Garfield Continuum White Paper Explains Economics of Securitization of Residential Mortgages

SEE The Economics and Incentives of Yield Spread Premiums and Credit Default Swaps

March 23, 2010: Editor’s Note: The YSP/CDS paper is intentionally oversimplified in order to demonstrate the underlying economics of securitization as it was employed in the last decade.

To be clear, there are several things I was required to do in order to simplify the financial structure for presentation that would be understandable. Even so, it takes careful study and putting pencil to paper in order to “get it.”

In any reasonable analysis the securitization scheme was designed to cheat investors and borrowers in their respective positions as creditors and debtors. The method used was deceit, producing (a) an asymmetry of information and (b) a trust relationship wherein the trust was abused by the sellers of the financial instruments being promoted.

So before I get any more comments about it, here are some clarifying comments about my method.

1. The effects of amortization. The future values of the interest paid are overstated in the example and the premiums or commissions are over-stated in real dollars, but correct as they are expressed in percentages.

2. The effects of present values: As stated in the report, the future value of interest paid and the future value of principal received are both over-statements as they would be expressed in dollars today. Accordingly, the premium, commission or profit is correspondingly higher in the example than it would be in real life.

3. The effects of isolating a single loan versus the reality of a pool of loans. The examples used are not meant to convey the impression that any single loan was securitized by itself. Thus the example of the investment and the loan are hypothetical wherein an average jumbo loan is isolated from the pool from one of the lower tranches and an average bond is isolated from a pool of investors, and the isolated the loan is allocated to in part to only one of the many investors who in real life, would actually own it.

The following is the conclusion extracted directly from the white paper:

Based upon the foregoing facts and circumstances, it is apparent that the securitization of mortgages over the last decade has been conducted on false premises, false representations, resulting in intentional and inevitable negative outcomes for the debtors and creditors in virtually every transaction. The clear provisions for damages and other remedies provided under the Truth in Lending Act and Real Estate Settlement Procedures Act are sufficient to make most homeowners whole if they are applied. Since the level 2 yield spread premium (resulting from the difference in money advanced by the creditor (investor) and the money funded for mortgages) also give rise to claim from investors, it will be up to the courts how to apportion the the actual money damages. Examination of most loans that were securitized indicates that they are more than offset by undisclosed profits, kickbacks, fees, premiums, and rebates. The balance of “damages” due under applicable federal lending and securities laws will require judicial intervention to determine apportionment between debtors and creditors.

20 Responses

  1. […] Garfield Continuum White Paper Explains Economics of Securitization of Resi… […]

  2. CW Capital: Back off, Appaloosa

    By KAJA WHITEHOUSE

    Last Updated: 2:13 AM, March 16, 2010

    Posted: 1:44 AM, March 16, 2010
    Comments: 0
    | More Print

    The company that controls troubled Manhattan apartment complex Stuyvesant Town-Peter Cooper Village told hedge fund Appaloosa to back off yesterday, saying the New Jersey bondholder has no right to try to scuttle the property’s foreclosure proceedings.

    In a brief filed with Manhattan federal court, CW Capital — which represents holders of the $3 billion defaulted mortgage — argued that the hedge fund must gain the support of 25 percent of bondholders to have a say in the foreclosure.

    CW also accused Appaloosa of trying to hold up the foreclosure to “maintain its stream of payments” on its bonds, which were bought “at a steep discount” when it was clear foreclosure was coming.

    Late last month, David Tepper’s hedge fund filed a motion to stop recent foreclosure proceedings on StuyTown, saying the move would hurt its investment.

    Read more: http://www.nypost.com/p/news/business/cw_capital_back_off_appaloosa_jZLbYV6qhv4GxtoqSOFTNP#ixzz0j6F35nJF

  3. Have the servicers advanced anything? Depends on funding and non-accrual status – for GSEs – non-accrual status is only 90 days before loan is purchased out ot the pool.

    For most others, 180 days is the max time required to report charge-off to credit bureaus.

  4. Just another angle to look at.

    For anyone interested see

    http://www.ocwenbusiness.com/documents/pdf/LoanAdvancesReceivables.pdf

    Interesting is that the servicer’s position, after advances, is senior to the AAA tranche (a senio tranche definitely covered by swaps in non-agency paper).

