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1.5.4 Securitization Players

Securitizations can be structured in many different ways and the parties involved can be given many different names. These different entities are often not unrelated or independent of each other. Instead, a complex web of relationships has been consciously worked out in an attempt to insulate various parties from the conduct of the originating lender. The players and structure also vary depending on whether the loans are securitized on the private-label securities market (in other words, Wall Street) or through one of the government sponsored enterprises. Government-insured programs, such as those sponsored by the Federal Housing Administration or the United States Department of Agriculture, also add a layer of complexity.

Lender. The lender is the originator of the loans.

Aggregator. An aggregator is an intermediary that sometimes buys loans from a lender or multiple lenders for eventual resale to a seller/sponsor. This aggregator may simply be the parent company of the original lender.415

Seller/Sponsor. The seller or sponsor buys loans from a lender or aggregator and resells them to an “issuer” or “depositor.” (The term “seller” is also used in a different context as the entity that sells securities certificates to investors.) The sponsor can be the original lender, an affiliate of the original lender, or an aggregator. Alternatively, the original lender can sell the loans to a wholesale lender who, in turn, becomes the sponsor. When the sponsor is a wholesale lender, it may sell the loans to one of its own subsidiaries or a subsidiary of the sponsor’s parent company.

Issuer/Depositor. The sponsor transfers the notes to an “issuer,” also called a “depositor,” a “bankruptcy remote entity,” or a “special purpose vehicle” (SPV). (Sometimes, though, the trust is termed the SPV.) The depositor is a temporary, intermediary owner of the mortgages. It may be little more than a legal entity with a mailing address.416 The depositor creates a trust and transfers (“deposits”) title to the loans to the trust in return for certificates, which can be sold like securities (for example, bonds).417 The certificates represent undivided interests in the cash flows from the pool of loans now owned by the trust.418 The depositor then sells the securities to an underwriter who will market them.419

The depositor’s primary function is to create a legal separation between the entity that is producing the loans (the originator or sponsor) and the trust, which ultimately holds the loans.420 This separation is also intended to create holder-in-due-course status.421 This separation is referred to as “bankruptcy remoteness” and the issuer is often referred to as a “bankruptcy remote entity.” Bankruptcy remoteness is an attempt to insulate the loans in the trust from the claims of the originator or the seller’s creditors and other economic difficulties that might affect the financial integrity of the securities.422 This separation also is intended to create holder-in-due-course status for the trust.423

Servicer. A loan servicer collects monthly payments from borrowers and manages the borrower’s account. The servicer is responsible for passing borrowers’ payments of principal and interest onward to the trustee. The servicer must advance to the trust payments due from delinquent borrowers and also must advance the costs of foreclosure. The servicer retains a fee from borrower payments and is usually contractually entitled to pocket late charges, bad check charges, and other costs. The right to service a portfolio of securitized loans is regarded as a valuable asset and has been traditionally reserved by the seller for itself. As a result, in many securitization transactions the seller and the servicer are the same company. When these companies file bankruptcy, it is often these servicing rights that are their principal assets. But there is also a growing trend to use third-party servicers who are not affiliated with the seller. A servicer that supervises other servicers is referred to as a “master servicer.” There are also specialty servicers that may concentrate on distressed loans.

Trustee. The trustee is usually a commercial bank and acts on behalf of the trust and the investors. It is essentially an administrative function, to represent the trust, to monitor the effectiveness of the servicing, to manage and oversee the payments to the bondholders and to administer any reserve accounts. Should the servicer fail, it is the trustee’s job to step in as temporary servicer until a replacement can be hired.

The Trust. The pool of securitized loans is usually transferred to a trust organized under Delaware or New York law. But other legal structures, such as limited liability corporations, may be used as well. Each trust will own one pool of loans, which usually number in the thousands, and will have no other assets. The trust’s sole function is to own the loans. It will continue to own them until maturity, foreclosure, or prepayment. An exception, however, may occur when one of the entities involved in transferring the loans to the trust violates one of the representations and warranties they made upon transferring the loan. If that occurs, some contractual agreements may require the entity to buy the loan back from the trust.

Securitization trusts are often structured to qualify as “real estate mortgage investment conduits” (REMICs) under the Internal Revenue Code424 in order to reduce taxes on income generated by the pool of loans. The trust is sometimes referred to as a “special purpose vehicle.”

Custodian. The custodian is often the trustee or the servicer. The custodian is typically in possession of a “collateral file” for each loan within a given pool. The collateral file should contain the original note, original mortgage, original title insurance policy, original assignments and other origination documents. If a note is bearer paper,425 and not payable to the order of a named party, a custodian may hold onto the bearer paper for safekeeping as an agent for the trust. The custodian does not own the notes, even when they are bearer paper.

