Government Makes Investors Nervous

Yesterday I was listening to a West Legal Ed Center program called "Reviving Securitization," and I was struck by how much of the discussion was about fear of doing business with the government. Entities that invest in asset-backed securities are nervous about two bills making their way through Congress. Both laws aim to do the same thing: make it easier to modify mortgages that have been securitized. To accomplish this, they give mortgage servicers (the intermediary agencies that administer the underlying mortgages) more flexibility to restructure mortgages. The idea is that servicers won't renegotiate mortgages because they're afraid of being sued by ABS investors (like pension plans and hedge funds).

The first bill, HR 1106 - the Helping Families Save Their Homes Act, has passed the House and is currently before the Senate Banking Committee. It contains a section called the "Servicer Safe Harbor" which immunizes servicers from suit for modifying mortgage terms. What really has investors agitated is a section that retroactively defeats a clause that appears in most securitization agreements. Most agreements (called pooling and servicing agreements) have a clause that allows the investor to force the servicer to buy back securities under certain circumstances. Servicers see this clause as a threat that hamstrings their ability to renegotiate mortgages. Investors see this clause as a brake on abusive servicer practices.

The second bill, S 376 - the Real Estate Mortgage Investment Conduit Improvement Act of 2009, (The REMIC Improvement Act) would control the activities of REMICs by taking away their tax-exempt status. The government classifies certain real estate investment securitization entities as tax exempt (REMICs) to promote investment in the residential mortgage sector. The REMIC Improvement Act takes away REMIC status when the pooling and servicing agreement has the tyoe of buy-back provision discussed above.

If either of these laws is enacted, the lawyers will be busy. As Dechert put it in a recent memo, "all pooling and servicing agreements will need to be reviewed ... we expect that the great majority ... may need to be amended." This kind of government modification of previously settled rights is becoming more common. At the beginning of the year, Congress used an amendment to the Emergency Economic Stabilization Act to change the terms of all the TARP loan agreements. Last week, the President used moral suasion to abrogate the rights of Chrylser's senior debt holders.

It made me wonder - how much will this uncertainty affect how investors gauge risk? Lucky for me, there's a ready-made example from the last economic catastrophe. In 1933 and 34, mortgage default hit an all-time high. To keep people in their homes, 27 states passed foreclosure moratoria. These laws were challenged as a violation of the contract clause, but in 1934 the Supreme Court found that the economic emergency warranted a little clause-stretching (Home Bldg. & Loan Ass'n v. Blaisdell, 290 U.S. 398, 54 S.Ct. 231, 1934). Taking away the foreclosure remedy "appear[s] to have reduced the supply of loans and made credit more expensive for subsequent borrowers." (Wheelock, Changing the Rules, Federal Reserve Bank of St. Louis Review, November / December, 2008)