Mortgage Securitization, Servicing, and Consumer Bankruptcy

By O. Max Gardner III

Wayne Gretzky once said that his success was due to the fact that he focused on where the puck was going to be, not where it was. For most consumer debtors who have home mortgage loans and are involved in Chapter 13 bankruptcy cases, this Gretzkyism is somewhat of a double entendre. The fact of the matter is that most of these debtors have no idea who really owns their home mortgage loan and they most assuredly do not know why the balance owed keeps going up. Or, as Yogi Berra might say, these “guys have been double-pucked!”

And, the so-called “double-pucking” all starts with mortgage securitization. Securitization is a complex series of financial transactions designed to maximize the cash flow and cash out options for loan originators. The securitization and sale of assets is what gets the “off the balance sheet” boost in reported income for the originator. The originators secure immediate liquidity from assets that, in some circumstances, could not be readily traded in the capital markets. On paper, it sounds simple, in the real world it involves the creation of numerous Special Purpose Vehicle Corporations (SPV) designed to create the legal impression of an actual BPF sales transaction. However, the residuals, credit enhancements, and other derivative rights retained by the originators in the transferred assets create a Pandora’s Box of problems. A good example is Enron. Enron had enhanced the credit worthiness of thousands of asset-backed securitizations with Enron stock. When the Enron stock tanked so did the securitizations and Enron had to “recognize” all of these “off the books” transactions as liabilities. We know the rest of the story.

To securitize an asset, the loan originator creates a pool of financial assets such as mortgage loans. It then uses one or more SPV corporations to convert the large pools of these mortgages into complex investment certificates, backed or securitized by valid liens on the transferred collateral. These certificates are then rated and offered for sale to asset capital investors, foreign investors and life insurance companies to name a few. The certificates are normally split into various types or tranches, each of which has pre-determined cash flow or equity positions in the underlying collateral.

Unlike conventional bonds, payments of principal and interest from these mortgage backed securities (MBS) are based on the cash generated by the pooled assets. Cash can be generated by monthly mortgage payments and the pre-payment of the mortgage instruments by refinancing or early payment. The collateral for all of these bonds is always a pooled trust of the underlying assets, administered by a designated Trustee. The Trustee then enters into an agreement with a third-party to actually service the collection of the income from the pooled assets. These servicing agreements are normally consummated prior to the initial funding or transfer of the assets to the trust and are normally referred to as a Pooling and Servicing Agreement (PSA).

In many cases, the entity that originates or aggregates the assets for securitization will retain the rights to service the pool of mortgage loans for the trustee. These rights are referred to in the mortgage context as retained mortgage servicing rights (MSR). The entity holding the MSR rights is normally referred to as the Master Mortgage Servicer. The PSA may give the Master Mortgage Servicer the right to “farm-out” the actual servicing and collection of the mortgage loans to a primary servicer, a secondary or subservicer, or a default servicer. In the vast majority of cases, the consumer-mortgagor is making his or her monthly payments to one of these servicers, whom they erroneously believe is the entity that actually “owns their mortgage.”

The rights to service a mortgage loan are considered to be assets with recognized value. In fact, Mortgage Servicing Assets (MSA) are sold, assigned, and securitized just like the mortgage loans they service. Suffice it to say, the buying and selling of servicing rights accounts for much of the consumer confusion that leads to the common misstatement that “my mortgage has been sold 4 times in the past five years.” The mortgage has not been sold, just the rights to service the mortgage, the mortgage is still swimming in a pool with other similar debt instruments. And, since a Master Mortgage Servicer receives a service release premium (SRP) when it sells the servicing rights, the market is certainly active.

The final element in understanding this financial model is that you have public and private label placements of mortgage securitizations. All of the public placements are originated by the Government Sponsored Entities (FannieMae, FreddieMac, and GinnieMae commonly referred to as the GSE’s) and normally involve a single form of an investment bond or certificate called Pass-Through Certificates. All of these placements are the subject of detailed SEC filings and other public reports. The private-label placements, on the other hand, represent mortgages that have been aggregated on the secondary market by private investors and the pooled trusts of these assets are normally not subject to any SEC reporting or filing requirements. The private placement MBS’s also normally offer multiple forms of investments and create these instruments by splitting the income and principal aspects of the MBS trust into many different segments or tranches. The GSE’s have historically purchased for securitization only traditional mortgage products but in recent years have expanded into a variety of areas such as loan size, higher loan-to-value loans, alternative mortgages (ARMS, Hybrid ARMS, Interest Only ARMS, etc.). The private label aggregators, on the other hand, have purchased all of the others including Alt-A, sub-prime, etc.

