FOR INSTITUTIONAL INVESTORS. Who Can You. Trust? The Failure of RMBS Trustees to Protect Investors

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1 Who Can You Trust? The Failure of RMBS Trustees to Protect Investors Mounting evidence shows that the trustees of the RMBS that precipitated the financial crisis knew of pervasive deficiencies in the securitization and servicing of the mortgage loans underlying the RMBS, yet failed to take action to protect investors rights. By Benjamin Galdston, Dave Kaplan and Lucas Gilmore In the aftermath of the largest financial crisis since the Great Depression, of 25 to 50 percent in order to demand join forces to reach an ownership threshold investors in residential mortgagebacked securities ( RMBS ) who sus- satisfy because investors in RMBS are action. No action clauses are difficult to tained billions of dollars in losses are still typically hard to organize since they are trying to figure out who is legally responsible for the mess. Naturally, the banks diverse and geographically dispersed. Is nobody working for the investors to that feverishly churned out the trillions of protect the RMBS trusts and certificateholders and enforce the contractual obli- dollars in toxic loans bear responsibility. But so many of those once-household gations in the agreements establishing names have been shuttered, bankrupt or the RMBS trusts? In theory, the RMBS bought. Similarly, the loan originators trustees are supposed to act as stewards and sponsors that promoted and sold the for the trust assets. Under the Pooling RMBS as investment-grade products despite knowing of lenders wanton disre- and Servicing Agreements ( PSAs ) governing the RMBS trusts, as well as statutory and common law, the trustees have gard for sound underwriting standards should have been called to account for duties and obligations to take all actions their misdeeds. However, many RMBS necessary to protect the trusts and certificate-holders. However, it is clear that the originators and sponsors have succeeded in avoiding liability altogether mostly trustees have repeatedly turned a blind through clever no action clauses in eye to hundreds of thousands of bad agreements underlying the RMBS, which loans that could have been returned for allow them to sit back and do nothing unless a sufficient number of investors Continued on next page. 1 Bernstein Litowitz Berger & Grossmann LLP

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3 The trustees have duties and obligations to take all actions necessary to protect the trusts and certificate-holders. However, it is clear that they have repeatedly turned a blind eye to hundreds of thousands of bad loans that could have been returned for full price and to the predatory servicing practices that harm borrowers and investors alike. full price, as well as to the predatory servicing practices that have harmed borrowers and investors alike. As we now know, the six principal trustee banks of the financial crisis era U.S. Bank, Deutsche Bank, Wells Fargo, Citigroup, HSBC and Bank of New York Mellon saw their role differently. Mounting evidence now shows that these trustees knew of rampant underwriting violations and pervasive deficiencies in the securitization and servicing of the mortgage loans underlying the RMBS trusts, yet failed to take action to protect investors rights. The trustees rarely, if ever, demanded that the originators of the loans or anyone else repurchase defective loans. They did little or nothing to protect investors, and even erected roadblocks to investors who tried to take matters into their own hands. Rather than demanding that the toxic loans be repurchased by the Wall Street banks that packaged and sold the RMBS, or put back the loans to the complicit lenders, for years the trustees stuck their heads in the sand. In so doing, the trustees allowed these valuable contract rights to lapse, while investors bore the brunt of the losses. The trustees continue to allow loan servicers, who collect mortgage payments and manage defaulted loans, to engage in abusive servicing practices that exacerbate the enormous losses suffered by investors. This total failure of responsibility bears striking similarities to the events that led to the Great Depression and is a key factor in causing today s private mortgage finance market to evaporate. For its part, Congress and other governmental authorities have shown little if any interest in holding the trustees accountable. To date, there have been no investigations or enforcement actions against RMBS trustees. Private litigation against the RMBS trustees may prove to be the last hope for any meaningful recovery for investors and to spur reform among the trustees. The RMBS Trustees As Gatekeepers And Guardians Mortgage securitization has long provided the capital needed to maintain the high rates of home ownership that the U.S. enjoys. Public pension funds and other types of institutional investors provide the primary source of capital behind the mortgage finance markets. Indeed, between 2003 and 2007, more than $3 trillion worth of residential home loans were securitized and sold to institutional investors as RMBS. Central to the securitization process and investor protection is the corporate trustee. The corporate trustees failure to protect the RMBS trusts and certificate holders is nothing new. Spurred by trustees abusive practices in the aftermath of Black Tuesday, Congress passed the Trust Indenture Act of 1939 ( TIA ) to make clear that corporate trustees have non-delegable duties to protect trust beneficiaries and that they cannot stand by idly in the face of clear harm to trust assets. Indeed, the RMBS trustees are supposed to confirm that each and every trust holds good title to the loans, enforce the representations and warranties associated with the loans, and take other measures to protect the RMBS investors. As the SEC explained, 3 Bernstein Litowitz Berger & Grossmann LLP

