A significant percentage—by some estimates, more than half—of the recent rise in home ownership in the United States can be attributed to the expansion of subprime credit. The increasing flexibility and ability of lenders to price loans to take into account the higher risk of default posed by subprime borrowers has driven this expansion. This increased flexibility is in turn the direct result of major structural changes in the market for mortgage financing, as the development and refinement of the process whereby mortgage loans are securitized has permitted the private secondary mortgage market to provide capital to subprime mortgage loan originators. By allowing for disaggregation of the idiosyncratic risks associated with both individual loans and loan originators, securitization enables investors to take a relatively secure and quantifiable investment position on subprime mortgage lending. The remarkable expansion of subprime credit that has occurred over the last two decades, and the dramatic growth in home ownership that it has facilitated, would have been impossible without a functioning market for the product of the securitization process—mortgage-backed securities that investors can buy and sell on markets like any other commodified asset.
The recent volatility of the housing market, in combination with the increasing number of subprime borrowers who have taken out mortgage loans, often under terms that are not appropriate to their circumstances, has resulted in a substantial rise in levels of borrower default and foreclosure. The vast majority of subprime loans are extended through legitimate and transparent lending practices, and the basic reality is that defaults happen even when the conduct of originators and brokers is exemplary. Moreover, in a disturbingly large number of instances, borrowers get themselves into trouble by making misrepresentations during the loan application process about their income or intention to occupy the property.
Nevertheless, the American Securitization Forum (the “ASF”)1 is concerned that some subprime borrowers appear to have been victimized by the abusive lending practices involving fraud, deception, or unfairness that are grouped under the term “predatory lending” and that such predatory practices, among other factors, have contributed to the current problems in the subprime market. The ASF also agrees that capital provided through securitizations, along with capital from a variety of other sources, has sometimes been harnessed by unscrupulous lenders and brokers engaged in predatory practices. However, the ASF believes that further expansion of the liability to which direct and indirect assignees of mortgage loans are subject would be an unwise and unfair mechanism for remedying the problems in the subprime loan origination process, unless such expansion is undertaken in a careful, reasoned, and balanced manner. This paper seeks to offer a roadmap for a potentially fruitful legislative approach to this issue at the federal level.
The ASF is a broad-based professional forum of over 350 organizations that are active participants in the U.S. securitization market. Among other roles, ASF members act as issuers, investors, financial intermediaries and professional advisers working on securitization transactions. ASF’s mission includes building consensus, pursuing advocacy and delivering education on behalf of the securitization market and its participants. This position paper was developed principally in consultation with ASF’s Subprime Mortgage Finance Task Force and Assignee Liability Working Group, with input from other ASF members and committees. Additional information about the ASF, its members and activities may be found at ASF’s internet website, located at www.americansecuritization.com. ASF is an independent, adjunct forum of the Securities Industry and Financial Markets Association.
An ad hoc body of federal and state law currently governs the extent to which secondary market assignees that are innocent of any wrongdoing may nonetheless be subject to liability. The primary component of the federal statutory scheme governing liability for assignees is the Truth in Lending Act (“TILA”), which was amended and supplemented in 1994 by the Home Ownership and Equity Protection Act (“HOEPA”). HOEPA applies narrowly to certain high-interest and high-fee equity loans (“covered loans”) that are perceived as potentially predatory, and imposes strict liability on voluntary participants in the market for covered loans for violations committed by loan originators. In addition to federal law, a number of states and localties have responded to the problem of abusive loan origination by promulgating legislation that imposes liability on assignees. Although these state and local laws generally build on the HOEPA approach, they often have triggers that are set at levels that are lower than the HOEPA triggers, and they also usually impose more severe and more subjective restrictions on covered loans than does HOEPA.
The premise behind the calls for expanded assignee liability—that the secondary subprime mortgage market aids and abets predatory practices by primary lenders and brokers—is substantially overblown. In addition to being largely unnecessary, any federal legislation that would expose secondary market participants to assignee liability that is very high or unquantifiable would have severe repercussions. It would likely cause a contraction and deleterious repricing of mortgage credit, thus harming both prospective subprime borrowers and current borrowers seeking to refinance their existing loans on more favorable terms—especially those borrowers with impending rate increases on their adjustable rate mortgage loans. And this contraction and repricing would occur at precisely the time when the provision of further liquidity, spurred by the willingness of investors to expose themselves to additional risk, is essential to ensuring the financial health of the housing market. Thus, a poorly thought-out expansion of assignee liability in response to present concerns about predatory lending practices in the subprime sector would serve merely to multiply the number of victims of those practices.
