Inside Mortgage Finance Sees Private Label Rep and Warranty Claims Increasing

The following story appeared in the September 3, 2010 issue of Inside Nonconforming Markets, a biweekly newsletter focusing on news and data on non-agency mortgages.  This story reflects the growing awareness in the marketplace of the undisclosed mortgage repurchase liabilities facing this nation’s largest financial institutions.  Though Barclays makes a statement in this story that buybacks peaked in 2007, note that the mortgages that made up those repurchases were home equity lines of credit, second liens and first lien deals wrapped by mortgage insurers.  This shows that the banks have not even begun to face the bulk of first lien loan-level repurchase requests from private investors.  As the Investor Syndicate continues to organize and move forward, that is certain to change…

Loan originators and underwriters of non-agency mortgage-backed securities face increasing repurchase requests due to widespread breaches of representations and warranties, according to industry analysts. While the claims will likely rise, the eventual impact on the non-agency mortgage market remains unclear.

Isaac Gradman, an attorney with Howard Rice Nemerovski Canady Falk & Rabkin in San Francisco, estimates that 50 percent to 80 percent of the mortgages in non-agency MBS are missing documents or are in a direct breach of rep and warrant guidelines. Gradman and his firm represent PMI Mortgage Insurance Co., which recently alleged misrepresentations by WMC Mortgage on a $1 billion subprime MBS pool.

Non-agency MBS repurchase requests based on rep and warrant violations are currently low because MBS investors have had difficulties obtaining loan files from trustees. However, lawsuits by mortgage insurers and some Federal Home Loan Banks, as well as separate pending actions by the Federal Housing Finance Agency, the Federal Reserve and an investor consortium could trigger a rush of non-agency repurchase requests.

While obtaining and analyzing loan files can be costly for non-agency MBS investors, Gradman predicted that investors are going to find that it is worth the up-front cost. “The cost is very small compared to the amount you can recover,” he said.

Analysts at Compass Point Research and Trading estimate that the total liability for rescission requests on subprime MBS is $80.3 billion, with a worst-case estimate of $89.3 billion in liability for the sector and a best-case estimate of $46.6 billion. The research firm’s estimate of the total liability for rescission requests on Alt A MBS is $67.9 billion, with a $99.1 billion worst-case estimate and a $13.4 billion best-case estimate.

Analysts at Barclays Capital agree that non-agency buybacks will likely increase going forward but they suggest buybacks will still be limited due to the numerous obstacles non-agency MBS investors face when seeking buybacks. “Bank losses due to rep and warranty related repurchases should also be more manageable than what many investors might be assuming,” Barclays said.

The quarterly volume of non-agency MBS repurchases has been between $60 million and $100 million since the beginning of 2009, according to Barclays. The repurchases have been dominated by home-equity lines of credit, second liens and by first lien deals wrapped by mortgage insurers.

Non-agency MBS buybacks on a quarterly basis peaked at about $2.75 billion in the first quarter of 2007, according to Barclays. Buybacks at the time were tied to early-payment defaults.

HELOCs and second lien deals account for about 42 percent of the $550 million in non-agency MBS repurchases from the beginning of 2009 through the second quarter of 2010, despite forming only about 15 percent of the delinquent loans, according to Barclays.

Alt A deals accounted for another 35 percent of the repurchases during the period. Barclays said HELOCs and Alt A mortgages likely dominated non-agency repurchases because they were the deals most likely to have mortgage insurance.

With the majority of subprime and Alt A originators out of business, most rep and warrant activity has focused on non-agency MBS underwriters. Those pursuing repurchase requests generally claim that securitization underwriters misrepresented the profile of loan standards within a security’s initial prospectus.

Gradman said rep and warrant violations were flagrant during the subprime boom. “Once the loan files are received, there’s not going to be a lot of debate,” he said.

He predicted that banks will seriously consider settling with non-agency MBS investors instead of risking even larger losses by fighting the claims in court. Gradman said the few settlements that have already been reached are confidential.

Gradman noted that compensating factors could help originators and MBS underwriters defend against rep and warrant claims, but he said such factors were rarely documented by lenders. Recouping buyback losses from borrowers could also be difficult.

Gradman said borrowers often were not complicit in mortgage fraud and borrowers are unlikely to pay anything material. “It’s hard to prove that the originator did not participate in the fraud,” he said.

Banks have also argued that rep and warrant breaches are minimal and that non-agency MBS investors’ losses have been due to the mortgage crisis in general.

However, judicial momentum could be shifting in favor of non-agency MBS investors. “There is a dawning of understanding in a lot of courts across the country that these losses were not due only to a drop in home prices,” Gradman said.