4 the TIA s goal was to enlarg[e] the definition of [a] trustee s duties in those cases where a failure to take swift and positive action [would leave] investors without effective protection of their interests. The TIA was intended to address the common practice by trustees of writing exculpatory provisions into the indenture that immunized trustees from liability for deliberate and negligent misconduct. It was also designed to put an end to trustees practice of including no action provisions in trust indentures that allowed them to turn a blind eye to problems. In addition, the TIA imposed uniform duties and responsibilities on indenture trustees of nearly all public bond issuances. These reforms were aimed at protecting investors and could not be avoided by exculpatory provisions. Still today, the TIA requires trustees to follow their obligations as outlined in the indenture and to act akin to a fiduciary after any default. The RMBS Trustees Have Failed To Protect Investors From 2001 to 2007, investment banks issued more than $4.3 trillion in RMBS. To make the RMBS certificates marketable, both the originators and sponsors made specific representations and warranties regarding the credit quality and characteristics of the mortgage loans, and promised to repurchase, substitute or cure any loans that were in breach of the representations and warranties. The loan servicers similarly agreed to service the loans in a usual, customary and lawful manner consistent with prudent servicing standards. Institutional investors and public pension funds, which bought roughly 25 percent of the RMBS market over $1 trillion in original face value exposure were attracted to the bonds reasonable returns and the promised safety of investmentgrade ratings (often AAA or greater). Investors also relied upon the protection of the trustees, whose contractual obligations were set forth in the securitization documents, including the PSAs. These documents required the trustees to represent and enforce the rights of investors and to serve as an independent watchdog. Such duties included providing notice of representation and warranty violations, ensuring that the loans were serviced in accordance with customary standards, and giving written notice to investors of any known defaults. Where defaults went uncured, the PSAs required the trustees to exercise all of their vested rights and powers, and to use the same degree of care and skill as a prudent person would exercise or use under the circumstances in the conduct of such person s own affairs. Through public and private investigations and Congressional reports, there is now overwhelming evidence that most of the loans sold to the RMBS trusts during this era breached numerous representations and warranties made by mortgage originators and sponsors. Breach rates have been found as high as 99 percent meaning that, in some pools, virtually every loan was originated in violation of underwriting standards, materially and adversely impacting the value of the loans. Equally well documented has been the RMBS servicers departure from prudent Continued on next page. Congress and other governmental authorities have shown little if any interest in holding the trustees accountable. To date, there have been no investigations or enforcement actions against RMBS trustees. Private litigation against the RMBS trustees may prove to be the last hope for any meaningful recovery for investors and to spur reform among the trustees. Summer 2014 The Advocate for Institutional Investors 4