At his point, you might ask what does any of this have to do with consumer mortgages and Chapter 13 bankruptcy cases. Well, in short, in the words of the Rapper Puff Daddy 1. “It’s all about the benjamins, Baby.” The problem arises out of the fact that in most cases the “income” for servicing a mortgage is “fixed” at the time of securitization. The “fixing” of this compensation is based on historical financial models of the pooled mortgages that make certain assumptions on default rates, foreclosure rates, the ability to market REO (real estate owned) properties, and the like. If these projections are not accurate, then the costs of servicing an above average pool of defaulted mortgage loans may be a money losing proposition for the servicers. And there is a fine margin in the mortgage servicing business between operating in the black or in the red.

One of the most startling statements about these revenue reduction problems that this writer has seen was one reported in the August 2005 edition of Mortgage Banking. Mortgage Banking is published monthly by the Mortgage Bankers Association of America and touts itself as “the magazine of real estate finance.” In an Article by Thomas J. Healy, a Certified Mortgage Banker employed by HanoverTrade Inc. the following statement is made:

“Because servicers average approximately $60 per loan per year in net profit, it does not take much in the way of additional non reimbursable inspections/collections/foreclosure costs to wipe out the profits on a lot of loans.”

This statement is supported by a “cost of servicing” survey that is being conducted by the Research Department of the Mortgage Bankers Association of America. Marina Walsh, the Director of this Department, was recently quoted as saying that “in general, servicing costs [for subprime mortgages] were about three times that of the prime side.” Ms. Walsh went on to state that when subprime loans go into default, the servicing costs are 4.5 times higher than for defaulted prime loans.

These quotes and these statistics remind me of some advice I received about 30 years ago from a veteran personal injury attorney. We were about to settle a very large medical malpractice case and our fee was based on a percentage of the total recovery. I remember asking the veteran, “How much is 33% of that settlement?” He responded as follows: “I don’t know for sure but 33% of a lot is a lot! Well, in order to enhance their default servicing revenues, mortgage servicers “involved in” consumer bankruptcy cases have created all sorts of new fees and charges that are not assessed against the investors (the holders of the certificates in the pooled trusts, who will not pay these fees) but against the poor Chapter 13 debtors.

What type of fees are we talking about? Well in Mr. Healy’s article, he writes about inspections. What type of inspections is he referring to? I guess the best place to start would be with Gerald Stark, a civil engineer for whom I filed a Chapter 13 case about 10 years ago. Gerald had a mortgage loan that had been securitized by FannieMae and was being serviced by Crestar Mortgage Corporation. The mortgage was current on the petition date and remained current during the course of the plan. Notwithstanding the Chapter 13 filing, Crestar continued to send monthly billing statements to the debtor. It was not the billing statements that concerned Gerald but the $9.00 additional fee added to his statement each month designated as “other charges.” Mr. Stark called Crestar numerous times about these charges and was told everything from “we have no idea” to they are just “bankruptcy fees.” Mr. Stark took the matter up with me when the total amount of the monthly property inspection charges reached $135.00.

Mr. Stark subsequently filed a motion for sanctions against Crestar for violations of the automatic stay. Crestar admitted that it had caused the home to be inspected once per month so as to make sure it had not been vacated, which was curious in itself since the debtor at all times remained current on his mortgage payments. If Gerald had abandoned his home, you would assume he would have stopped making the mortgage payments.

