Levitin on Kemp v Countrywide, Bank Regulator Incentives

Adam Levitin has two posts up at Credit Slipson the US Bankruptcy Court for the District of New Jersey opinion in Kemp v. Countrywide Home Loans, Inc. The first post, The Big Fail, covers the decision and many of the legal issues surrounding it.  The second post surrounds the shock many people new to this might think by asking Lots of Smart People Couldn’t Possibly F*%! Up, Could They?

He points out, correctly that the “this isn’t generally a question of deal design, which is where the brain power in securitization was applied.  Chain of title is a question of deal execution…the best legal minds in the country weren’t doing diligence on endorsements on securitization deals…there was certainly no incentive for an associate to be overly diligent.”   The best minds were sitting at the top, while a minimum amount of effort, diligence, oversight and other robustness checks were in place for what was going on down below.  This brand new system had never been stressed, and now we see it collapse at the core.

The first post walks you through the legal issues at hand as well as the new stakes for several different types of players.  In his testimony last week, Levitin said that it appeared Treasury, the Federal Reserve and the bank regulators were ignoring this issue hoping it would go away:

Levitin expands on this idea in his recent post:

Bank Regulators

Federal bank regulators should be all over this; there is monstrous systemic risk potential. The new Financial Stability Oversight Counsel, as well as the OCC and the Fed and FDIC should all be doing very targeted examinations of the large trustee banks’ collateral files to grasp the scope of the problem. I don’t know what they’re actually doing, but I’m afraid that they aren’t undertaking the proper investigation. Fortunately, this particular issue is easily within the expertise of bank regulators: just go to the collateral files and start looking at a large sample of notes. See how many are missing complete chains of endorsement or lack signatures altogether. That will be a very quick way to tell if there is a problem.

I’m also very concerned that some banks might decide to start filing in chains of endorsement and backdating. But that’s fraudulent, you protest! Surely no bank would ever engage in fraud! Of course backdating signatures is fraudulent, but if the signatures aren’t there, the banks are dead, so there’s really no downside in having some underlings fill in their signatures. If caught there likelihood of jail time is low. Why not bet the farm? Bank regulators should be very sensitive to this potential problem. They should insist on being the ones who actually select the collateral files to be reviewed and that they are the ones who pull the actual note out of the file. The examiners should be making digital images of all notes that they review and keeping those for potential examination against the actual notes if those notes are produced in future foreclosure cases.

My concern here is that the bank regulators so badly don’t want for there to be a problem that they won’t look at the notes in the hopes that this issue goes away. I hope that they are sensible enough to know that if there is a problem, they cannot prevent it, and would do best by gathering up all the information they can.

This is crucial. Everything about the Obama administration approach to economics and finance, in the housing sector most of all, seemed like a bet that the economy would be growing again by the “Recovery Summer” of 2010 as long as we protected the major banks. That’s the easiest (and most charitable) way to understand HAMP, stress-test valuations and the approach to mortgage debt in the financial sector. Obama and his team thought that serious credit writedowns weren’t needed at the major banks. We just needed an insurance policy against the worst and the economy would fix itself.

Yet here we are. The regulators have an interesting set of incentives in this game. As long as the financial system isn’t going to crash again, their incentives are to pretend everything is going fine.    However if it looks like there is going to be a crisis, their incentives are to be in front of it.  So right now they are locked into an strategy of hiding until it is too late and then looking as busy as possible.

Dodd-Frank was a regulator regulation bill, and now is exactly the time to put the regulators to work. Banking regulators should be collecting and documenting random samples of notes from the collateral files, ASAP. If they are not, given what we know and the court decisions that have already appeared, we must assume that they are not interested in doing their jobs as the crisis comes into focus.

Levitin also comments on the Ratings Agencies:

Ratings Agencies

The ratings agencies should be all over this issue. It goes to the question of whether the collateral backing the MBS is there and whether the representations made to them about deals was in fact correct. I have heard, but cannot verify, that ratings agencies were themselves able to inspect the actual notes. If so, then there is a real conflict of interest on this point, as they should have caught this facially obvious problem. Unfortunately, the materials I’ve seen coming out of some of the ratings agencies make me concerned that they simply don’t understand the legal issue involved and may not even understand the difference between the note and the mortgage.

If that’s the case, we could see a snap from the Agencies giving everything an “A-Ok” check to one where everything is in deep legal trouble over the course of a very short time.  Especially if the Ratings Agencies themselves start to get scrutiny. At the next hearing for foreclosure fraud, it would be great to get testimony from some in the Ratings Agencies about what they are doing to check this.