What will happen to the role of the trustee in securitization?

Over the past few weeks, the bond trustees have been officially dragged into the slugfest over who will ultimately pay for  investor losses in the US mortgage-backed and CDO markets.

For the most part, the trustees have been able to stay out of the flames over the past 2-3 years as issuers, servicers, rating agencies, bond insurers and underwriters have alternately felt the wrath of investors looking for some scalp.  However, the recent and seemingly unrelated hub-bub over the processing of foreclosures wound up creating a number of “ah-ha” moments in the media, as several ongoing legal tangles involving informational requests related to mortgage files held by the trustees in connection with their role as “document custodian” for mortgage-backed trust appointments also kicked up some dust.   Several theories were connected to the performance of these trustees which might suggest some liability issues for these organizations.

At first blush these concerns seem logical as most think of a trustee as a person or entity entrusted with looking out for the best interests of the trust that they oversee.  In this case, one might think that the trustee for a mortgage-backed bond or CDO program might have the responsiblity for doing everything or at least many things on behalf of bondholders to ensure that their investment is protected.  Isn’t that what a trustee does?  Certainly that would fit under a generic definition of what most folks think a trustee does.

The connection between the foreclosure mess and the trustee role has been tied by some into the trustee’s responsibility to conduct a review of the mortgage files delivered to it by the issuer at the time of issuance (or shortly thereafter).  Just as it can be easy to assume that everyone knows what a trustee does, so too can it be easy to assume what constitutes the trustee’s “mortgage review” process.  Wouldn’t it mean that the trustee is providing a learned-eye to the collateral pool which has been set aside to protect the interests of the bondholders?

The answer is no.  The trustees document review process is almost always limited to an acknowledgement that a list of several documents (mortgage note, insurance, etc.) is included in each file that is delivered to it as part of the trust.  It is almost always the responsibility of the issuer or the issuer/servicer to “properly convey” each asset (mortgage file) to the trust.  The trustee does not perform any validation process except to confirm that each file has been delivered and that each file is complete.  Even to the extent that it has these limited responsibilities, the trustee is usually afforded significant indemnities from the trust for all but its own negligence (a very high standard).  So, you see, we do not believe that the trustees will wind up with the tab in this bar fight.

Having said that, we do find it interesting to read the recent white paper released by the American Bankers Association’s Corporate Trust Committee which sounds more like a “run for the bushes” strategy than it does a defense of an important role played by the trustee in a securitization.

The analysis uses arguments such as relatively low compensation and trustees are usually appointed very late in the formation of the transaction.  We took the major thrust of the argument to be “We don’t have any control over how the deal is put together, we don’t do very much and we don’t get paid much anyway, so don’t blame us!”

While we agree with the final conclusion that the trustee (unless they signed off on documents that are outside of what we would consider to be industry norms) has no material role in the conveyance of the mortgages (assets) to the trust, we do take issue with the trustees trying to shield themselves as they have.

Trustee Role – Agent or Fiduciary:  

We would begin with the definitional role of the trustee.  As we stated above, we agree that the role of a trustee in a typical securitization is unlike what most people assume it to be.  The trustee in a securitization is usually viewed as a “stakeholder trustee” in that its fiduciary role is to protect the cash flows attributable to the bondholders under the trust.  It is responsible for monitoring that the proper amounts are received each month and that those payments are properly distributed.  Further, when insufficient funds are provided, it is tasked with tapping into certain reserves and other resources (e.g. servicer advances) to keep payments on track.  Essentially, the role of the trustee for a performing securitization is more administrative in nature then it is fiduciary.  What the trustees fail to mention is that for the past 20 years, not unlike the rating agencies, the trustees have been very happy to let investors and other assume that their role was much more fiduciary in nature then they had negotiated in their agreements.  How else to hold the line on their compensation levels (something they have not actually done a very good job of)?

