Securitization Process (Simple Model)
Transfer by the Mortgagee:
Assignment of Mortgage Loans
Securitization Process (Simple Model)
$$
Securitization
Trust (SPV)
Note/
Mtge
Note/
Mtge
Borrower (x10,000±)
(Notes)
Warehouse
Lender
Monthly P&I payments
on Borrower’s mortgage
(through Servicer)
$$
Investors
P&I payments
on Bonds/MBS
Originator
Loan
$$
$$
Note/Mtge
Secondary
Market
Buyer
Note/Mtge
Trustee
$$
Securitization
Trust (SPV)
Note/
Mtge
Originator
Loan
$$
Note/
Mtge
Borrower (x10,000±)
Monthly P&I payments
on Borrower’s mortgage
(through Servicer)
$$
Investors
P&I payments
on Bonds/MBS
– 1) Outright sale of ownership (transferee takes on all risks and
benefits associated with enforcing the note)
– 2) Collateral assignment or “assignment for security”
(transferee receives a lien on the right to collect payments due
under the mortgage loan, as security for another debt)
$$
Note/Mtge
Note/Mtge
• Transfer/assignment of a mortgage loan can occur in one
of two basic ways:
Secondary
Market
Buyer
Trustee
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
– The pool of mortgage notes (secured by mortgages) serves as
collateral for these bond repayments
• 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)
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”
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
• 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)
– This separation creates potential confusion, however, given
the underlying requirements of commercial law
Negotiable Instruments [§ 3-104(a)]
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 non-negotiable instrument (a nonnegotiable 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)]
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]
• 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
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)
– In some cases, the owner of a “lost” 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?
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)
• 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)
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
• Thus, if the note is nonnegotiable, Wells Fargo (as servicer
for Horizon) COULD enforce the note vs. Mitchell
Next Assignments
• Monday, Nov. 30: after completing the current reading
assignment on Transfer by the Mortgagee, we’ll discuss
pages 969-991 (Special Priority Rules: Purchase Money
Mortgages and After-Acquired Property Clauses)
• Full reading assignments for Nov. 30-Dec. 3 will be
posted later today
Problem 5: Payment/Discharge
• Mitchell borrows $100K from Bowman and signs a
negotiable note, secured by mortgage on Mitchell’s land
– Bowman later negotiates the note to Uphoff (by proper
indorsement and delivery), but does not advise Mitchell
– Mitchell tenders $100K prepayment to Bowman (who promptly
disappears with the money)
• Can Uphoff enforce the note v. Mitchell, or can Mitchell
argue that it has been paid/satisfied?
If Mortgage Note Is a Negotiable Instrument
• The right to enforce it can be transferred only by a delivery of
physical possession of the note [§ 3-301]
– Note can be enforced by the holder (a person to whom the note is
properly indorsed and delivered)
– Can be enforced by a nonholder in possession of the note but with
the rights of a holder (e.g., someone to whom note was physically
delivered, but without effective indorsement)
• It can be discharged only by payment to the PETE [§ 3-602]
• Problem: Mitchell did not pay the
PETE (Uphoff, the then-holder of the
note, is the PETE)
• Thus, Mitchell’s obligation on the
note was not discharged by his
payment to Bowman [§ 3-602(a)]
• Uphoff (the PETE) can enforce the
note and collect from Mitchell!
• Is this the appropriate result?
• Revised Art. 3 changed the “payment rule” [p. 569]
– Under revised § 3-602(b), Mitchell would be discharged b/c
he paid Bowman before he received notice of the assignment
(this is consistent with how UCC Article 9 treats the collection
of accounts receivable)
– Problem: Revised Article 3 has been adopted only in 11
states (MO and 38 other states have original Article 3)!
– Under the “payment rule,” Mitchell is at risk of having to make
double payment in this circumstance
• What should Mitchell have done?
The “Payment Rule”
• In a state with original Article 3, Mitchell is at risk of
making sure that he is paying the right person (the
PETE)
– He could ask Bowman to “show him the note” to ensure
Bowman is still the holder of it
– He can ask for some other proof that Bowman is the PETE
(or the agent of the PETE)
Problem 2: Defenses
Payment Rule: Nonnegotiable Note
• The same rule was applied to nonnegotiable notes, under the
common law of contracts (although, as the Problem
demonstrates, it makes little sense)
• Restatement of Mortgages § 5.5 rejects the payment rule and
instead provides that the maker of a nonnegotiable note
should be able to pay the original mortgagee and discharge
the obligation, until the maker receives notice of assignment
of the note
• August 1: Mitchell signs a note to pay Crouch $1,500, +
interest @ 10% annual rate, on Sept. 1
• August 2: Lynch buys the note from Crouch for $1,475
– Crouch indorses the note to Lynch, who takes possession of
it in good faith
• On September 1, Lynch presents the note to Mitchell and
demands payment
– Mitchell says: “Crouch didn’t provide the services for which I
agreed to sign the note, so I don’t have to pay.”
