Assignee Liability in the Secondary Mortgage Market

8/9/2019 Assignee Liability in the Secondary Mortgage Market

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Assignee Liability in theSecondary Mortgage Market:

Position Paper

of the

American Securitization Forum

June 2007


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Table of Contents

I. Executive Summary...........................................................................................................2II.

Introduction........................................................................................................................7

III. The Growth of the Secondary Mortgage Market has Increased the Availability ofMortgage Credit to Subprime Borrowers .......................................................................8

A. The Importance Of The Secondary Market As A Capital Source for SubprimeLoans ..........................................................................................................................8

B. The Securitization Process .........................................................................................9IV. Recent Calls to Extend Liability for Abusive Loan Origination Practices to the

Secondary Mortgage Market are Misguided ................................................................11

A. Recent Turmoil In The Housing Market, And Its Causes And Consequences ........11B.

The Current Status Of The Law Governing Assignee Liability...............................12C. The Analysis Underlying the Expansion Of Assignee Liability ThroughHOEPA And Many State Laws Is Fundamentally Misguided.................................15

1. Secondary market participants have no incentive to purchase predatoryloans ..................................................................................................................15

2. Secondary market participants are not well-suited to regulating theprimary market, and trying to force them to conduct such regulationwould increase the cost borne by subprime mortgage borrowers.....................16

3. The primary market actors directly responsible for harmful predatorypractices already are subject to extensive, if sometimes ineffective,government regulation ......................................................................................19

4. Shifting the burden for predatory practices from cheated subprimeborrowers to passive investors and other subprime borrowers simplyshifts the burden of predatory practices among innocent parties......................19

D. Why The Holder Rule Approach Should Not Be Applied To Mortgage Credit......20V. Recommendations for a New Framework for Assignee Liability ...............................21

A. Entities Covered By Assignee Liability...................................................................22B. Mortgage Loan Triggers For Coverage....................................................................22C. Prohibited Practices And Restrictions On Loan Terms............................................23D. Scope Of Assignee Liability ....................................................................................24E. Limitations On Monetary Liability For Assignees ..................................................25F. Limitations On Rescission Claims Against Assignees ............................................25G. Types Of Legal Action Against Assignees ..............................................................26H. Safe Harbor Based Upon Loan Review ...................................................................27I. Statute of Limitations ...............................................................................................29J. Right to Cure Errors In Loan Documents ................................................................30K. Uniform National Standard ......................................................................................30

VI. Conclusion ........................................................................................................................31


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I. Executive Summary

A significant percentageby some estimates, more than halfof the recent rise in homeownership in the United States can be attributed to the expansion of subprime credit. Theincreasing flexibility and ability of lenders to price loans to take into account the higher riskof default posed by subprime borrowers has driven this expansion. This increased flexibilityis in turn the direct result of major structural changes in the market for mortgage financing,as the development and refinement of the process whereby mortgage loans are securitizedhas permitted the private secondary mortgage market to provide capital to subprimemortgage loan originators. By allowing for disaggregation of the idiosyncratic risksassociated with both individual loans and loan originators, securitization enables investors totake a relatively secure and quantifiable investment position on subprime mortgage lending.The remarkable expansion of subprime credit that has occurred over the last two decades,and the dramatic growth in home ownership that it has facilitated, would have beenimpossible without a functioning market for the product of the securitization processmortgage-backed securities that investors can buy and sell on markets like any othercommodified asset.

The recent volatility of the housing market, in combination with the increasing number ofsubprime borrowers who have taken out mortgage loans, often under terms that are notappropriate to their circumstances, has resulted in a substantial rise in levels of borrowerdefault and foreclosure. The vast majority of subprime loans are extended through legitimateand transparent lending practices, and the basic reality is that defaults happen even when theconduct of originators and brokers is exemplary. Moreover, in a disturbingly large numberof instances, borrowers get themselves into trouble by making misrepresentations during theloan application process about their income or intention to occupy the property.

Nevertheless, the American Securitization Forum (the ASF)1 is concerned that some

subprime borrowers appear to have been victimized by the abusive lending practicesinvolving fraud, deception, or unfairness that are grouped under the term predatory lendingand that such predatory practices, among other factors, have contributed to the currentproblems in the subprime market. The ASF also agrees that capital provided throughsecuritizations, along with capital from a variety of other sources, has sometimes beenharnessed by unscrupulous lenders and brokers engaged in predatory practices. However, theASF believes that further expansion of the liability to which direct and indirect assignees ofmortgage loans are subject would be an unwise and unfair mechanism for remedying theproblems in the subprime loan origination process, unless such expansion is undertaken in acareful, reasoned, and balanced manner. This paper seeks to offer a roadmap for apotentially fruitful legislative approach to this issue at the federal level.

1 The ASF is a broad-based professional forum of over 350 organizations that are active participants in the U.S.securitization market. Among other roles, ASF members act as issuers, investors, financial intermediaries and professionaladvisers working on securitization transactions. ASFs mission includes building consensus, pursuing advocacy anddelivering education on behalf of the securitization market and its participants. This position paper was developedprincipally in consultation with ASFs Subprime Mortgage Finance Task Force and Assignee Liability Working Group, withinput from other ASF members and committees. Additional information about the ASF, its members and activities may befound at ASFs internet website, located at www.americansecuritization.com. ASF is an independent, adjunct forum of theSecurities Industry and Financial Markets Association.

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http://www.americansecuritization.com/http://www.americansecuritization.com/


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Assignee Liability in the Secondary Mortgage Market:

Position Paper of the American Securitization Forum

June 2007

An ad hoc body of federal and state law currently governs the extent to which secondarymarket assignees that are innocent of any wrongdoing may nonetheless be subject to liability.The primary component of the federal statutory scheme governing liability for assignees isthe Truth in Lending Act (TILA), which was amended and supplemented in 1994 by the

Home Ownership and Equity Protection Act (HOEPA). HOEPA applies narrowly tocertain high-interest and high-fee equity loans (covered loans) that are perceived aspotentially predatory, and imposes strict liability on voluntary participants in the market forcovered loans for violations committed by loan originators. In addition to federal law, anumber of states and localties have responded to the problem of abusive loan origination bypromulgating legislation that imposes liability on assignees. Although these state and locallaws generally build on the HOEPA approach, they often have triggers that are set at levelsthat are lower than the HOEPA triggers, and they also usually impose more severe and moresubjective restrictions on covered loans than does HOEPA.

The premise behind the calls for expanded assignee liabilitythat the secondary subprime

mortgage market aids and abets predatory practices by primary lenders and brokersissubstantially overblown. In addition to being largely unnecessary, any federal legislation thatwould expose secondary market participants to assignee liability that is very high orunquantifiable would have severe repercussions. It would likely cause a contraction anddeleterious repricing of mortgage credit, thus harming both prospective subprime borrowersand current borrowers seeking to refinance their existing loans on more favorable termsespecially those borrowers with impending rate increases on their adjustable rate mortgageloans. And this contraction and repricing would occur at precisely the time when theprovision of further liquidity, spurred by the willingness of investors to expose themselves toadditional risk, is essential to ensuring the financial health of the housing market. Thus, apoorly thought-out expansion of assignee liability in response to present concerns about

predatory lending practices in the subprime sector would serve merely to multiply thenumber of victims of those practices.

Many of the proponents of expanded assignee liability assert that the flow of capital from thesecondary market to loan originators constitutes a major factor contributing to the frequencyof lending abuses in the loan origination process. These proponents envision investors,investment banks, and the other financial entities that participate in the secondary markettaking on additional roles as regulators of subprime mortgage lenders and brokers, exercisingoversight functions over current bad practices, and even rationalizing inefficiencies in thepricing and supply of subprime credit. But the analysis justifying expanded assignee liabilitysuffers from a number of conceptual flaws.

