PO Box 2400
An Expert’s - Case Study
Date - April 7, 2006
Loan - $1,000,000
Secondary Financing - $195,000
Total Indebtedness - $1,195,000
Purchase Price - $1,230,000
Ratio Loan to Purchase Price 97.2 %
Borrower’s Income – Not Required
A Co-signer was Required (60% of income to housing costs)
RESULT- Borrower unable to afford monthly payment.
Defaulted on loan October ’08 and Foreclosure ensued.
The Parties continue in Litigation thru 2011
In the present case, a Morgan Stanley (“MS”) originated or acquired thousands of residential mortgages which bundled and sold to another MS entity (“depositor”) which assigned the mortgages to trusts created by a third MS entity. In exchange for the mortgages, the trusts issued certificates to the depositor, backed by the mortgage loans now held by the trusts. These certificates were acquired from the depositor by another MS entity serving as the underwriter or distributor. This entity serving as the underwriter sold the certificates to various institutional investors.
Prior to placing the certificates on the market, MS worked with the rating agencies to structure the pool of mortgage loans by dividing the cash flow from the loans into tranches in order to cause some of the certificates to receive AAA ratings1. AAA ratings are important because many potential investors could (or would) purchase only AAA-rated securities2.
For example, assume a trust owns 1,000 mortgaged-backed loans with an aggregate principal balance of approximately $150 million. If the trust issued certificates that placed the same risk of nonpayment on each certificate, the rating agencies would not rate any of the certificates as AAA. In these circumstances, many institutional investors could not purchase these certificates, and the purchase price for all the certificates would be less than the purchase price for all certificates where a substantial portion of the pool would receive AAA ratings.
Rather than creating no AAA-rated certificates, frequently it would be possible for a trust or underwriter to achieve AAA ratings for a portion of the pool by creating groups of loans to back various certificates (tranches). The highest tranche would be the first to receive its share of the mortgage proceeds and the last to absorb any loses if the mortgage proceeds were insufficient to pay each certificate holder because mortgage borrowers are in default. The participation of rating agency in the creation of the tranches was necessary because the trust or the underwriter needed the rating agencies to indicate where lines could be drawn, based on credit enhancements, in order to maximize the number of certificates that would achieve AAA ratings.
Predatory lending is defined as enriching the lender and having no foreseeable benefit to the borrower. In other words, the borrower would have been better off without the loan.
While this practice includes the willful misrepresentation of material facts about a real estate transaction by an insider without the knowledge of a borrower, it has been defined much more broadly. For example, the New Jersey Division of Banking and Insurance (2007) defines predatory lending as an activity that involves at least one, and perhaps all three, of the following elements:
Loans to borrowers who do not demonstrate the capacity to repay the loan, as structured, from sources other than the collateral pledged are generally considered unsafe and unsound.
Although predatory lending was initially directed at the American underclass (poor people of color, the elderly, etc.). The voracious appetite, for an “Investment” product of the Wall Street Bankers, having found a new market place for the securitization of debt, gradually moved the predatory lending model into the middle class.
The present case is a classic example how this expansion of fraud into the monetary markets with every participant in the food chain denying responsibility, which resulted in the losses to investors, the ultimate holders of the questionable debt instruments. These securities were knowingly fostered upon the public by the participants (originator, primary lender, intermediate holder, and rating agencies) all of whom profited and knew or should have known the negative consequences of their actions.
The mortgage financing for the purchase of the property on Clover Hill Road, in Colts Neck, NJ was provided by Worldwide Financial ($1,000,000) and Saxon Mortgage (an affiliate of MS)($195,000) totaling $1,195,000 on a net purchase price of $1,230,000 97.2% - the 2.8% equity and closing fees were paid from refinancing other properties of the borrower
The machination noted on the appraisal for the subject loan indicate that the listed sale price was $1,249,000 in January 2006. The mortgage banker inflated the sale price to $1,260,000 in order to accommodate the seller’s shortfall of $30,000 for fees to the mortgage broker, thus increasing the indebtedness of the buyers on the combined mortgages (1st and 2nd).
The institutions involved in this case were making loans and investments predominately based on the liquidation value of the borrower’s home rather than on the borrower’s repayment ability. This practice not only increases the risk to the lender/intermediary that the loan will default, but also the potential loss to the final investor. The financial institutions involved herein were not making long term loans for their portfolio; they were actually granting loans to be passed on, utilizing a relatively new concept in raising secured capital from institutional investors which is proven to be a worldwide disaster.
