One of the more controversial statements I have made is that certain types of payments from third party sources should be applied, pro rata, against loan balances. Some have stated that the collateral source rule bars using third party payments as offset to the debt. But that rule is used in tort cases and contract cases are different. There are certain types of payments, like guarantees from Fannie and Freddie that might not be susceptible to use as offset because they are caused by the default of the debtor and because they are not paid until the foreclosure is complete.
But the insurance, credit default swaps and other hedge products that caused the banks to receive payment are a different story. Those are not paid because of a default by any particular borrower but rather are caused by a unilateral declaration of a “credit event” declared by the Master Servicer and are paid to the holder of the mortgage bonds. The mortgage bonds are issued by a trust based upon the advance of money by investors who wish to pool their money into an asset pool and receive income with what was thought to be a minimum of risk.
Since the broker-dealers (investment banks) were acting as agents for the trust and the bond holders, any money received by them should have first been allocated to the trust, then pro rata to the bond holders. Whether or not this money was actually forwarded to the bond holders is irrelevant if the investment banks were the agents of the investment vehicle and thus owed a duty to the investors to whom they sold the mortgage bonds.
Logic dictates that if the money was paid to the banks as “holders” of the bond (because they were issued in street name as nominee securities) that the balance owed by the trust to the investors was correspondingly reduced — reflecting the devaluation of the bonds declared by the master servicer based upon such criteria as the lack of liquidity of the bonds that had been trading freely on a weekly basis, or because of the severe drop in real estate prices down to their actual values, or because of other factors.
It should be noted that the declaration of the banks is unilateral and in their sole discretion and not subject to challenge by anyone because the declaration creates an irrefutable presumption that the content of the declaration is true. Thus the insurance company must pay, the credit default swap counterparty must pay and other hedge partners must pay as a result of an act by the bank, not the investor nor the borrower.
All the loans contained in the asset pool subject to the declared credit event are affected. And since the reason for the declaration has little relationship to defaults, and plenty of other more important reasons, the amount owed to investors is reduced by the receipt of the payments by their agent, the bank. That means the account receivable of the lender is reduced, regardless of which bank account the money happens to be deposited.
If the account receivable is reduced before, during or after a delinquency of the borrower (assuming the loan is actually in existence) then the borrowers’ balances should be reduced, pro rata for each loan in the asset pool that was the subject of the declaration of a credit event. It is therefore my opinion that the homeowner could and probably should file an affirmative defense for offset for the pro rata share of insurance, credit default swaps etc.
There is one more source that should be considered for offset. Several investors have made claims against the banks claiming that their money was misused and that the terms of the loan were not followed including, bad underwriting and unenforceable documents created at closing. Many of them have already settled those claims and received payment, thus reducing their account receivable from the trust (and by pure logic reducing, dollar for dollar the account payable from the trust). Since the sole source of payment on the bond is the payment of the mortgages, it follows that by utilizing the most simple of accounting standards, the balance owed by the homeowner would be correspondingly be reduced, pro rata, dollar for dollar.
The fact that the underwriting was bad, the loans were not viable or enforceable and based upon inflated appraisals and lies about the income of the borrower, is not something caused by the borrower. The fact that the money was paid to all of the investors in that particular asset pool means that each investor should get a share equal to the amount of money they invested compared to all the money that was invested in that pool.
As to figuring out how much of the offset goes to the borrower’s account payable, it should be calculated in the same way. The amount of the borrower’s debt should be compared with the total amount of loans in the asset pool. This percentage should be applied against all third party payments that did not arise out of the default by the borrowers. In fact, it should be applied against all borrowers whose loans were claimed by that asset pool, whether they were in default or not. This would be grounds for a claim by people who are “current” in their payments for a credit or refund of the amount received from insurance, credit default swaps, or payments by the banks in settlement of investors’ claims of fraud.
This approach should be brought up very early in litigation so that there is plenty of time to pursue the discovery required to determine the amount received and the proper calculation of pro rata shares. If you do it at trial, the best you can hope for is that the judge will take notice of the fact that the foreclosing party only brought part of the documents relating to the loan instead of all of them, which should be the subject of a subpoena for the designated witness of the bank to bring with her or him all of the documents relating to the subject loan or any instrument deriving its value in whole or in part from the subject loan’s existence.
Thus at trial you can have a two pronged attack, getting them coming and going. The first is of course the fact that the originator did not fund the loan and that the break between the money trail (actual transactions) and the paper trail (fictitious transactions) occurred at the closing table. In most cases that is true, but it can be replaced or buttressed by the fact that the same argument holds true for acquired loans that were previously originated. The endorsement of the note or assignment of mortgage is a fictitious instrument if there was no sale of the loan. The important thing is to talk about the money first and then use that to show that the documents are fabricated relating to no real transaction.
Then you also have the argument of offset which hopefully by then you will have set up by discovery.
Practice Note: Many lawyers are accepting fee retainers far below the level that would support properly litigating these cases. Now that the marketplace has matured, lawyers should reconsider their pricing and their prosecution of the defenses, affirmative defenses and counterclaims. Even clients who announce a goal of just staying as long as possible without paying rent or mortgage are probably saying that because they think they owe more money than is actually the case.
Filed under: CDO, CORRUPTION, evidence, Fannie MAe, foreclosure, investment banking, Investor, MODIFICATION, Mortgage, Motions, Pleading, securities fraud, Servicer | Tagged: Allocation of Third Party Payments, asset pool, credit default swaps, CREDIT EVENT, discovery, foreclosure, guarantees, insurance, Master Servicer, offset | 20 Comments »