First, the assumption that secondary market participants are indifferent to the wrongfulconduct of primary loan originators and mortgage brokers, and care only about funnelingnew capital to the primary market, is mistaken. In fact, secondary market participantsalready face strong economic incentives to avoid unprofitable loans, including those thathave been originated in a predatory manner. Indeed, the recent rise in default rates andfailure of a number of originators have spurred a tightening of standards and more stringentevaluation of loan pools by investors and securitization sponsors. Intrusive governmentregulation would therefore pose a serious threat to the markets own corrective processes.

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Second, secondary market participants simply are not well-situated to take on an additionalrole conducting legally imposed, intrusive regulatory oversight over the very market in whichthey participate. Indeed, because the secondary market is unable and unprepared to make thefine distinctions between proper and improper loans that are necessary under the HOEPA

regime, HOEPA has had the predictable effect of discouraging the flow of capital to alllenders, not just unscrupulous ones. Many state and local laws, by precipitating a completewithdrawal of secondary market capital from the high-cost loan sector, have also had theeffect of reducing significantly the overall availability of funding for subprime lending.

Third, it is essential to remember that the actors directly responsible for the harm that resultsfrom predatory practicesmortgage originators and brokersalready are subject toextensive, if sometimes ineffective, government regulation. Although a more comprehensiveregulatory scheme could help reduce predatory conduct in the primary market, and predationby mortgage brokers in particular, this goal should be pursued through government actionthat is directed specifically at the culpable actors. If the current regulatory framework is

defective in its design or implementation, legislators should openly acknowledge and addressthe problem rather than shifting the responsibilities of government regulators onto thesecondary market.

Fourth, most assignees are individual passive investors or entities that are far removed fromthe loan origination process. These parties have nothing to do with any predatory practicesof brokers and originators, and have no way of either knowing when such practices are takingplace or reasonably discerning from review of the loan that they have invested in the fruits ofillegality. Over the short term, shifting the burden for predatory practices from the cheated(if not necessarily blameless) home owner to the passive investor or securitization sponsorsimply shifts the burden from one innocent party to another. Over the long term, thosesecondary market participants that do not exit the market entirely in response to heightenedprospective legal liability will demand a greater return on their investments as compensationfor taking on additional legal exposure. Thus, the burden of enhanced regulation willultimately fall on all borrowers, including the vast majority who are served by responsibleoriginators and brokers.

For certain consumer credit transactions that involve goods or services (but not real estate),the Federal Trade Commissions Holder Rule for the Preservation of Consumers Claims andDefenses, which was promulgated in 1975, effectively abrogates the protections affordedassignees by the holder-in-due-course doctrine. Many commentators point to the HolderRule as offering a viable model for the imposition of liability on assignees of mortgage loans.Even to the extent that the rationales underlying the Holder Rule are persuasive in the context

of consumer credit, they are inapplicable in the mortgage context because (i) thecircumstances of cheated consumer credit borrowers are not comparable to those of cheatedmortgage borrowers, (ii) assignees of defective consumer credit are subject to a very differentincentive structure than that to which assignees of mortgage credit are subject, and (iii) thesecuritization of subprime loans already presents vexing problems of risk evaluation andmitigation that are not present in the market for consumer credit.

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In sum, the secondary market is unsuited to playing the role of primary regulator of mortgagelenders and brokers, and it should not be asked to do so. To the extent that there is to beassignee liability for secondary market participants, it should be imposed pursuant to auniform national standard that is crafted carefully to serve the primary goal of reinforcing the

extant market forces that already provide substantial incentives for those parties that sponsorand invest in MBSs to make responsible investment decisions. The ASF believes that such acarefully crafted regime, even if extended to apply at triggers that are modestly lower thanthe current HOEPA triggers, would be preferable to the current patchwork of state andfederal laws, which has done little more than generate tremendous costs and inefficienciesthat, at the end of the day, are shouldered by all subprime borrowers.

Any assignee liability regulatory scheme should simultaneously (i) protect and provideredress for individual borrowers, (ii) protect the interests of secondary market participants,and (iii) promote the systemic interests in ensuring the continued flow of capital to thesubprime market. We would expect that such legislation would amend the current legal

regime under TILA/HOEPA. The contours of a scheme that would achieve these goals andthat the ASF could support include:

A definition of the term assignee that excludes certain types of entities that are notdirectly involved in purchasing loans.

Loan restrictions that are clear and objective. Restriction of assignee liability under the statute to violations of TILA, as amended.

The statute should be clear and explicit in establishing the scope of authorizedliability.

Limitation of an assignees prospective liability to the sum of the remaining value ofthe indebtedness and the total amount paid by the borrower, plus reasonableattorneys fees. The ASF strongly objects to the imputation of any statutory,enhanced, or punitive damages to an assignee based on the conduct of the lender orbroker, except in cases where the assignee acts with reckless indifference or knows ofthe violation.

Clarification of the circumstances in which a borrower can exercise the right rescindand specification that rescission is a personal remedy which can only be raised in anindividual action.

Authorization of borrowers to bring all those affirmative and defensive claims againstassignees that they can bring against the lender, subject to conditions to ensure boththat wronged borrowers will be able to obtain redress for their injuries and thatassignees will have the opportunity to control their litigation exposure and render thepotential scope of their liability more manageable. These conditions include:

Restriction of the right of a defaulting borrower to assert a violation of thestatute as a defense to an innocent assignees enforcement of the mortgage

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agreement. Unless the assignee acts with actual knowledge of, or displays areckless indifference to, the originators violation, a borrower should bepermitted to assert such a defense only in situations where the violationbears a reasonable relation to the default.

Authorization of affirmative claims subject to: an absolute defense for assignees that can demonstrate that a

reasonable person exercising ordinary due diligence could not havedetermined with reasonable certainty that there had been a violationof the law; and

a safe harbor, as described below, that would give assignees somecontrol over their exposure to liability from both affirmative anddefensive claims.

Express prohibition of class action claims against assignees. Creation of a safe harbor that is both effective and reasonable for secondary market

participants to satisfy, thus promoting the dual goals of encouraging participation inthe covered subprime market and incentivizing those secondary actors that doparticipate to scrutinize a statistically significant sample of the loans in which theyinvest. In addition to maintenance of the existing protections for assignees thatpurchase covered loans unintentionally, this safe harbor would afford shelter toassignees that, at the time of the purchase or assignment of the loan or within acertain period soon after:

had in place policies expressly prohibiting the acceptance of covered loansor covered loans that violate the statute;

required by applicable contract that the assignor of covered loans representand warrant at the time of assignment either (i) that it will not assign eitherany covered loan or any covered loan that violates the statute or (ii) that it isa beneficiary of a representation or warranty from a previous assignor to thateffect, and the assignee will benefit from that representation or warranty; and

had procedures in place to review either a fixed percentage of loans or areasonable percentage of loans in a pool, even if this review failed to detect

the loan that is the subject of a claim. This review provision of the expandedsafe harbor should have the following features:

Authorization of statistical sampling;

Allowance for assignees to satisfy the requirement by reviewing thedocumentation required by a specific law, the itemization of theamount financed, and other disclosures of disbursements;

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Authorization of post-purchase due diligence; and

Applicability of cure through the requisite loan review to the entirechain of title, such that assignees can rely on satisfactory due

diligence performed by either the seller or any other entity in thechain of title.

Inclusion of a robust cure provision allowing assignees to bring their loans intoconformity with statutory requirements. Within 60 days after discovering an error,and prior to the institution of a legal action, the creditor or assignee should beauthorized to effect cure by:

notifying the borrower of the error and making appropriate restitution; if it appears that the provision of a covered loan was a mistake, modifying the

terms of the credit transaction to bring it outside of the ambit of statutorycoverage; or

deleting any provisions in a mortgage agreement that violate applicable lawand taking other steps as necessary to prevent the violation from harming theborrower.

Replacement of the existing patchwork of federal, state, and local laws with auniform national standard for assignee liability that covers all mortgage lenders. Inparticular, the statute should contain an explicit clause preempting any state or locallaws that attempt to impose assignee liability or that limit a creditors ability to makecertain types of mortgage loans. States would have primary enforcement authority

under the statute for state-licensed entities.

