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1.5.1 Overview

Securitization is the process of bundling loans and selling, in the form of securities, the right to receive a portion of the future income stream coming from the debtors’ payments on the loans.394 Mortgages have been securitized through a variety of means for over a century.395 The modern securitization of residential mortgages, however, has its roots in the 1970s, when the Ginnie Mae guaranteed the first residential mortgage-backed securities (RMBS) by pooling Veterans Administration and Federal Housing Administration loans.396 Bank of America followed in 1977 by issuing the first “private-label” RMBS, backed by jumbo loans ineligible for GSE purchase.397 Freddie Mac and, later, Fannie Mae began issuing their own RMBS in the 1980s.398

Understanding securitization has become essential to effectively representing mortgage borrowers for several reasons:

  • ● Securitization results in a transfer of ownership of the underlying loan (usually to a trust), making the concept of “real party in interest” more complex to analyze.399 With a securitized loan the entity pursuing foreclosure may not be the entity that actually holds the loan.
  • ● It is often the case that wrongdoing lenders go out of business or become insolvent, so the existence of a consumer remedy may depend on evaluating liability theories against other participants in the securitization transaction. Perhaps more importantly, in defending against foreclosure, the borrower will want to raise defenses that she could raise against the originating lender.400 Whether the borrower can raise these defenses and claims against subsequent note holders in a securitization transaction requires thorough analysis, because one of the very purposes of securitization is to insulate participants from legal responsibility for the liability-producing activities of the originating lender.401
  • ● Securitizations generate extensive transactional documentation and extensive ongoing reporting. Reading this paperwork, coupled with an understanding of the securitization process, can provide important sources of information about the companies involved and about the underlying loans.
  • ● The secondary market’s appetite for certain types of loans can depress entire segments of the real estate market or promote the extension of loans that are profitable for investors regardless of their suitability for consumers. The dramatic rise and crash in subprime lending in the 2000s is largely due to secondary market demand for securities backed by subprime loans.

There can be loosely said to be two markets for securitization. The private securitization market is characterized by Wall Street investors, including banks, that use their own funds to purchase and securitize mortgages. These are called “private-label securitizations.” The other market consists of the government-affiliated entities: Fannie Mae, Freddie Mac, and Ginnie Mae. They purchase and securitize millions of loans in order to free up capital for extending more loans. They facilitate this by guaranteeing the timely payment of principal and interest on their securities. These are sometimes called “agency mortgage-backed securities.” The structure of private-label securitizations tends to be more diverse than the standardized structures used by Fannie Mae, Freddie Mac, and Ginnie Mae.

Mortgage securitization transforms the risk of individual mortgages, which is hard for investors to understand and price, into risk on a large, diversified pool of loans whose performance can be better understood by investors. Investors rely upon those offering the securities to understand and price the risks of the individual mortgages. In the agency world, this is accomplished through the standardized underwriting requirements, augmented in the 1990s by automated underwriting technologies that further standardized the process. In addition, a guarantee that the security will pay on a timely basis insulates the investor from the risk of default on individual mortgages.

Securitization also broadens the pool of capital available for mortgage lending from deposit-based creditors (traditionally banks) to the much larger pool of capital markets investors. The upside of securitization, for consumers, has been mortgage interest rates that are consistent across geographic markets and access to long-term fixed rate credit that would be more expensive, if available at all, without it. The downsides for consumers are discussed in § 1.3.2, supra.

Private firms, unlike the GSEs, may securitize any type of loan. Boosted by federal laws,402 private-label mortgage securitization became increasingly popular, peaking in the first decade of the twenty-first century. Subprime loans were particularly popular, because they generated higher returns for investors and represented a market in which the GSEs were not competing for assets (as the loans did not conform to the GSEs’ guidelines). Private label securities do not offer investors a full guarantee of timely payment of principal and interest but typically use subordination of some investors behind others to offer protection from credit risk for investors willing to pay a higher price for the security.403 Investors typically relied on approved credit rating agencies to understand the relative risks of these different so-called classes or “tranches” of risk.

The GSEs historically have been the biggest issuers of RMBS. But during the housing boom in the early 2000s, private-label issuances exceeded agency issuances for several years. After the foreclosure crisis began, private-label securitization experienced high levels of loan defaults and large losses for investors, even in the more highly rated tranches. As a result, investor interest virtually disappeared and this business largely ended. It is expected to resume, although perhaps not at the levels seen in the early 2000s, when investors feel that market conditions are suitable and they are willing to accept the higher level of credit risk involved.404

Mortgage loan securitization is attractive to creditors who originate mortgage loans because it enables them to transfer risk from their own balance sheets to someone else’s. Mortgage lending requires the management of three types of risk: credit risk (the risk that the borrower will default), interest-rate risk (the risk that rates will rise after the loan has been made), and prepayment risk (the risk that the borrower will repay the loan earlier than expected). Interest-rate risk is particularly high for long-term, fixed rate loans, which are favored by consumers for their stability and predictable payments. For agency RMBS, the credit risk is borne by Ginnie Mae, Fannie Mae and Freddie Mac, who charge a “guarantee fee” (or “g-fee”) in return.