The property inspection fees in Stark’s case were allegedly paid to third parties who would simply ride by the house and file a written report indicating such things as the grass was mowed. Crestar’s defense to Gerald’s motion was that, as servicer, it was only acting in compliance with the Mortgage Servicing Guidelines issued by FannieMae. In rejecting this defense, and holding in favor of the debtor, the Bankruptcy Court stated: “The $9.00 monthly inspection fee that Crestar imposed on the debtors in this case was in effect a monthly bankruptcy ‘monitoring fee’ ”. Stark v. Crestar Mortgage Corp. 242 B.R. 866, 871 (Bankr. W.D.N.C. 199). The Court went on to hold that “since Crestar attempted to collect these ‘inspection or bankruptcy monitoring fees’ from the debtors while the stay was in effect, by adding fees to the debtor’s monthly statements, Crestar violated Section 362(a)(3).” Id. at 873.

Gerald Stark’s case turned out to be the tip of a very large ice-berg of unlawful and illegal mortgage servicer fees in consumer bankruptcy cases. The next case that came to light involved the practice of advancing various sums of money against the mortgage for the costs of alleged legal fees related to the filing of a proof of claim in a Chapter 13 case. Samuel and Melinda Smith filed a Chapter 13 case in 2000 (W.D.N.C. 00-31220) and scheduled a secured debt to TMS Mortgage, Inc (now HomEq). TMS filed a proof of claim that included the sum of $125.00 for “legal fees related to the preparation and filing of the claim.” TMS admitted that it had never filed a motion under Code Section 506(b) or Bankruptcy Rule 2016 for approval of this fee. About the same time, Jason and Sherri Tate, who had filed a Chapter 13 case in 1997 (W.D.N.C. 97-32126), noticed that the proof of claim on their home mortgage filed by Nationsbanc Mortgage Corporation (now Bank of America) included the sum of $125.00 for “bankruptcy fees”. Tate v. Nationsbanc Mortgage. 253 B.R. 653,660 (Bankr. W.D.N.C 2000). Nationsbanc’s defense was that it had outsourced the proof of claim process to a law firm in Texas and the $125.00 was a reasonable fee for their services. The charge was a flat fee that the lawyers charged per case, per claim.

In rejecting these arguments, the Court in Smith and Tate found these attorney fees to be procedurally “per se unreasonable.” Id. at 665. Specifically, the Court noted that Rule 2016 sets forth “a straight forward methodology for requesting payment of attorney fees. The rule applies to any person or entity seeking compensation for services or reimbursements of expenses from estate assets.” Id. To the Court, it seemed pretty simple: 11 U.S.C. Section 506(b) authorizes the payment of legal fees to secured creditors who seek such fees upon the filing of a proper application with adequate notice; and, the Court has authority under 11 U.S.C. 105 to enforce a failure or refusal of a creditor to so comply. Id. at 668. In concluding the decision in Tate. the Court stated: “In summary, Section 105 authorizes this Court to take whatever action is necessary to enforce the Code’s provisions. The bankruptcy court is entitled to exercise its powers under the Code to restrain a creditor from overreaching. To do otherwise would allow Nationsbanc to perpetuate a fraud on the Court and other parties in interest.” Id. at 669.

Unfortunately, the only thing the Mortgage Servicers appear to have learned from any of their cases is that the vast majority of Chapter 13 debtors and their attorneys do little or nothing about these illegal fees and charges. As a result, it is actually profitable to “perpetrate a fraud” on the Bankruptcy Courts, the Bankruptcy Trustees, the attorney for the debtors, and of course the debtors. A good example of these practices can be found in a trilogy of cases presented to the Bankruptcy Court in New York in November of 2002. In Re Gorshtein. 285 B.R. 118, 120 (Bankr. S.D.N.Y. 2002).

One of the Gorshtein cases was a Chapter 13 case, which had been filed by Mandy Abrue in July of 2000. On February 7. 2001, Fairbanks Capital Corp. (now Select Portfolio Servicing) filed a motion for relief from stay in which it alleged that “no post-petition payments have been received from the Debtors.” Id. The debtor objected and provided proof that all these payments had been made. The motion was thereafter withdrawn. Exactly one year later Fairbanks filed a second motion for relief from stay in which it made the same allegations as the first motion (no payments had been made on the mortgage since filing). This second motion was filed by the same attorney who filed the first motion. Once again the debtors objected and provided proof of all post-petition payments. Fairbanks explained that due to some type of internal accounting function the motions had been filed because the payments had been placed “into a debtor’s suspense account” and therefore they had never been applied to the mortgage loan. Id. at 123. (FN2). The use of various forms of “suspense accounts” by the mortgage servicers deserves a separate Chapter. The accounts, in short, allow the servicers to “hide payments” and then raid the accounts to pay themselves bogus fees and charges.

