September 29, 2014

Reiss on Green Bonds

By David Reiss

Law360 quoted me in Green Bond Bandwagon Promises Cash Returns For NYC (behind a paywall). It opens,

A New York City proposal to market billions in so-called green bonds could reduce debt costs for the city by enticing investors who have stampeded toward guilt-free returns elsewhere, but buyers must tread carefully lest their money ends up funding projects not seen as environmentally relevant.

New York City Comptroller Scott M. Stringer put forth a plan last week that would see the city’s capital spending program add municipal bonds for financing environmentally friendly projects to its plans to issue $30 billion in new debt over four years.

The proposal, which Mayor Bill de Blasio’s administration is studying, suggests moving quickly while there this still a focus on reinforcing the city after Superstorm Sandy and amid the strong demand for green bonds in the private sector as well as in California, Massachusetts and Washington, D.C. As soon as next year, the city could being to convert a large portion of its Municipal Water Finance Authority debt — some $1.5 billion per year — into green bonds and could allocate up to $200 million per year in Transitional Finance Authority and general obligation bonds to similar use.

“Green bonds should be another example of how New York City leads the nation in finding solutions that work,” Stringer said.

While experts in public debt investment largely see the proposal as a promotional bid to market New York City debt, they note that the city’s high national profile could make such a move profitable amid investor hunger to capitalize environmentally friendly projects.

“The big question is: How much demand would this create? One of the main points of the green bonds would be to increase demand,” said Brooklyn Law School professor David Reiss, an expert in real estate finance and community development. “If there really is pent-up demand, and New York City acts as an early mover, it might get a short-term benefit in the cost of borrowing.”

Stringer’s prediction that New York City could spark others to follow suit would also likely come true, Reiss said.

“If this is demonstrated to materially drive down borrowing costs, you’ll see others doing the same thing,” he said. “I’m a little skeptical, over the long term, that you’d have serious savings. But in the shorter term, you might.”

September 29, 2014 | Permalink | No Comments

September 26, 2014

Weaker Reps and Warranties on the Horizon

By David Reiss

Inside Mortgage Finance highlighted a DBRS Presale Report for J.P. Morgan Mortgage Trust, Series 2014-IV3.  This securitization contains prime jumbo ARMS, some with interest only features. So, these are not plain vanilla mortgages.

The report raises some concerns about loosening standards in the residential mortgage-backed securities market, particularly relating to standards for the representations and warranties that securitizers make to investors in the securities:

Relatively Weak Representations and Warranties Framework. Compared with other post-crisis representations and warranties frameworks, this transaction employs a relatively weak standard, which includes materiality factors, the use of knowledge qualifiers, as well as sunset provisions that allow for certain representations to expire within three to six years after the closing date. The framework is perceived by DBRS to be weak and limiting as compared with the traditional lifetime representations and warranties standard in previous DBRS-rated securitizations. (4)

 DBRS noted, however, that there were various mitigating factors.  They included:
Representations and warranties for fraud involving multiple parties that collaborated in committing fraud with respect to multiple mortgage loans will not be allowed to sunset.

Underwriting and fraud (other than the above-described fraud) representations and warranties are only allowed to sunset if certain performance tests are satisfied. . . .

Third-party due diligence was conducted on 100% of the pool with satisfactory results, which mitigates the risk of future representations and warranties violations.

Automatic reviews on certain representations are triggered on any loan that becomes 120 days delinquent, any loan that has incurred a cumulative loss or any loan for which the servicers have stopped advancing funds.

Pentalpha Surveillance LLC (Pentalpha Surveillance) acts as breach reviewer (Reviewer) required to review any triggered loans for breaches of representations and warranties in accordance with predetermined procedures and processes. . . .

Notwithstanding the above,DBRS reduced the origination scores, assigned additional penalties and adjusted certain loan attributes based on third-party due diligence results in its analysis which resulted in higher loss expectations. (4-5)
All in all, this does not sound so terrible. But it is worth noting that the tight restrictions in the jumbo RMBS market appears to be loosening up. As the market cycles from fear to greed, as it always does, it is worth keeping track of each step that it takes toward greed. We can always hope to identify early on when it has taken one step too many.

September 26, 2014 | Permalink | No Comments

September 23, 2014

Is Freddie the “Government” When It’s In Conservatorship?