According to the testimony by MS Vice President, Anton Peterson, to the Financial Crisis Inquiry Commission on October 14, 2010, Clayton Holdings LLC, a subcontractor, preformed a review of the documents submitted by Worldwide (original mortgager) for approval by MS as part of their general procedures. MS would then review only loans that were red flagged by the contractor (to date this report and review have not been submitted to [Borrowers] as part of the plaintiff MS discovery answers) and (MS) ignored over 50% of Clayton’s negative comments (including the subject loan).
A review of the file would indicate that this report would disclose and validate the predatory nature of the material that was in the file.
Primarily that [Borrowers] did not have the resources to make the monthly payments on the loans which is one of the important elements of predatory lending.
Our review of the mortgage loan documents in the subject case, find the statements contained in the following “…Complaint for violation of the Federal Securities Law “to be the true and relevant to “predatory” nature of the loan granted to [Borrowers] in April of 2006 by Worldwide Mortgage as the Straw Party to Morgan Stanley Capital.
“…Morgan Stanley Capital established the…Trusts (and then), acquired the mortgage loans that were transferred to the Trusts, and then issued Certificates of various classes or tranches that were sold to investors pursuant to the Registration Statement and Prospectus Supplements. While these offering documents contained data about the mortgage loans, some of the most important information for (the Investors)…was false or was omitted from the Registration Statement and Prospectus Supplements. This misrepresented or omitted information related to the most important aspect of the Certificates – the loan underwriting processes and the collateral that secured the loans. Specifically, the false or omitted information involved the underwriting, quality control, due diligence, approval and funding practices and policies for the mortgage loans, the appraisal processes concerning the underlying properties, and the likelihood that borrowers would (or would not) repay the mortgage loans according to the terms of the loans. These omissions caused the Registration Statement and Prospectus Supplements to be materially false and misleading.
Residential Mortgage Loan Categories
Typically, borrowers who require funds to finance the purchase of a house, or to
refinance an existing mortgage, apply for residential mortgage loans with a loan originator. Loan originators assess a borrower’s ability to make payments on the mortgage loan based on, among other things, the borrower’s Fair Isaac & Company (“FICO”) credit score. Borrowers with higher FICO scores are able to receive loans with less documentation during the approval process, as well as higher LTV ratios. Using a person’s FICO score, a loan originator assesses a borrower’s risk profile to determine the interest rate of the loan to issue, the amount of the loan, the LTV ratio, and the general structure of the loan.
A loan originator will issue a “prime” mortgage loan to a borrower who has a high credit score and who can supply the required documentation evidencing their income, assets, employment background, and other documentation that supported their financial health. Borrowers who are issued “prime” mortgage loans are deemed to be the most credit-worthy and receive the best rates and structure on mortgage loans.
If a borrower has the required credit score for a “prime” mortgage loan, but is unable to supply supporting documentation of his or her financial health, then a loan originator will issue the borrower a loan referred to as a “low doc” or “Alt-A” loan, and the interest rate on that loan will be higher than that of a prime mortgage loan. In addition, the general structure of the loan will not be as favorable as it would be for a prime borrower. While borrowers of low doc or Alt-A loans typically have clean credit histories, the risk profile of the low doc or Alt-A loan increases because of, among other things, a higher LTV ratio, a higher debt-to-income (“DTI”) ratio, or inadequate documentation of the borrower’s income and assets/reserves.
A borrower will be classified as “sub-prime” if the borrower has a lower credit score and higher debt ratios. Borrowers who have low credit ratings are unable to obtain a conventional mortgage because they are considered to have a larger than average risk of defaulting on a loan. For this reason, lending institutions often charge interest on sub-prime mortgages at a rate that is higher than a conventional mortgage in order to compensate for assuming more risk.
The Secondary Market
Traditionally, the model for a mortgage loan involved a lending institution (i.e., the loan originator) extending a loan to a home buyer in exchange for a promissory note from the home buyer to repay the principal and interest on the loan. The loan originator also held a lien against the home as collateral in the event the home buyer defaulted on the obligation. Under this simple model, the loan originator held the promissory note until it matured and was exposed to the concomitant risk that the borrower may fail to repay the loan. As such, under the Traditional Model, the loan originator had a financial incentive to ensure that: (1) the borrower had the financial wherewithal and ability to repay the promissory note; and (2) the underlying property had sufficient value to enable the originator to recover its principal and interest in the event that the borrower defaulted on the promissory note and the property was foreclosed.
Beginning in the 1990s, persistent low interest rates and low inflation led to a demand for mortgages. As a result, banks and other mortgage lending institutions took advantage of this opportunity, introducing financial innovations in the form of asset securitization to finance an expanding mortgage market. As discussed below, these innovations altered: (1) the foregoing traditional lending model, severing the traditional direct link between borrower and lender; and (2) the risks normally associated with mortgage loans.