II. Introduction

The purchase of a home is a defining and life-changing event for many Americans. Over thelast two decades, through the securitization process, the capital markets have enabledrealization of the dream of home ownership by a group of subprime borrowers whopreviously had been excluded because they could not obtain mortgage credit. However,recent turmoil in the housing market, which along with other factors has driven up rates ofmortgage borrower delinquency and home foreclosure, now threatens these importantadvancements. A disquieting number of observers place a substantial share of the blame for

the recent troubles on the capital markets, positing specifically that the increased availabilityof capital for subprime mortgage lending contributes to the prevalence of abusive lendingpractices perpetrated by those entities that originate and broker subprime loans. As a result,there is a growing call from certain quarters for federal legislative action to expand the scopeof the liability to which capital market participants that are assignees of mortgage loans aresubject for the actions of loan originators and brokers.

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Although the ASF shares the concern of legislators, bank regulators, and others regarding theapparent increased incidence of abusive lending practices, it strongly opposes the broadexpansion of assignee liability in the subprime mortgage loan sector and has serious concernsregarding current and potential future legislative changes at both the federal and state levels.

This report presents the ASFs perspectives on the importance of the capital markets toensuring home ownership opportunities for subprime borrowers, recent developments in thesubprime sector, and the pitfalls of enhanced assignee liability.

The ASF is particularly concerned that a poorly considered expansion of assignee liabilitywould reduce the availability of mortgage credit for both prospective subprime borrowersand current borrowers seeking to refinance their existing loans on more favorable terms(especially those borrowers with impending rate increases on their adjustable rate mortgageloans). Such a response to present concerns about predatory lending practices in thesubprime sector would serve merely to multiply the number of victims of such practices. Thereport offers a framework for a potential way forward that simultaneously (i) protects and

provides redress for individual borrowers, (ii) protects the interests of capital marketparticipants, and (iii) promotes the systemic interests in ensuring the continued flow ofcapital to the subprime mortgage market.

III. The Growth Of The Secondary Mortgage Market Has Increased The

Availability Of Mortgage Credit To Subprime Borrowers.

A. The Importance Of The Secondary Market As A Capital Source For Subprime

Loans.

Between 1989 and 2006, the percentage of Americans who owned their homes rose from 64

percent to 69 percent, an increase equivalent to 12 million additional home owners.1 Asignificant percentageby some estimates, more than halfof this growth in homeownership can be attributed to the increased availability of credit for subprime borrowers. 2Despite possessing the desire and the means to own homes, these borrowers traditionallyhave had difficulty obtaining mortgage credit because of impaired or limited credit histories,a high debt load, or variable or hard to document income. 3 Between 1994 and 2005,however, loans to subprime borrowers quadrupled as a percentage of total originations, from5 percent to 20 percent.4 This relative quadrupling was accomplished through a remarkableincrease in the total value of subprime mortgage originations, which rose from $35 billion in1994 to $640 billion in 2006.5 These trends are particularly salutary given thathomeownership is the primary method of wealth accumulation available to the vast majority

of subprime borrowers who are low- or middle-income.6

Driving the beneficial increase in subprime lending was the increasing flexibility and abilityof lenders to price loans to take into account the greater risk of delinquency and default posedby subprime borrowers.7 Although the vast majority of subprime borrowers are able to maketheir monthly loan payments in a timely manner and avoid default and foreclosureproceedings, such borrowers do pose greater risks than prime borrowers.

8Subprime loans

must be priced to take these risks into account.

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Technological innovation in underwriting was responsible for some of the enhancedflexibility and ability of originators to engage in risk-based pricing, but the primary causewas major structural changes in the market for mortgage financing.9 Prior to the 1990s,bankstraditionally the principal suppliers of mortgage creditrelied almost exclusively on

customers deposits as the source of funding for mortgage loans. Accordingly, the volume ofsuch deposits largely dictated the availability of mortgage credit, and the availability of creditfor nontraditional, often riskier borrowers was extremely limited.10 Although there weresome finance companies involved in the subprime market, they tended to rely primarily ondebt to finance this lending, which also strictly constrained the volume and types of loansthat could be made.

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Beginning in the 1990s, the private secondary mortgage market began providing the capitalto fund a dramatic expansion of lending to subprime borrowers. The key to the emergence ofthe secondary market was the development and refinement of the process whereby mortgageloans are securitized. The securitization process allows pools of mortgage loans to be

transformed into a type of security, known as a mortgage-backed security (MBS), thatinvestors can buy and sell on markets like any other commodified asset. This powerful andefficient mechanism for linking individual borrowers to arms-length investors with capitalspread rapidly, and, by 2005, almost 80 percent of subprime mortgages, at a total value of$450 billion, were undergoing securitization.12

The securitization process functions as a pipeline through which investors seeking afavorable investment return can supply significant quantities of capital to subprime loanoriginators. In turn, the availability of an increased supply of capital and the diversificationof risks has enabled originators to escape the constraints imposed by their prior reliance ondeposits and debt as capital sources.13 Indeed, the private secondary market is a particularlyimportant source of capital for subprime borrowers because the government-sponsoredenterprisesFannie Mae and Freddie Macthat do the lions share of securitizations in theconventional prime loan mortgage market, and that also guarantee the principal and interestincome on the securities that they issue, employ underwriting guidelines that exclude mostsubprime loans.

14Quite simply, in the absence of a functioning market for MBSs, the

remarkable expansion of subprime credit that has occurred over the last two decadesandthe dramatic growth in home ownership that it has facilitatedwould have been impossible.

B. The Securitization Process.

In order to fully comprehend the potential pitfalls posed by expanded assignee liability, it isnecessary to understand the nuts and bolts of the securitization process. A borrowers only

direct dealings are with the loan originator, which supplies the capital for the loan anddecides on its terms, and often a loan broker, which will assist in bringing together theoriginator and the borrower and identifying the loan terms that are suited to the borrowersindividual circumstances.15

Upon completion of the origination process, the originator generally will sell the loan to asecuritization sponsor, often the subsidiary of an investment banking firm, which in turn willtransfer the individual loans into a pool that aggregates subprime loans from many different

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sources.16 The pool of loans then typically is transformed into a business entity called aspecial purpose vehicle (SPV), usually a trust, which will issue the securities backed bythe loans.17 In setting up the SPV, the sponsor will work with the rating agencies to obtainevaluations of the credit risks associated with the various anticipated securities.18 Before

they will grant a desirable investment-grade rating to these securities, the rating agencies willsometimes require that the trust employ a variety of credit enhancement techniques, whichprovide a financial cushion to absorb losses resulting from unanticipated rates of default onthe underlying loans.19

Once the vehicle is established and the securities issued, an underwriter will purchase all thesecurities and resell them to investors.20 Although sometimes the loan originator will retainthe rights to service the pool of loansa role that involves corresponding with borrowers,processing monthly loan payments, and addressing loan delinquencythe sponsor or trusteeof the SPV often will contract with a third-party servicer to perform these functions.21

Because they are highly differentiated and their payoff relatively unpredictable, individualmortgage loans are unattractive assets for the general investor, who has limited time andresources to investigate the details of potential investments. Although investors could avoidsome of the risks posed by individual loans by investing in the loan originators, originatorsthemselves pose idiosyncratic risks of failurefor example, originators are susceptible toregion-wide adverse events, such as declines in real estate prices, that can have asimultaneous, negative impact on a significant number of mortgage loans.22 By facilitatingdisaggregation of the risks associated with both individual loans and loan originators,securitization allows investors to take a pure, relatively quantifiable investment position onsubprime mortgage credit, thus attracting significant capital to the market. Other features ofthe securitization process, such as the reliance on the rating agencies to evaluate the risk ofthe securities backed by the pool of mortgage loans, reduce the information costs to potentialinvestors even further.23