An important point that is missing from the discussion is the possibility that the role of the trustee may be different in a post-default scenario then it is pre-default.  Once again, we believe the ABA white paper may have taken a wrong turn as it included a section detailing the “history of the trustee” including the Trust Indenture Act of 1939 (“TIA”) and the 1990 Reform Act.  We think it a mistake to even bring a discussion of a qualified indenture (qualified under the Act) into a discussion about the trustee’s role in a securitization.  To do so, immediately brings in a proverbial smoking gun in the form of the prudent man standard.  Without going into too much detail, the prudent man standard establishes a standard of care for trustees of debt financings qualified under the TIA.  The standard essentially required a trustee in a post-default scenario to serve their bondholders with the same level of care and interest as if it were managing its own affairs.  Clearly, this standard was/is meant to provide bondholders with a high degree of comfort that the trustee has their back.  The paper goes on to argue that even if you apply a prudent man standard to a trustee for a securitization, the trustee must have “actual knowledge” of a condition before it is required to act.  Here’s the problem though…… The ABA goes on to argue that the trustee in a securitization has much more difficult duties to perform than would be found in a regular corporate bond offering and we think this only seems to work against their “the trustee needs actual knowledge” argument.  OF COURSE, an asset-backed trustee knows more about the relative stability of that bond issue then they would for the typical unsecured bond.  So, armed with this information what would a “prudent man” do?

The slippery slope here is….. If the assets conveyed to the trust were not properly conveyed and if the trustee has any information to the effect that there may be a problem with the mortgage collateral it is holding then hasn’t an even of default occurred?  If the answer is yes, then the prudent man standard may already be in play for the many of the issues that continue to make principal and interest payments. 

We would not have even gone in the direction that the ABA has chosen in defending the role of the trustee in a securitization.  It could come back to bite them.  While we believe that the trustee typically only needs to ensure that payments are being made, pre-default, it may come down to an argument over whether the ONLY default that the trustee needs to concern themselves about is a payment default.

The Trustee Comes In Late:

The ABA goes on the record stating that in many or most transactions the trustee is brought into the transaction very late in the process and infers that this negates any influence the trustee may have on forming the structure.  We buy this argument but only to a degree.  Once again, we would probably have not chosen this argument to support our case for the trustee.

Let’s be honest, when looking at the asset-backed trustee market in the US over the past 15 years, this market has been dominated by just a handful of providers.  If you go back to the league tables for 2005, ’06 or ’07 you will find that The Bank of New York Mellon, US Bank, Wells Fargo and Deutsche Bank controlled nearly the entire market, with a handful of other providers holding very small shares of the market.

The facts are that these large providers (and most of the smaller providers giving chase) were all very well versed in the nuances of their roles, the standards that various issuers of asset-backed securities wanted in their agreements and were all very happy to continue to provide these profitable services under conditions which put continuous pressure on both their roles/duties and their compensation levels.  We would also note that each of these trustees would pay good money for expert legal advice in connection with these appointments.

Perhaps the ABA was not trying to suggest that the trustees did not understand what they were getting into with these programs but with most big issuers utilizing standardized documentation time and time again, we find this argument to be weak at best.

Why Not Stand on Your Principles?

For so many years, the trustee community has wrung its collective hands suggesting that it is not paid anywhere near what it should be for its “critical” role in these complex financings.  Given their response in moment of crisis, is it any wonder they get little respect?

We would suggest that the trustees stop hiding and get involved in the solution to these bad bond programs, instead of continuing to perpetuate the problem.

We would start with a staunch definition and defense of their role.  No, they do not have the responsibility to put themselves at financial risk on behalf of their bondholders.  Their role IS mostly administrative in nature but, if bondholders want them to take action on their behalf then those holders (a majority thereof) must provide direction and proper indemnities and the trustees should be willing to take up the charge.

Secondly, we would get more proactively involved with determining if the programs for which they serve contain assets that may not be eligible (conveyance issues or other reasons).  Once again, this should be done only where the trustee will be paid for its work and will be properly indemnified.

Third, we would suggest that trustees become much more engaged in providing investors, issuers and other related parties with a “transparent” description of the roles and duties that they will assume for these transactions.

We suspect that unless trustees, collectively or individually, begin to change how they do business and how they conduct themselves in crisis, their role in securitization will only continue to become less and less relevent over time.  We suppose that might culminate with changing the name from “trustee” to “paying agent” to eliminate any illusion of a meaningful fiduciary role for these providers.

About markferraris
Managing Principal Orchard Street Partners LLC

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