Business, Law

Another predictably preventable securitization fail

The New York Times reports one of the top private student loan servicers, American Education Services (AES), routinely hires lawyers that file flawed lawsuits. As Paperwork Goes Missing, Private Student Loan Debts May Be Wiped Away.

We’ve been here before.

Having looked at this issue during the financial crisis using data analysis or large datasets I’ve come to the conclusion that servicers often just don’t care. Maybe they’re hoping for default judgments but, for whatever reason, they just do not and will not take the time to verify that their lawsuits are correct.

If the article is reporting correctly the debt is owned by Vantage Capital Group through an entity named the National Collegiate Student Loan Trust. Vantage has sued AES. “We don’t want National Collegiate to be the poster boy of bad practices in student loan collections,” said Vantage founder Donald Uderitz.

I’m guessing that Vantage buys bad debt from securitized pools and does not own enough of the pool to fire the servicer.

Let’s take a brief primer on securitization. Lenders lend money then create a trust, a pool of all the debts. They then create a structure that shows how debt and defaults will be handled which is why this field is called structured finance.

Payouts are divided into slices, called tranches. Defaults come from the lowest tranches and pre-pays from the top. No tranche holds a loan until it either defaults and is liquidated or is prepaid. Each tranche has an income stream unless defaults or prepays have left the tranche with no loans. Tranches are technically individual securities – businesses on their own – each with an individual CUSIP number.

To actually collect the loans the trust hires one or more servicers: that is what people tend to think of as their bank but they’re really more bill collectors. Servicers collect payments and send funds to the trustee who distributes the payments to the owners of the securities.

If all this sounds like a bond you’re right. Except you’re not because, as one senior banker told me, “Don’t call it a bond – never use the word bond – because if it was a bond it would be illegal.” There is also default insurance for the various tranches but it’s called a “credit default swap” because, again, if it were called insurance it would be illegal.

If is sounds confusing it’s arguably purposefully so. Take the use of the term tranche, a French word that means slice. Not figuratively; next time you’re in France you can ask for trois tranche of salami and your Parisian waiter will appreciate the effort. Since securitization was invented in the US, by Michael Milken, why use unfamiliar language except to create confusion.

Vantage, through Collegiate, must be purchasing the right to the income streams on the loans at a discount.

We can assume that Vantage can’t simply fire the servicer — or they wouldn’t have bothered suing them — so we can surmise that the defaulted loans remain in the pool, which is normal. Mortgages also remain with the servicer but do eventually drop from the pool when the house is repossessed or the loan is paid.

The US government pays off the defaulted loans for non-private, federally guaranteed loans, then seeks repayment. It appears that Vantage is doing the same, probably at a steep discount, for private loans.

Student loans cannot be discharged in bankruptcy so creditors can attempt to collect the loans forever unless they file and lose a lawsuit. At that point the case becomes res judicata and, in most cases, cannot be refiled. Florida has changed these rules for mortgages, creating legal fictions to prevent people from receiving free houses when they win a foreclosure case, but the basic rule usually applies to other debt.

Hoping the servicer files a botched lawsuit seems to be the only way to rid oneself of a private student loan without paying it off.

It’s unclear whether Vantage does not want the bad publicity or if they are worried about losing too many lawsuits and causing an avalanche of defaults to force the lawsuits (or even declaratory lawsuits, filed by borrowers seeking to prove Vantage does not own the debt).

One item that remains crystal clear, especially after the foreclosure crisis, is that Pooling & Servicing Agreements — the contracts that create the pools of loans — should be amended to allow the owner of the debt to fire incompetent servicers. The separation from the debt owner and servicer and the conflicts those two often have with one another are well understood. But, ultimately, there is a common-law and common-sense obligation to mitigate a breach of contract that seems to evade servicers, especially those who enjoy increased fees for loans in default.

If Vantage is serious they should consider going after not only the servicer but also the law firms that file the botched cases. Those cases arguably represent legal malpractice harming the reputation and bottom line of Vantage and National Collegiate.

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