Although the story of the development of the market for MBSs is by now three decades old,the myriad investment challenges posed by loans that are subprime meant that securitizationsinvolving those loans were uncommon until the early 1990s. Subprime loans are not onlygenerally more risky than prime loans, but also have a long-term performance that is lesspredictable. Pools of subprime loans also span a much broader range of credit risks thanprime loans, meaning that the variance of the distribution of credit risks in subprimesecuritizations is higher than for prime securitizations.24

The need to overcome these and other challenges repeatedly has propelled bursts of financial

innovation that have served the interests of all parties and driven overall economic growth.For example, sponsors gradually have designed a set of techniques for structuring MBSs toovercome the various impediments to turning pools of mortgages into an attractiveinvestment vehicle for the average investor, including the long and uncertain return horizonof mortgage loans and varying investor risk preferences. Payments on the loans in a pool arenow apt to be subdivided into different cash flow streams, which in turn back securitiespartitioned according to the desired level of risk and the term of the investment. 25 As aresult, investors may have the option of investing in principal- or interest-only securities,

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securities at particular positions in the priority of payment in case the underlying borrowerdefaults, and securities that are backed by loans at a particular level of maturity.26

This ability to tailor investment vehicles to segmented investor preference has increased

significantly the attractiveness of MBSs to investors. It demonstrates the extent to which thesubprime MBS market has matured, and is a testament to the ability of the financial sector toinnovate and adapt in ways that serve both investors and the general public.

IV. Recent Calls To Extend Liability For Abusive Loan Origination Practices To

The Secondary Mortgage Market Are Misguided.

A. Recent Turmoil In The Housing Market, And Its Causes And Consequences.

Even under the best of circumstances, some subprime mortgage borrowers will default ontheir loans. And the current circumstances characterizing the subprime market are not thebest. The recent volatility of the housing market, in combination with the increasing numberof subprime borrowers who have obtained mortgage loansoften at terms that are notappropriate to their circumstanceshas resulted in a substantial increase in the number ofdefaults and foreclosures.27 From 2005 to 2006, foreclosure filings increased 42 percent tomore than 1.2 million.28 Clearly, an inordinate number of borrowers are finding themselvessaddled with mortgage debt that they cannot afford.

In spite of these troubling developments, it is important to remember that the vast majority ofsubprime borrowers have benefited from the rapid expansion of subprime mortgage capital.In addition, while there has been a rush to cast blame for the suffering of delinquent anddefaulting subprime borrowers on third parties, the reality is that many borrowers now find

themselves in trouble because of their own unwise decisions. Borrowers frequentlymisrepresent their financial circumstances in applying for loansone recent review foundthat 90 percent of a sample of borrowers had inflated the income that they stated on theirmortgage loan applications, with 60 percent inflating their stated income by more than 50percent.

29Relatedly, the recent bull market in real estate has encouraged a rash of reckless

speculation, with many home buyers eschewing a down payment on their home purchases25 percent of all home buyers chose to make no down payment in 2004or borrowingexcessively to purchase homes beyond their means.

30

Only a very small percentage of subprime loans involve abusive lending practices by loanoriginators or brokers.31 The underlying and unavoidable reality is that subprime borrowers

are more likely than prime borrowers to default, even when the conduct of originators andbrokers is exemplary. Nevertheless, the ASF accepts the proposition that capital providedthrough securitizations, along with capital from a variety of other sources, has sometimesbeen harnessed by unscrupulous lenders and brokers to engage in those abusive lendingpractices involving fraud, deception or unfairness that are grouped under the term predatorylending. Further, it is likely that such predatory practices have contributed to the currentproblems in the subprime market.32 Beyond the systemic economic and financialimplications of sharp practices engaged in by certain unscrupulous lenders and brokers, the

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ASF also is cognizant of the sometimes tragic consequences at the level of individualborrowers, including financial ruin or the loss of a home.

Of particular concern are the risks to vulnerable borrowers who lack the experience or the

ability to evaluate loan terms offered by originators or the promises and statements made bybrokers. Instead of reading and reviewing their loan documents, many borrowers rely ontheir mortgage broker to explain the terms and conditions of the loan. Although mostmortgage brokers provide borrowers with accurate descriptions of terms and conditions,borrowers sometimes are misled. Furthermore, mortgage brokers have no duty to findborrowers the best mortgage loan, and are compensated according to the type and amount ofthe loan; therefore, a broker may have an incentive to push certain loan products that areinappropriate for a particular borrower.

As Congress considers a variety of options for addressing problems in the subprimemortgage market, the suggestion has come from a number of quarters that there should be an

expansion, through federal legislation, of the extent to which secondary marketparticipantsincluding passive investors, investment banks, and the other entities thatpurchase or hold, however briefly, loans during the securitization processare subject toliability as assignees for misconduct in the loan origination process. The ASF believes thatfurther expansion of such assignee liability would constitute an unwise and unfair mechanismfor remedying the problems in the subprime loan origination process, unless such expansionis undertaken in a careful, reasoned, and balanced manner.

The very existence of a national mortgage market that is liquid and efficient depends oninvestment risk being manageable and quantifiable, since investors must be certain thatpurchasing mortgage loans, or merely investing in such loans, will not give rise tocatastrophic legal liability and investment loss. The imposition of overly burdensome andpotentially unquantifiable liability on the secondary marketfor abusive originationpractices of which assignees have no knowledge and which were committed by parties overwhom they have no controlwould therefore severely affect the willingness of investors andother entities to extend the capital necessary to fund subprime mortgage lending. 33 As aresult, at precisely the time when increased liquidity is essential to ensuring the financialhealth of the housing market, schemes imposing overly burdensome assignee liabilitythreaten to cause a contraction and deleterious repricing of mortgage credit. By reducing theamount of capital available for originators to lend, and thus hurting both current borrowersseeking to refinance their existing loans on more favorable terms prior to an interest rateadjustment and prospective borrowers entering the market for the first time, a poorlyconceived expansion of assignee liability merely would multiply the number of victims of

predatory lending.

B. The Current Status Of The Law Governing Assignee Liability.

The default assumption is that the assignee of a mortgage loan takes subject to those claimsand defenses that the borrower has against the original lender. However, the common-lawholder-in-due-course doctrine provides that an assignee that paid value for a loan in goodfaith and that lacked notice of certain claims and defenses to payment that the borrower has

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against the original lender, such as fraud, takes the loan free of those claims and defenses; theassignee remains subject to real defenses, such as duress. 34 The rationale behind the holder-in-due-course doctrine is promotion of the free market transfer of negotiable instruments.Indeed, by encouraging the liquid secondary market to purchase large quantities of loans

without the need for costly and intrusive vetting of each individual loan for potential claims,the holder-in-due-course doctrine serves as an essential cornerstone underpinning the currentplentiful availability of mortgage credit to prospective home owners. The doctrine alsorecognizes that, in the vast majority of cases, it is neither fair nor efficient for innocentassignees to be held responsible for the predatory lending practices of loan originators.

It is important to remember that, although the holder-in-due-course doctrine constitutes animportant protection for innocent assignees, it does not afford an absolute protection to allassignees. In order to benefit from holder-in-due-course status, an assignee must take theloan in good faith and cannot have actual or implied knowledge of a variety of loan defects,including that the loan was originated through fraudulent means. Courts will also deny

holder-in-due-course status to an assignee that has such a close connection with theoriginator that the originator effectively is an agent of the assignee 35 or where knowledge ofthe originators wrongdoing can be imputed to the assignee on some other basis, such as joint-venture or aiding-and-abetting theories.

36In addition, assignees that engage in

wrongful conduct themselves in connection with mortgage loans are subject to potentiallyserious liability under a variety of federal and state legislation.37

The ASF does not contest the scope of liability under these laws for secondary marketassignees that are culpable. Rather, the ASFs concern is the ad hoc body of federal and statelaw that currently subjects innocent secondary market assignees to liability. This body oflaw lacks coherence and is often internally inconsistent, in part because the perception thatassignees must be held responsible for the sins of loan originators becomes more politicallysalient during periods of turmoil in the housing market. At such times, there is a tendencyfor lawmakers to turn to the secondary market as the deep pockets available to compensatefor the failure of regulatory authorities to effectively oversee and punish those loanoriginators that engage in illegal conduct.