By David Reiss

Professor Dale Whitman posted a commentary on Federal Home Loan Mortgage Corp. v. Kelley, 2014 WL 4232687, Michigan Court of Appeals (No. 315082, rev. op., Aug. 26, 2014)  on the Dirt listserv:

This is a residential mortgage foreclosure case. The original foreclosure by CMI (CitiMortgage, apparently Freddie Mac’s servicer) was by “advertisement” – i.e., pursuant to the Michigan nonjudicial foreclosure statute. Freddie was the successful bidder at the foreclosure sale. In a subsequent action to evict the borrowers, they raised two defenses.

Their first defense was based on the argument that, even though Freddie Mac was concededly a nongovernmental entity prior to it’s being placed into conservatorship in 2008 (see American Bankers Mortgage Corp v. Fed Home Loan Mortgage Corp, 75 F3d 1401, 1406–1409 (9th Cir. 1996)), it had become a federal agency by virtue of the conservatorship with FHFA as conservator. As such, it was required to comply with Due Process in foreclosing, and the borrowers argued that the Michigan nonjudicial foreclosure procedure did not afford due process.

The court rejected this argument, as has every court that has considered it. The test for federal agency status is found in Lebron v. Nat’l Railroad Passenger Corp, 513 U.S. 374, 377; 115 S Ct 961; 130 L.Ed.2d 902 (1995), which involved Amtrak. Amtrak was found to be a governmental body, in part because the control of the government was permanent. The court noted, however, that FHFA’s control of Freddie, while open-ended and continuing, was not intended to be permanent. Hence, Freddie was not a governmental entity and was not required to conform to Due Process standards in foreclosing mortgages. This may seem overly simplistic, but that’s the way the court analyzed it.

There’s no surprise here. For other cases reaching the same result, see U.S. ex rel. Adams v. Wells Fargo Bank Nat. Ass’n, 2013 WL 6506732 (D. Nev. 2013) (in light of the GSEs’ lack of federal instrumentality status while in conservatorship, homeowners who failed to pay association dues to the GSEs could not be charged with violating the federal False Claims Act); Herron v. Fannie Mae, 857 F. Supp. 2d 87 (D.D.C. 2012) (Fannie Mae, while in conservatorship, is not a federal agency for purposes of a wrongful discharge claim); In re Kapla, 485 B.R. 136 (Bankr. E.D. Mich. 2012), aff’d, 2014 WL 346019 (E.D. Mich. 2014) (Fannie Mae, while in conservatorship, is not a “governmental actor” subject to Due Process Clause for purposes of foreclosure); May v. Wells Fargo Bank, N.A., 2013 WL 3207511 (S.D. Tex. 2013) (same); In re Hermiz, 2013 WL 3353928 (E.D. Mich. 2013) (same, Freddie Mac).

There’s a potential issue that the court didn’t ever reach. Assume that a purely federal agency holds a mortgage, and transfers it to its servicer (a private entity) to foreclose. Does Due Process apply? The agency is still calling the shots, but the private servicer is the party whose name is on the foreclosure. Don’t you think that’s an interesting question?

The borrowers’ second defense was that Michigan statutes require a recorded chain of mortgage assignments in order to foreclose nonjudicially. See Mich. Comp. L. 600.3204(3). In this case the mortgage had been held by ABN-AMRO, which had been merged with CMI (CitiMortgage), the foreclosing entity. No assignment of the mortgage had been recorded in connection with the merger. However, the court was not impressed with this argument either. It noted that the Michigan Supreme Court in Kim v JP Morgan Chase Bank, NA, 493 Mich 98, 115-116; 825 NW2d 329 (2012), had stated

to set aside the foreclosure sale, plaintiffs must show that they were prejudiced by defendant’s failure to comply with MCL 600.3204. To demonstrate such prejudice, they must show they would have been in a better position to preserve their interest in the property absent defendant’s noncompliance with the statute.

The court found that the borrowers were not prejudiced by the failure to record an assignment in connection with the corporate merger, and hence could not set the sale aside.

