Housing Finance

SEC Issues Controversial Rule Regulating Asset-Backed Securities

By by Andrew Sioson, J.D. Class of 2013 | Posted on

The SEC will soon put the finishing touches on a rule stemming from one of the most infamous cases of fraud from the 2007-08 financial crisis. The new rule prohibits certain material conflicts of interest between those who create or distribute asset-backed securities (ABS), including synthetic ABS, and the investors in the ABS. This proposal takes direct aim at a transaction that, within the securities industry, has become a symbol of greed and profiteering: Goldman Sachs’s Abacus transaction.

Abacus 2007-AC1 (“Abacus 2007” or “Abacus”) was an investment vehicle designed to fail. It was created in February 2007 at the request of John Paulson, the hedge fund manager who made billions of dollars during the recession by shorting subprime mortgage-backed securities (MBS). Paulson selected the pieces of toxic subprime MBS that he wanted to short which were then packaged together and sold by Goldman to its clients, including German bank IKB and Dutch bank ABN Amro. The buyers were not aware that Paulson selected Abacus’s underlying portfolio; in fact, these banks were led to believe that an independent third party selected the mortgages. The Abacus 2007 transaction resulted in massive losses for IKB and ABN Amro, while Paulsen profited from the investment vehicle’s demise to the tune of over $1 billion.

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Second Circuit Holds that Calculations of Goodwill and Loan Loss Reserves Constitute Opinions; FASB Goes a Step Further to Insulate Yearly Declarations Regarding Goodwill Impairment

By Peter Benesch, J.D. Class of 2013 | Posted on

On August 23rd the Second Circuit affirmed a lower court’s dismissal of a suit alleging securities fraud in Fait v. Regions Financial. The plaintiffs, securities holders of Regions, asserted that Regions violated Section 11 and 12 of the Securities Act of 1933 by making material misstatements with regard to goodwill and loan loss reserves in its 2007 10k and 2008 10Q. However the Second Circuit held that the plaintiffs failed to plead a claim under Sections 11 and 12 because calculations of goodwill and loan loss reserves were issues of opinion, not fact, and the plaintiffs did not plead any facts that demonstrated that the officers of Regions knew, at the time the filings were made, that the calculations were incorrect.

In the years prior to 2008, Regions had acquired several businesses that derived a substantial portion of their profits from mortgage-backed securities. In February 2006, Regions reported goodwill (calculated as the difference between the purchase price and the net fair value of a target’s assets) as $11.5 billion and declared its loan loss reserves were $555 million. These amounts remained relatively constant through the first three quarters of 2008. In January 2009, when the company released its fourth quarter 10Q, goodwill decreased by roughly 50% to $5.5 billion and its loan loss reserves doubled to $1.15 billion. For perspective, Lehman Brothers, Bear Sterns, and Washington Mutual had all gone under, and Congress had initiated the Toxic Asset Relief Program (“TARP”) more than three months before Regions recognized any impairment to its goodwill or declared any increase in loan loss reserves.

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SEC Rolls Out the “Skin in the Game” Regulation to Mitigate Moral Hazard for Lenders and Bond Issuers Involved in Asset-Backed Securities

By Peter Benesch, J.D. Class of 2013 | Posted on

On March 31 the SEC began seeking public comment on its proposed “skin in the game” regulation, which would require lenders and bond issuers of asset-backed securities (ABS’s) to retain 5% of the credit risk of the securities they issue. This requirement would apply to each of the tiers of ABS’s issued individually, preventing a lender or bond issuer from issuing a large proportion of risky securities and yet only retaining its 5% stake in those safer, higher-grade securities it issues. In the alternative, a lender or bond issuer could also comply with the regulation by retaining 5% of the first-loss residual interest of all ABS’s issued or a 5% interest in a representative sample of the underlying securities.

The rule is one of the many proposed by the SEC in accordance with the mandates of the Dodd-Frank Act. The rule was motivated by the public perception that there was an incentive problem, often referred to as a moral hazard, inherent in lending practice that became hegemonic in the mortgaged-backed securities (MBS’s) market. The potential problem lies in the fact that the banks and lenders extending loans to home buyers may not fully appreciate the credit risk of doing so because of their ability to turn around and easily sell these mortgages on the secondary market (commonly referred to as the “originate-and-distribute” model). Large financial institutions, acting as intermediaries between these lenders and investors, would buy mortgages and combine many of them into an investment tool, dividing the pool of mortgages into traunches (with returns on investment commensurate with the perceived security of the traunch invested in). While this securitization process is effective at providing greater liquidity in the mortgage market (as more investors will be willing to invest in the industry if the risk of default can be managed and mitigated through diversification and stratification inherent in the securitization process) the process also debased the incentive for lenders and bond issuers to ensure that borrowers were truly credit-worthy and able to sustain their mortgage payments.

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Live Blogging at the Dodd-Frank Symposium: Tracking Securitized Residential Mortgages

By James Nguyen, J.D. Class of 2013 | Posted on

Nancy Wallace from the Haas School of Business followed her fellow Haas colleague with a talk on the evolution of residential mortgage recording and tracking and the legal implications of MERS.