    And yet the government had to step in with “TALF” to provide support for credit lines to mortgage servicers who could not advance payments. Details of TALP are not yet available. “Non-accrual” comes into play – at what point were loans placed in “non-accrual” (charged-off as dubious for collection). Servicers have been trouble – some are even bankrupt. Where are the defaults – on whose balance sheet- and how did the Legacy Program intervene?

  5. Thanks Deontos

    Do not think I was clear about Pierce v Novastar. Although, in Pierce, the court denied violations of RESPA regarding table-funding, the court denied the violations because there was no obligation for table funder to purchase the mortgage. The key was whether there was a pre-arranged agreement that obligated a purchase – and the court found that there was not.

    In my opinion, this is not the case with “Pooling and Servicing Agreements” and “Mortgage Loan Purchase/Repurchase Agreements” in which there were pre-arranged agreements prior to the table funding of mortgages purchased by Wall Street. In these cases – the originator had an obligation to sell the originations to Wall Street underwriters.

    Had a conversation with Paul Muolo- author of “Chain of Blame – How Wall Street Caused the Mortgage and Credit Crisis” – quite some time ago. I asked – “did Wall Street purchase these mortgages? – answer – “yes.”

    My own opinion, is that the agreements to purchase were pre-arranged. Wall Street knew where the money was – in subprime mortgages – higher interest rates – and inflated appraisals- to the “bad” people who had poor credit. The plan was well thought out and – pre-arranged. Pierce vs Novastar implies that if the there was an obligation for the table-funder to sell the mortgage – this would be a violation. Mortgages were sold before the dotted line was signed at closing. Case law for RESPA violations is alive and well.

    Also, I urge Mr. Garfield to look into mortgage servicer “advance payments” and “non-accrual” status.

    Disclaimer – I not an attorney and this not to be construed as legal advise and only for education purposes.

  6. ANONYMOUS

    Thank you for insight.

    I really appreciate your
    efforts here. Still don’t
    understand the fine points;
    but the more you patiently
    explain the more I and likely
    others GRASP.

  7. Brian Davies

    But – Pierce v Novastar, US DIst. Ct. Wash., which came after Chandler – determines that RESPA was not violated since the table-funding entity was not obligated to purchase the mortgage-originated loan.

    Hence, there was no obligation to purchase the mortgages. Pooling and Serving Agreements and Mortgage Loan Purchase account do not give the same “option” to not purchase – the loans agreements are pre-arranged.

    Also, in Brewer v. Indymac Bank, Residential Mortgage Capital (RMC), (2009) the U.S. Dist. Ct. for the E.D. of Calif., denied defendant’s motion to dismiss plaintiffs’ RESPA claim. Plaintiffs allege that defendants benefited from secret profits by “disguising the table funded transaction as a secondary market transaction,” that was in violation of RESPA. (do not know if decision came down after this).

  8. Deontos

    Sorry, my post for “Repossession Hell” was to PJ – not you!!

  9. Deontos

    First, just want to say that I did not write the quote – someone else did – what is in quotes is from someone else. Do not know how reliable the source is – but other research tends to support and – it makes sense.

    Credit default swaps have been used under many scenarios – including hedging against interest rate changes. It is my understanding that the GSEs, backed by the government, have their own internal guarantee (credit enhancement) due to the government guarantee. In private agency paper, credit swaps were used directly to support credit enhancement and ratings since there was no government guarantee. However, credit swaps were also written directly against Fannie/Freddie debt and traded in the market.

    My point for the post is that if your loan was Fannie/Freddie – it appears it was purchased out of the pool at 90 days. If MERS was involved in foreclosure, and this was the case, clearly MERS involvement is not valid. I have heard analysts state that Fannie/Freddie tended to keep default loans in the pool longer than 90 days, but due to the new FASB rules they are purchasing default loans much sooner – and that their balance sheets are a mess. The debt on these balance sheets (and if loans were purchased back – balance sheet includes these loans) is likely insured by swaps – but the size of the increasing debt appears to be a big problem – and could trigger another “swap” crisis – or bailout. Congress is discussing Fannie/Freddie today with Geithner.