The primary component of the statutory scheme governing liability for assignees that hasemerged at the federal level is the Truth in Lending Act (TILA), which was amended andsupplemented in 1994 by the Home Ownership and Equity Protection Act (HOEPA). 38The purpose of TILA is to facilitate informed decision making by borrowers, which thestatute furthers by requiring lenders to provide standardized disclosure regarding the costsand terms of credit. To comply with the statute, lenders must use statutorily specified

terminology to explain to borrowers the salient provisions of loan agreements.39 Lendersthat violate TILA are subject to a strict liability standard, which is breached even byviolations that are merely technical or minor.40

In contrast with TILAs broad applicability to most consumer loans, HOEPA appliesnarrowly to certain high-interest and high-fee refinancing (covered loans or HOEPAloans) that are perceived as potentially predatory. In 2005, such loans accounted for lessthan one-half of 1 percent of originations of home-secured refinance or home-improvement

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loans.41 HOEPA augments TILAs disclosure provisions, requiring lenders to provide aspecial statement to borrowers of covered loans that warns them of the risk that default on theloan might lead to the loss of their homes. 42 This warning, in conjunction with standardTILA disclosures, must be provided three days prior to loan settlement, thus affording

borrowers a cooling-off period to reconsider their decision.43

HOEPA also prohibitscertain loan provisions that have been deemed to pose inappropriate risks in conjunction withloans that are either high cost or that carry high fees. 44

As to assignee liability, TILA provides borrowers with a limited cause of action against theassignees of creditors who have violated the statute. Although the scope of assignee liabilityunder HOEPA is unclear,45 for the class of covered loans, the plain language of HOEPAsubjects assignees to liability for all claims and defenses with respect to th[e] mortgage thatthe consumer could assert against the creditor * * *.46 Unless the assignee can prove that itdid not know, and was reasonable in not knowing, that the loan was a HOEPA loan, thisprovision at a minimum effectively eliminates the protections afforded to assignees by

holder-in-due-course status.

47

The HOEPA assignee liability provision is modeled after the Federal Trade CommissionsHolder Rule for the Preservation of Consumers Claims and Defenses (the Holder Rule),which nullifies the holder-in-due-course doctrine for certain types of non-real estateconsumer credit transactions, including financed sales of consumer goods or services andcertain purchase money loans.48 The Holder Rule mandates that any contract pertaining tosuch a transaction contain language subjecting the holder to liability on all claims anddefenses that the debtor could assert against the seller, such as a breach of warranty claimrelated to the sale of goods that are defective. Recovery pursuant to the Holder Rule iscapped. Like the Holder Rule, the plain language of HOEPA would seem to render anassignee liable for any claim or defense relating to a mortgage loan that the borrower couldassert against the creditor, regardless of the particular law under which the claim or defensearises.49

As a result of HOEPAs authorization of broad liability for innocent assignees, loanpurchasers that wish to participate in the market for HOEPA loans can control their liabilityexposure, but never eliminate it, only through painstaking scrutiny of both the content ofevery individual loan and the legitimacy of practices engaged in by individual originators andbrokers. Because the statute imposes strict liability on voluntary participants in the marketfor covered loans, even those assignees that take these steps are still subject to liability if theyfail successfully to discover and to avoid loans that have been made in violation of thestatute. Thus, as one commentator has observed, for loans that fall under the ambit of

HOEPAs triggers, consumers will generally have a strong case for extending liability forall predatory lending claims and defenses deep into securitization conduits.

50

In addition to these sources of federal law, over the last several years a number of states andlocalities have responded to the problem of abusive loan origination by promulgatinglegislation that imposes liability on assignees. Although these state and local laws generallybuild on the HOEPA approach, they often have triggers that are set at levels that are lowerthan the HOEPA triggers, thus reaching a larger share of the subprime market. In addition,

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these laws often impose more severe restrictions on covered loans than HOEPA, resulting inthe potential for unquantifiable and unduly burdensome liability.51 Such liability can pose aconcrete threat to the willingness of the secondary market to continue to provide capital tothe originators of subprime loans in the affected jurisdictions.

C. The Analysis Underlying the Expansion Of Assignee Liability Through HOEPA

And Many State Laws Is Fundamentally Misguided.

Many of the proponents of expanded assignee liability assert that the flow of capital from thesecondary market to loan originators contributes to the posited prevalence of lending abusesin the loan origination process. They paint a dark picture of insatiable investor appetite forMBSs driving the entities that structure securitizations to demand more and more loans fromthe primary market, thus incentivizing primary loan originators and brokers to engage ininappropriate, and even fraudulent, behavior to satisfy this demand. Moreover, according tothe proponents of this view, none of the actors involved have any incentive to end the

pernicious cycle. Before loan originators incur liability or suffer losses from default, theycan transfer their loans to the secondary market, thus rendering themselves judgment proof.And secondary market participants are protected from liability by the holder-in-due-coursedoctrine.

According to those pushing for a major expansion of assignee liability, such liability willhelp to break the cycle by incentivizing the secondary market to police unscrupulousmortgage originators, to stamp out current bad practices, and even to rationalize the pricingand supply of subprime mortgage credit.

It is true that a robust and liquid secondary mortgage market does free originators from theneed to fund mortgage loans out of their own capital resources and hold loans on their

balance sheet, and this liberation from resource constraints benefits both scrupulous andunscrupulous lenders. However, the analysis that underlies the assignee liability provisionsof HOEPA and that continues to be advanced by the proponents of expanded assigneeliability suffers from a number of conceptual flaws.

1. Secondary market participants have no incentive to purchase predatoryloans.

The assumption that secondary market participants are indifferent to the wrongful conduct ofprimary loan originators, and care only about funneling new capital to the primary market, ismistaken. In fact, secondary market participants already face strong economic incentives to

avoid unprofitable loans, including those loans that have been originated in a predatorymanner.

From the perspective of an investor, a predatory loan is a bad loan, since the borrowerstargeted by predatory lenders tend to be economically vulnerable and financiallyunsophisticated, and the terms of predatory loans frequently are inappropriately onerous, thusincreasing the risk of borrower delinquency and foreclosure.52 Foreclosure is a costly lastresort that benefits no party involved. The loan servicers that process foreclosures are not in

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the real estate business, and often have to resell the foreclosed property at auction or at aforeclosure sale at a substantial loss. This loss ultimately is borne by investors. Theinclusion of risky, default-prone predatory loans in the pools that back MBSs thus worsensthe benefit-risk profile of the securities and reduces their desirability to investors. Indeed, as

a result of the recent turmoil in the market, the rating agencies have been forced todowngrade the credit ratings on a number of MBSs, thus negatively impacting the investorswho purchased these securities.53

Moreover, investor aversion to predatory loans means that few of the large institutionalplayers that participate in securitizations, particularly the investment banks that distributeMBSs, wish to lose their credibilitythe very lifeblood of their businessby participating insecuritizations backed by such loans.54 Many investment banks also hold a large share oflower-rated securities for their own account; since they bear any initial losses, investmentbanks are thus further incentivized to screen effectively.

It is also the case that, although some loan originators and brokers may be judgment proof,the secondary market suffers when these parties incur heavy liability as a result of legal judgments or loan default, since the sponsors of securitizations frequently have substantialsums invested in the loan origination process. In fact, the recent failures of major subprimelenders threaten to inflict heavy losses on the very secondary market actorsprimarilyinvestment banksthat have been the source of much of the capital that has driven the recentgrowth in subprime mortgage credit.55

In sum, even absent the prospect of assignee liability, it is simply not in the economic self-interest of secondary market participants to purchase predatory loans.