Some Key Highlights:

  • Residential Mortgage Recording and Tracking has Diverged: while so-called “Shoebox” technology continue to be used to record and track property interest transfers (property sales) at county-level recording offices, the MERS system has supplanted the old technology and now comprises over 60% of the recording/tracking market.
  • Chain of Title and Chain of Mortgage (Promissory Note) Separated Under MERS: the MERS system has detached the dual-recording/tracking of both property title and mortgage, which has significant complications for determining property ownership and mortgage liability.
  • Transfer Language in Pooling-Servicing Agreement (PSA): the property transfer language MERS-tracked PSAs use stock MERS language that some courts have not given full recognition.
  • Why does this matter: participants in the market for mortgage-backed securities may suffer significant financial losses if the validity of MERS transfers cannot be upheld.

A complete description of the presentation can be found here.

Live Blogging from the Dodd-Frank Symposium: Bank Regulation and Mortgage Market Reform

By James Nguyen, J.D. Class of 2013 | Posted on

We’re blogging live from today’s Dodd-Frank Symposium!

Dwight Jaffee from the Haas School of Business kicked off the first set of Securitization and Governance panel presentations with a talk on Bank Regulation and Mortgage Market Reform.Key Highlights from the presentation:

  • Moral Hazard in Securitization is wrong: Jaffee says that the hoopla over securitization causing the mortgage bubble and financial crisis is misplaced and the 5% risk-retention requirement will do nothing but restrict fundamental value of securitization, which is to spread out and segment risks.
  • The private market can fully replace the GSEs: Jaffee thinks the proposals to wind down the GSE are generally a good thing and believes that the private market is more than capable of meeting the credit demand the GSEs currently now provide.  Citing Europe, which Jaffee says has similar rates of homeownership as the U.S., Jaffee says that the GSEs have had minimal if any impact on spurring additional homeownership.
  • Mortgage Contracts will Default to Safe, Low Risk Terms: Jaffee argues that in the absence of GSEs in housing market, the lack of conforming loan standards would nonetheless push borrowers toward the safest, least risky loan terms (i.e., the market would correct itself and move away from costly terms like prepayment penalties.

For a full read of Dwight Jaffee’s ideas, see his working paper on mortgage market reform.

Yield-Spread Premiums Prohibited Under New Loan Origination Compensation and Steering Rules

By James Nguyen, J.D. Class of 2013 | Posted on

Under Loan Originator Compensation and Steering rules issued by the Federal Reserve, new restrictions on loan originator compensation and steering practices will go into effect on April 1, 2011.  The new rules amend Regulation Z, Federal Reserve rules for implementing provisions of the Truth in Lending Act (TILA), and are consistent with the § 129 TILA provisions in the Dodd-Frank Act (15 U.S.C. 1639(l)(2)).  In particular, the new rules have three major prohibitions:

  • Loan originators compensation must be based on the principal loan amount and cannot be based on any other loan terms or condition, such APR or interest rate.  These new restrictions effectively end the practice of loan originators receiving yield-spread premium compensation from lenders. (more…)

National Mortgage Servicing Standards and Looming Litigation

By James Nguyen, J.D. Class of 2013 | Posted on

When the Obama Administration released the Treasury’s white paper to propose reforms to the national housing finance market, it also called for the establishment of national standards for mortgage servicing.  The paper put forth a set of basic proposals to reform mortgage servicing and foreclosure processing practices but stopped short of comprehensive and detailed solutions.  Recently, however, Acting Chairman of the Office of the Comptroller of the Currency, John Walsh, went further and provided the first glimpse in his testimony at the Senate Banking Committee of what could form the backbone of national mortgage servicing standards.

These new standards come on the heels of reports that federal regulators will be taking legal action against the 14 largest U.S. mortgage servicers for failure to comply with foreclosure laws and for the pervasive problems that arose out of processing foreclosures.   Also, a new NERA study looks at the economic implications of foreclosure suspensions and potential litigation related to problems associated mortgage servicing and foreclosure processing.

James Nguyen, National Mortgage Servicing Standards and Looming Litigation, Berkeley Bus. L.J. Network (February 23, 2011), http://thenetwork.berkeleylawblogs.org/2011/02/23/national-mortgage-servicing-standards-and-looming-litigation/.

Bigger than Fannie and Freddie: Defining Qualifying Residential Mortgages

By James Nguyen, J.D. Class of 2013 | Posted on

A prominent feature of the Dodd-Frank Act is the risk-retention provision in Title IX (Subtitle D, § 941).  It requires banks that originate mortgages to retain 5 percent of the credit risk in their portfolios.  The risk-retention requirement was created in direct response to the oft-cited lending practice that contributed to the housing bubble where mortgage originators would sell off the securitized loans without retaining any of the credit risk.  A key exception to the provision concern “qualified residential mortgages” (QRM) and loans designated as QRMs are exempt from the risk-retention requirement.

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