As a quick review, I would like to restate that mortgage-backed securities are the result of a process of securitization that takes place when a real estate lender sells a package of its loans to an entity, called and SPE. The SPE receives the money to purchase the loans from the sale of either securities, beneficial interests in the entity or trust certificates from a trust set-up to hold the loans. If securities or trust certificates are sold, they are called mortgage-backed securities (MBS). Through the securitization process, real estate lenders are provided with cash to originate more loans and investors are able to purchase MBS and invest in the real estate market without having to hold real property. If you question why one would want to invest in the real estate market at all, please see my earlier post, “Why I Choose Real Estate.”
Now, let’s review the bankruptcy process. Bankruptcy is a
way for an insolvent company or individual to manage their debt through either
reorganization, repayment pursuant to a court-approved plan or liquidation.
There are various types or chapters of bankruptcy, however, the bankruptcy court
has certain powers that it can use to facilitate the bankruptcy process, no
matter which chapter is filed. The first is that the court can create a
bankruptcy estate for the bankrupt entity and appoint a bankruptcy trustee to
be in charge of the estate. Second the court can impose an automatic stay,
under which creditors are prevented from pursuing a bankruptcy debtor any
further for debts owned. Third, in the case of a business bankruptcy, a court can
allow a debtor access to any of the property in the bankruptcy estate for
ordinary business purposes, so long as the collateral is replaced with assets
of substantially the same value. This is the power of adequate assurances. Fourth a court can recharacterize
transactions undertaken by the debtor prior to bankruptcy. In this way a sale
of assets can be recharacterized as a loan and the sold assets can be brought
back into the debtor’s bankruptcy estate. Similarly, the bankruptcy court can rescind
any sale that was completed within a year of the filing of a bankruptcy
petition, if it deems the sale to be a fraudulent conveyance. Finally, a
bankruptcy court can consolidate closely held subsidiaries of debtors into the
bankruptcy estate of the debtor.
Having reviewed the powers of the bankruptcy court, I feel
it best to organize them in a way that was not explicitly stated in my previous
post—based on function. Among the powers of the bankruptcy court that I have mentioned
above, each can be placed into one of two categories based on their
function—powers that place property into the bankruptcy estate and powers that
affect property once it is in the estate. Recharacterization, fraudulent
conveyance and substantive consolidation are all powers that the court employs
to expand the reach of the bankruptcy estate in order to include more property.
The automatic stay and the doctrine of adequate assurances are powers that
affect assets, once they are in the bankruptcy estate.
Given that an empowered bankruptcy trustee has the ability
to liquidate all property of the estate that it deems necessary to further the
interests of the estate, an SPE bankruptcy is of particular concern to MBS
investors. If a SPE is driven into bankruptcy, its primary and sometimes only
assets will be the mortgages from which it derives its income. If these
mortgages are found to be a part of the SPE’s bankruptcy estate, MBS investors
will be deemed to be creditors of the SPE and MBS cash flow can be adversely affected
for a significant period time. The primary concern regarding a SPE bankruptcy
for an MBS investor is the high likelihood that the mortgage assets will be
placed in the bankruptcy estate and subject to the automatic stay and adequate
assurances. Efforts to mitigate an SPE bankruptcy will therefore focus on
attempting to create a degree of separation between the SPE and the mortgages
and on making the filing of bankruptcy by the SPE a more onerous process.
Regarding the separation of assets from the SPE, the most
effective method of creating such a separation is a commercial trust. Once the
assets of an SPE are placed in a trust, the SPE ceases to have legal title and
control over them. The SPE is merely the settlor/grantor of the trust and the
investors are the beneficiaries. As such the SPE serves only to distribute
payments to the investors of the MBS or SPE, in the case that equity shares of
the SPE are sold. Legal title of the assets belongs to or “vests” in the trust
and is managed through the chosen trustee. In effect, the trust has removed the
assets from the SPE through operation of law.
Grantor trusts or master trusts best suit securitization purposes, since
they are recognized as a separate entities from the SPE both legally and for
tax purposes. Grantor trusts are suitable for mortgage assets, but are required
to be passive in nature. This requirement restricts the trustee from adding
assets to the trust or from replacing assets in the trust with other assets.
These restrictions make them unsuitable to securitize revolving assets like credit
cards and home equity loans. Master trusts do not have these same restrictions,
allowing them to support most securitizations.
One may wonder why every securitization is not structured as
a trust in order to provide added protection from a possible SPE bankruptcy.
The answer to this quandary is that most trusts are limited in the amount of
different types of trust certificates they are able issue. These limitations do
not facilitate the various types of ownership opportunities necessary to create
the robust credit enhancements that most securitizations are able to offer to
their senior investors through a diverse capital structure. In other words, a
limitation to one or two forms of ownership may not facilitate the
securitization’s ability to redistribute the risk of default away from the more
senior class of investors enough to make the senior securities attractive. If the
senior securities are not desirable, the securitization will struggle to find
the desired level of investment necessary to fund the transaction. With real
estate securitizations, however, this is less of an issue, since the REMIC or
Real Estate Mortgage Investment Conduit has been created to specifically to
facilitate MBS and functions as both a pass-through security and a trust.
Nevertheless, a continuum clearly exists along which the benefits to the use of
a securitization trust are weighed against its effects on the securitization’s
credit enhancement.
As mentioned, the other way to
mitigate the possibility of a SPE bankruptcy is to restrict the ability of the SPE
to declare bankruptcy. These restrictions are typically placed in the SPE’s
governing documents and may include:
1) Provisions
restricting the SPE’s activity to that which is related to the securitization
2) Provisions
restricting amendments to the SPE’s governing documents
3) Provisions
prohibiting the SPE from taking on debt other than the debt from the
securitization
4) Provisions
restricting the placement of liens on the securitized loans outside of that
which is necessary for securitization
5) Provisions
prohibiting any merger, consolidation or dissolution of the SPE, as long as the
securitization is outstanding
6) Appointment
of independent directors or managers approved by the financing lender.
It is important to remember that
the SPE is typically a passive entity that is used to facilitate the cash flow
of the securities that result from the securitization for which it was created.
SPE bankruptcies are, therefore, usually filed as a result of a board action.
Such actions are usually influenced by parties that will benefit from the disruption
of the MBS cash flow or a parties that will receive more through a SPE
bankruptcy than at maturity or during default. These parties could be creditors
of the original lender, mezzanine participants in the capital structure, disgruntled
investors that want out of the deal or a whole host of other potentially
interested entities. Making the passing of such decisions more difficult through
the SPE’s governing and operating documents is one of the more effective ways
to mitigate a SPE bankruptcy risk.
Those are my thoughts on the
effects of a SPE bankruptcy on MBS. Please check back next week for the final
post in my Bankruptcy & MBS series—The Effects of Consumer Bankruptcy
Filings on Mortgage-Backed Securities and, as always, feel free to leave a
comment below.
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