It also bears remembering that the subprime mortgage securitization process is still relatively

novel and complex. The recent rise in delinquencies and defaults, in conjunction with thefailure of a number of originators, has spurred a tightening of standards and more stringentevaluation of loan pools by investors and securitization sponsors. The moment at whichmarket forces are correcting for prior inefficiencies (and perhaps some overexuberance) isprecisely the wrong time for intrusive government regulation, whichbecause it is usuallypoorly targeted and bluntruns the risk of counterproductively impeding market forces.

2. Secondary market participants are not well-suited to regulating theprimary market, and trying to force them to conduct such regulationwould increase the cost borne by subprime mortgage borrowers.

Contrary to the wishful assumptions of proponents of expanded assignee liability, investors,investment banks, and other financial entities in the secondary market are adapted toparticipating in markets, not regulating them; therefore, they have little capacity or aptitudefor such a regulatory role. A regime that authorizes the imposition of substantial liability onassignees for the wrongful conduct of primary lenders may create strong incentives for thosesecondary market participants that remain in the subprime market to endeavor to scrutinizemore closely the quality and provenance of the loans that they fund. But inevitably, suchliability also will increase the cost, risk, and complexity of secondary market operations. At

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a minimum, burdensome assignee liability will drive loan purchasers to demand higheryielding loans for their portfolios and force loan originators to deny mortgage credit to manysubprime borrowers and impose higher rates and fees on all approved subprime borrowers.

Furthermore, the likelihood that market participants will exercise the exit option in responseto a regime that subjects them to liability that is unfair, inefficient, and potentiallyunmanageable is particularly high in the case of the secondary market for subprime loans. Ingeneral, investors must be able to value the asset in which they invest, and for a long time thedifficulty of valuing a pool of subprime mortgages retarded the development of thesecondary market.56 Although investors have, over time, developed very sophisticatedpricing models that enable such valuations, the injection of legal risk into the calculusthreatens to render accurate valuations impossible.57

Indeed, the advent of significantly expanded potential liability for lenders and assigneesunder HOEPA has had a dramatic effect on the market for covered loans. Neither Freddie

Mac nor Fannie Mae will purchase any mortgage loan that meets the HOEPA triggers.

58

S&P initially required that HOEPA-covered loans be excluded entirely from ratedtransactions,

59and now will allow such loans in rated transactions only subject to additional

credit enhancements.60 Given the heightened risk and uncertainty, most investors simplywill not invest in securities backed by pools containing HOEPA-covered loans, thusdepriving certain borrowers of access to any mortgage credit at all.61 In sum, because thesecondary market is unable to make the fine, difficult distinctions between proper andimproper loans that are necessary under the HOEPA regime, HOEPA predictably hasdiscouraged the flow of capital to all lenders, not just unscrupulous ones.62

Many state and local laws have also had a significant impact on the availability of secondarymarket capital to fund subprime lending in the relevant jurisdictions. Such laws often imposeunmanageable liability on assignees, and rely heavily on standards that are subjective andundetectable through review of the loan file. This makes it effectively impossible forassignees to control, and rating agencies to assess, whether loans meet these standards. 63Indeed, the rating agencies have announced that they will not rate MBS transactionsinvolving mortgage loans originated in jurisdictions that impose potentially unquantifiable orunlimited liability on assignees.64 Even if a law imposes assignee liability that is reasonablylimited and quantifiable, the rating agencies will only rate transactions involving coveredloans if onerous conditions are satisfied, including the provision of additional creditenhancements and additional representations and warranties, and the performance of acompliance review.

65Because of the threat of liability and the difficulty of meeting the

rating agencies conditions, most MBS transactions exclude loans covered by burdensome

state laws.66

There are, unfortunately, a number of specific examples of state anti-predatory lending lawsthat were extraordinarily ill-conceived and poorly drafted, including laws in New Jersey,Massachusetts, Rhode Island, and Indiana. Perhaps the worst example of problematic statelegislation was the Georgia Fair Lending Act (GAFLA),67 which followed the (apparent)HOEPA model of subjecting assignees to both defensive and affirmative liability for anyclaim that the borrower could assert against the original creditor. Compounding the

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problems posed by this model, the statute authorized punitive damages against passiveinvestors and failed to contain important safeguards. GAFLA was also too complicated anddifficult to apply in practice; for example, it required lenders to document that a refinancingof certain loans provided the borrower with a net tangible benefita standard that is

hopelessly subjective.

As it became clear that GAFLA subjected assignees to liability that was essentiallyunquantifiable, all three of the major rating agencies announced that they could not rate anyMBSs containing any loans subject to GAFLA, thus effectively ending the secondary marketfor loans originated in Georgia.68 As a result, the availability of subprime credit declinedprecipitously. In response, the Georgia legislature decided to amend GAFLA to removeseveral of its worst provisions. Nevertheless, there currently is no market for the few highcost loans originated during the period between the date on which GAFLA was enacted andthe date on which it was modified.

Likewise, the threat of assignee liability under New Jerseys Home Ownership ProtectionAct (HOSA)69viewed by the National Association of Mortgage Brokers as one of thetoughest anti-predatory lending laws in the countryled S&P to refuse to rate anysecuritizations that contain covered loans.70 To the extent that there is still demand in thesecondary market for subprime mortgages originated in New Jersey, it is only because thatlaw contains some minimal protections for assignees, such as a safe harbor, a damageslimitation, and a prohibition of class actions.71 Nevertheless, HOSA has made it much morelikely that creditors in New Jersey will reject a prospective subprime borrower.72

Even laws that adopt an approach that is more moderate than GAFLA and HOSA havestaunched the flow of capital to fund covered loans and thus had a dramatic impact on theoverall availability of subprime mortgage credit. North Carolinas high-cost mortgagelegislation, like many of the state laws that followed it, set lower triggers than HOEPA andimposed more severe restrictions on covered loans. Although the legislation did notexplicitly impose liability on assignees, previous interpretations of North Carolina lawrendered such liability a distinct possibility, as was noted by S&P in its review.73 Empiricalstudies have shown that, predictably, this new legal exposure markedly reduced lending tohigher risk borrowers in North Carolina, with the largest impact falling on low income andminority borrowers.74

In addition to the specific concerns generated by the content of individual state and locallegislation, the sheer volume of these often conflicting standards compels secondary marketparticipants to incur substantial additional costs in investigating legal provisions and

evaluating their risk exposure.75 Even after these resources have been expended, secondarymarket participants that have purchased potentially covered loans still remain subject toliability that is fundamentally unmanageable and unquantifiable, since the models used toassess risk depend on the contractual terms of loans remaining stable. The rapid proliferationof state laws imposing increasingly expansive liability thus injects significant change-of-lawrisk into the investor decision-making process. Since this risk cannot be modeled effectively,it cannot be managed by investors.

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3. The primary market actors directly responsible for harmful predatorypractices already are subject to extensive, if sometimes ineffective,government regulation.

The actors directly responsible for the harm that results from predatory practicesmortgageoriginators and brokersalready are subject to extensive, if sometimes ineffective, oversightby state and federal regulatory authorities.76 A corporate originator may not originate aresidential mortgage loan without a state license or a bank charter, and mostalthough notallstates require all brokers to register or to hold a license before they may broker amortgage loan.77 Fraud and predatory practices are illegal in every state, and violators of theapplicable laws and regulations are subject to a host of civil and criminal penalties.

Rather than shifting responsibilities onto the secondary market, legislators shouldacknowledge and address any deficiencies in governmental oversight of originators andbrokers. A more comprehensive scheme for regulating the primary market could help reduce

predatory conduct, and predation by mortgage brokers in particular. For example, if thecurrent system of regulating mortgage brokers at the state level does not protect consumersadequately, then a more comprehensive federal regulatory scheme could be considered.

78

Reform options that directly address any governmental regulatory failures promise to bemuch more effective than reliance on the secondary market. Specific governmental bodiesare established for the very purpose of regulating lenders and brokers, and, in order to carryout their mandate effectively, the relevant bodies collect fees and possess wide-ranging legalauthority to examine and investigate participants in the primary market. The secondarymarket has neither these powers and resources nor the aptitude to carry out such a regulatoryfunction.