• Can Lynch enforce the note against Mitchell, or can
Mitchell raise a defense to payment?
Negotiable Promissory Note
Non-negotiable Promissory Note
• If the note is not a negotiable instrument, its enforcement
is governed by the common law of contracts (not UCC
Article 3)
– Under contract law, the assignee of a contract right to payment
takes that right subject to all defenses of the counterparty to
the contract (derivative rights doctrine)
– Thus, if the note is non-negotiable, Lynch’s ability to collect the
note from Mitchell is subject to Mitchell’s valid defenses
• If the note is a “negotiable instrument,” it is governed by Article 3,
including Article 3’s “holder in due course” (HIDC) rule
• A HIDC of a negotiable instrument takes it free of the maker’s
personal defenses (e.g., failure of consideration) [UCC § 3305(b)]
• Thus, if note is a negotiable instrument and Lynch is a HIDC, he
can collect the note from Mitchell, even if Mitchell’s failure of
consideration defense would’ve been valid against Crouch!
“Real” and “Personal” Defenses
Holder in Due Course [§ 3-302]
• To be a HIDC of a negotiable instrument, Lynch must:
–
–
–
–
Be a “holder” (i.e., indorsement + delivery)
Pay value to acquire the instrument
Take the instrument in “good faith,” and
Take the instrument “without notice” that it is/has been (a)
overdue or dishonored, (b) forged or altered, (c) subject to
claim of another party, or (d) subject to defenses
• Real defenses (even a HIDC
takes subject to them)
–
–
–
–
–
–
Infancy
Lack of capacity
Duress
Forgery
Fraud in the factum
Bankruptcy discharge
• Personal defenses (HIDC
takes free of personal
defenses)
– Any general contract
defense (breach of warranty,
failure of consideration)
– Fraud in the inducement
Fraud in Mortgage Loans
• Going back to Problem 1: Assume that Mitchell’s loan
was supposed to bear a 6% fixed interest rate
– Instead, the note Mitchell signed bore a variable rate that is
now scheduled to adjust upward to 12%
– Mitchell refuses to pay more than the payment that would’ve
been due on a 6% fixed loan, claiming fraud by Horizon
• Can Wells Fargo (as servicer for the SPE) accelerate
the loan and start foreclosure?
Questions
• Should HIDC rule apply in the
modern mortgage market?
• Does it create the appropriate
incentives for those involved in
the process of making and
securitizing mortgage loans?
• If the note is non-negotiable, Mitchell’s fraud defense
(if proved) would give him a defense to payment of
anything more than the payment that would’ve been
due under the agreed terms
• If the note is negotiable, however, and Wells Fargo is
a HIDC, then Wells Fargo can enforce the note
against Mitchell as written (despite the fraud)
– If Mitchell doesn’t pay, Wells Fargo can accelerate the
mortgage debt and institute a foreclosure action
Rationale for HIDC Rule?
• Promotes commercial activity by facilitating the
availability of credit for business activity on more
favorable terms
– Policy argument: “Investors would be less likely to buy
promissory notes (or lenders would be less likely to lend using
notes as collateral) if the notes were subject to the maker’s
defenses or third party claims. Without HIDC protection,
investors or lenders would demand higher returns.”
Holder in Due Course
• Note that the holder in due course doctrine has been
largely abolished in the consumer credit context
(introductions of the Uniform Consumer Credit Code, the
FTC rule, state “lemon laws” and other state consumer
protection laws)
– This abolition was based, in part, on the perception of
substantial abuses/frauds in the making and transfer of
consumer loans
FTC Rule
• Consumer credit contract for $25,000 or less must say:
“NOTICE. ANY HOLDER OF THIS CONSUMER CREDIT
CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES
WHICH THE DEBTOR COULD ASSERT AGAINST THE
SELLER OF GOODS OR SERVICES OBTAINED WITH THE
PROCEEDS HEREOF.”
