Massachusetts Court Ruling has Global Economic Implications

Last Friday, the Massachusetts Supreme Court issued a ruling that could have global economic implications particularly as it applies to structured finance.

By way of background, on January 1, 2011, Article 122a of the Capital Requirements Directive took effect in Europe.  Article 122a requires that European credit institutions acting as investors know what they own before investing in either a securitization or covered bond transaction or not invest.

Last Friday, the Massachusetts Supreme Court issued its decision in the Ibanez case.  At a minimum, the court found that issuers of structured finance securities appear to be less then careful about making sure that the collateral behind a deal makes it into the trust for the investors' benefit.

The intersection of Article 122a and the Ibanez decision is the point where the buying and selling of structured finance securities covering all asset types freezes.

The market has to freeze because investors no longer know if the collateral backing the deal was actually transferred to the trust.

• Investors cannot rely on issuers' representation that the collateral was transferred because clearly a state supreme court has shown these representations to be false.  

• Was there a trustee that signed off and said it received the collateral behind the Ibanez decision?  If so, it shows that trustee representations are also worthless.

Without certainty that the assets were transferred, European investors cannot even begin to make the case that they know what they own.

Update

As reported on NakedCapitalism, in Adam Levitin Takes Apart Securitization Industry Posturing on Ibanez, Harp Decisions: [emphasis added]

So what does this mean? There’s still a valid mortgage and valid note. So in theory someone can enforce the mortgage and note. But no one can figure out who owns them…Ibanez did not address any of the trust law issues revolving around securitization, but there might be problems assigning defaulted mortgages into REMIC trusts that specifically prohibit the acceptance of defaulted mortgages. 

If an investor does not know if a trust owns a mortgage, it is by definition impossible for the investor to say they know what they are buying when they buy the securities issued by that trust.

Update 2

In Europe, credit institution investors that manage money on a fiduciary basis have a liability under the know what you own provision of Article 122a.  The credit institution investors must be able to prove that there is collateral backing the structured finance securities.  With the Ibanez ruling, they cannot rely on the trustee saying the collateral is there.  Credit institution investors actually have to go to the trustee and verify that the collateral has been transferred properly.  Without this, they cannot credibly say that they know what they own and they are liable for any losses incurred on the structured finance securities that they purchase.