But this holding raises an interesting issue: When is failure to record a mortgage assignment ever prejudicial to the borrower? One can conceive of such a case, but it’s pretty improbable. Suppose the borrowers want to seek a loan modification, and to do so, check the public records in Michigan to find out to whom their loan has been assigned. However, no assignment is recorded, and when they check with the originating lender, they are stonewalled. Are they prejudiced?

Well, not if it’s a MERS loan, since they can quickly find out who holds the loan by querying the MERS web site. (True, the MERS records might possibly be wrong, but they’re correct in the vast majority of cases.) And then there’s the fact that federal law requires written, mailed notification to the borrowers of both any change in servicing and any sale of the loan itself. If they received these notices (which are mandatory), there’s no prejudice to them in not being able to find the same information in the county real estate records.

So one can postulate a case in which failure to record an assignment is prejudicial to the borrowers, but it’s extremely improbable. The truth is that checking the public records is a terrible way to find out who holds your loan. Moreover, Michigan requires recording of assignments only for a nonjudicial foreclosure; a person with the right to enforce the promissory note can foreclose the mortgage judicially whether there’s a chain of assignments or not.

All in all, the statutory requirement to record a chain of assignments is pretty meaningless to everybody involved – a fact that the Michigan courts recognize implicitly by their requirement that the borrower show prejudice in order to set a foreclosure sale aside on this ground.

September 23, 2014 | Permalink | No Comments

September 22, 2014

Lending to Keep Housing Affordable

By David Reiss

New York State Comptroller DiNapoli issued a critical audit of a loan program of the New York City Department of Housing Preservation and Development. HPD disagreed with many of the audits key findings. For the purposes of this blog post, however, I am more interested in the Article 8A loan program itself. The program derives its name from its enabling statute, Article 8A of the New York State Private Housing Finance Law.

According to the audit, the program is intended

to improve living conditions and to preserve safe and affordable housing for low- and moderate-income households. The Program attempts to achieve this goal by providing low interest rate loans, of up to $35,000 per unit, to owners of rent-regulated, multiple dwelling buildings in New York City (City). The loans are to be used to correct substandard or unsanitary conditions, to replace and rehabilitate building systems (i.e., heating, plumbing, and electrical work), or for other necessary improvements. (4)

To become eligible for this program, building owners “applying for Article 8-A loans must submit an application demonstrating that the physical condition of the property in question, and the owner’s property-related finances, warrant Program funding; and the applicant was unable to obtain a loan from at least two traditional lenders.” (5)

This is an interesting program design because it makes low-cost City funds available to owners who are already required to provide affordable housing pursuant to applicable rent regulation statutes. Given that many other owners of rent regulated buildings are able to operate their buildings without subsidized loans, one wonders why the relatively small number of buildings in this program should receive special treatment.

Legitimate policy rationales could include (i) preventing rent-regulated units from being left vacant due to their poor condition or (ii) preventing units from exiting rent regulation because they are eligible for the “substantial rehabilitation” exception to further rent restrictions. But better than assuming that a particular subsidized loan was made consistent with a legitimate policy rationale, would be for the City to make a specific finding of what it was getting in return for this subsidy. If subsidized loans were just going to (i) owners who had made bad choices in the past that led them to be rejected by private lenders or (ii) to owners in the “know” about this program, that would be a poor use of public funds.

