Custom and Usage Defenses in Securitization:

Courts Must Deny Access to the Last Refuge for Scoundrels

Richard F. Kessler, Documentary Clearing House and Associates

richardfkessler@verizon.net Documentaryclearinghouse.com

Disputes over contractual terms have kept lawyers in good business over the centuries. There is an
unofficial hierarchy of ways of establishing contractual rights. The ideal is an unambiguous term in a
contract signed by both parties. One of the hardest ways of establishing a contractual right is to rely on
custom and practice. However custom and practice are protean forces for the development of decisional
law.

Change is an essential, continuing condition for creative capitalism to function. To earn profits,
competitor must come up with new and better ways to provide goods and services at the lowest
price. The purchase of long term mortgages for transformation into short term mortgage backed
securities by both public and private corporations was a hallmark achievement of creative
capitalism at the end of the 20th Century. This procedure became known as “securitization”. It
created a market where the lender originating a loan could immediately sell the loan for
investment. It also created a daily market value for what had been an illiquid asset. Essentially,
securitization converted an illiquid, long term asset into a liquid short term asset. Placed in the
hands of Wall Street financial institutions, the mechanics of securitization became obscure,
arcane, complex and recondite. The original function of freeing up capital for reinvestment
opened the doors for speculation, under-capitalized leveraging, moral hazard and widespread
fraud. Some financial instruments became so complex and obscure that some experts believe that
no investor could understand precisely which assets became securitized.

Something went very wrong with securitization as an engine for economic growth when
securitization became the business of funding, originating or selling bad loans instead of good
ones. Having depleted the supply of mortgages obligating creditworthy risks, banks began
making loans to individuals known to be financially unqualified to repay the loans. These loans
were self-destruct loans. It was predictable and foreseeable that such high risk loans would never
be repaid by the borrower. In fact, in all likelihood at the inception of the loan, it was highly
probable that the loan would go into default and require foreclosure within a few years after it
was made. Such loans were predatory because they preyed upon the borrowers, among others.
Few borrowers would have accepted the loan secured by the mortgage if the borrower
understood that, in a matter of months, not years, the home would be in default and foreclosed.
Such loans became the common place assets that were loaded into the portfolios of ALT A and
Sub Prime mortgage backed security trusts (“MBS”). Such self-destruct loans were transformed,
as if by magic, into AAA rated mortgage backed securities.

The cascade of defaults starting in 2006 was inevitable. It was merely a question of time. So
devastating was the financial carnage that it obliterated mortgage financing and even threatened

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the survival of global credit markets. Despite the financial devastation, many on Wall Street and
at the highest echelons of government argue that it would be tragic if necessary reform of Wall
Street mortgage securitization threw out the baby with the dirty bathwater. Securitization itself,
these advocates would argue, is not inherently meretricious. It only became so in the hands of
unscrupulous manipulators who sold bad loans in place of good loans. Accordingly, the creative
genius of securitization should be institutionalized and protected by our courts in decisional law.

One issue the courts must address in this context is the traditional requirement of a chain of title
and assignment for the mortgage note to make it enforceable by a successor in interest to the
original mortgagee. This is the foundation for the well known : “Show me the original Note”
defense and countless sound legal defenses based upon lack of standing and, more recently, lack
of capacity to act on behalf of the secured creditor.. Second, the requirement that each successive
owner in the securitization process must execute an assignment in recordable form appears to be
not only contrary to current industry practice, but also may be impossible to accomplish. Here is
a classic example where industry custom and practice conflicts with the traditional standards
prescribed for transferring a mortgage, Specifically lacking is compliance with the requirements
for delivery and possession, negotiation, assignment or allonge. Also the industry practice
eliminates the safeguards provided when the transfer is recorded in the public records.

I respectfully suggest that traditional notions of Standing are waging a rear guard action in the
defense against foreclosure of securitized mortgages likely to fall to the onslaught of creative
capitalism. No one should be surprised if the courts help pave the way with changes to decisional
law. For example, the organic document which establishes the MBS trust known as the “Master
Pooling and Servicing Agreement (“Pooling Agreement”) states that all loan documents for each
mortgage purchased will be transferred to the MBS trust within 90 days of the start date of the
investment. The typical MBS trust contains 2,000-9,000 mortgages. It strains credulity to believe
that all of these loan documents can be properly transferred to the MBS trust within a 90 day
period.

It has been observed by others that custom and practice are the last defense counsel makes for a
scoundrel. No one today would feel comfortable defending slavery in the United States because
it was the custom and practice in certain states prior to the Emancipation Proclamation.
Accordingly, in assessing the role of custom and practice in modifying the rules for mortgage
foreclosure and securitization, it is highly important to make sure that this approach is not being
used to protect scoundrels.

Securitization became the mechanism by which a business enterprise systematically and

continuously funded, originated or sold bad loans in the guise of good loans. The common
enterprise involved those who borrowed, funded, invested, underwrote loans, appraised, rated
securities, brokered real estate, underwrote securities, or otherwise organized or administered
MBS trusts. When it comes to the misuse of securitization, as Pogo said, “WE have found the
enemy, and it is us.” This article does not address how securitization needs to be reformed to

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prevent recurrence of the debilitating financial debacle just inflicted upon the United States and
other nations.

Instead, it addresses the question what specific limitations must courts impose upon efforts to
defend or rationalize non-compliance with traditional strict standing and capacity arguments to
take cognizance of changed conditions precipitated by new investments. Because predatory
lending can be so profitable, because its serves as such a narcotic for greed, decisional law
should not facilitate the predatory practices of making bad loans and foisting them either upon
borrowers or investors.