Unlike the traditional lending model, an asset securitization involves the sale and
securitization of mortgages. Specifically, after a loan originator issues a mortgage to a borrower, the loan originator sells the mortgage in the financial markets to a third-party financial institution. By selling the mortgage, the loan originator obtains fees in connection with the issuance of the mortgage, receives up front proceeds when it sells the mortgage into the financial markets, and thereby has new capital to issue more mortgages. The mortgages sold into the financial markets are typically pooled together and securitized into what are commonly referred to as “mortgage-backed securities” or “MBS.” In addition to receiving proceeds from the sale of the mortgage, the loan originator is no longer subject to the risk that the borrower may default; that risk is transferred with the mortgages to investors who purchase the MBS.
As illustrated below, in a mortgage securitization, mortgage loans are acquired,
pooled together or “securitized,” and then sold to investors in the form of MBS, whereby the investors acquire rights in the income flowing from the mortgage pools:
When mortgage borrowers make interest and principal payments as required by the underlying mortgages, the cash-flow is distributed to the holders of the MBS certificates in order of priority based on the specific tranche held by the MBS investors. The highest tranche (also referred to as the senior tranche) is first to receive its share of the mortgage proceeds and is also the last to absorb any losses should borrowers become delinquent or default on their mortgage. Of course, since the investment quality and risk of the higher tranches is affected by the cushion afforded by the lower tranches, diminished cash flow to the lower tranches results in impaired value of the higher tranches.
In this MBS structure, the senior tranches received the highest investment rating by the Rating Agencies, usually AAA. After the senior tranche, the middle tranches (referred to as mezzanine tranches) next receive their share of the proceeds. In accordance with their order of priority, the mezzanine tranches were generally rated from AA to BBB by the Rating Agencies.
The process of distributing the mortgage proceeds continues down the tranches through to the bottom tranches, referred to as equity tranches. This process is repeated each month and all investors receive the payments owed to them so long as the borrowers are current on their mortgages. The following diagram illustrates the concept of tranches within a MBS comprised of residential mortgages (sometimes referred to as a “residential mortgage backed securities” or “RMBS”):
As illustrated below, in the typical securitization transaction, participants in the transaction are: (1) the servicer of the loans to be securitized, often called the “sponsor”; (2) the depositor of the loans in a trust or entity for securitization; (3) the underwriter of the MBS; (4) the entity or trust responsible for issuing the MBS, often called the “trust”; and (5) the investors in the MBS.
The securitization process begins with the sale of mortgage loans by the Sponsor (here, MSMC) – who acquired the mortgage loans from various originators – to the Depositor (here, Morgan Stanley Capital) in return for cash. The Depositor then sells those mortgage loans and related assets to the individual Trusts (here, the Trusts identified in paragraph 13), in exchange for the Trusts issuing the Certificates to the Depositor. The Depositor then works with the Underwriter (here, MS&Co) of the individual Trusts to price and sell the Certificates to investors. As noted in the Registration Statement, MS&Co and MSMC both work with the rating agencies, loan sellers and servicers in structuring the securitization transaction. Because of this interlocking process, each defendant entity described in this paragraph engaged in the steps necessary to the distribution of the Certificates:
Thereafter, the mortgage loans held by the trusts are serviced, i.e., principal and interest are collected from mortgagors by the servicer, which earns monthly servicing fees for collecting such principal and interest from mortgagors. After subtracting a servicing fee, the servicer sends the remainder of the mortgage payments to a trustee for administration and distribution to the trust, and ultimately, to the purchasers of the MBS certificates.
Sub-Prime and Low Documentation Alt-A Loans and the Secondary Market
Over the past 30 years, the sub-prime mortgage market has evolved from being just a small percentage of the overall U.S. home mortgage market to one that has originated hundreds of billions of dollars of sub-prime loans annually. While several important legislative and regulatory changes have induced such growth, the sub-prime mortgage market would not have experienced such enormous growth without the development of a strong secondary market for home mortgage loans.
During the 1980s, credit rating agencies began rating privately-issued MBS, which made them more suitable to a wider range of investors and expanded the market for MBS. By 1988, 52% of outstanding residential mortgage loans had been securitized, up from 23% four years earlier.
This rapid expansion of the secondary mortgage market significantly increased mortgage lenders’ access to capital and dramatically reduced the need for loan originators to possess a large deposit base in order to maintain their liquidity. As a result, non-depository mortgage lenders proliferated, comprising approximately 32% of lenders of home mortgage loans by 1989.