    Also, my point is “servicing advances” have not been addressed here (I may have missed). And for how long can servicers support default payments, insurance not paid, and tax liens. However, if servicer is a subsidiary of the Bank then the loan could be supported in the pool for quite some time.

    Question also is – at what point does the loan become “non-accrual” – meaning the servicer no longer has to advance payments. “Non-accrual” is an accounting term – for when a loan is basically written-off by the bank as doubtful to be collected. It does not mean that the loan stops adding interest to the debtors. Also, see my post to Deontos at “Repossession Hell.”

  10. ANONYMOUS,

    You said in part,
    “After 90 days the GSE buys the loan out of the pool. This “prepays” the principal to the investor, which is now made whole, although it is no longer earning interest on that principal. The GSE directs the servicer to foreclose and is made whole out of the proceeds as is the servicer who advanced those delinquent payments plus the expense cost of the foreclosure process.”

    I am little confused here? I thought somewhere in the mix the debt was actually paid off through some security or insurance implementation. Thereby extinguishing the debt and without rights to subrogation due to the nature of the instrumentality that effected payment?

    Is it that this is TRUE if it is not a GSE related securitization only?

  11. original lender uamc as of 11-17-06

    UAMC allegedly sold both servicing and loan rights to Opterum financial(uamc said 12-21-06)

    opteum financial(supplied their colonial warehouse)

    discovery doc from Indymac who bought on 3-15-07 and sold it to Indymac MBS who put it in the RAST 2007-a5 with DBNTC as Trustee.

    It appears there should have been undisclosed payments by RESPA since there was no secondary sale until Indymac sold. RESPA follows in case below

