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

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1 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) Secondary Market Buyer Loan Originator Borrower (x10,000±) Monthly P&I payments on Borrower s mortgage (through Servicer) Securitization Trust (SPV) P&I payments on Bonds/MBS Trustee Investors Securitization Process (Simple Model) Secondary Market Buyer Loan Originator Borrower (x10,000±) (Notes) Securitization Trust (SPV) Warehouse Lender Monthly P&I payments on Borrower s mortgage (through Servicer) P&I payments on Bonds/MBS Trustee Investors 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

2 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) This separation creates potential confusion, however, given the underlying requirements of commercial law

3 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)] 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 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

4 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 Thus, if the note is nonnegotiable, Wells Fargo (as servicer for Horizon) COULD enforce the note vs. Mitchell

5 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! Is this the appropriate result?