January 16, 2012
Complexity, Complicity, and Liability up the Securitization Food Chain
Posted by Tom Fitzpatrick

´╗┐This post is a summary of a working paper the two of us finished recently, available here.

There are numerous discussions taking place about the future of housing finance, most focusing on the secondary market.  The central themes in theses discussions have been the government's future role in secondary markets and restarting private secondary markets.  But one area that is not receiving much attention is the potential liability of either the entities that arrange securitizations or the trusts (the assignees) that end up owning loans, for unlawful acts at loan origination. 

During the housing boom, everyone seemed to think that assignees were shielded from the consequences of lenders' illegal acts.  It appears that the market assumed that the holder in due course (HDC) rule(which protects note purchasers from most defenses to non-payment on notes) and originators' loan repurchase obligations through representations and warranties would take care of assignee liability risk.  These turned out to be pretty bad assumptions.  Originator repurchase obligations are only effective if the originator is still around to repurchase loans, which has been the case less and less frequently through the crisis.

In addition, assignees are not protected from liability by the HDC rule unless the notes are negotiable instruments, and the buyers and sellers of the notes observed the formalities necessary to obtain the rules protection. As we have seen with the shoddy foreclosure documentation, the industry ignored fundamental formalities and undermined the HDC shield.

The more interesting point is that many securitization arrangers may find themselves exposed to liability for the illegal actions of originators based on theories such as joint venture.  Such claims have survived summary judgment motions when the arrangers prospectively agreed to purchase all or some of the loans originators made, and the arrangers had some knowledge of the originators' illegal acts.  Arrangers could often glean information on lenders and their loan practices through due diligence, media reports, and informal information sharing in vertically-integrated firms (the last being very difficult to prove).  Arrangers have also exposed themselves to liability by actually supplying deceptive disclosures and payment schedules to originators, who then provided the documents to borrowers.

So far, consumer claims against securitization arrangers have been rare and most have been settled, but this trend may reverse.  Now that litigators and judges better understand the organization of the private label securities markets, these claims may have sturdier footing and judges and juries may be more sympathetic to consumers.

Uncertainty is clearly the theme when it comes to both assignee and arranger liability.  This uncertainty impedes accurate pricing of MBS, especially given the potential for claims by attorneys general, large class actions, and widespread borrower rescission of loans.  Policy-makers that want to stimulate the secondary market need to address the legal complexity that causes uncertainty (among other things).  Going forward, the simplest solution is to create incentives for the market to police itself, by allowing assignee and arranger liability for originator wrongdoing.  The next step should be to set parameters for arranger and assignee liability to allow it to be quantified and priced into credit.  Together these actions will sanction future bad actors, protect consumers, and help the MBS market by making it possible to price litigation risk.

Economics, Finance, Financial Institutions, Securities | Bookmark

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