August 18, 2017 Alert - SFIG Addresses Recent Events in Legacy-RMBS Space

Background:

In late June 2017, SFIG, together with many industry participants, was made aware of actions taken by a Trustee of approximately 20 legacy RMBS deals issued in 2004 and 2005, with an outstanding balance of $540mm, redeemed from the BOAA/BOAMS shelves. The liquidation of these transactions was initiated by the party holding the call rights, not the Trustee.

SFIG understands that the Trustee held back approximately $94mm of reserves in connection with costs of ongoing litigation against the Trustee by certain institutional bondholders in the related transactions. According to the Trustee, the reserves were deposited into transaction specific Reserve Accounts, to be used to meet the Trustee's current and future expenses, incurred in connection with this litigation and/or claims relating to such Trusts. No definitive period has been established over which the reserves will be held. The Trustee has stated that when it determines that such reserves are no longer necessary, the remaining funds will be distributed to the bondholders. These Trusts are involved in a legal action wherein certain institutional bondholders are suing the Trustee (along with numerous other trustees) for, among other things, allegations of breach of contract and negligence, which the Trustee denies.

Subsequent to the initial action by the Trustee, both Moody's and Fitch have taken credit actions on these transactions and other outstanding legacy RMBS transactions. Certain bondholders involved in the ongoing litigation have also filed new litigation against the Trustee for losses claimed to result from this action.

SFIG Policy Regarding Legacy Transactions:

SFIG has a clear policy of not engaging in issues pertaining to legacy transactions that may be associated with litigation, especially where such litigation is between various organizations within our membership.

However, due to the significant level of concern raised by SFIG member firms/multiple market participants, including investors, issuers and broker/dealers, and the potential negative ramifications across the entire RMBS and ABS markets, including new issue, we have felt obliged to issue this statement.

Questions/Issues Raised By Market Participants:

There have been numerous concerns raised by SFIG member firms/market participants, many of which are not restricted to the impacted deals alone. Concerns extend beyond legacy RMBS transactions and even include new issue ABS. Questions raised by market participants include:

  • What is the basis under the relevant documentation for the withholding of cash:
    • While Pooling and Servicing Agreements generally indemnify Trustees against loss, liability or expense, there is a carve-out if there is a breach of contract, gross negligence and willful malfeasance. Where a trustee is being sued and the allegations include breach of contract and negligence on any deals in question, can they withhold funds?
    • On the other hand, Pooling and Servicing Agreements generally indemnify the Trustee for "reimbursement" of costs, losses, and liabilities. On the basis that the withheld funds include reserves against future costs, is it appropriate that this be classified as reimbursement, and therefore allowed under the transaction documents?
    • To the extent a transaction document provides for indemnification of litigation expenses, what is the best means of ensuring that sufficient indemnity funds are available following a transaction's termination?
    • Specifically, in the case of a clean up call, the issued securities are required generally to be redeemed at a value that reflects stated principal balance. The withholding of the reserve causes a reduction against that value, so is this approach contemplated under the transaction documents?
  • What is the basis of the calculation of the reserve amount and, without knowing that basis, how can a stakeholder assess the reasonableness of the calculation?
  • What is the expectation for return of funds both in terms of mechanism of return and timing?
  • How does the amount of any reserve compare to rating agency assumptions and what impact does the action have for credit ratings?
  • If a Trustee has such a right and can act unilaterally regarding these specific transactions, should it be assumed they, and indeed other trustees, may act similarly and such actions may affect other transactions and, if so, what does that mean for potential shortfalls and ratings actions for other transactions?
  • Is the potential for such actions limited to legacy RMBS transactions, or do they extend across more recent RMBS transactions or other ABS asset classes?

Regarding questions around document provisions regarding entitlement/basis, basis of calculation and expectation around returns of funds, SFIG will not take a position for legacy transactions. However, we advocate for a swift resolution of these issues under the recently commenced litigation, as we believe it would be a positive development for the market and help reduce market uncertainty.

While we do not take a position on the litigation at hand, SFIG, by charter and consistent with its initiatives and written statements, seeks to promote a robust and liquid securitization market, a market upon which consumers and businesses depend to fund the real economy. A robust market must be built upon certain bedrock principals such as sanctity of contracts, accordance with law, and full transparency. In other instances, such as Department of Justice dictated RMBS settlements and State Governments attempts at exercise of Eminent Domain in RMBS transactions, SFIG has been vocal in its stance that sanctity of contract must prevail, without which investor confidence vanishes, market participants may be unwilling to serve in essential roles and the market ceases to function properly.