During the early to mid-1990s, rising interest rates decreased the demand for prime mortgage loans. To spur continued sales of mortgages, lenders became amenable to originating subprime mortgages. This willingness, coupled with technological advances that helped credit rating companies accumulate credit information on a greater number of debtors, increased the market for sub-prime mortgage loans. By 1998, approximately $150 billion in sub-prime mortgage loans were originated, up from approximately $35 billion in 1994.
The growth in the sub-prime mortgage loan market during the 1990s was also aided by mechanisms that allocated and/or moderated risk in sub-prime MBS. These mechanisms, called “credit enhancements,” allowed issuers to obtain investment-grade ratings on all, or part of, their MBS, despite the higher risk on the sub-prime mortgages upon which the MBS were based.
As a result of these credit enhancement mechanisms, MBS were deemed to be suitable to a wider market of investors, and the value of sub-prime MBS sold in the secondary mortgage market grew from $10 billion in 1991 to more than $60 billion in 1997. These sales of MBS provided lenders, including non-depository and mortgage-only companies who were responsible for much of the sub-prime mortgage lending, with ample liquidity to originate new subprime loans. By 2005, the amount of new sub-prime mortgage loans that were originated grew to over $620 billion.
During the 1990s, a new category of mortgage loans emerged. These loans, which became very popular between 2004 through 2006, offered more lenient lending standards than “prime” loans, but were considered less risky than “sub-prime” loans. This loan category, which consisted primarily of Alt-A loans, was originally designed for self-employed borrowers who had high FICO scores and were able to document assets, but could not easily document their income. The Alt-A loans enabled these borrowers to be approved for a mortgage without extensive supporting documentation of their financial history or income.
While Alt-A loans generally have hard to define characteristics, their most distinctive attribute is that borrowers are not required to provide supporting documentation with their applications. For example, a borrower typically did not provide complete documentation of his or her assets or the amount or source of his or her income. Other characteristics of Alt-A loans included: (i) LTV ratios in excess of 80% without primary mortgage insurance; (ii) borrowers who were temporary resident aliens; (iii) loans secured by non-owner occupied property; or (iv) a DTI ratio above normal limits. MBS that are backed by Alt-A loans are appealing because Alt-A loans are perceived to offer temporary protection from prepayment risk, which is the risk that borrowers will pay off their loans immediately. Mortgage loan securitizations were traditionally valued using prepayment speeds as an important component. Alt-A loan borrowers exhibit greater resistance to prepayments during the first nine to twelve months following their origination. Prime borrowers, by contrast, tend to be very sensitive to changing interest rates and they refinance or prepay their mortgage loans on a continual basis as interest rates decline.
The market for Alt-A Loans had increased faster than that for sub-prime.
Approximately $325 billion of Alt-A loans were originated during 2007 and accounted for approximately 13% of all mortgages originated in that year. In 2006, a record $400 billion of Alt-A loans were originated and accounted for 13.4% of all mortgages originated that year. In 2003, only 2.1% of loan originations were Alt-A. However, the delinquency rate for Alt-A loans also increased. After 21 months, loans that were securitized in 2007 had a delinquency rate of more than 13% for fixed-rate loans and more than 26% for adjustable-rate loans. For 2006 securitizations, the delinquency rate exceeded 8% for fixed-rate loans and 18% for adjustable-rate loans. This is compared to 2005 securitizations which only experienced a 2% delinquency rate for fixed-rate loans and a 4% delinquency rate for adjustable-rate loans, and to 2004 securitizations which only experienced a 1.7% delinquency rate for fixed-rate loans and a 2.5% delinquency rate for adjustable rate loans.
Additionally, over the past several years, the quality of the borrowers of Alt-A-type mortgage loans weakened. During this time, Alt-A-type loans were extended to borrowers who would otherwise have qualified only for: (i) sub-prime loans; (ii) much smaller dollar value loans at lower LTV ratios; or (iii) no mortgage loans at all. These lower quality Alt-A-type loans were either “Alt-B” loans, sub-prime loans, or loans for completely unqualified borrowers and included increased risks such as a high LTV ratios and the lack of supporting financial documentation. (As in the subject “Borrower”)
THE FALSE AND MISLEADING REGISTRATION STATEMENT AND PROSPECTUS SUPPLEMENTS?
The Issuers caused the Registration Statement and Prospectus Supplements to be filed with the SEC during 2005, 2006 and 2007 in connection with the issuance of hundreds of millions of dollars in Certificates. The Registration Statement incorporated by reference the Prospectus Supplements. The Registration Statement and Prospectus Statements allegedly contained materially false and misleading statements and omitted material information.