  12. UNIVERSAL AMERICAN MORTGAGE COMPANY OF CALIFORNIA ___ACQUIRED BOTH LOAN AND SERVICING 12-21-06—OPTEUM(COLONIAL WAREHOUSE LINDE BY SEC DOCS.)
    11-17-09____________________________________________COLONIAL WARE HOUSE__________________INDYMAC PURCHASE————–SOLD TO TRUST 3-15-07___
    UNDISCLOSED PROFITS WITH OPTEUM INVOLVED. CASE BELOW SHOWS THIS SET UP WAS SEVERAL THOUSANDS. THIS RESPA FOLLOWS MY CASE.
    The Chandlers’ claim rests on alleged violations by Norwest and Custom of RESPA. Consequently, the Chandlers must establish that their mortgage loan transaction is covered by the Act. If the transaction falls outside the coverage of RESPA, the Chandlers’ claim necessarily fails.
    Specifically, the Chandlers contend that Norwest and Custom table funded the Chandlers’ mortgage loan thus bringing the transaction under the coverage of RESPA, and that Norwest thereafter violated Section 8 of the Act by paying Custom referral fees or unearned and excessive fees. Custom, according to the Chandlers, also violated Section 8 of RESPA by receiving the referral fees or excessive and unearned fees from Norwest. Norwest and Custom, on the other hand, claim that the Chandlers’ mortgage loan was sold to Equicon pursuant to a transaction that is exempt from RESPA and that the Chandlers’ claims fail as a matter of law.
    RESPA and its accompanying regulations “apply to all federally related mortgage loans,” 24 C.F.R. § 3500.5(a), including the Chandlers’. Section 8 of RESPA prohibits all kickback and referral fee arrangements whereby any payment is made or “thing of value” is furnished for the referral of real estate settlement services, 12 U.S.C. § 2607(a), and also prohibits a person that renders a settlement service from splitting with or rebating to any other person any portion of the charges associated with real estate settlement services except in return for services actually performed, see id. § 2607(b); see also Bloom v. Martin , 77 F.3d 318, 320 (9th Cir. 1996); Durr v. Intercounty Title Co. of Illinois , 14 F.3d 1183, 1186 (7th Cir.), cert. denied , 513 U.S. 811 (1994); Mercado v. Calumet Fed. Sav. & Loan Ass’n , 763 F.2d 269, 271 (7th Cir. 1985). Section 8 specifically permits, however, “the payment to any person of a bona fide salary or compensation or other payment for . . . services actually performed.” 12 U.S.C. § 2607(c)(2).
    The regulations under RESPA, Regulation X, exempt from the provisions of Section 8 those fees and charges paid in connection with legitimate secondary market transactions involving a ” bona fidetransfer of a loan obligation in the secondary market” taking into consideration “the real source of funding and the real interest of the funding lender.” 24 C.F.R. § 3500.5(b)(7). Regulation X excludes table funded transactions from the scope of a legitimate secondary market transaction, thus, table funded transactions are covered by Section 8 of RESPA. See id. In order to prevail, the Chandlers must present some evidence that their loan was table funded–that the loan was funded at settlement by a contemporaneous advance of loan funds and an assignment of the loan to the person advancing the funds. See id. § 3500.2(b).
    We agree with the District Court that the Chandlers have failed to produce any evidence that the $57,156.25 disbursed to them on January 26, 1996 in connection with their mortgage loan came from any source other than Custom. The documentation prepared by the parties to the transaction indicates that Custom obtained the capital necessary to fund the Chandlers’ mortgage loan exclusively through its credit arrangement with CoreStates. 5 Furthermore, the evidence establishes that Custom repaid its CoreStates loan, with interest, on January 31, 1996. Contrary to the Chandlers’ assertions, their mortgage loan was not table funded by Norwest–their loan was not funded by an advance of loan funds to Custom by Norwest coupled with a contemporaneous assignment of the loan by Custom to Norwest.
    The Chandlers point to the existence of the Purchase and Sale Agreement between Custom, Equicon, and Norwest as evidence to support their allegation that Norwest, as trustee of the Equicon Trust, was somehow the source of funding for the Chandlers’ mortgage loan. This argument is without merit. The uncontroverted evidence confirms that Custom closed the loan in its own name with funds borrowed from CoreStates under an established line of credit. Three days later, the loan was sold by Custom to Equicon, not Norwest. Equicon transferred by wire the funds necessary to purchase the Chandlers’ loan to Custom’s CoreStates account, and Custom thereafter repaid its outstanding loan balance to CoreStates. The Purchase and Sale Agreement cannot and does not raise a material question of fact necessary to defeat a summary judgment motion. The District Court did not err in granting summary judgment to Norwest and Custom.
    III.
