False Security: How Securitization Failed to Protect Arrangers and Investors from Borrower Claims
78 Pages Posted: 27 Mar 2011
Date Written: March 21, 2011
The future of housing finance is in a state of flux. Fannie Mae and Freddie Mac, the two largest loan arrangers in the United States, are in conservatorship. Private sector securitization of mortgages has almost completely stopped. As a result, Fannie, Freddie and Ginnie Mae now own or guarantee almost all new residential mortgage loans. In February 2011, the Obama Administration released a proposal outlining three plans for the future of housing finance. In all three plans, Freddie and Fannie will be phased out over a period of years and replaced with a private securitization market which may be backed, in whole or in part, by a government guarantee. Whether the final plan relies upon government guaranteed securities or private label securities, and there are strong opinions on both sides, Congress will have to resolve a range of complex legal aspects of securitization from the bankruptcy remoteness of pools of securities to setting national standards for loans and financing.
One issue that does not appear to be getting much attention is the potential liability of the parties to a securitization for the unlawful actions of loan originators. In this paper, we take the position that any new housing finance system must clarify the liability of participants in the securitization pipeline so that the market can more accurately price securities up-front and create incentives for more effective compliance programs to stop problem loans from entering the pipeline.
For over a decade, the securitization of home loans was considered a low-cost method to expand the availability of credit, lower the cost of credit and make otherwise illiquid assets liquid. From investors’ perspective, securitization created attractive bonds that provided them with direct exposure to housing markets with good returns that appeared to be highly liquid and low risk. From its infancy, securitization promised to insulate investors and the arrangers that structured securitization deals from the risk that they could be found liable for the unlawful acts of mortgage loan originators. This protection was important because some lenders - particularly in the subprime market - were known to make loans that violated consumer protection and other laws.
For a short time around 2003, a combination of state anti-predatory lending laws and a lawsuit against Lehman Brothers opened up the possibility that aggrieved borrowers might begin obtaining relief against investors and arrangers. This threat never materialized. Over time, investment banks and other arrangers increased their involvement in financing subprime loans. We believe that, in the process, arrangers ultimately exposed themselves and investors to the very liability they thought they had avoided.
Through civil litigation, governmental investigations, Congressional hearings, and the confessions of market participants, new information is emerging on arrangers’ roles in subprime lending. These revelations have shown deep connections between Wall Street money and unfair lending and may open the door for borrower claims further up the lending food chain to arrangers and trusts.
This article proceeds in six parts. Following this introduction, in Part II we briefly describe the history and process of securitization. Part III is a review of the potential claims borrowers can pursue against holders of their loans based on theories of derivative liability, with particular focus on the holder in due course rule. In Part IV, we describe theories that could expose investment banks and other arrangers to direct liability. In part V, we discuss the implications and possible policy responses to assignees’ and arrangers’ exposure to borrower claims and defenses. In part VI, we conclude. Throughout the article, our focus is on the securitization of subprime loans because reports of unlawful lending have been concentrated in the subprime sector.
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