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As reported in Bloomberg, the Federal Bank of New York has announced that it is involved in “multiple efforts” to exercise its rights with respect to its holdings in faulty mortgages an other assets acquired through the bailouts of Bear Stearns and AIG. The Fed holds nearly $70 billion in assets such as mortgage backed securities and collateralized debt obligations that were placed in holding companies established during the rescue of Bear and AIG in 2008. BlackRock, which has led the charge among investors to force banks to absorb losses, is purportedly advising the Fed on its rights with respect to its holdings. The Fed joins Fannie Mae and Freddie Mac among the federal regulators that have recently turned their attention to putting back defective loans to the banks that originated them, which in the Fed’s case includes Countrywide/BofA, Goldman Sachs, UBS and defunct lender New Century Financial.
Just last month, the Federal Housing Finance Agency, which oversees Freddie and Fannie, issued 64 subpoenas to loan servicers and securitization trustees seeking loan files underlying the securities bought by the GSEs. The GSEs reportedly held nearly $255 billion of mortgage related securities as of the end of May 2010.
As discussed in prior posts, loan originators generally sold loans into securitizations with extensive representations and warranties regarding underwriting methodology and compliance with strict guidelines designed to ensure the loan value and the borrower’s ability to pay were supported. Where loan files underlying the mortgages in securitization reveal that those guidelines or underwriting methodologies were not followed, lenders have contractual obligations to repurchase the loans or substitute the loans with comparable performing mortgages. According to the Bloomberg article, violations of these reps and warranties cost the Big Four U.S. lenders about $5 billion last year, but that number is expected to skyrocket as more regulators and private investors jump on the put-back bandwagon. These prospective losses have attracted the attention of the SEC, which issued a demand to JP Morgan in January for more disclosure on its repurchase liabilities.
Indeed, the holdings of the New York Fed and the GSEs in mortgage related securities constitute only a fraction of the $1.5 trillion private label bond market, and just over half of the pool represented by the Investor Syndicate, first introduced here and here. The Syndicate fired its first warning shot across the bows of securitization trustees and servicers last month, and is expected to begin identifying specific breaches and enforcing its rights to documents and repurchases this month. Various estimates from loan auditors have placed the percentage of deficient loans in 2005 to 2007 vintage private label securitizations anywhere from 40 to 90 percent (MBIA alleges in its complaint against Countrywide and BofA in Los Angeles County Court that it found deficiencies in 91% of the loans it reviewed in a particular sample). If you do the math, that’s a massive amount of potential liability for the surviving subprime-era lenders.
The recent flurry of activity by federal regulators provides perfect political cover for the Syndicate and should grease the wheels of document production and lender cooperation. It’s one thing to resist the efforts of a private consortium representing over one-third of the private label bond market. It’s another to refuse compliance with the federal government.
In short, the concerted resistance to turning over loan files and servicing loans in accordance with bondholder wishes displayed by banks over the last year should begin to erode as banks realize that they can stall no longer. Investors have clear rights to the documents underlying their investments, and to mortgage buy-backs where those documents reveal loan quality was deficient. The problem up to now has been enforcing those rights.
Because the inherent strategy of a mortgage securitization was to spread out mortgage risk among a large pool of investors, no one private investor had the authority (or the incentive) to take action against the banks and force repurchases. Generally, at least 25% of the asset class is required to petition the Trustee, and 50% is required to have a credible threat of firing the Trustee if it does not respond to entreaties for action. Moreover, any benefit of a mortgage put-back would be dispersed among the entire pool of securities, or even several pools of securities, so the benefit to any one investor would be diffuse and freerider problems would abound.
Now that investors have organized, and have sufficient numbers and the proper incentives to take action, and now that federal regulators have joined the fray, I see the banks changing their strategy from one of postponing and delaying losses, to one of trying to resolve their repurchase liabilities through settlement. Whether that’s a global settlement or a number of individual deals remains to be seen, but what is certain is that the major banks face a slew of lawsuits and a hefty repurchase tab if they don’t acknowledge their repurchase risk and take a seat at the negotiating table.