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REQUIRED READING: It is no secret that investors, extremely disappointed with the performance of private-label mortgage-backed securities, have been aggressively pursuing remuneration from counterparties. Up until this point, the blitz has been mostly endured by the front office. With the push for mortgage putbacks growing daily, investors have been clamoring for access to loan data that might support their claims that sellers misrepresented loan quality or breached contractual warranties.

Although much of investors' ire has been directed toward originators, servicers - fresh off a nearly industry-wide admission of flawed foreclosure processes, never mind persistent consumer complaints of bad-faith negotiations - are increasingly finding themselves in the crosshairs. Previously, sloppy servicing - drawn-out foreclosure timelines, for example - was viewed as simply inefficient work, grounds for reminding servicers of their obligations under loan pooling and servicing agreements (PSAs).

"The servicer's response was, 'We'll correct it,' but it was highly unusual to be able to get money out of the servicer, to get a servicer to pay damages for not doing their job optimally," says Sue Allon, CEO of Allonhill, a provider of due-diligence services.

Perhaps the most high-profile example of the divide between servicers and investors is  the notice of nonperformance that residential mortgage-backed securities (RMBS) certificate holders, including Blackrock and PIMCO, sent last October to Countrywide Home Loan Servicing under PSAs. The master servicer and trustee, respectively, on 115 Countrywide-issued RMBS deals, Countrywide and Bank of New York were accused of defaulting on their obligation.

The investors have alleged a variety of PSA breaches, with the general theme being that the trust’s losses were exacerbated by Countrywide’s servicing failures. More specifically, the institutional investors decried shoddy collateral files, the failure to follow up on deficient loan files and alleged attempts to maximize servicing fees at the expense of investors and borrowers.

“Everyone is sympathetic to the fact that servicers haven’t had it together,” says Allon, “but investors in these RMBS are pretty mad that things went as badly as they did, and they want to hold servicers accountable.”

The allegations in the Countrywide example appear to straddle the servicing and origination functions: Countrywide, the investors say, failed to enforce the sellers’ repurchase obligation and failed to notify the trustee of representation-and-warranty breaches that could have been discovered as part of loss mitigation activity.

While investors’ chief avenue for remedying origination mistakes is to demand that sellers repurchase non-compliant loans, their opportunities for recourse over servicing errors often fall into one of two categories: suing for damages or transferring servicing rights, according to Isaac Gradman, an independent attorney and consultant based in San Francisco.

But before investors can act, they must first reach critical mass. Under the terms of most PSAs, the holders of 25% or more of the voting rights in an RMBS deal have the authority to make certain demands, such as requiring the trustee to investigate claims of contractual breaches. When the percentage of holders grows to 50%, investors become empowered to essentially fire a servicer or trustee.

“Private-label investors have had to overcome a number of procedural hurdles to even get standing to petition a trust for action or to file a lawsuit,” Gradman says. In the case of Countrywide, the Bank of New York originally rejected a request by investors to investigate perceived breaches. A month later, the investors sent their notice of nonperformance.

Investors gain steam

Around the time when robo-signing became headline news, reports began re-emerging that investors were joining forces in preparation for large-scale litigation against banks over RMBS deals. One of the largest initiatives is the quickly growing investor clearinghouse being organized by Dallas-based attorney Talcott Franklin. In October, the clearinghouse had 25% or more of voting rights on some 2,600 RMBS deals and 50% or more on 1,150 deals. As of early January, Franklin was representing 25% or more of voting rights on about 3,000 deals.

While 2010 was the year of “probing quietly to determine who our friends are,” he explains, the clearinghouse may begin filing lawsuits this year.

“We don’t have a choice but to be more aggressive now,” Franklin says, adding that the investors will decide on a case-by-case basis whether to pursue loan putbacks, servicing transfers or compensation for damages. Servicers are often affiliates of, or the actual parties involved in, repurchase obligations, he adds. The way Franklin sees it, servicers are too often acting in their own self-interest rather than the interest of investors. “There are huge conflicts of interest all over these deals, and those conflicts are starting to manifest themselves in a bad way for borrowers and in a bad way for investors,” he says.