With the seemingly endless numbers of foreclosures, court dockets have been overwhelmed.
Creditors have taken short cuts. Judges have looked the other way. All kinds of parties who had
no legal right to foreclose whatsoever have filed and too often succeeded in obtaining
uncontested summary judgment of foreclosure. Similarly many foreclosures have taken place
where the secured creditor has received timely payment of an installment, and the foreclosure is
used to recover advances made by a third party who may well be a creditor of the debtor but not
secured by the mortgage.

It is true that a mortgage can be sold or otherwise transferred to another party. When this has
been accomplished, the other party now stands in the shoes of the original mortgagee as a
successor in interest. In plain English, the transferee becomes the new mortgagee.

In the future, the effective conduct of securitization may require modification of the traditional
norms for becoming a note holder. Traditionally a mortgage may be conveyed by endorsement of
the mortgage note, assignment preferably with recordation, delivery and by attachment of an
allonge to the original promissory note. In a typical securitization, a mortgage is passed from the
originator, to the donor to an interim trust to the mortgage trust. Sometimes there is a warehouser
to assemble all the mortgages for the donor between the originator and the donor. That makes a
minimum of four parties and three documentary transfers. A typical MBS trust has 2,000 to
9,000 mortgages. If an average MBS trust contains 5,000 mortgages, traditional requirements
compel the creation and preservation of 15,000 instruments to document the chain of title.

Now suppose each mortgage is registered with its own identification number just as any stock
certificate issued has a CUSIP number. In addition, suppose there is a tracking system which
enables the user to obtain all the salient and current financial information about the loan
including its exact location. Under such circumstances, so long as the MBS trust is registered as
the holder of legal title to the registered mortgage, what difference how does the date of its
formal delivery to and receipt by the MBS trust make any real difference? Because of the loan
registration and the data system, the financial institution responsible for servicing the loan is able
to do so and meet all servicing obligations to the mortgage debtor continuously and throughout
the securitiztion process. Viewed this way, the traditional chain of title requirement becomes

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obsolete, redundant and anachronistic. It stands in the way of capital formation without
providing meaningful protection to either debtors or creditors.

Judicial efforts to encounter and begin to accommodate new structures for transacting business
and financing capital need to be constrained by overriding principles which include the
following:

1. No exception to traditional requirements for standing can serve as a vehicle for fraud,
deceit or misrepresentation. Specifically, custom and usage cannot be used as a
subterfuge to conceal the origination, funding or selling of bad loans.

A mortgage may become unenforceable when procured by fraud, deceit or misrepresentation.

Such a mortgage should not become enforceable through foreclosure if the loan is transferred to
an MBS trust.

2. Custom and practice for securitization should not result in a waiver of the requirement
that the consent of the mortgagor is necessary for any change to the mortgage created by
the Pooling Agreement.

Changes to the mortgage made by the Pooling Agreement modify the mortgage without the
consent of the mortgagor. An amendment of the mortgage, as in the amendment of any contract
not to be performed within a year, requires the written consent of the parties... Failure to inform
and obtain the consent of the mortgagor is fatal. The fact that such restrictions are contained in
almost every Pooling Agreement should not allow revision of the requirement that a contract no
one party to a contract can change its terms and conditions without the consent of the other
parties.

3. No exception to the standing requirement should be made to allow foreclosure for the
benefit of a general creditor substituted for the secured creditor or the secured creditor’s
successor in interest. No third party not standing in the shoes of the mortgagee should be
allowed to foreclose.

A promissory note is promiscuous; a mortgage is monogamous. Any holder in due course of a

note not in default, for value and without notice can demand payment upon the terms and
conditions of the note. Generally possession suffices for a claim for payment to be valid. Anyone
can become the holder. A promissory note need not be with the one she loves to love the one she
is with. The holder of a note is a general creditor and is unsecured. Only when a promissory note
is used as a mortgage note and accompanied by a security agreement referred to either as a
mortgage or deed of trust does the general creditor become a secured creditor, i.e. secured by the
mortgage as a security agreement. (For this discussion, no distinction need be drawn between
lien theory and title theory states.

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By contrast, the mortgage agreement is monogamous. It cannot be used for the benefit of anyone
or everyone. Only the mortgagee, a creditor specifically named and identified by the mortgage
agreement, is secured by the mortgage. The mortgage only protects the secured creditor. Only
the secured creditor, the mortgagee, has the right to foreclose. No one else has the right to
foreclose. Foreclosure may not be instituted to recover funds for the benefit of any person other
than the secured creditor even if the other person is a creditor of the debtor.

4. In the absence of a statutorily authorized record-keeping system for mortgage transfers,

some courts may accept an assignment from the originator to the MBS trust. Such a short
cut grants a judicial waiver of the requirement to document each successive transfer of
the mortgage involved in conveying the mortgage to the MBS trust.

Given all of the problems besetting the court with applying the chain of title requirements, the
very least a court must do is strictly apply the requirement to produce the original note. Where a
plaintiff pleads that the original note has been lost or destroyed, the courts must actually require
proof that the plaintiff is legally entitled to foreclose and entitled to receive payment under the
terms of the note. In examining the new custom and usage being created for MBS trusts, there
may be room to consider new or alternative ways of conveying a mortgage. However, what
should not be changed is the basic operating principle. Only the secured creditor can bring
foreclosure. Foreclosure is for the exclusive benefit and protection of the secured creditor and no
one else.

Conclusion

As the decisional law of securitization evolves, it is important for courts to remain vigilant. New
business practices which are predatory, either because they prey upon borrowers or upon
consumers, should not receive judicial confirmation and validation. Custom and usage should not
become the last, best defense for scoundrels. The courts must maintain the distinction between
legitimate entrepreneurial creativity and skullduggery.