Clarity on Trustee Responsibilities Arrives Slowly

Five years after the meltdown of the subprime mortgage market left investors in residential mortgage backed securities (RMBS) with billions of dollars in losses, participants are still trying to clarify the responsibilities of trustees, servicers, and various other constituents in these deals.

Some clarity may eventually emerge from a slew of lawsuits that are slowly working their way through the legal system, most notably Bank of America’s $8.5 billion settlement with 22 of the nation’s largest institutional investors, which is being contested by numerous other investors.

Market participants aren’t waiting on the courts, however. Sponsors of private label deals that have come to market since the financial crisis are more carefully defining the roles of the servicer and trustee. Congress is also starting to look at these roles.

In the BofA settlement, 65 institutions, including AIG subsidiaries, and the home loan banks of Boston, Indianapolis and Chicago opposed the settlement, saying losses to the 530 securitization trusts could exceed $100 billion and an award of eight cents on the dollar was insufficient.

BNY Mellon, the trustee for the trusts holding the securities, had asked the court to approve the settlement and declare it binding on all investors. Objectors petitioned to intervene and have since sought to overturn it, resulting in the trial that started in early June. The objecting investors argue BNY Mellon failed to adequately pursue claims that Bank of America’s Countrywide unit made false representations and warranties (R&Ws) regarding the securitized loans sold to investors, and it inadequately represented them in the settlement negotiations, alerting them to the initiative only after it was announced.

Creating the Right Incentives

“A big concern for investors is to what extent do trustees or some other transaction parties have incentives and/or obligations to enforce reps and warranties,” said Tom Deutsch, executive director of the American Securitization Forum.

The Bank of New York’s decision to pursue an Article 77 filing, postponing consummation of the settlement until judicial approval of its reasonableness is obtained, is highly particular. Nevertheless, it’s likely to produce some of the early legal decisions that will aid in clarifying the role of participants in RMBS deals, especially trustees. Several dozen other legal suits are in progress, in which investors are suing trustees and, more recently, trustees are pursuing actions against servicers.

The federal government has so far focused its efforts on modifying mortgages and otherwise reducing the burden on borrowers, typically by requiring concessions from mortgage servicers. Members of Congress are now mulling language to clarify the responsibilities of the various parties in RMBS transactions.

Congressional efforts are a part of much broader legislation aimed at reforming the mortgage market and reducing the role of the home loan banks and government conservators Fannie Mae and Freddie Mac, which currently guarantee the vast majority of mortgages. Reforming those entitities has been the primary focus, arguably putting the cart before the horse.  

“Frankly, it’s backwards. Fixing the private-label mortgage market would allow for the rational reformation of the GSEs,” said Josh Rosner, managing director of independent research firm Graham Fisher & Co.

Redwood Trust Leads the Way

The private RMBS market has had only one regular issuer, Redwood Trust, and more recently Wall Street firms including Credit Suisse and J.P. Morgan have entered the market with privately placed RMBS transactions. Those sponsors, in fact, have laid the first marks for what a vibrant private-label RMBS market—capable of replacing much if not all the mortgage volume guaranteed by the federal government—may someday look like.

Redwood introduced its structure in 2010 and has used it in all of its deals since, including the eight transactions it has done so far this year. The structure creates a new entity referred to as a “controlling holder” that is tasked with hiring a third-party to analyze loans after they become delinquent to determine whether there were violations of R&Ws.

In much of the current litigation, still in its early stages, investors are suing trustees, claiming the trustees were in breach of contract because they did not actively analyze loans for those violations and later obstructed investors from pursuing claims against servicers.

Redwood’s transaction structure in some cases removes that responsibility from trustees entirely until it is determined that an R&W violation occurred, restricting them to their reporting and payments role. The trustee only takes responsibility if Redwood is the party marking the R&W or there is no controlling holder.