The Gorshtein court imposed sanctions on its own motion pursuant to Bankruptcy Rule 9011 in all three of the consolidated cases including the one involving Fairbanks. The Court noted that whether “the cause of the false certification [of a serious payment default in each case] should be labeled intent to deceive, gross negligence, incompetence or mere inadvertence is indeterminable and, in any event, it really does not matter. It does not matter because the result is the same for the debtor and the judicial process, which will be victimized by the misstatement if for any reason the debtor fails to respond timely to a baseless motion.” Id. at 126.

Fairbanks learned little if nothing from the Court in Gorshtein. On July 16, 2002 the Bankruptcy Court for the District of Massachusetts entered a judgment for sanctions against Fairbanks (including rescinding the mortgage) in the case of Pearl Maxwell, an 83 year old woman with minimal schooling and limited financial recourses. This case provides a textbook illustration of the extent to which the mortgage servicing industry is out of control.

During the Maxwell case, Vince Brando, who identified himself as a Special Default Technician, testified that “ Fairbanks buys loans in bulk without checking to ascertain whether each loan is accompanied by proper documentation.” Maxwell v. Fairbanks. 2002 W.L. 1586325 (Bankr. D. Mass. 2002). Mr. Brando testified at one time Fairbanks paid $129,344.00 for the Maxwell loan but admitted that Fairbanks at another point claimed to have paid $175,955.00. In trying to explain this and other inconsistencies in the amount of the default, the principal balance owed, the corporate advances and the use of suspense accounts, Mr. Brando indicated that “Fairbanks has no documents in its possession to substantiate payments of that amount, and Fairbanks cannot identify any account, fund or other source of monies from which that amount was paid.”

Brando later testified that rather than purchase the mortgage Fairbanks actually only acquired the servicing rights. When questioned about the payment history, he said that Fairbanks, “never had the prior payment history from the prior servicer.” He added that “he could not say what happened when the prior lender owned the loan.” And, when pressed how Fairbanks could determine the amount owed, the amount of arrears, or the current payment status without a payment history, he said: “I go off of whatever the computer has for me and what it offers me, because that’s all the information we would have. No one would have any more than that.” Id. Fairbanks, of course, was later involved in a consumer class action and was named in a Fair Debt Collection Act enforcement proceeding filed by the FTC. In addition to agreeing to pay more than $56,000,000.00 in the class action, Fairbanks also agreed to terminate the CEO and president, and to terminate many officers, attorneys, agents, and employees.

The abuses of the mortgage servicers have been described by many knowledgeable commentators as “predatory mortgage servicing.” This term does not do justice to the current practices of these parties. These practices are beyond predatory in that they constitute more of a premeditated plan to ignore the entire bankruptcy process. The actions of these mortgage servicers in consumer bankruptcy cases are nothing more or less than an intentional abuse of the judicial process and the rule of law. It is also part of a pervasive pattern of chicanery, fraud, trickery, deceit, double-dealing and just plain old-fashioned illegal conduct.

During the past 7 years I have compiled a list of my own Top 10 Mortgage Servicer Abuses. The list is reprinted below along with representative cases if applicable:

1. The systematic and universal creation of junk fees such as monthly property inspections, monthly property preservation fees, broker price opinion fees, proof of claim preparation fees, review of Chapter 13 plan fees, and other similar and related charges. Case Examples: In Re Coates. 292 B.R. 894 (Bankr. D. Ill 2003) and Dawkins v. Chase Manhattan. unpublished Slip Opinion, Case No. 99-40552. (Chase was actually seeking over $11,000 in attorney fees for simply a motion for relief from stay that Chase lost).

2. The systematic failure to disclose any of the junk fees during the pendency of the Chapter 13 case by way of the filing of a proper Rule 2016 Fee Application with adequate due process notice and the right to object. Case Example: Tate v. NationsBanc Mortg. Corp. (In Re Tate). 253 B.R. 653 (Bankr. W.D.N.C. 2000); Harris v. First Union Mortg. Corp. (In re Harris). 2002 Bankr. LEXIS 771 (Bankr. D. Ala. 2002) (awarding $2,000,000 in damages).