    We next turn to the District Court’s decision to impose Rule 11 sanctions against the Chandlers’ counsel. Rule 11 requires all parties who file a complaint in federal court to ensure “that to the best of the person’s knowledge . . . formed after an inquiry reasonable under the circumstances, . . . the claims . . . are warranted by existing law or by a nonfrivolous argument for the extension, modification, or reversal of existing law” and that the “allegations and other factual contentions have evidentiary support.” Fed. R. Civ. Proc. 11. The rule allows a district court to impose an “appropriate sanction” when a party files a complaint in derogation of this responsibility. Id. We review a court’s decision to impose Rule 11 sanctions for abuse of discretion. See Cooter & Gell v. Hartmarx Corp. , 496 U.S. 384, 405 (1990); Landscape Properties, Inc. v. Whisenhunt , 127 F.3d 678, 682 (8th Cir. 1997). The District Court determined that, while the Chandlers arguably may have had a reasonable belief that their claim against Custom had or was likely to have evidentiary support, their counsel could not have conducted the inquiry necessary to support the Chandlers’ claim against Norwest. We agree with the District Court that the Chandlers failed to produce even a scintilla of evidence that Norwest was involved in their mortgage loan transaction in any capacity other than as trustee of the Equicon Trust, or that Custom table funded for Norwest their mortgage loan as defined under Regulation X, or that Norwest paid improper referral fees or unearned and excessive fees to Custom in violation of Section 8 of RESPA. In these circumstances, the District Court did not abuse its discretion by imposing sanctions under Rule 11.
    IV.
    For the foregoing reasons, we affirm the District Court’s grant of summary judgment to Norwest and Custom and the court’s imposition of Rule 11 sanctions against the Chandlers’ counsel.
    FLOYD R. GIBSON, Circuit Judge, dissenting:
    I respectfully dissent. The Real Estate Settlement Procedures Act (“RESPA”) was enacted “to insure that consumers throughout the Nation . . . are protected from unnecessarily high settlement charges caused by certain abusive practices.” 12 U.S.C. § 2601 (1994). To facilitate this purpose, RESPA prohibits kickbacks and unearned fees:
    No person shall give and no person shall accept any fee, kickback, or thing of value pursuant to any agreement or understanding, oral or otherwise, that business incident to or a part of a real estate settlement service involving a federally related mortgage loan shall be referred to any person. 12 U.S.C. § 2607(a) (1994). While secondary market transactions are exempted from RESPA’s coverage,see 24 C.F.R. § 3500.5(b)(7) (1997), I believe the Chandlers presented a genuine issue of material fact as to whether the arrangement designed by Custom, Norwest, and Equicon was a bona fide secondary market transaction. Therefore, I would reverse the district court’s judgment.
    The regulations under RESPA provide that “[a] bona fide transfer of a loan obligation in the secondary market is not covered by RESPA.” Id. The regulation further provides that “[i]n determining what constitutes a bona fide transfer, HUD will consider the real source of funding and the real interest of the funding lender.” Id. Custom was able to show that the funds it borrowed for the Chandlers’ loan came from its direct line of credit with CoreStates. However, Custom had previously entered into a Purchase and Sale Agreement with Equicon and Norwest, under which Equicon would purchase loans from Custom to be held in trust with Norwest as the Trustee. Custom and Equicon had already agreed that Equicon would transfer funds to Custom’s CoreStates account to cover the loan amount shortly after the Chandlers’ loan closed. In fact, Custom and Equicon notified CoreStates of the planned funds transfer on January 3, 1996, three weeks before Custom provided the Chandlers with the loan amount. Therefore, even though Custom borrowed $57,156.25 against its line of credit with CoreStates, Custom knew that “[Equicon], on behalf of [Norwest],” Appellant’s App. at 16, would deposit that amount shortly afterwards. In fact, for Custom’s part in the deal, it received $3,018.75 from the Chandlers in loan origination and discount fees, as well as $7,160.43 from Equicon, on behalf of Norwest which included (1) the $3,018.75 loan origination and discount fees; (2) interest on Custom’s loan from CoreStates; and (3) $3,881.27 in yield spread points.
    A bona fide secondary market transaction is one where a mortgage lender makes loans for its own portfolio and finances these loans from its own or borrowed funds and holds the loans for varying periods of time, or until maturity, with the option of selling its loans, usually in batches on the open market, and not in a preordained procedure where a party makes a loan knowing it will be transferred in due course in a matter of days to the ultimate lender. It appears to me that the transaction involved in this case is a pure circumvention of the Congressional legislation relating to federally related mortgage financing and marketing.
    Based on the structure of the overall transaction, I believe that the “real source of funding” for the Chandlers’ loan was Equicon, acting on behalf of Norwest. 6 In my view, the Chandlers presented a genuine issue of material fact as to whether Norwest gave and Custom accepted a fee based on Custom’s servicing of the Chandlers’ loan in violation of RESPA. See 12 U.S.C. § 2607(a). After viewing the facts in the light most favorable to the Chandlers, see Reich v. ConAgra, Inc. , 987 F.2d 1357, 1359 (8th Cir. 1993), the facts show that Custom and Norwest engaged in a sham transaction which was purposely designed to avoid coverage under RESPA. I do not believe Congress authorized this type of transaction; nor do I believe that this type of transaction is deserving of our judicial stamp of approval. Therefore, I would reverse the district court’s summary judgment in favor of Norwest. Accordingly, I would also reverse the district court’s imposition of Rule 11 sanctions on the Chandlers’ attorney.
    A true copy.
    Attest:
    CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.
    FOOTNOTES
    ————–
    [1]
    The Honorable Catherine D. Perry, United States District Judge for the Eastern District of Missouri.

