Recent data from the Mortgage Bankers Association shows the extent of the collapse of new applications for mortgages. The numbers are down 60% annually and reached a 13-year low. However, higher interest rates are not the chief reason for poor mortgage market performance by a long shot.
Most economists think only in terms of consumer demand, but the reasons for the sharp declines in new mortgage originations also have to do with supply — namely the willingness of lenders to actually make loans. The poisonous combination of the 2010 Dodd-Frank legislation, the mortgage foreclosure settlement by the state attorneys general, and the Basel III capital rules, prevents commercial banks from making anything but prime loans. Add to this the end of the safe harbor for “true sales” of asset-backed securities by the Federal Deposit Insurance Corp. in 2010 and you can virtually guarantee that no FDIC-insured commercial bank will ever underwrite a non-prime, non-QM loan ever again.
What is a true sale and why is it important to the mortgage market? Adam Levitin, professor of Law at Georgetown University, wrote in simple terms about this important issue on the blog Credit Slips back in 2011 in “Skin in the Game-True Sale Implications:”
The economics of many securitization deals hinge on the transfer of assets to the securitization vehicle being a “true sale,” meaning that they are property of the securitization vehicle and not the assets’ originator (or aggregator) and thus bankruptcy remote in the sense that they cannot be claimed as part of the originator or aggregator’s bankruptcy estate.
But even Levitin’s explanation does not fully explain why the concept of true sale is important to the functioning of the mortgage industry. In the 1980s, S&Ls got into trouble because the federal government started to dismantle the prohibitions on fraudulent transfers of assets by banks that dated back to the 1920s. The landmark 1925 Supreme Court decision authored by Louis Brandeis, Benedict v. Ratner, had slammed the door on fraudulent “pledges” of assets by banks, but also stifled credit creation in the U.S .for 50 years afterward. When Congress began to loosen the standard in the 1980s, FDIC Chairman William Seidman called it “the biggest mistake in the history of government.”
After the S&L debacle, the rules on asset sales were tightened temporarily in 1997 — so much that it made it impossible for banks to sell financial assets. In revising the standard in 2001, as former Foley & Lardner partner Fred Feldkamp notes in a draft book, the “FDIC adopted a safe harbor that, it later noted, gave a ‘bye’ on legal compliance for bank transfers to be reflected as sales” despite the fact that these transactions violated the standard set by the Supreme Court in Benedict v. Ratner.
From 2000 through September 2010, when the FDIC adopted new rules for asset sales, the largest commercial banks were given a “get-out-of-jail-free” card to commit acts of financial duplicity with impunity. Transactions were clearly pledges of assets but instead treated as true sales, allowing the largest banks to create tens of trillions of dollars’ worth of bad assets that cut U.S. stock prices in half and nearly destroyed the global economy. Citigroup and other banks failed as a result and many large financial institutions required a government rescue.
The changes made by the FDIC in 2010 to the rules for a safe harbor for asset securitizations, combined with the new rules put in place by the Financial Accounting Standards Board regarding the transfer of financial assets, effectively make it impossible for commercial banks to conduct fraudulent asset sales. But unfortunately, the FDIC’s safe harbor rule also effectively makes it impossible to prosecute the officers and directors of the largest banks for acts of bank fraud committed between 2000 and the end of 2010. By waiving its right to challenge asset sales by banks, the FDIC also gave the officers, directors and attorneys working for these banks carte blanche in a legal sense to commit the worst acts of financial malfeasance in U.S. history. Now you know why Lehman Brothers owned a federally insured bank.
The moral of the story is that acts of criminality like financial skullduggery are only possible in a free and democratic society. The roots of the subprime crisis of 2008 actually stretch all the way back to the 1980s S&L crisis, which itself was a political reaction against the draconian rules put in place in the U.S. in the 1920s in response to the gigantic financial swindles of that era. Decisions like Benedict v. Ratner not only limited financial schemes but also restrained credit expansion and economic growth for decades afterwards.
Finding a balance between regulation and economic freedom is a constant and continuing challenge for us all. Indeed, attorneys for some of the largest U.S. banks are already trying to undermine the new limits put in place by the FDIC and FASB in 2010.
Simply stated, the return of the old, pre-2000 rules on true sales at FDIC is having a stifling effect on the willingness of banks to underwrite non-agency mortgages. The reason is that many of the asset securitizations that have been created by banks over the past several decades are at odds with the Brandeis decision in Benedict v. Ratner. The relevant part of the decision follows below:
But it is not true that the rule stated above and invoked by the receiver is either based upon or delimited by the doctrine of ostensible ownership. It rests not upon seeming ownership because of possession retained, but upon a lack of ownership because of dominion reserved. It does not raise a presumption of fraud. It imputes fraud conclusively because of the reservation of dominion inconsistent with the effective disposition of title and creation of a lien.
Brandeis’ decision struck down the practice of making a simple, often verbal common law pledge of receivables. The claims supposedly held by Ratner, the creditor of a defunct company over which Benedict was the receiver, were eventually rejected by Brandeis in a decision that shook the ground of American finance and began a seven-decade-long debate over the proper construction of secured financial transactions in the U.S. It led to the adoption of Article 9 of the Uniform Commercial Code, which even today governs the methods used to create most commercial security interests in collateral.
In plain terms, the paragraph cited above means that an assignment of collateral is deficient without “the effective disposition of title and creation of a lien.” A financial transaction involving security that lacks these features “imputes fraud conclusively,” Justice Brandeis concluded. By that standard, many mortgage-backed securities created by banks over the past few decades could never have existed. Common practices by bank issuers of mortgage securities such as substitution of collateral, undocumented cash advances, and the appointment of nominee trustees, arguably made these securities resemble “secured borrowings” rather than true sales. So with the withdrawal of the FDIC’s safe harbor in 2010, the enactment of the Dodd-Frank law that same year, and the hysterical regulatory obsession with “reputational risk,” no bank is able to create an asset securitization involving non-agency mortgages — especially one that will meet the requirements of investors and rating agencies in terms of the “isolation” of the assets sold from the receivership powers of the FDIC.
“The Federal Deposit Insurance Act grants the FDIC the power in its capacity as conservator or receiver for an insured depository institution (IDI) to repudiate unperformed contracts of the insured depository where the FDIC determines such contracts to be burdensome,” notes an October 2010 memo by the firm of Cleary Gottlieb. “This power has been construed by the FDIC to allow the FDIC to ‘repudiate’ a secured financing of an IDI by repaying the financing amount and recovering the relevant collateral…. While the Safe Harbor Rule is cast as a non-exclusive safe harbor, the FDIC plainly intends the rule to have a prescriptive effect. Whether driven by rating agency concerns, a desire for greater investor certainty or otherwise, market participants face significant new burdens in complying with the conditions of the rule.”