Many of the proponents of expanded assignee liability assert that the flow of capital from the secondary market to loan originators constitutes a major factor contributing to the frequency of lending abuses in the loan origination process. These proponents envision investors, investment banks, and the other financial entities that participate in the secondary market taking on additional roles as regulators of subprime mortgage lenders and brokers, exercising oversight functions over current bad practices, and even rationalizing inefficiencies in the pricing and supply of subprime credit. But the analysis justifying expanded assignee liability suffers from a number of conceptual flaws.
First, the assumption that secondary market participants are indifferent to the wrongful conduct of primary loan originators and mortgage brokers, and care only about funneling new capital to the primary market, is mistaken. In fact, secondary market participants already face strong economic incentives to avoid unprofitable loans, including those that have been originated in a predatory manner. Indeed, the recent rise in default rates and failure of a number of originators have spurred a tightening of standards and more stringent evaluation of loan pools by investors and securitization sponsors. Intrusive government regulation would therefore pose a serious threat to the market’s own corrective processes.
Second, secondary market participants simply are not well-situated to take on an additional role conducting legally imposed, intrusive regulatory oversight over the very market in which they participate. Indeed, because the secondary market is unable and unprepared to make the fine distinctions between proper and improper loans that are necessary under the HOEPA regime, HOEPA has had the predictable effect of discouraging the flow of capital to all lenders, not just unscrupulous ones. Many state and local laws, by precipitating a complete withdrawal of secondary market capital from the high-cost loan sector, have also had the effect of reducing significantly the overall availability of funding for subprime lending.
Third, it is essential to remember that the actors directly responsible for the harm that results from predatory practices—mortgage originators and brokers—already are subject to extensive, if sometimes ineffective, government regulation. Although a more comprehensive regulatory scheme could help reduce predatory conduct in the primary market, and predation by mortgage brokers in particular, this goal should be pursued through government action that is directed specifically at the culpable actors. If the current regulatory framework is defective in its design or implementation, legislators should openly acknowledge and address the problem rather than shifting the responsibilities of government regulators onto the secondary market.
Fourth, most assignees are individual passive investors or entities that are far removed from the loan origination process. These parties have nothing to do with any predatory practices of brokers and originators, and have no way of either knowing when such practices are taking place or reasonably discerning from review of the loan that they have invested in the fruits of illegality. Over the short term, shifting the burden for predatory practices from the cheated (if not necessarily blameless) home owner to the passive investor or securitization sponsor simply shifts the burden from one innocent party to another. Over the long term, those secondary market participants that do not exit the market entirely in response to heightened prospective legal liability will demand a greater return on their investments as compensation for taking on additional legal exposure. Thus, the burden of enhanced regulation will ultimately fall on all borrowers, including the vast majority who are served by responsible originators and brokers.
For certain consumer credit transactions that involve goods or services (but not real estate), the Federal Trade Commission’s Holder Rule for the Preservation of Consumers’ Claims and Defenses, which was promulgated in 1975, effectively abrogates the protections afforded assignees by the holder-in-due-course doctrine. Many commentators point to the Holder Rule as offering a viable model for the imposition of liability on assignees of mortgage loans. Even to the extent that the rationales underlying the Holder Rule are persuasive in the context of consumer credit, they are inapplicable in the mortgage context because (i) the circumstances of cheated consumer credit borrowers are not comparable to those of cheated mortgage borrowers, (ii) assignees of defective consumer credit are subject to a very different incentive structure than that to which assignees of mortgage credit are subject, and (iii) the securitization of subprime loans already presents vexing problems of risk evaluation and mitigation that are not present in the market for consumer credit.
In sum, the secondary market is unsuited to playing the role of primary regulator of mortgage lenders and brokers, and it should not be asked to do so. To the extent that there is to be assignee liability for secondary market participants, it should be imposed pursuant to a uniform national standard that is crafted carefully to serve the primary goal of reinforcing the extant market forces that already provide substantial incentives for those parties that sponsor and invest in MBSs to make responsible investment decisions. The ASF believes that such a carefully crafted regime, even if extended to apply at triggers that are modestly lower than the current HOEPA triggers, would be preferable to the current patchwork of state and federal laws, which has done little more than generate tremendous costs and inefficiencies that, at the end of the day, are shouldered by all subprime borrowers.
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