4. Shifting the burden for predatory practices from cheated subprimeborrowers to passive investors and other subprime borrowers simplyshifts the burden of predatory practices among innocent parties.

Many proponents of expanded assignee liability rest their analysis in part on the argumentthat such liability corrects a fundamental unfairness. Why must an innocent borrower who is,almost by definition, in a financially precarious situation shoulder the burden of having beenpreyed upon by an unscrupulous, but now judgment-proof, originator or broker?

Of course, over the long term, investors will shift their capital out of the subprime market inresponse to the imposition of burdensome liability, thus ultimately harming all subprime

borrowers. And although these proponents do have a point from the short-term perspective,by focusing so narrowly on the plight of individual defrauded borrowers, they overlook andundervalue the other innocent parties who would be hurt by expanded assignee liability.Most assignees are individual passive investors or institutions far removed from the loanorigination process.79 These parties have no way of either knowing when predatory practicesare taking place or reasonably discerning from review of the loan that they have invested inthe fruits of illegality. Shifting the burden for predatory practices from the cheated (if not

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necessarily blameless) subprime borrower to the passive investor simply shifts the burdenfrom one innocent party to another.

Moreover, it bears repeating that those secondary market participants that do not exit the

market entirely in response to heightened prospective legal liability will demand a greaterreturn on their investments as compensation for taking on additional legal exposure. Thisburden, in the form of higher rates and fees for subprime loans, ultimately will fall on allborrowers, including the vast majority who are served by responsible originators and brokersand never subjected to predatory practices.

D. Why The Holder Rule Approach Should Not Be Applied To Mortgage Credit.

Unfortunately, the current legal framework governing assignee liability reflects the partialadoption of elements of the rationale underlying the Holder Rule without considering thedifferences presented by mortgage and other types of consumer credit.80 For example, inpassing HOEPA, Congress explicitly embraced the theory that the mere availability ofsecondary market capital as a source of funding for subprime lending is a direct inducementto wrongful behavior by originators and brokers.81 The assignee liability provision inHOEPA was intended to encourage investors in the secondary market for HOEPA loans toscrutinize more carefully the backgrounds and qualifications of those loan originators withwhich they conducted business.82 HOEPA thus endeavored to harness the incentives createdby legal liability effectively to deputize secondary market participants to police and to punisheconomically the predatory lending practices of primary market actors.

Some commentators believe that federal legislation should address the question of assigneeliability simply by extending the Holder Rule to all residential mortgage loans. This belief ismistaken because there are a number of reasons why the rationales supporting total

abrogation of the holder-in-due-course doctrine for transactions that involve goods andservices, even to the extent that they are persuasive in that context, are inapplicable in themortgage loan context.

First, as has been demonstrated above, local, state, and federal laws governing the primarymarket for mortgage credit form a patchwork of substantive regulation that is alreadycomplex and that continues to grow more so as the pressure for government action mounts. 83Many of these regulations are extremely subjective, rendering compliance by arms-lengthsecondary market participants difficult. This is not the case for other types of consumercredit, which tend to be governed by relatively simple, and objective, common law rules.84

Second, state predatory lending laws often impose liability that is substantially higher thanthe recovery that is possible under the Holder Rule, which imposes a cap on damages.85

Third, the circumstances of defrauded mortgage borrowers differ in important ways from thecircumstances of borrowers of other types of consumer credit. The Holder Rule mainlyallows borrowers who incurred a debt in purchasing a defective good or service to obtainredress. The borrower in such a situation suffers a loss that is actual and substantial. Bycontrast, the value of the principal of a mortgage loan to a borrower is immutable, even if the

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loan is predatory.86 Therefore, the amount of recovery necessary to make a victimizedmortgage borrower whole is extremely limitedfor example, an amount equal to thedifference between the actual interest paid and the amount of interest that the borrower wouldhave paid at a fair interest rate. In addition, as noted above, it is often the case that

borrowers of mortgage credit share at least some of the blameat least in comparison withinnocent assigneeswhen they are victimized by predatory originators and brokers; the samecannot be said for consumers duped into purchasing defective goods or services. As a resultof these considerations, the full range of actions that can be brought against originators andbrokers of predatory subprime mortgage loansto the extent that they afford damages tocheated borrowers that reflect punitive principles of deterrence and retribution rather than thenarrow goal of making the borrowers wholeare not appropriately enforced againstassignees.

Fourth, assignees of consumer credit have little interest in whether the good or service isdefective, because the ability of the borrower to repay the loan is not linked to the soundness

of the product purchased. Therefore, there is an argument that the Holder Rule corrects for amarket failure. However, because borrowers of subprime mortgage loans that are predatoryare much more likely to go into default or foreclosure on those loans, secondary marketparticipants usually have a strong economic incentive to ensure that they do not purchasesuch loans, even absent the prospect of legal liability.

Finally, the securitization of subprime loans already presents vexing problems of riskevaluation and mitigation that are not present in the market for consumer credit. Moreover,securitization sponsors, underwriters, and investors currently are skittish in light of the extentto which recent the turmoil in the market has forced them to reevaluate prior risk and pricingassumptions. This makes it highly plausible that the imposition of legal liability in a fashionakin to the Holder Rule would drive many secondary market participants out of the marketentirely. Indeed, the experience with state predatory lending laws and HOEPA demonstratesthat this risk is more than theoretical.

V. Recommendations For A New Framework For Assignee Liability

The framework that currently governs assignee liability for participants in the secondarysubprime mortgage market applies to a limited number of high cost loans, but the costs ofcompliance that it imposes on participants in the market for such loans are prohibitive. Thescheme is not workable, and certainly should not be expanded to encompass a broader shareof the subprime market.

To the extent that there is to be assignee liability for secondary market participants, it shouldbe imposed pursuant to a uniform national standard that is crafted carefully to serve theprimary goal of reinforcing the market forces that already provide substantial incentives forthose parties that sponsor and invest in MBSs to make responsible investment decisions.The ASF believes that such a carefully crafted regime, even if extended to apply at triggersthat are modestly lower than the current HOEPA triggers, would be preferable to the current

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patchwork of state and federal laws, which has done little more than generate costs andinefficiencies that, at the end of the day, are shouldered by all subprime borrowers.

The following recommendations for amendments to existing federal law assume that any new

legislation will modify the statutory scheme consisting of TILA/HOEPA. Theserecommendations draw in many instances on prior suggestions for reform, particularly theResponsible Lending Act (or, the Ney-Kanjorski Bill),87 which was proposed in 2005, butwas never enacted into law. As with the recommendations that follow, the ResponsibleLending Act proposed to modify TILA/HOEPA by establishing a national uniform standardgoverning assignee liability that preempted contrary state law and established objectivestandards, a limitation on affirmative claims, a due diligence safe harbor, a reasonable cap ondamages, and a right to cure.

A. Entities Covered By Assignee Liability

Neither TILA nor HOEPA (nor many state laws) defines the term assignee, although TILAis clear that loan servicers generally are not treated as assignees.88 The absence of a clearstatutory definition poses the risk that courts will define the term too broadly, sweeping insecondary market participants who are only very tangentially related to the loan.

The term assignee should be defined clearly and narrowly in any future legislation. Inparticular, the ASF urges the exclusion of certain types of entities that are not directlyinvolved in purchasing loans. In addition to servicers, the following parties should beexcluded:

(i) parties possessing only a security interest in the mortgage loans and parties thathave acquired title to the loan through foreclosure;

(ii) broker-dealers and their affiliates that trade in mortgage loans and relatedmortgage securities but that are not involved in any material respect in the terms andconditions of the loans or securities;

(iii) passive investors in securities backed by a pool of mortgage loans, includingguarantors of the principal and interest of securities held by other investors; and

(iv) parties that have purchased mortgage loans under a repurchase agreement.89

B. Mortgage Loan Triggers For Coverage

TILA, which establishes general disclosure requirements, applies to every home mortgageloan. HOEPA, which imposes far more restrictions on the substantive contents of loansthemselves, applies only to a class of refinancings of residential mortgage loans (high costmortgages), a categorization that is triggered either by a loans high interest rate or itsimposition of a specified level of costs and fees.