The point has been raised that the language in PSAs pertaining to servicing is often nebulous, at best. The contracts are usually awash in generalities about administering loans in accordance with customary and reasonable industry practices. Despite the vague verbiage, several allegedly widespread abuses - such as reversing lien priority in loss mitigation or advising borrowers to default on their mortgages in order to qualify for loan modifications - are viewed by many as open-and-shut cases.

“I think almost any court would say, ‘I’m not sure what customary servicing obligations are, but they certainly aren’t to service a loan in your own interest,’” says Gradman. “Servicers may benefit from the squishy language, but I think the breaches we’re talking  about here are pretty clear-cut.”

Servicers’ actions “add up, probably, to a decent portion of the losses that we’re seeing,” Franklin adds.

Worlds apart

Litigation is unlikely to bring servicers and investors any closer together. By most accounts, the current relationship might generously be described as strained.

“I would portray it as fairly removed, and the reason is that servicers have gotten away from investors,” says Allon. “There’s been a lot of consolidation of servicing shops, and there’s also been a lot of changing of hands of private-label RMBS.”

Gradman similarly notes that there has not been much direct dialogue between servicers and investors. More often than not, servicers do not respond to investor requests unless they receive instructions from trustees to do so, he explains.

Part of the explanation for the seeming apathy toward investor requests for data is that servicers and trustees fear that responding to one-off questions could equate to opening the floodgates. Respond to one inquiry, and a deluge of requests will follow, the thinking goes.

Investor requests typically start at the macro level, says Kelly Ballenger, a senior manager in Clayton’s servicer surveillance unit. Armed with little more than remittance statements, data from trustees’ websites and, in more sophisticated circumstances, data sets provided by third parties, investors are left trying to make informed decisions based off of reconciled reports.

“With the deterioration of portfolios, the interest in what servicers are actually doing has increased, and there’s extra scrutiny,” Ballenger says. Extra scrutiny does not necessarily imply greater clarity. Remittance statements might show that losses spiked, but they rarely provide the necessary context. In some situations, alterations to a servicer’s loss mitigation policy or inaccurate reporting by trustees are to blame, she says.

“What [investors] have to realize is that it may or may not be a servicing practice that’s leading to losses,” Ballenger explains. “Although the pursuit might be there, I don’t know that many investors are getting all the data they want in the current environment.”

Trustees have “put up very high walls,” Allon adds, explaining that trustees are unlikely to respond to an investor unless it can prove the necessary voting interest has been assembled.

“It is the trustee’s job to make the servicer respond, but they won’t do that now,” she says.

It is unclear how the inability of investors to get hold of loan-level data will affect their attempts to litigate over servicing failures. Grais & Ellsworth LLP partner David Grais has previously referred to court battles over putback liability as a “war of attrition.”

“Any investor who chooses litigation as the path of recourse ought to know in advance that the opposition will be fierce,” Grais said at an investor conference last October. Servicing-based litigation is unlikely to be much different. A “flood of litigation” is forthcoming, Allon projects, adding that the expense to investors could be huge.

“I have witnessed what it takes to investigate loans; a detailed forensic review of loans is where it starts,” she says. “You have to build a case and have enough loans to pursue to make it worthwhile.”

A recent court ruling in New York, however, could lessen the costs of litigation
for investors. In late December, New York Supreme Court Judge Eileen
Bransten approved bond insurer MBIA Inc.’s request to use a statistical sampling methodology to support its claims that it was fraudulently induced to insure MBS. The ruling “has a huge impact on private-label litigation in terms of proving breaches of reps and warranties,” says Gradman. That impact could extend into future servicing-related litigation.

“It’s a setback,” Gradman says. “If you proceed under the assumption that servicers are going to be sued more frequently, in the same manner as originators, over servicing breaches, then it is a setback, because it means that liability can be more readily and easily established.”




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