In private-label securitization, securities issuers use subordination to distribute and price the credit risk; some investors pay a higher price to enjoy the last-loss position (a concept similar to priority in bankruptcy), while others pay less and accept higher risk. In all cases, investors bear the risk of interest rate fluctuations (for example, the risk that the rate of return on an RMBS may become significantly lower than market rates at another time) or that reductions in market rates for mortgages will cause borrowers to refinance their loans before their full maturity, reducing the long-term yield on the securities.

Many RMBS are “pass-through certificates.” The certificates entitle investors to receive a share of the income that passes through the entity owning the loans.405 Pass-through RMBS offer the benefit of geographical diversity, by providing income from loans around the country. Owners of pass-through certificates, however, still face the risk that mortgagors will refinance their loans early, hurting investors who were looking for a long-term, consistent income stream.

To address this problem, Freddie Mac developed a more complex type of RMBS—the “collateralized mortgage obligation” (CMO). CMOs are structured to allocate the risk of early payment and borrower default in a variety of ways depending on each investor’s appetite for risk. The risk is allocated to different tranches of securities. Each tranche represents a different allocation of risk and potential reward.406 Senior tranches have a higher priority claim on income from the pool of mortgages. Subordinate tranches carry lower credit ratings and face greater risk.407 CMOs also offer investors the option to purchase different streams of income from the pool of mortgages—interest only, for instance, in which the investor receives no share of the repayment of principal, even if a loan fails. This flexibility further broadens the pool of investors willing to add capital to support mortgage lending. In the case of agency CMOs, Ginnie Mae, Fannie Mae and Freddie Mac still provide a full guarantee of the timely payment of principal and interest to investors, which distinguishes them from private-label CMOs, which do not.

Footnotes

  • 394 {394} See Kurt Eggert, Held Up in Due Course: Predatory Lending, Securitization, and the Holder in Due Course Doctrine, 35 Creighton L. Rev. 507 (2002); Christopher L. Peterson, Predatory Structured Finance, 28 Cardozo L. Rev. 2185 (2007).

    For more technical sources see Frank Fabozzi, The Handbook of Mortgage-Backed Securities (2005); Talcott J. Franklin & Thomas F. Nelson, Mortgage and Asset Backed Securities Litigation Handbook (2010). A good discussion of how mortgages are priced on the secondary market can be found in 77 Fed. Reg. 55,721, 55,275–55,276 (Sept. 7, 2012).

  • 395 {395} See William N. Goetzmann & Frank Newman, Nat’l Bureau of Econ. Research, Working Paper No. 15650, Securitization in the 1920s (Jan. 2010), available at www.nber.org.

  • 396 {396} Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J. 447, 459 (2009) (citing Charles R. Geisst, Visionary Capitalism: Financial Markets and the American Dream in the Twentieth Century 91–93 (1990)).

  • 397 {397} Congressional Budget Office, Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market 53 (Dec. 22, 2010), available at www.cbo.gov.

  • 398 {398} Id.

  • 399 {399} See National Consumer Law Center, Home Foreclosures § 3.3.5 (2019), updated at www.nclc.org/library.

  • 400 {400} See § 12.6, infra (third-party and assignee liability); National Consumer Law Center, Home Foreclosures § 7.16 (2019), updated at www.nclc.org/library (assignee liability).

  • 401 {401} See Kurt Eggert, Held Up in Due Course: Predatory Lending, Securitization, and the Holder in Due Course Doctrine, 35 Creighton L. Rev. 507 (Apr. 2002); Lynn M. LoPucki, The Death of Liability, 106 Yale L.J. 1, 23–30 (1996) (“Asset securitization is both a substitute for borrowing and a powerful new strategy for judgment proofing.”); Christopher L. Peterson, Predatory Structured Finance, 28 Cardozo L. Rev. 2185 (2007); Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stan. J.L. Bus. & Fin. 133 (1994).

  • 402 {402} See Congressional Budget Office, Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market 54–55 (Dec. 22, 2010), available at www.cbo.gov; Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J. 447, 467–468 (2009).

  • 403 {403} Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441, 464 (S.D.N.Y. 2015) (describing credit enhancement and subordination), aff’d, 873 F.3d 85 (2d Cir. 2017).

  • 404 {404} In 2006 private-label RMBS were nearly sixty percent of the securitization market. But in 2017 that number was only about five percent, with the rest of the market coming from the GSEs and Ginnie Mae. Diana Olick, Realty Check, CNBC, Private-Label Mortgage Bonds Are Rising from the Grave (Mar. 20, 2017), available at https://web.archive.org.

  • 405 {405} Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441, 458 (S.D.N.Y. 2015) (lengthy explanation of RMBS industry and securitization), aff’d, 873 F.3d 85 (2d Cir. 2017).

  • 406 {406} Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J. 447, 461–462 (2009); Congressional Budget Office, Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market 53 n.8 (Dec. 22, 2010), available at www.cbo.gov.

  • 407 {407} Congressional Budget Office, Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market 53 n.8 (Dec. 22, 2010), available at www.cbo.gov.