5 The trustees have done virtually nothing to enforce investor rights. Hundreds of billions of dollars in RMBS trust assets have been destroyed over the last six years, with the trustees sitting idly by. RMBS issued between 2004 and 2006 alone have lost over $450 billion, or 20 percent of the debt outstanding. servicing practices. Highly publicized servicer violations include failing to maintain accurate account statements, engaging in robo-signing and charging unnecessary and excessive fees, and failing to timely foreclose on uncollectible loans, all of which have harmed investors by escalating borrower defaults, increasing the costs of foreclosure and fostering uncertainty as to the timely recovery of trust collateral. As a result of their illicit servicing practices, many of the major mortgage servicers have faced federal and state regulatory enforcement actions and substantial penalties. Notably, without receiving certificate-holder approval, many of the servicer settlement agreements offer credits to the servicer for reworking the loans backing the RMBS. Thus, as one major portfolio manager stated, The banks are trying to pay [their] fines with our money. The trustees have done virtually nothing to enforce investor rights. Hundreds of billions of dollars in RMBS trust assets have been destroyed over the last six years, with the trustees sitting idly by. RMBS issued between 2004 and 2006 alone have lost over $450 billion, or 20 percent of the debt outstanding. Amazingly, however, no RMBS trustee has independently sued to put back defective mortgage loans, or seek reimbursement from the servicers. One obvious reason the trustees have failed to take any action is because they are so deeply conflicted. For example, one of the largest servicers of the RMBS trusts over which Wells Fargo Bank, N.A. presides as trustee is none other than Wells Fargo Bank itself. Moreover, the trustee is selected by the sponsor, and therefore risks losing future business if it vigilantly enforces seller repurchase obligations. Echoing the same arguments of Depression-era indenture trustees, modern RMBS trustees have justified their failure to act by interpreting the securitization agreements to permit them to turn a blind eye to the defaults. The trustees also argue they are free from TIA responsibilities because RMBS are supposedly equity and not debt. While procedures exist for investors to initiate repurchase demands and the servicers compliance with prudent servicing standards, investors are confronted by many of the same walls Congress sought to tear down through the TIA. Under the securitization documents, investors cannot file suit directly against the loan sellers or servicers for breach of contract. Rather, investors must first make a demand on the trustee to act, which typically requires the support of 25 to 50 percent of the trust s investors. However, the trustee controls the list of the investors, who are otherwise anonymous to one another and, unlike the trustees, investors do not 5 Bernstein Litowitz Berger & Grossmann LLP

6 have access to the loan or servicing files. Accordingly, investors have been able to force the trustees to act in very few instances. What s more, some courts have ruled that the statute of limitations on put-back claims has now expired. The RMBS market continues to suffer from a crisis of investor confidence. Effectively no subprime, alternative-a or jumbo RMBS have been issued in the last five years. The lack of new RMBS issuances has decreased liquidity in the housing market hurting consumers and eliminated a valuable investment option for institutional investors. A revival of the private mortgage finance market is desperately needed, but it will not occur until the institutional investor community s faith in the corporate trustee is restored. The RMBS Trustees Now Face Enormous Liability Private investors have recently taken the lead in holding trustees responsible. Lawsuits have now been filed against all of the major financial crisis-era RMBS trustees, including U.S. Bank, Deutsche Bank, Wells Fargo, The Bank of New York Mellon, HSBC, and Citibank. Courts have thus far sustained claims in at least six cases against the trustees for breach of contract or Trust Indenture Act violations. As one court explained, to accept that the Trustee was unaware of reports and investigations [regarding underwriter and servicer misconduct] would require the Court to find that the responsible officers of Defendants had been living under a rock and that [i]f the Trustee was indeed living under a rock, it had no right to do so given its role and responsibilities. The importance of these lawsuits to RMBS investors cannot be understated. Not only do these cases pursue large amounts of damages suffered by investors, but they could pave the way for industry-wide reforms. Reinforcing the fundamental role and responsibilities of the trustees will enhance the value of RMBS certificates, revive the private mortgage finance market, jump-start the fledgling housing recovery, and entice institutional capital to return what was a historically safe and valuable investment. Benjamin Galdston is a Partner in BLB&G s California office. He can be reached at beng@blbglaw.com. Dave Kaplan is an Associate in BLB&G s California office. He can be reached at davidk@blbglaw.com. Lucas Gilmore is an Associate in BLB&G s California office. He can be reached at lucas.gilmore@blbglaw.com. The RMBS market continues to suffer from a crisis of investor confidence. Effectively, no subprime, alternative-a or jumbo RMBS have been issued in the last five years. A revival of the private mortgage finance market is desperately needed, but it will not occur until the institutional investor community s faith in the corporate trustee is restored. Summer 2014 The Advocate for Institutional Investors 6