The Issuers caused the Registration Statement to be filed with the SEC on December 23, 2005 and amended the Registration Statement on February 17, 2006 and March 14, 2006. The Registration Statement discussed the mortgage loans contained in the mortgage pools held by the defendant Issuers, representing that the mortgage loans were made to creditworthy borrowers whose documentation was not subject to quite as rigorous a set of standards as other borrowers, but that the loans were made based on the value of the underlying properties, as confirmed by appraisals of the properties.
The Registration Statement and Prospectus Supplements Misrepresented and Omitted Material Facts Regarding the Underwriting Standards Applied by the Loan Originators
The March 14, 2006 amendment to the Registration Statement and each of the Prospectus Supplements discussed the standards by which MSMC purchased the mortgage loans that were eventually transferred to the Trusts in nearly identical language. The Registration Statement and each of the Prospectus Supplements stated:
Generally, each mortgagor will have been required to complete an application designed to provide to the original lender pertinent credit information concerning the mortgagor. As part of the description of the mortgagor’s financial condition, the mortgagor will have furnished information with respect to its assets, liabilities, income (except as described below), credit history, employment history and personal information, and furnished an authorization to apply for a credit report which summarizes the mortgagor’s credit history with local merchants and lenders and any record of bankruptcy. The mortgagor may also have been required to authorize verifications of deposits at financial institutions where the mortgagor had demand or savings accounts.
* * *
Based on the data provided in the application and certain verifications (if required), a determination is made by the original lender that the mortgagor’s monthly income (if required to be stated) will be sufficient to enable the mortgagor to meet its monthly obligations on the mortgage loan and other expenses related to the property such as property taxes, utility costs, standard hazard insurance and other fixed obligations other than housing expenses. Generally, scheduled payments on a mortgage loan during the first year of its term plus taxes and insurance and all scheduled payments on obligations that extend beyond ten months equal no more than a specified percentage of the prospective mortgagor’s gross income. The percentage applied varies on a case by case basis depending on a number of loan purchasing criteria, including the LTV33 ratio of the mortgage loan. The originator may also consider the amount of liquid assets available to the mortgagor after origination.
Certain of the mortgage loans have been originated under alternative, reduced documentation, no-stated-income, no-documentation, no-ratio or stated income/stated assets programs, which require less documentation and verification than do traditional full documentation programs. Generally, under an alternative documentation program, the borrower provides alternate forms of documentation to verify employment, income and assets. Under a reduced documentation program, no verification of one of either a mortgagor’s income or a mortgagor’s assets is undertaken by the originator. Under a no-stated-income program or a no-ratio program, certain borrowers with acceptable payment histories will not be required to provide any information regarding income and no other investigation regarding the borrower’s income will be undertaken. Under a stated income/stated assets program, no verification of both a mortgagor’s income and a mortgagor’s assets is undertaken by the originator. Under a no-documentation program, no verification of a mortgagor’s income or assets is undertaken by the originator and such information may not even be stated by the mortgagor. The loan purchasing decisions for such mortgage loans may be based primarily or entirely on an appraisal of the mortgaged property and the LTV ratio at origination.
These representations appear false and misleading because they failed to disclose that MSMC purchased loans from its correspondents and originators that did not meet MSMC’s stated loan purchasing guidelines. (See the subject loan conditions)
Contrary to the representations that lenders were determining whether borrowers could afford the loan payments, loans were made to borrowers regardless of their ability to repay.
Borrowers were approved for loans they could not afford and could not repay. For example, MSMC purchased loans where the mortgagor provided the original lender with patently false information regarding the mortgagor’s financial condition. In addition, MSMC purchased loans where the original lender failed to determine that the mortgagor’s monthly income was sufficient to enable the mortgagor to repay the loan…”
This case is an illustration of the “perfect storm” of the capital markets, expanding at a great neck pace, with the misguided governmental, economic and social policies. The Wall Street Players and the entire food chain of Borrowers, Appraisers, Brokers, Lenders, Investment Bankers4, Investors (and their agents and contractors) all took advantage of a lax regulatory environment to make a profit and create an International Financial Crisis.
1 Each certificate represents the right of the investor that purchased it to receive a portion of the cash flow, i.e., the principal and interest paid on the mortgages, generated by the pool of the mortgage loans underlying the certificate.
2 Investors may purchase only AAA-rated securities.
3 The quoted language is from the Registration Statement. The Prospectus Supplements contain identical language except that the abbreviation “LTV” is written out in full as “Loan-to-Value Ratio.”
4 An earlier version of this scenario is noted in http://www.thenortongroup.net/subprime-lending.html