The Securities and Exchange Commission (SEC) recently took a much needed step towards improving the transparency of bank balance sheets, particularly when it comes to the adequacy of reserves for mortgage repurchase obligations stemming from banks’ violations of representations and warranties.
As an investor, I have long been concerned with whether the banks’ levels of reserves represent accurate reflections of their true liability. Just to get a sense of the magnitude of this issue, in SEC v. Angelo Mozilo, the SEC alleges that Countrywide originated over $450 billion of mortgages annually during the boom years. What percentage of those Countrywide mortgages were fraudulently originated? What percentage are getting sent back for repurchase? Even a modest percentage could lead to substantial losses for Bank of America (“BofA”), Countrywide’s parent and potential successor in liability (see Subprime Shakeout post on recent ruling in MBIA v. Countrywide).
Additionally, there is some alarming evidence that BofA actually did assume the liabilities of Countrywide, and is thus on the hook for the liabilities of its subsidiary. At the time of Bank of America’s purchase of Countrywide, Scott Silvestri, a Bank of America spokesperson is quoted as saying, “[w]e bought the company and all of its assets and liabilities. We are aware of the claims and potential claims against the company and factored these into the purchase” (emphasis added). This led Florida Attorney General Bill McCollum, in announcing his intention to negotiate a settlement with Countrywide regarding predatory lending practices, to say, “there is technically a deep pocket. They’ve [BofA] acquired them [Countrywide], they assume their liabilities.”
The SEC’s actions are very important in this debate over mortgage buybacks. The SEC has asked JP Morgan to clarify its reserving methodology in the following five areas:
a) The specific methodology employed to estimate the allowance related to various representations and warranties, including any differences that may result depending on the type of counterparty to the contract.
b) Discuss the level of allowances established related to these repurchase requests and how and where they are classified in the financial statements.
c) Discuss the level and type of repurchase requests you are receiving, and any trends that have been identified, including your success rates in avoiding settling the claim.
d) Discuss your methods of settling the claims under the agreements. Specifically, tell us whether you repurchase the loans outright from the counterparty or just make a settlement payment to them. If the former, discuss any effects or trends on your nonperforming loan statistics. If the latter, discuss any trends in terms of the average settlement amount by loan type.
e) Discuss the typical length of time of your repurchase obligation and any trends you are seeing by loan vintage.
The monoline insurers have constantly complained that banks have continued to be amenable to processing repurchase requests and repurchasing loans associated with Fannie and Freddie due to the necessity of continuing a business relationship with the GSEs. They claim that for similar violations of rep & warranties, however, the mortgage originators have denied their repurchase requests. This requirement from the SEC asking for clarification on discriminating between repurchase requests from the GSEs versus the monolines/other investors should have interesting consequences. As Jay Brown, the CEO of MBIA, recently stated in the company’s Q1 2010 conference call, “we have discussed the process that Fannie and Freddie use with their folks to see how it compares to the process that we use both from examining the loans and also in terms of the accounting, and both approaches are consistent with our own.”
The SEC’s requirement to provide clarity on the counterparties to repurchase requests should lead to more fair treatment for the insurers. The requirement to provide increased disclosure on mortgage putbacks from the insurers could also ratchet up the pressure on the banks to settle repurchase requests. If they honor repurchase requests from Fannie and Freddie for very similar violations of reps & warranties but refuse to honor them for the insurers, continuing to litigate could lead to large damage claims for adverse rulings in court.
For investors who may not be aware of how significant of an issue this is for the banks, it is imperative to read the testimony of Richard Bowen in front of the Financial Crisis Inquiry Commission. Dick Bowen was the Senior Vice President and Chief Underwriter for Correspondent Acquisitions for Citigroup Mortgage. In early 2006, he was promoted to Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group. The numbers he cites in his testimony are astounding. I will allow his testimony to speak for itself:
The delegated flow channel purchased approximately $50 billion of prime mortgages annually… In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets. This situation represented a large potential risk to the shareholders of Citigroup…I started issuing warnings in June of 2006 and attempted to get management to address these critical risk issues. These warnings continued through 2007 and went to all levels of the Consumer Lending Group…We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production. (emphasis added)
Digging through Citi’s public financials, it is unclear what reserves have been set aside to reflect the possibility of these noncompliant mortgages travelling back to Citi’s balance sheet. The SEC’s recent letter to JP Morgan should provide increased disclosure for these types of liabilities lurking on bank balance sheets.
David Grais’s lawsuits on behalf of the Federal Home Loan Banks (“FHLB”) against investment banks involved in the packaging of RMBS securitizations that were bought by the FHLB also provide for interesting reading. The Federal Home Loan Banks bought $23 billion of RMBS securitizations from a number of investment banks. These structured products contained representations regarding maximum LTV ratios on the underlying mortgages. In these lawsuits, the FHLBs of San Francisco (complaint available here) and Seattle (complaint available here) contend that widespread appraisal fraud led to incorrect LTV reps on the pools of mortgages purchased by the FHLBs. They are suing to recover losses stemming from their purchases of these mortgage securities. David Grais was a roommate of Supreme Court Justice Samuel Alito for three years while they were undergraduates at Princeton University. His legal credentials and ability to undertake complex litigation should not be underestimated.
As Gretchen Morgenson writes in the New York Times, though disputes over losses from mortgage-backed securities are hard to litigate because investors must persuade factfinders that their losses were not simply the result of a market crash,
[r]ecent filings by two Federal Home Loan Banks — in San Francisco and Seattle — offer an intriguing way to clear this high hurdle. Lawyers representing the banks, which bought mortgage securities, combed through the loan pools looking for discrepancies between actual loan characteristics and how they were pitched to investors.
You may not be shocked to learn that the analysis found significant differences between what the Home Loan Banks were told about these securities and what they were sold.
The rate of discrepancies in these pools is surprising. The lawsuits contend that half the loans were inaccurately described in disclosure materials filed with the Securities and Exchange Commission.
These findings are compelling because they involve some 525,000 mortgage loans in 156 pools sold by 10 investment banks from 2005 through 2007. And because the research was conducted using a valuation model devised by CoreLogic, an information analytics company that is a trusted source for mortgage loan data, the conclusions are even more credible . . .
The model concluded that roughly one-third of the loans were for amounts that were 105 percent or more of the underlying property’s value. Roughly 5.5 percent of the loans in the pools had appraisals that were lower than they should have been. That means inflated appraisals were involved in six times as many loans as were understated appraisals . . .
It is unclear, of course, how these court cases will turn out. But it certainly is true that the more investors dig, the more they learn how freewheeling the Wall Street mortgage machine was back in the day.
Investors should take a hard look at bank balance sheets to understand the adequacy of reserves for this huge contingent liability. It is not surprising that banks have stonewalled any attempt to get clarity on this issue – hopefully the SEC’s explicit demands from JP Morgan to increase their disclosure will have a knock-on effect for the others.
Manal Mehta is a Principal at Branch Hill Capital, which invests in Special Situations.