Ever wonder how so many Collateralized Debt Obligations (CDO) were able to get their footing?
Of course, the banks are eager to blame the borrowers, who they say
were reckless and bought homes above their income brackets. But no one
talks about the bank’s participation and the concept of "packaging." Well, no one was really talking about it before this week, anyway. But
that might be about to change. We’ll get to "why" in a moment.
Just Because it’s a Package, Doesn’t Mean it’s a Gift
Packaging is nothing new in the banking / brokerage world. It’s the
norm, not the exception. But in the case of CDOs, this was "packaging
on steroids." Many do not fully understand what happened behind the
scenes and many others may be facing foreclosure. So I thought I’d
give you some insight as to what happened that might help you
understand or even take action if you may be faced with foreclosure yourself.
What are CDOs? Wikipedia has this "unintelligible" definition —
collateralized debt obligations: a type of structured asset-backed
security (ABS) whose value and payments are derived from a portfolio of
fixed-income underlying assets. Sounds ominous, doesn’t it?
Here’s a "behind the scenes" look at this gift that keeps on giving … a lot of pain. While many borrowers might have bought above their means, the banks were just as complicit in creating the CDO disaster.
When you purchase a home with a mortgage, you sign a note. The
loan-originating company sells the note to an investment banker or
hedge fund and collects the full value of the note upfront. A copy of
your note is created and stamped "paid in full." The loan-originating
company has no right to foreclose because it received all its money
when it sold the note.
Before greed took control of the market, the holder of the note (i.e.,
an investment banker) would store the note in a vault. If someone
defaulted on their loan, the investment bankers would produce the note
to prove they owned it and that they had bought it from the
But greed changed all that.
Instead of vaulting the original note, those notes were "re-packaged"
with thousands of other notes into what became known as CDOs. There
were low-risk CDO mortgage packages, moderate-risk CDO mortgage
packages and high-risk CDO mortgage packages. The low-risk mortgage packages were easy to sell to conservative
investors looking for long-term income. Most of those original packages
are still valid and producing income.
However, the moderate-risk and high risk-mortgages were not easy to
sell. To resolve this, these mortgages were re-packaged by mixing them
with low-risk mortgages, and sold to conservative investors. The same
mortgage could have been re-packaged and sold a dozen times.
Remember, the investment banker paid only one time for the instrument
and only has the right to place the note in one package. Repackaging
was a highly illegal use of mortgages. In order to hide the trail of their activities, investment bankers
destroyed the notes so no one could trace which CDO packages the note
was actually put in. But since the notes are destroyed, ownership is
difficult to establish.
Who Really Owns Your Loan?
When borrowers default on their loans, investment bankers want to
foreclose quickly so they can retain some value to their mutual funds.
They quickly sell the mortgage to a foreclosure bank. They can’t sell
the note because it was destroyed. This leaves the foreclosure bank
vulnerable because it does not have proof that it owns the note.
Remember, the only thing that the borrower signed is a note. The
borrower did not sign the right to repackage the mortgage. The only
asset is the note that represents the actual property. And even though the investment banker has a record of monthly payments
that he sells to the foreclosure bank, this may not be sufficient to
establish actual ownership.
When a borrower is foreclosed upon, the foreclosure represents a
lawsuit. The foreclosure bank brings a lawsuit against the borrower for
failure to pay. The bank is the plaintiff and the borrower is the
defendant. Since the borrower is the defendant, he has the right to call for
"discovery." Discovery is the pre-trial litigation procedure in which
both the plaintiff and defendant request relevant information and
documents from each other. Discovery generally includes depositions,
requests for inspection and document production. In the case of
foreclosure, the defendant requires the plaintiff to produce the note.
The problem for the foreclosing bank is either it does not have the
note at all because it was destroyed to stop the audit trail, or it
says "paid in full" — in which case, nothing is owed to the bank.