  13. Just want to make a point. CDOs are derivatives and synthetically created – they are derived from the securities that are backed by the loans. After the loans are put into the trust, the security underwriters purchase the certificates from the trust and use these certificates (securities) to structure CDOs. CDOs are not backed directly by the loans but by the securities to the loans. In CDOs – the securities are packaged.

    Also, have been trying to look at mortgage “servicer advances.” In order for loans to remain in security pools, servicers must advance all delinquent payments, taxes, and insurance not paid, to the trust. Found this on GSEs (not sure policy for private label securitizations), but understand that as part of TALF funding though bonds is available to support servicer responsibilities.

    “In any case, all Ginnies and Fannies, and Freddies, guarantee timely payment of principal and interest to the investor, even if it has not been collected from the borrower. “Timely” means as scheduled. The guarantor makes sure that the investor receives its pass-through payments each month, even if the borrower did not make the payment.

    · The GSEs require the mortgage servicer to advance payments on delinquent loans, so that the timely remittance to the investor can happen, and then to collect on those loans to pay itself off. Only when the loan gets to 90 days delinquent does the loan become “non-accrual” and the servicer’s obligation to advance end.

    · After 90 days the GSE buys the loan out of the pool. This “prepays” the principal to the investor, which is now made whole, although it is no longer earning interest on that principal. The GSE directs the servicer to foreclose and is made whole out of the proceeds as is the servicer who advanced those delinquent payments plus the expense cost of the foreclosure process.”

  14. Jan van eck. Thankyou your posts are excellent and my suit us indeed placing the blame where it belongs fraud in the inducment of the contract and those intermediaries that made the whole ponzi scheme work well those that I know of to date are named in the suit. I love how more and more the word us out pandoras box is OPEN

  15. to Steven Smith:

    The gravamen of the argument is that the loan product was specifically designed “to have negative outcomes for the debtors…”

    The “loan product” was deliberately designed to fail. For example, a loan could be designed to have a 0.25% interest rate for three years, or even a negative interest rate, then jump to a 15.5% interest rate for the next 27 years, on a 30-year Note. It would be “sold” on the premise that the debtor could “re-finance” before the jump or balloon kicked in. If not, then the Note would fail, by going into default. The designers of these loans then “securitized” them by “selling” them into CDO (debt instruments) that were re-sold in slices at a huge profit to “investors.” The designers knew that the loans would fail; they were deliberately designed to do that. So the designers (the “securitizers”) purchased “insurance,” or credit-default swaps (CDS) on their own products. Like insuring against a house fire, then setting the house on fire to collect.

    The argument is that, if the loan was deliberately designed to produce some later default or “failure” (so that the hustlers could cash in on the “insurance” they planned to buy from say AIG), then the loan product was not fully disclosing all the aspects of the loan; that is a violation of the Truth in Lending Act. the representation that the borroweer would be able to “re-finance” was also untruthful and a violation. From those types of violations, damages flow. So you sue them.

    Meanwhile, your (and the government bail-out) cash has long gone into mega-estates in Greenwich, CT, large yachts, private airplanes, and fancy country-club memberships. The rest of your cash has vanished into places like the Cayman Islands. These are not nice people. Try to understand that.

  16. THE JUDGE OR HIS STAFF SHOULD REMOVE HIMSELF/HERSELF FROM THIS CASE IF HE/SHE HAS RECEIVED A LOAN, CONTRIBUTIONS OR DONE ANY BUSINESS, OR ARE RELATED TO ANYONE WHO WORKS WITH BANK OF AMERICA, COUNTRYWIDE, US BANK OR WELLS FARGO OR ANY OF THEIR AFFILIATES.

    ESPECIALLY IF JUDGES OR HIS STAFF RECEIVED IOU’S (IN THE PAST 25 YEARS) FROM BANK OF AMERICA OR ITS AFFILIATES.

    GOD BLESS AMERICA

  17. Judges need to be competent with the subject matter to rule there’s the problem so the skill of ones legal council must also be more competent and might I add honest and willing to put in the hours.

  18. I am not understanding this. If a loan was made and then sold, how does the sale of the loan invalidate the origination or have anything to do with Truth and Lending?

  19. It’s more a matter of getting around corrupt judges.

  20. Way to go Neil! Can’t wait to read this.

    One thing about your TILA comment above…it seems the judges would need to go along with the law for TILA to rescue us. From what I hear, judges are ignoring TILA.

    Until we get around this, true remedy is still elusive.

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