– Legend prevents transferee from qualifying as HIDC
– Not including the legend is an “unfair trade practice” (fines)
UCCC § 3.404(1)
• “With respect to a consumer credit sale or consumer
lease, an assignee … is subject to all claims and
defenses of the consumer against the seller or lessor
arising from the sale or lease of property or services,
notwithstanding that the assignee is a holder in due
course of a negotiable instrument ....”
– E.g., assignee of retail installment sale contract for sale of a
car would take subject to buyer’s warranty defenses
• A lender holding mortgage loans in its own portfolio has
a strong incentive to maintain rigorous underwriting
standards
• “Loan-to-sell” lenders may have less incentive to
maintain rigorous underwriting standards
• In turn, HIDC rule creates less pressure for secondary
market purchasers to vet and monitor loan originators
– Abolition would give investors greater incentive to vet and
monitor loan originators. Would the additional cost be
justified?
Transfer of the Mortgage
• When a mortgage loan is assigned, a separate written
assignment is not needed to transfer the mortgage
• Instead, the mortgage “follows the note” automatically,
even w/out a written assignment [note 1, p. 533]
• Nevertheless, it is common for the purchaser of the loan
to obtain a written assignment of the mortgage from the
assignor. Why, if it isn’t required?
Fraud Risk: Example
• Problem 1: After Horizon sells Mitchell’s loan to Golden Sacks,
Mitchell pays a $5,000 bribe to a Horizon loan officer to record a
release of the mortgage
• Mitchell then sells the land to Smith (a BFP), who thinks (based on
the fraudulent release) that Mitchell has clear title
• Smith takes title to land free of the mortgage
– As record mortgagee, Horizon has apparent power (but not the legal
right) to record a release; its wrongful release is voidable, not void
– Smith, as BFP, would take free of the apparently released mortgage
under the recording act
Note Purchaser May Ask for Written
Assignment of Mortgage Because ....
• 1) If purchaser has to foreclose the mortgage if borrower
later defaults, purchaser will want to record evidence of the
assignment of mortgage (to establish a proper chain of title to
the land and thus marketable title)
• 2) If purchaser does not record an assignment of the
mortgage, the purchaser becomes subject to the risk that the
mortgage might be extinguished by a wrongful release
• Given this risk, why wouldn’t Golden Sacks record an
assignment of the mortgage?
– Cost of recording a mortgage assignment ≈ $25-50
• Boone Co. recording fee = $24 + $3/page for each extra page
– If Golden Sacks is pooling 20,000 mortgages into an RMBS
pool, the cost of recording assignments for mortgages in the
pool = $500K-$1MM per assignment!
– Thus, purchasers would often have the originating mortgagee
execute an assignment of the mortgage, but would only record
it if borrower defaulted and foreclosure became necessary
MERS
• Mortgage Electronic Registration System (MERS) was
created by the mortgage industry to deal with this issue
• Buyers/sellers of mortgage loans on secondary market
become members of MERS
• Members register their loans with MERS
• MERS system keeps track of who owns the loan as the
loan is transferred through the securitization process
Attacks on MERS [p. 528]
• There have been numerous judicial attacks on MERS
– 1) Borrowers: “MERS results in separation of note and
mortgage, rendering the mortgage invalid”
– 2) Recorders: “MERS is an illegal scheme to avoid paying
recording fees”
– 3) Borrowers: “MERS cannot legally foreclose the mortgage
because it isn’t the owner of the note”
• Problem 1: when Horizon (a MERS member) makes a
mortgage loan to Mitchell, the mortgage doesn’t name
Horizon as mortgagee; instead, it names MERS as the
mortgagee
– MERS is just a nominee (agent) for the note owner (Horizon)
• When Horizon sells loan to Golden Sacks (a MERS
member), MERS tracks the transfer of the note to Golden
Sacks, but no assignment of the mortgage is needed
– MERS remains the mortgagee of record, but now, as the
nominee/agent for Golden Sacks
• As the text suggests (p. 529), nearly all of the litigation
attacks on MERS have failed
• Foreclosures in the name of MERS have been the
most controversial practice
– Legally, it’s not problematic: if Wells Fargo is a member of
MERS and the owner and holder of a note, Wells Fargo
could direct MERS to foreclose on its behalf as an agent
– From a PR perspective, it is problematic — it enabled Wells
Fargo to conduct foreclosures without the PR hit (“MERS is
taking my house” not “Wells Fargo is taking my house”)