Underwriter. Not to be confused with someone who underwrites an individual loan application, the underwriter in a securitization transaction is the Wall Street investment firm that provides the initial capital to purchase the securities from the depositor/issuer. The underwriter then sells them to its customers at a profit. The customers are typically institutional investors like insurance companies and mutual funds. As the initial purchaser of all of the bonds, the underwriter plays a key role in structuring the entire transaction, including a role in determining the characteristics of the underlying loans. Underwriters often review (or hire an outside firm to review) a portion of the loans in the pool to determine whether they comply with the terms of the transaction. This is referred to as “due diligence.”426

Rating agency. A rating agency makes a supposedly independent evaluation of the credit quality of the securities. Rating agency websites can be a good source of information about asset-based security transactions. There are four rating agencies: Standard & Poor’s; Moody’s; Fitch; and Duff & Phelps. One of them must rate the bonds as having AAA quality for the transaction to be regarded as marketable.427 The agencies are supposed to research the characteristics and performance of any asset-based security. But during the frenzy of lending and securitization preceding the last foreclosure crisis, some rating agencies rubber-stamped securities in return for repeat business from underwriters.428

Insurer. In order for some asset-based securities to be graded as AAA, they must be “credit enhanced.” This refers to measures intended to reduce the risk to security buyers. Often these enhancements come in the form of bond insurance provided by firms that historically insured municipal bonds.429

Warehouse Lender/Facility. This financial entity provides the short-term capital that a small lender needs to fund mortgages until the loans are sold to someone else—usually to be securitized. Once the underwriter purchases the securities, there should be enough cash to repay the warehouse lender. The warehouse role has been played by large commercial banks, but underwriting firms have provided warehouse funding as well, sometimes taking a security interest in the loans up until they are transferred to the securitization trust.

The multiplicity of these entities underscores the complexity of the securitization process. The ability to securitize mortgage loans that become due years in the future provides an effective means by which an originating lender can sell all of its loans and receive cash immediately, allowing it to then make new loans. By providing liquidity, securitization benefits consumers. On the other hand, the securitization process is designed to insulate those supplying the capital from any wrongdoing by the originating lender.

Footnotes

  • 415 {415} See Talcott J. Franklin & Thomas F. Nelson, Mortgage and Asset Backed Securities Litigation Handbook § 1:4 (2010).

  • 416 {416} Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441, 463 (S.D.N.Y. 2015) (“Depositors are special purpose vehicles . . . essentially shell corporations. . . .”), aff’d, 873 F.3d 85 (2d Cir. 2017).

  • 417 {417} Id.

  • 418 {418} 17 C.F.R. § 2403b-19(a) (depositor is considered the issuer of the securities on behalf of the trust).

  • 419 {419} Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441, 463 (S.D.N.Y. 2015), aff’d, 873 F.3d 85 (2d Cir. 2017).

  • 420 {420} Id. (“Depositors . . . exist for one purpose: to purchase the loans from the sponsor and deposit them in a trust. This step creates a true sale of the assets, thereby protecting certificate-holders against the risk of a subsequent bankruptcy by the sponsor.”).

  • 421 {421} See National Consumer Law Center, Home Foreclosures § 7.16.2 (2019), updated at www.nclc.org/library.

  • 422 {422} See Thomas J. Gordon, Securitization of Executory Future Flows as Bankruptcy-Remote True Sales, 67 U. Chi. L. Rev. 1317 (2000); Lynn M. Lopucki, The Death of Liability, 106 Yale L.J. 1, 23–30 (1996).

  • 423 {423} See § 12.7, infra (limits on holder-in-due-course doctrine); National Consumer Law Center, Home Foreclosures § 7.16.2 (2019), updated at www.nclc.org/library.

  • 424 {424} 26 U.S.C. §§ 860A–860G.

  • 425 {425} Bearer paper is a negotiable instrument that is payable to “bearer” or otherwise indicates that the person in possession of the instrument is entitled to payment. A negotiable instrument that does not state a payee or is payable to “cash” or the like is also bearer paper. Unif. Commercial Code § 3-109.

  • 426 {426} Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441, 463 (S.D.N.Y. 2015), aff’d, 873 F.3d 85 (2d Cir. 2017).

  • 427 {427} See David Reiss, Subprime Standardization: How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market, 33 Fla. St. U. L. Rev. 985 (2006) (reviewing the literature on rating agencies and providing detailed explanation of their function in rating loan pools). See also Christopher L. Peterson, Predatory Structured Finance, 28 Cardozo L. Rev. 2185 (2007) (“Credit ratings on each tranche are essential, since they obviate the need for each individual investor to do due diligence on the underlying mortgages in the pool.”).

  • 428 {428} See Elliot Blair Smith, Bringing Down Wall Street As Ratings Let Loose Subprime Scourge, Bloomberg (Sept. 24, 2008), available at www.bloomberg.com.

  • 429 {429} See Christopher L. Peterson, Predatory Structured Finance, 28 Cardozo L. Rev. 2185 (2007) (discussing internal credit enhancement, for example, dividing the loan pool up into classes which receive payment in descending order of risk, and external enhancement, including bond insurance).