3. The sinister collection of these fees post-discharge in Chapter 13 cases when the debtor no longer has the benefit of a bankruptcy attorney or any other party who can review a payoff statement for accuracy. Since many Chapter 13 debtors are eligible to refinance their mortgage loans after a Chapter 13 discharge, many of these charges are secretly collected at closing. And, most of the software systems used by the servicers are programmed to automatically download all of the fees and charges held in “suspense” into a payoff quote.

4. The use of these fees to create negative payment histories that result in motions for relief from stay. The system developed by the servicers is both complex and simple. The servicer establishes a software program that automatically adds a late charge to any post-petition payment based solely on the pre-petition default. The system is also designed to transfer any post-petition payment that does not include the “secret late fee” into a suspense or forbearance account. The funds in these accounts are obviously not applied to the post-petition mortgage payments. The debtor receives no interest on these funds and the suspense account is not a trust account. In many instances, the servicers will raid the suspense accounts to pay the unlawful corporate advances and other undisclosed fees and charges.

5. As the court noted in Gorshtein. the attorneys for the mortgage servicers are guilty of the repeated and systemic filing of false representations of defaults in motions for relief from stay. The attorneys know or should know that the data they are receiving from the servicers is not accurate or otherwise reliable; yet, in order to keep a “good client” they continue to accept the cases and file the motions.

6. The attorneys for the servicers who do ask for court approval of their legal fees in connection with a motion for relief from stay are also guilty of making false representations to the Court, the Trustee, the debtor, and the attorney for the debtor. These false representations relate to the nature and extent of their attorney fee agreements with the servicers. For example, many courts have a presumed no-look fee of $450.00 for a motion for relief from stay plus the filing fee of $150.00. Many attorneys for the servicers agree to these fees with full knowledge that their firm has been paid $850.00 plus the $150.00 filing fee by the servicer and that these “actual” fees and not the court approved fees will be charged back to the debtor’s account.

7. The creation of bogus “escrow” accounts to fund unlawful corporate advances. The obvious intent is to use these “escrow accounts” to hide the improper application and disbursement of funds from the debtor’s contractual payments and from the Trustee arrearage payments.

8. The practice of including undisclosed legal fees in attachments to proofs of claim and then inserting language in a hidden addendum that the failure of the debtor to object to these fees constitutes a waiver, estoppel, or res judicatta defense. See Slick v. Norwest Mortg. Inc. (In re Slick), 2002 Bankr. LEXIS 772 (Bankr. D. Ala. 2002 ).

9. The placement of forced-place insurance with a captive company (i.e. a wholly owned or related subsidiary) when debtors have such insurance. This triggers an escrow review, an enhanced payment, and more money for the suspense accounts.

10. The advancement of funds against the debtor’s mortgage loan for monetary damages actually paid to the same debtor for violations of the bankruptcy law. The servicer will also charge the debtor for the attorney fees incurred in defending such action. Case Example: In Re Riser. 289 B.R. 201 (Bankr. D. Fla. 2003).

1 The writer is fully aware that Puff Daddy is currently known as “Diddy” per his request, but thought Puff Daddy to be the more accurate name for such an old school song reference.

Mr. Gardner received his undergraduate degree from the University of North Carolina at Chapel Hill in 1969 and graduated with high honors from the UNC School of Law in 1974. Among others, he was a member of the Law Review, President of the Student Bar Foundation and elected to the Order of the Coif. Following graduation, he served as law clerk to the Hon. William H. Bobbitt, the late Chief Justice of the North Carolina Supreme Court, and to the Hon. William Copeland, an Associate Justice.

He opened a law practice in Shelby, NC in 1977 and currently limits his practice to consumer bankruptcy issues and related law.

Gardner was named the Outstanding Consumer Lawyer of 2004 by the National Association of Consumer Bankruptcy Lawyers and was elected a Member of the North Carolina Legal Elite by Business North Carolina in December of 2004. He is a long-time member of NACBA and NACA and a frequent national speaker on bankruptcy law and consumer representation.