Tuesday, February 24, 2015

Lender Bankruptcy and Mortgage-Backed Securitization

Mortgage-backed securitization is an essential part of the mortgage secondary market, as it provides both liquidity and expanded sources of funding for real estate lender. Securitization also allows for more widespread participation in the real estate market, since MBS bonds are an asset class that can be held by classes of investors that are restricted by law from retaining extended ownership in real property. More participation in the real estate secondary market, of course, translates to a more robust market with more available real estate funding and more real estate activity.

Despite its role in the market down-turn of 2007/2008, securitization of real estate assets has been and continues to be an important part of the U.S. real estate finance market. Securitization, however, heavily depends on a bankruptcy remote structure.

Securitization of real-estate assets is typically accomplished by having the originator or lender, in the case of mortgage-backed securities, transfer its loans to a special purpose entity (SPE) in exchange for the proceeds from the sale of bonds issued through the SPE, beneficial ownership interests in the SPE or trustee certificates in a commercial trust retained by the SPE upon the establishment of a grantor or master trust. These bonds, ownership interests or trust certificates are typically purchased by investors, who expect a cash flow in return for their investment. Given the parties involved, there are two potential bankruptcies that could adversely affect the cash flow to the investors—an originator bankruptcy and an SPE bankruptcy.

If some of the terminology is confusing, essentially what is taking place is that mortgage lenders, who do not have unlimited capital for lending, must find ways to replace the funds tied up in 5, 10, 15, 20, 30 and sometimes 40 year mortgages in order to make more loans. One way to create liquidity is to package the loans and sell them on the whole loan market. Another way to do so is to create an entity, called an SPE, sell the loans that to that entity and effectively have more capital to makes loans. The SPE obtains the cash to purchase loans from the sale of bonds, trust certificates or equity funded by the payments of the loans. The bonds or trust certificates sold by the SPE are called mortgage-backed securities. Naturally, the bankruptcy of the SPE will affect the cash flow from a MBS to its investors, but under bankruptcy laws, the bankruptcy of the lender could also affect MBS cash flow.

Now, let’s discuss bankruptcy. Bankruptcy is a process under both state and federal law that allows for a debtor (a party that owes money) to reorganize its obligations to various creditors. When bankruptcy is filed, a bankruptcy trustee is appointed by the court to bring the debtor through the process, determine which property belongs to the bankruptcy estate and execute a bankruptcy plan. This trustee’s duty is to the bankruptcy estate as a whole, which includes the interests of the debtor, equity holders in the debtor and creditors. Given the various parties involved, there are many times when interests of the various parties may be counter to one-another and to the bankruptcy estate.

There are various bankruptcy types or chapters, but the bankruptcy chapters of most concern to MBS holders are chapter 7, chapter 11 and chapter 13. A chapter 7 filing serves to liquidate and completely wind-up a business or liquidate the personal property of an individual debtor to pay off debts. A chapter 11 filing seeks to reorganize and recharacterize debt, so that a business debtor is able to move forward in a modified form. A chapter 13 filing is a personal bankruptcy filing that allows for the debtor to create a 3 – 5 year repayment plan using their personal income, avoiding the liquidation of personal property, where possible

There are five powers that a bankruptcy court gains from the bankruptcy code that are potentially troublesome to MBS investors. The first is the automatic stay, which restricts creditors from attempting to collect any debt from the debtor from the time the debtor files a bankruptcy petition until the time of the conclusion of the bankruptcy proceeding. The second is the court’s ability to recharacterize transactions, which allows the bankruptcy court to redefine a sale as a loan, thereby pulling previously sold assets back into the bankruptcy estate. Similarly, the third bankruptcy power is the bankruptcy court’s ability to undo what it deems to be a fraudulent conveyance, which essentially amounts to the court stating that a sale was conducted to remove assets from a bankrupt entity in order to avoid bankruptcy. The fourth is the bankruptcy court’s power of substantive consolidation. This power allows the court to treat the entities of a larger company in bankruptcy as closely subsidiaries of the company, placing the assets of the entities within the bankruptcy estate of the larger company. The final power of a bankruptcy court that may be problematic for MBS investors is the ability of the court to determine adequate protection for an asset. This power allows the court to give the a bankruptcy debtor access to any of the assets in the bankruptcy estate for business purposes, so long as it replaces the assets with other assets of reasonably the same value. In some instances, the replacement value can be cash.