September 22, 2014 | Permalink | No Comments

September 19, 2014

Performance-Based Consumer Law

By David Reiss

Lauren Willis has posted Performance-Based Consumer Law to SSRN. This article

makes the case for recognizing performance-based regulation as a distinct tool in the consumer-law regulatory toolbox and for employing this tool broadly. Performance-based consumer law has the potential to incentivize firms to educate rather than obfuscate, develop simple and intuitive product designs that align with rather than defy consumer expectations, and channel consumers to products that are suitable for the consumers’ circumstances. Moreover, the process of establishing performance standards would sharpen our understanding of our goals for consumer law, and the process of testing for compliance with those standards would produce data about how to meet those goals in a continually evolving marketplace. Even if performance-based regulation does not directly lead to dramatic gains in consumer comprehension or marked declines in unsuitable uses of consumer products, the process of establishing and implementing such regulation promises dividends for improving traditional forms of regulation. (1)
This seems like a pretty radical change from our current approaches to the regulation of consumer financial transactions. Willis argues that disclosure does not work (no argument there) and industry can easily circumvent bright line rules (no argument there). She claims that a suitability regime, like ones that exist in the brokerage industry, offer a superior alternatives.  She writes,
Suitability standards would be closer to traditional substantive regulation, but more flexible. Regulation might define suitable (or unsuitable) uses of types or features of products, or firms might define suitable uses of their products, provided that they did so publicly. Although suitability might be required of every transaction, testing every transaction for suitably would often be prohibitively expensive and ad hoc ex post enforcement would create only limited incentives for firm compliance. Better to set performance benchmarks for what proportion of the firm’s customers must use the products or features suitably (or not unsuitably) and use field-based testing of a sample of the firm’s customers to assess whether the benchmarks are met. Enforcement levers could include, e.g., fines, rewards, licensing consequences, regulator scrutiny, or unfair, deceptive, or abusive conduct liability. (4)
This is certainly intriguing. But just as certainly, one can see the consumer finance industry raising concerns about a lack of clear rules to guide their actions and the after-the-fact evaluations that this approach would subject them to. Willis is too quick to reject such concerns, but they are legitimate ones that would need to be addressed if performance-based consumer law was to be widely adopted. Nonetheless, this is an intriguing paper and its implications should be further explored.

September 19, 2014 | Permalink | No Comments

September 18, 2014

Frannie Reps and Warranties Crisis Brewing

By David Reiss

The Inspector General of the Federal Housing Finance Agency released an audit, FHFA’s Representation and Warranty Framework. Reps and warranties are a risk-shifting device that sophisticated commercial parties use in transactions. If a party makes a representation or warranty that turns out to be false, they other party may have some remedy — maybe the ability to return something or to get some kind of payment to make up for the failure to live up to the promise.

For instance, a lender may sell a bunch of mortgages to a securitizer and represent that all of the borrowers have FICO (credit) scores of 620 or higher. If it turns out that some of the borrowers had scores of less than 620, the securitizer may be able to make the lender buy back those mortgages pursuant to a rep and warranty clause. The IG undertook this audit because of recent changes to the reps and warranties framework for Fannie and Freddie. Before these changes were implemented,

the Enterprises’ risk management model primarily relied on reviewing loans for underwriting deficiencies after they defaulted as the representations and warranties were effective for the life of the loans. In contrast, the new framework transfers responsibility to the Enterprises to review loans upfront for eligible representation and warranty deficiencies that may trigger repurchase requests. If the Enterprises fail to do so within the applicable period, their ability to pursue a repurchase request expires if it is based upon a representation and warranty that qualifies for repurchase relief. (2)

The IG’s findings are disturbing. It “found that FHFA mandated a new framework despite significant unresolved operational risks to the Enterprises.” (3) It also found that

FHFA mandated a 36-month sunset period for representation and warranty relief without validating the Enterprises’ analysis or performing sufficient additional analysis to determine whether financial risks were appropriately balanced between the Enterprises and sellers. Freddie Mac, in contrast to Fannie Mae which provided analysis limited to a 36-month period, provided FHFA with the results of an internal analysis of loans that indicated loans with a 48-month clean payment history were significantly less likely to exhibit repurchaseable defects than loans with a 36-month clean payment history. Thus, losses to the Enterprise could be less with a longer sunset period. Therefore, FHFA cannot support that the sunset period selected does not unduly benefit sellers at the Enterprises’ expense. (3)

This is all very technical stuff, obviously. But it is of great significance. Basically, the IG is warning that the FHFA has not properly evaluated the credit risk posed by changes to the agreements that Fannie and Freddie enter into with the lenders who convey mortgages to them. It also implies that this new framework “unduly” benefits the lenders.

The FHFA’s response is unsettling — it effectively rejects the IG’s concern without providing a reasoned basis for doing so. Its express rationale for doing so is to avoid “adverse market effects” and because addressing the IG’s concern “may not align with the FHFA objective of increased lending to consumes . . ..” (32)

Whenever federal regulators place increased lending as a priority over safety and soundness, warning bells should start ringing. Crises at Fannie and Freddie (and the FHA, for that matter) begin with this kind of thinking. Increased lending may be important today, but it should not be done at the expense of safety and soundness tomorrow. We are too close to our last housing finance crisis to forget that lesson.

September 18, 2014 | Permalink | No Comments