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Can trusts be trusted?

Yves Smith

Yves Smith

In the repo world, the most serious allegations against mortgage servicers may be that during the housing boom servicers did not correctly transfer mortgage documents to the trusts that created the mortgage-backed securities that became collateral for repurchase loans.

This would mean that the trusts can’t prove they own the loans they pooled to back up the mortgage-based securities they issued.

Money market funds, commercial and investment banks and other financial instituions make repo loans based on the soundess of the collateral. If trusts can’t be trusted to own the loans they’re pooling, these lenders might stop making repo loans collateralized by mortgage-backed securities, which would wipe out about a third of the repurchase market, one of the largest financial markets in the world.

Could that be the reason there seems to be little official action on the document-transfer problems?

Yves Smith at her Naked Capitalism blog makes some interesting points on this issue today. She uses them to illustrate her fear that “we now have rule by banks, with occasional gestures to disguise that fact, rather than rule of law.” This is a point made frequently by Massachusetts Institute of Technology economist Simon Johnson at his Baseline Scenario blog.

Among Smith’s points today:

And the most important issue that was and continues to be ignored is: why are servicers counterfeiting transfer documents in the first place? It’s pretty obvious why all the authorities are trying to ignore the worst form of chicanery. But it is not clear why the parties most directly harmed, the investors, are doing nothing, at least so far.

As an attorney and former Congressional staffer pointed out by e-mail, the problem with the failure to convey assets into the trust as stipulated in the pooling and servicing agreement is not breach of contract issue. It is a contract formation failure issue and the remedy is restitution. And if you argue that the contract was never formed, that would seem to surmount a restriction in pooling and servicing agreement that 25% of the investors need to band together to sue the trustee to then enforce the contract.

RMBS investors thus have a nuclear weapon in their hands. If they want deep principal mods, and we are told in no uncertain terms that they do, a credible threat of litigation on this front ought to bring recalcitrant banks and trustees to heel, quickly. The last thing the mortgage industrial complex wants is litigation on an issue that would both call into question the validity of RMBS and if successful, would leave the banks with massive damages. And you don’t need to do this publicly and rattle the markets; some investors with the right legal top guns could spell out the consequences if the banks failed to get off their duffs and enter into serious negotiations.

Now perhaps these very conversations are underway now, but I strongly suspect not. The continued arrogance of the banksters is a big tell. And you therefore have to wonder why nothing of the kind is happening. A sad but obvious reason is fixed income investors don’t have any incentives to rattle the cage. Their job is just to beat the index by a little bit and call it a victory. We are also told that some investors are afraid of rattling their relationship with their banks, since they depend on them for information (hate to tell you, but if you think your bank is your friend, I have a bridge I’d like to sell you). But there are some investors, such as the major public pensions fund like Calpers, who take a more aggressive stance.

But there is a second, more ugly, possibility. I’m not a fan of conspiracy theories, but it would not be a stretch to imagine that if the Fed or the Treasury were to get wind of any such contemplated litigation, they’d use every avenue at their disposal to discourage it. China is already worried about the wind-down of Fannie and Freddie. What would the reaction be if the US media were to start discussing, as Adam Levitin put it in Congressional testimony, that RMBS are not mortgage backed securities?

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