Furthermore, we have seen how ambiguous documents and lack of transparency can lead to disputes between transaction participants, like those experienced since the financial crisis, and have contributed to a crisis of confidence from which the securitization market is still trying to recover. Therefore SFIG and its membership believes it is imperative to foster a constructive dialogue around the current situation, briefly explain why current RMBS transactions mitigate, in varying degrees, the likelihood of a similar situation occurring, and through its RMBS 3.0 initiative provide a venue for members to come together and craft market-based solutions to ensure that contract rights and obligations are clear and transparent and that sanctity of those contracts is maintained. 

SFIG recognizes that existing litigation may contribute to a lack of full transparency on this issue and we do not expect transaction parties to make disclosures that may jeopardize their litigation positions. Nevertheless, absent these considerations, we believe the market is best served, as a matter of principle, by a transparent approach to decisions and information that will have a material and direct impact on transaction stakeholders. SFIG remains committed to working with its multiple constituencies to seek best practice solutions aimed at providing more transparency and greater clarity concerning indemnification language. We expect to engage those same constituencies through our existing RMBS 3.0 framework to ensure that we have properly addressed those risks for new transactions and to offer such best practices, to the extent practical and relevant, to participants in legacy transaction.

Post-crisis Deals are Fundamentally Different than these Legacy Transactions:

Many hard lessons were learned from the Financial Crisis by the RMBS market. An effort to avoid a repeat of some of those lessons led to an evolution of many of the accepted market practices, rating agency criteria, and contract terms seen in RMBS transactions. The first steps in such evolution was dubbed RMBS 2.0, a re-start of the private-label RMBS market. SFIG members have improved on 2.0 and in its 3.0 Green Papers, making critical improvements in contract language, disclosure, and oversight. 

Compared to legacy transactions, current RMBS transactions have experienced exceptional asset performance collateralized largely by loans underwritten to more stringent underwriting standards which have been, in most cases, subject to 100% third-party due diligence review.  Additionally, many of the contracts seek to address the most common operational, structural, and oversight shortcomings in legacy transactions. For these reasons, SFIG believes that the likelihood of similar actions in current transactions is significantly mitigated.

RMBS 3.0 and the Way Forward:

To the extent consistent with attorney-client privilege, we recommend that Trustees impacted by bondholder litigation, consider what additional information they may be able to provide to the market, or at a minimum to affected bondholders, in respect to the questions raised by market participants, which may include the basis of calculation of reserves withheld, clarity on the expected term of withholding and mechanism for return of cash to bondholders, and their intentions regarding such transactions.

Although the market has done much good work toward improving contract provisions and transparency, we also recommend full adoption of industry endorsed RMBS 3.0 standards and documents, including the use of a Deal Agent, in future RMBS transactions.

Other Asset Classes:    

With the vast majority of ABS deals having matured post crisis, the focus for ABS is on post-crisis transactions. On a similar basis to RMBS 2.0 and RMBS 3.0 transactions, we believe the risk of litigation is significantly reduced as compared to legacy pre-crisis RMBS deals.

Furthermore, the shorter lives of many ABS transactions and specifically the collateral backing them, makes it more straightforward to establish that such litigation risk is remote. However, we would make clear that SFIG is neither an investment advisor nor a credit rating agency and does not purport to give advice regarding the risk to any other RMBS or ABS transactions. We would welcome clarity from other market participants who have a direct role in these transactions, as to how they view the risk across the industry.

Conclusion:

On the basis that the recent actions, irrespective of contractual entitlement or non-entitlement, may cause investor shortfalls, widespread write-downs in value and rating agency downgrades, SFIG understands why its members have raised concerns.

However, in SFIG's opinion, the issue at hand appears to be concentrated around legacy RMBS transactions that are subject to litigation, and for ABS and for post crisis RMBS, the associated risk is significantly more remote.

Focusing purely on those legacy transactions, SFIG withholds any comment and takes no position on the contractual rights of any transaction party. However, in order for the market to make a clearer assessment of risk, SFIG believes additional efforts to support increased transparency, both for legacy and new-issue deals, would promote a robust and well-functioning securitization market.

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