90The HOEPA triggers are set by

regulations promulgated by the Federal Reserve Board. For a closed-end refinancing securedby a first lien, the triggers currently are set at (i) an interest rate at loan consummation that is

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8 percent over the comparable rate for Treasury Bills (10 percent for a subordinate lien) or(ii) total points and fees that exceed either 8 percent of the total loan amount or an annuallyadjusted fixed dollar ceiling.91 Many state predatory lending laws have triggers that arelower than those in HOEPA and/or require different calculations.

The ASF does not object per se to federal legislation that establishes triggers that aremodestly lower than those currently set by HOEPA and that thus brings a larger group ofmortgage loans within the ambit of potential assignee liability. However, the extent to whichlower triggers are appropriate will depend on whether the proposed legislation also (i)effectively addresses the concerns that the ASF has regarding other aspects of the currentTILA/HOEPA scheme and (ii) avoids instituting additional inappropriate burdens onassignees.

C. Prohibited Practices And Restrictions On Loan Terms

HOEPA diverged from the TILA disclosure model by substantively restricting the terms thatcould be included in covered loans. Restricted terms include: balloon payments, negativeamortization, advance payments, default interest rates, prepayment penalties, lending withoutregard to repayment ability, refinancing within the first year, loan flipping, and due-on-demand clauses.92 Although these practicesespecially loan flippinghave problematicsubjective elements,93 they generally have more objective, measurable, and well-accepteddefinitions than the additional practices prohibited under state predatory lending laws.Examples of such subjective standards under state law include prohibitions on deceptivepractices and the structuring of loans to avoid triggers and, perhaps most egregiously, therequirement that a loan confer a net tangible benefit on the borrower.

Given their remove from the lending process, secondary market purchasers have very limited

capacity to discern whether particular loans meet subjective standards.94 Much of theinformation required to make the necessary evaluations and screen problem loans is notpresent in the available loan files. Even when the information could potentially be found inthose files, secondary market purchasers simply are not situated to make fine-grained,context-dependent evaluationssuch as whether a specific loan confers a net tangible benefiton a borrower or has been structured to avoid triggersat a reasonable cost.95 Mostassignees are SPVsusually a trustthat given their limited capacity must rely in large partupon representations and warranties from the originator or seller regarding the loanscompliance with applicable law. Such SPVs have no capacity to determine the suitability ofa loan for a particular borrower or to assess the details of the origination process.

In sum, even if theoretically possible, the cost of a detailed determination of compliance withsubjective standards on a loan-by-loan basis is prohibitive.

The prohibition of practices according to objective standards carries some costs for loanoriginators, as it reduces their flexibility to structure loans so as to address evolvingcircumstances and serve deserving borrowers. However, the costs of such reduced flexibilityare swamped by the costs borne by assignees as a result of the uncertain liability imposed by

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subjective standards. Therefore, the ASF favors federal legislation that, to the extent that itimposes substantive restrictions on loan terms, does so clearly and objectively.

D. Scope Of Assignee Liability

Assignees of residential mortgage loans are subject to liability for TILA violationscommitted by the primary originator if the violation is apparent on the face of the disclosurestatement and the assignee obtained the loan voluntarily.

96The apparent on the face

standard is violated where (i) the disclosure statement is not in the statutorily mandatedformat or fails to contain the statutorily required terms or (ii) a simple comparison of thedisclosure statement to other supporting loan documentation would have revealed that thedisclosure was deficient.97 It is by now well-established that assignees are not liable forTILA violations that are not apparent, although the determination as to whether a violation isin fact apparent, on which TILA provides no guidance, is not always a simple one.

HOEPA effected a major expansion in the scope of assignee liability for covered loans,imposing broad potential liability on secondary market purchasers for the wrongful conductof loan originators. However, even more than a decade after its enactment, the outer reachesof liability under HOEPA remain somewhat murky. Indeed, a number of courts haveinterpreted HOEPA as subjecting assignees to broad liability under any consumer protectionstatute, regardless of whether the statute under which the borrowers claim or defense arisesis silent or expressly conflicts with HOEPA on the question of assignee liability.98

Such an interpretation is problematic. It implies that HOEPA authorizes assignee liability forviolations of other statutes when the body that enacted the particular statute supplying theright, be it a state legislature or Congress, implicitly (or even explicitly) declined to subjectassignees to liability for statutory violations committed by the originator. Moreover, a

statutory scheme that both purports to establish substantive regulations applicable to coveredloans and authorizes action pursuant to a host of other sources of positive law would seem ill-tailored to achieving a comprehensive and precise regulatory objective. In light of theseconcerns, a number of courts understandably have declined to interpret HOEPA as effectingsuch a dramatic expansion of assignee liability.99

In sum, HOEPAs lack of specificity on the scope of its right of action and whether itauthorizes affirmative claims has resulted in a split in judicial authority, adding further to theuncertainty of secondary market participants regarding the scope of their prospectiveliability.

To the extent that HOEPA is interpreted as supplying a right of action or a defense against anassignee for any statutory violation by a creditor, it is too broad. Nor should federallegislation authorize subprime borrowers to assert affirmative claims against assignees basedon violations of statutes that do not themselves provide a right of action to pursue suchclaims. Requiring assignees to screen loan pools for compliance with one legal regime is farmore efficient and fairer than requiring them to scour every law that could give rise to apotential claim.

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Therefore, any new federal legislation should restrict clearly the authorization of assigneeliability to violations of TILA, as amended by HOEPA and the new legislation.

E. Limitations On Monetary Liability For Assignees

A borrower who successfully sues an assignee for a violation of TILA or HOEPA may beentitled, subject to certain caps, to recover: actual damages, certain statutory damages,attorneys fees, and enhanced damages that include all finance charges and fees that havebeen incurred on the loan.100 Borrowers who use HOEPA to sue an assignee on another rightof action may recover the sum of (i) the borrowers remaining indebtedness and (ii) the totalamount that the borrower has paid in connection with the transaction.101 State predatorylending laws provide for varying degrees of assignee liability, and, in many instances, thisliability can exceed the amount of the loan and payments received by the assignee.

Any prospective federal legislation should adopt the HOEPA standard applicable to claimsbrought under another right of action, and thus limit an assignees liability to the sum of theremaining value of the indebtedness and the total amount paid by the borrower, plusreasonable attorneys fees. The ASF strongly objects to the imputation of any statutory,enhanced, or punitive damages to an assignee based on the conduct of the lender. Statutory,enhanced, and punitive damages serve purposes of punishment and deterrence that are of, atbest, only limited applicability in the case of an assignee that did not know of, or participatein, violations committed during the origination process. It hardly seems to serve the interestsof fairness to provide borrowers, even ones who have been duped by unscrupulous lenders,with a windfall profit at the expense of innocent assignees. The secondary market is notopposed to statutory, enhanced, or punitive damages in cases where the assignee actsknowingly or with reckless indifference to the violations.

F. Limitations On Rescission Claims Against Assignees

TILA provides borrowers with the right to rescind certain mortgage loans until: midnight ofthe third business day following consummation, delivery of the right to rescind noticerequired by TILA, or delivery of all material disclosures, whichever occurs first, up to amaximum of three years. Although the borrower is still required to repay the original loanamount, rescission permits the borrower to cancel the loan agreement, thus rendering thelenders security interest void and relieving the borrower of liability for any finance or othercharge.102 Although two circuit courts have concluded that the right of rescission is solelypersonal, at least one other circuit is considering whether it may also be asserted through thevehicle of a class action.103

HOEPA also allows a borrower to assert the right to rescind provided in TILAup to threeyears from the date of loan consummationagainst any assignee of the loan for any violationof HOEPAs disclosure requirements or its substantive provisions.104 HOEPA is clear thatthis rescission remedy is available even if the statutory violation is not appare

Assignee Liability in the Secondary Mortgage Market

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