Securitization Process (Simple Model) Transfer by the Mortgagee: Assignment of Mortgage Loans. Securitization Process (Simple Model)

Transfer by the Mortgagee:

Assignment of Mortgage Loans

• Transfer/assignment of a mortgage loan can occur in one

of two basic ways:

– 1) Outright sale of ownership (transferee takes on all risks and benefits associated with enforcing the note)

– 2) Collateral assignment or “assignment for security”

(transferee receives a lien on the right to collect payments due under the mortgage loan, as security for another debt)

Securitization Process (Simple Model)

Originator

Borrower (x10,000±)

Secondary

Market

Buyer

Securitization

Trust (SPV)

Investors

Trustee

Monthly P&I payments on Borrower’s mortgage (through Servicer) $$ P&I paym en ts on Bon ds /M B S N ote /M tge

Securitization Process (Simple Model)

Originator

Borrower (x10,000±)

Secondary

Market

Buyer

Securitization

Trust (SPV)

Investors

Trustee

Monthly P&I payments on Borrower’s mortgage (through Servicer) $$ P&I paym en ts on Bond s/M BS N ote/ M tge

Warehouse

Lender

Securitization (Simplified)

• Problem 1: Golden Sacks purchases many mortgage loans

from Horizon (the original mortgagee) and transfers them to a

“special purpose entity” (SPE)

• The SPE issues bonds, which are sold to investors

– The mortgage servicer collects monthly payments from the mortgagors (e.g., homeowners), as they come due

– After its servicing fee, the servicer transmits these funds to the trustee for the SPE

– The trustee then uses these funds to pay principal and interest payments due under the bonds

• Why create a special purpose entity (SPE) to hold title to the

pool of mortgages and issue the mortgage-backed securities

to investors? [E.g., why doesn’t Golden Sacks just issue the

bonds directly?]

– “Bankruptcy remoteness”: placing mortgage loans into the SPE isolates them from other assets of the securitizing party (e.g., in Problem 1, Golden Sacks)

– E.g., if Golden Sacks issued bonds directly and directly owned the mortgage loans, and it went bankrupt, the loans would become part of Golden Sacks’ bankruptcy estate (and bond repayments to investors would be stayed in bankruptcy)

Transfer of a Mortgage Note

• There are TWO key aspects to the transfer of a mortgage

note, and it is important to distinguish them

– The first is ownership of the note (i.e., who owns the right to the proceeds of the note if it is paid off or collected?)

– The second is the right to enforce the note (i.e., who has the right to bring an action against the maker of the note and to foreclose the mortgage, if the maker defaults?)

• These can reside in the same person, but do not have to

Problem 1

• Horizon loans Mitchell $150,000, and Mitchell executes

negotiable note payable to Horizon (secured by a mortgage of

Mitchell’s house)

• Suppose that Horizon sells the note to Golden Sacks (through

a “Pooling and Servicing Agreement”), and Golden Sacks

places the note into an SPE

• But, Horizon does not indorse the note and deliver it to

Golden Sacks; instead, it retains possession of the note as

“servicer”

• In this way, Golden Sacks has separated ownership of

the note (which is now in the SPE) from the right to

enforce the note (which remains in Horizon, which is

servicing the loan)

– Conceptually, Horizon (as servicer) would collect the loan payments (and, if Mitchell defaults, would initiate collection efforts such as foreclosure), but as agent for the owner of the note (the SPE)

Relevant Commercial Law

• UCC Art. 3: governs the right to enforce the obligation to

pay a negotiable instrument (negotiable promissory note)

• Common law of contracts: governs the right to enforce

the obligation to pay a negotiable instrument (a

non-negotiable promissory note)

• UCC Art. 9: governs the question of who owns a note

(whether it is negotiable or non-negotiable) [Article 9

applies to “sales” of promissory notes, § 9-109(a)(3)]

Negotiable Instruments [§ 3-104(a)]

• A promissory note is “negotiable” if

– It is an unconditional promise or order to pay a fixed amount of money (principal), either with or without interest

– It is payable “to bearer” or “to order” of a specific person – It is payable on demand or at a definite time, and

– It does not state any other undertaking to do any act in addition to the payment of money (other than an undertaking to provide or maintain collateral to secure repayment of the note)

• Most courts have concluded that the Fannie Mae/Freddie

Mac Uniform Note is a “negotiable” instrument

Transfer of a Negotiable Note: Say Hello

to PETE

• If a note is negotiable, the right to enforce it can be

transferred (whether in an outright sale or by a collateral

assignment for security purposes) ONLY as required by UCC

Article 3

– This typically occurs by indorsement of the note (i.e., the payee signs the back of the note) and delivery to the transferee

– By this act, the transferee becomes the holder of the note and the PETE (the “Person Entitled to Enforce” the note) [§ 3-301]

Say Hello to PETE

• UCC Article 3 provides that the obligation of the maker of a

note is owed to the person entitled to enforce the note (or the

PETE)

• UCC § 3-301 — the PETE is:

– The holder of the note (the original payee, or another person to whom the note was properly negotiated)

– A nonholder in possession of the note with the rights of a holder (someone with possession of an unendorsed note)

• Suppose that Horizon sells the Mitchell note to Golden

Sacks under a Pooling and Servicing Agreement, and

Golden Sacks assigns it to an SPE

– Golden Sacks is going to have Wells Fargo service the loan, and Wells Fargo notifies Mitchell and directs him to make payments to Wells Fargo

– However, the note was never actually indorsed to Golden Sacks or Wells Fargo or physically delivered into their possession (it is sitting in storage at Horizon)

• Do you see the problem?

• Here, even if Horizon transferred ownership of the note to

the SPE, Horizon remains the “holder” of the note (which

has not been properly negotiated to Golden Sacks or

Wells Fargo)

• As a result:

– Horizon is the PETE [§ 3-301]

– Mitchell can only discharge his obligation on the note by paying the PETE (Horizon) [§ 3-602(a)], and

– Wells Fargo (who is not a PETE) cannot legally enforce the note (or properly bring a foreclosure action)

Foreclosure of Securitized Mortgages

• In judicial foreclosure, lender/servicer must show that:

– It had possession of note, properly indorsed, at the time that it commenced the foreclosure action

– In cases where lender/servicer fails to make this showing, courts will dismiss the foreclosure action (without prejudice)

• In nonjudicial foreclosure states, nonjudicial foreclosure by

someone other than the PETE may create question about the

validity of the sale (more on this tomorrow)

Nonnegotiable Notes

• But, if the note is nonnegotiable, transfer of the right to

enforce it is governed by common law of Contracts

• That law is more flexible

– E.g., transfer could occur by a written agreement between Horizon and Golden Sacks, without indorsement of the note or delivery of physical possession

Problem 5: Payment/Discharge

• Mitchell borrows $100K from Bowman, signs a negotiable

note, secured by mortgage on Mitchell’s land

– Bowman later negotiates the note to Uphoff (by indorsement and delivery)

– Mitchell attempts to prepay the note by tendering $100K to Bowman (who disappears with the money)

• Can Uphoff enforce the note v. Mitchell, or can Mitchell

argue that it has been paid/satisfied?

• Problem: Mitchell did not pay the

PETE (Uphoff is the PETE), and thus

Mitchell’s obligation on the note was

not discharged by his payment to

Bowman [§ 3-602(a)]

• Uphoff (the PETE) is entitled to

enforce the note and can collect from

Mitchell!