Dilbert on Securitization: The hope that a chair will one day be made for you

Wherein I explain how a Dilbert cartoon explains some issues that lie at the heart of the foreclosure crisis and the validity of securitization.

My Encounter with the Dilbert Cartoon

My client wanted to enter into a long-term ground lease for real estate. The developer did not hold legal title (i.e., did not have a deed) or equitable title (i.e., did not have it tied up under a binding agreement of sale) to the ground; the developer had only the right to cause the owner of the ground to enter into a ground lease with third-parties, such as my client (the most important consequence of which right, from my client's point of view, was to exclude our client from entering into a direct deal with the ground owner).

As we negotiated the agreement with the developer, the developer kept backing off on even the most fundamental represenations and warranties that a purchaser customarily gets in these types of transactions. I said to the developer's lawyer, "Call me old fashioned, but, when my client pays someone $xxx in a real estate transaction, I tend to insist that they get, in return, a property interest."

While on a conference call with the developer that slogged across the same ground for the umpteenth time, I happened to glance down at the Sunday comics lying open on my desk, and saw the cartoon in question. (If I told you who the client was, you would understand why the cartoon was particularly apropos). The key line: "The truth is that we don't sell chairs at all. We sell the hope that a chair will someday be made for you." I immediately emailed the cartoon to the developer as a different way of trying to get my point across.

"The hope that a chair [or mortgage loan] will someday be made for you" 

Paul Jackson's analysis of assignments of mortgage loan documents in the context of securitization reminds me of the Dilbert cartoon. Mr. Jackson displays admirable hope that New York trust law, coupled with the language of most Pooling and Servicing Agreements (PSAs), will suffice to transfer ownership of mortgage loan documents (i.e., notes and mortgages/trust deeds) to a securitization trust:

If my interpretation is correct, then, and if there is somehow a failure to transfer the note and/or mortgage per the PSA terms, the trust still would clearly¹ own the obligations that were legally assigned to it via the PSA.

In reaching this interpretation, Mr. Jackson points out that, under New York law, a trust need not have actual possession of trust "property" (e.g., notes and mortgages/trust deeds), but only a legal assignment of the "property" + "the intention of passing legal title" to the trust:

The actual delivery of the fund or other property, or of a legal assignment thereof to the trustee, with the intention of passing legal title thereto to him as trustee.

Aye, there's the rub. What is the "property" to which title is being passed? And how do we measure "the intention of passing legal title?" Those are what lawyers like to call "proof problems," which sounds unexciting, but can become very exciting, indeed -- and potentially quite deleterious to one's career path.

Mr. Jackson takes comfort in the granting language of the typical PSA:

The Depositor, concurrently with the execution and delivery hereof, does hereby transfer, assign, set over and otherwise convey to the Trustee without recourse for the benefit of the Certificateholders all the right, title and interest of the Depositor, including any security interest therein for the benefit of the Depositor, in and to the Mortgage Loans identified on the Mortgage Loan Schedule

Assuming that Mr. Jackson is correct that, under New York trust law, the quoted PSA language adequately passes legal ownership of "Mortgage Loans identified on the Mortgage Loan Schedule" to a securitization trust, the trust's ownership is only as good as "the Mortgage Loan Schedule" in the PSA. The Ibanez case has already shown us a schedule that wasn't very:

 The copy of the PSA provided to the judge did not contain the loan schedules referenced in the agreement.  Instead, Wells Fargo submitted a schedule that it represented identified the loans assigned in the PSA, which did not include property addresses, names of mortgagors, or any number that corresponds to the loan number or servicing number on the LaRace mortgage. The agreement makes reference to a schedule listing the assigned mortgage loans, but this schedule is not in the record.

And Adam Levitin thinks that "there are lots of RMBS deals where the schedules in the PSAs are possibly insufficient to meet the Ibanez standard." Moreover, trying to prove "intention" of any kind is not necessarily a walk in the park: just ask the prosecutors trying to prove financial crimes. 

That's why, for centuries, the only "bulletproof" ways to pass legal title to loan documents from the original lender to an assignee is (i) an allonge signed by the original lender, assigning the note to its actual, named assignee (not "in blank"), with the allonge being physically attached to the note, and both in the actual possession of the lender, plus (ii) a recorded assignment of mortgage, also signed by the original lender and given to an actual, named assignee. 

Anything less than this is buying the hope of ownership of mortgage documents, rather than actual ownership of those documents. This is especially true in a securitization that requires several different assignments: the transaction structure itself is vulnerable, because it affords an opponent the opportunity to challenge, at every step, the assignor's "intention of passing legal title" to the assignee.  A trust that fails to document its ownership of a note via something less than a point-by-point chain of assignments via allonge attached to the original note, and its accompaying mortgage via something less than a point-by-point chain of recorded mortgage assignments, is vulnerable to attack at every step. I see that as a central flaw to the entire securitization concept; a flaw that, owing to the primacy and diversity of state law in this field, does not easily lend itself to any central solution.

Moreover, an underwriter who fails to disclose this as a potential risk to its investors may find itself on the wrong side of securities litigation. Many investors have already found, to their considerable chagrin, that they have not bought a stream of cash payments secured by mortgage loans; they have bought the hope of that stream of cash, and, in some cases, they might be better off going to the ATM and braying like a donkey in the hope that cash will come out.  

¹ Whenever I find myself asserting that my argument is "clear," it's usually a tip-off that I don't believe that it is. Otherwise, I wouldn't have to say so.