I want to be clear that what I have described is very simplified version of the multitude of powers that a bankruptcy court has at its disposal in order to facilitate the bankruptcy process. Moreover, each of the powers listed above have their own rules, exceptions and carve-outs. Furthermore, attempting to explain each of the mentioned bankruptcy powers in detail would more appropriately be the subject of a lengthy paper than a blog post. It is, however, important to note that both a SPE bankruptcy and a lender bankruptcy can affect MBS cash flow, however, the effects of the bankruptcy trustee and court powers differ depending on which party has filed the bankruptcy petition.

Given that the goal of a bankruptcy remote SPE is to have its asset excluded from the bankruptcy estate, the most palpable concerns for an MBS investor that arise from a lender bankruptcy are recharacterization, fraudulent conveyance and substantive consolidation. Recharacterization is of particular concern to a SPE, because the sale of mortgages by the lender to the SPE can itself be seen as a loan, if not structured properly. If the bankruptcy court determines that the transfer of mortgages to the SPE was in fact a loan, they become a part of the lender’s bankruptcy estate and can be sold to satisfy the debts of the estate. This leaves the SPE without assets and capital, which will adversely affects MBS cash flow.  
Fraudulent conveyance functions almost the same way as recharachterization, however, instead of the structure of the sale being the determining factor, it is the timing of the sale that is of concern. If the mortgage transfer to the SPE takes place within one year of the filing of a bankruptcy petition by the lender, the transaction may be subject to a fraudulent conveyance analysis by the court.  Without being too technical, there are two types of fraudulent conveyances: actual and constructive. Unfortunately for holders of MBS, a poorly structured SPE that executes a poorly timed loan transfer can be considered under both frameworks. The result of a loan transfer by a lender to a SPE being deemed a fraudulent conveyance is the same as it being it recharachterized—the loans in the SPE enter the bankruptcy estate of the lender.

Thankfully, the bankruptcy code offers way to structure the sale of assets by a lender to a SPE in a way that will minimize the likelihood that they will be included in the bankruptcy estate of the selling lender. This is accomplished through a “true sale” under the code. Once a bankruptcy court has determined that a true sale has taken place, the assets transferred in the course of that sale are deemed to be outside of the bankruptcy estate. As with any analysis under a legal framework, each determination will be fact-specific, however, some of the considerations under a true sale analysis are:  
1)   The existence of lender’s rights of a recourse to the assets sold
2)   Whether the rights of the lender over the asset are linked to another debt between lender and SPE
3)   The existence of retained benefits of ownership of the assets by the lender, such as a right to excess profits
4)   Whether the language of the transaction indicates a sale or security.
5)   Whether the asset transfer serves to discharge a debt between the lender and the SPE
6)   The degree of post-sale control that the lender has over the assets sold the to the SPE
7)   The lender’s accounting treatment of the sale.
Structuring the sale of loans in contemplation of a true sale analysis greatly reduces the likelihood that the assets sold will be pulled into the lender’s bankruptcy estate, if the lender files for bankruptcy.

Substantive consolidation is yet another power of bankruptcy that can potentially affect MBS cash flow. Unlike recharachterization or fraudulent conveyance, substantive consolidation has less to do with the sale of assets between the lender and the SPE and more to do with the SPE’s relationship to the lender. If the bankruptcy court determines that a SPE has behaved like a closely held subsidiary of the lender, it will treat the SPE as an extension of the lender and place all of its assets in the lender’s bankruptcy estate. Although a true sale may assist in showing the independence of a SPE during substantive consolidation analysis, such an analysis is much more focused on the SPE’s course of dealing with the lender, than it is on any particular transaction. The result of substantial consolidation, however, is the same as the other two powers described above: the assets of the SPE will be made available to the lender to satisfy the obligations of the lender’s bankruptcy estate. Once the assets of the SPE are placed in a bankrupt lender’s estate, the SPE is then subject to the automatic stay and possible asset replacement through the doctrine of adequate assurances.

We will end here. I would like to discuss the effects of a SPE bankruptcy on MBS cash flow and the ways to mitigate those effects, however, I believe that this post is long enough. Instead, I will save that topic for my next post. Stay tuned and feel free to post a comment below.

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