cut corners on documenting the transfer of title from the seller of the mortgages to the trust, relying on the revisionist view of the Benedict decision and other new era concepts like federal common law. This is one of the key complaints of mortgage insurers against the banks that created trusts and securities based upon false descriptions of the security.
But now we know that this was all nonsense. The creation of the ersatz housing title registry, Mortgage Electronic Registration Systems (MERS), by the banking and mortgage servicing industry was effectively an end-run around the clear legal standard set by Brandeis. In litigation and foreclosures, these make-believe standards for securitizing home loans are turning into dust in the hands of the banks and investors. Lenders who relied upon MERS to document their secured interest in a mortgage are increasingly at risk when the title is contested.
“Benedict v. Ratner is still the leading case on the question of when there is an invalid lien,” veteran securities attorney Fred Feldkamp said. “This is confirmed by the manner in which the requirements Brandeis stated in Benedict were incorporated when Frank Kennedy wrote the Bankruptcy Code (and the 1983 Uniform Fraudulent Transfer Act). Kennedy was ‘bowing’ to the genius of the Brandeis opinion, NOT denying it.”
In more and more cases where the supposedly secured party cannot produce a properly endorsed mortgage note, the courts are ruling in favor of the debtor. Experts in the fields of the law and forensic accounting tell me that missing or nonexistent mortgages leave investors effectively unsecured — and leave debtor homeowners unsure about the identity of the true note holder.
Anyone familiar with the carnage today in the mortgage servicing world understands that Benedict v. Ratner is again the operative standard for secured transactions in the state and federal courts. In particular, the ancient concept that “the collateral follows the note” affirmed and codified by Benedict is very much operative in the world of home foreclosures. As one attorney told me: “If you don’t have the note today, you don’t have no game.”
A very troubling issue raised by the last comment is related to the issue of missing documents, namely the growing number of foreclosure cases where a mortgage was pledged multiple times. One of the dirty little secrets about MERS and the use of electronic registry systems generally is that they enable fraud. A bank or non-bank seller can pledge the same loan as collateral multiple times if there is no hard requirement to deliver the physical note as per Benedict, which is an open invitation to fraud.
There are a number of proposals in Congress at present for fixing the private mortgage finance sector, but virtually none address the issue of what constitutes a good sale or pledge of a mortgage note in the US. It is interesting to note that a recent paper by the Federal Reserve Bank of New York on housing finance does not even mention the issue of collateral or Benedict v. Ratner.
Sad to say, neither federal regulators nor the large banks have any interest in talking about the issue of good sale and/or delivery of collateral to a trust because of the massive amounts of litigation presently underway. The question of documentation related to loan sales is at the forefront of some of these disputes. Investors want to know how these disputes will be resolved and, more so, what the rules are for loan sales going forward.
One thing you can depend upon is that there will be no fixing of what is wrong with the US real estate sector until Congress addresses once and for all the issue of delivery of a note as collateral for a mortgage backed security. Unless, and until, we fix the private mortgage securitization market, the housing sector will not stabilize and the chance of further deflation will remain a threat to economic recovery.