We are witnessing a pronounced, albeit gradual, reemergence of secondary residential mortgage market activity, like a phoenix rising through the ashes, led by among other things the establishment of jumbo prime and prime mortgage programs.
As secondary market investors wade back into the whole loan market, they would be well advised to heed certain regulatory requirements. One of these key requirements is that in certain jurisdictions, absent an exemption (discussed below), investors need licenses to acquire and sell mortgage loans secured by 1-4 family residential properties. In fact, approximately 1/3 of the states mandate that purchasers, and in certain instances sellers, of residential mortgage loans obtain residential mortgage lender licenses, depending upon the lien priority of the loan and/or its interest rate or annual percentage rate. For example, the Georgia Residential Mortgage Act defines "Mortgage Lender" as not only someone who originates loans, but also one who purchases them on a closed loan, secondary market basis, regardless of the type of lien, and consequently requires that such purchasers be licensed.
In a bygone era, some investors claimed immunity from the licensing requirements by invoking the Interstate Commerce Clause. These investors reasoned that because they only purchased and sold loans from their offices and were not originating or servicing loans, the Interstate Commerce Clause rendered these state licensing requirements inapplicable to them.
In recent years, however, certain states have vigorously rejected these constitutional arguments and have demanded that residential mortgage loan purchases be licensed in their jurisdictions. How do state regulators discover unlicensed entities? Notably, they detect them from, among other things, examinations of licensed originators ("to whom do you sell your loans") and from foreclosure proceedings.
The licensing process itself is time consuming, expensive and cumbersome. In many of the jurisdictions where licenses are required to acquire residential loans in the secondary market, the representatives of the entity must complete applications, answer corporate and litigation questions, and its designated officers must respond to invasive questions about their finances and submit to background checks. Most of these licenses may be obtained within three months, but a few take longer, as much as six months. Further, the licenses must be renewed on an annual basis, and state regulators periodically examine licensees.
There are alternatives to obtaining these licenses that investors should consider in special circumstances. For example, if the investor never intends to use the same entity or vehicle to acquire mortgage loans or will only use the purchasing entity for a brief period of time, licensing such an entity would be impractical. In these instances, the unlicensed entity could purchase the loans from a counterparty and simultaneously transfer legal title to the loans to a Delaware statutory trust with a national bank trustee. The trustee, which acts on behalf of the trust, is arguably exempt from state licensing requirements by virtue of federal preemption and in most instances, by explicit statutory exemption. (Alternatively, the Delaware statutory trust with the national bank trustee could be the direct purchaser of the loans from the seller in the transaction). While legal title is held by the exempt national bank trustee, beneficial or economic interest in the loans is retained by the beneficiary of the trust, which may be the mortgage loan purchaser. When the investor wishes to dispose of the loans, it merely instructs the Delaware statutory trust with the national bank trustee to retransfer the loans to it prior to their concurrent resale to a third party or to sell the loans directly to the third party. This structure can be deployed quickly and is relatively inexpensive.
When is it appropriate to use a Delaware statutory trust with a national bank trustee? The arrangement should only be used to acquire closed loans on a secondary market basis through an entity that will purchase the loans on a one-time or sporadic basis or when that entity will only be in existence for a short period (i.e., generally less than approximately 18 months). The structure should not be used to originate loans, to make advances under home equity lines of credit or by an entity that repeatedly engages in whole loan trades over a sustained period of time. Further, it is vitally important that at all times, the loans be serviced by a fully-licensed servicer.
If investors opt to acquire residential mortgage loans by using a Delaware statutory trust with a national bank trustee, there are two critical factors to keep in mind: first, in the event of a foreclosure, the loans must be foreclosed upon in the name of the trust itself, not the unlicensed investor.
Second, if the investor establishes a separate entity to hold the REO after a foreclosure, it is essential that the REO itself be transferred to the vehicle after the foreclosure, and that the pre-foreclosure loan not be transferred to the REO entity. Why go through these formalities? The REO entity will have to be licensed to take assignment of a pre-foreclosure loan in certain jurisdictions, and invariably it will not have these approvals. In jurisdictions where licenses are required to acquire residential mortgage loans, regulators have become very aggressive about unlicensed entities foreclosing in their own name.
Another alternative to licensing that investors should consider is a participation arrangement. Under this structure, investors purchase undivided ownership interests in mortgage loans evidenced by a participation certificate. While legal title to the mortgage loan remains with the principal (i.e., the seller of the participation interests), the certificate holders (i.e., the purchasers of the participation interests) are the beneficial owners of the loans. Under this arrangement, the purchaser of the participation interest would generally not be subject to the licensing requirements of state statutes because it would never hold legal title to any loan or undivided part thereof, but would only hold beneficial interest in the loan. The participation structure can be easily unwound when the purchaser wants to resell its interest in the loan to third parties.
It should be noted that these foregoing alternatives are not foolproof and there is no guarantee that an investor will not be exposed to regulatory scrutiny. The alternatives should again be employed under special circumstances and are not an absolute substitute for obtaining the requisite licenses.