Investor Syndicate Fires Warning Shot Across Trustee Bows

Posted on July 24, 2010 by Isaac Gradman

As first reported by Reuters on Wednesday, and as further detailed by Bloomberg today, the Investor Syndicate has finally begun to emerge from the shadows and give securitization trustees a hint at what’s coming.  According to Talcott Franklin, the Dallas attorney who is spearheading the Syndicate, the group sent letters to some of the major trustees of mortgage-backed securitizations, detailing the holdings of the group and urging trustees to help them enforce servicing breaches and pursue buybacks of improperly-originated loans.  The letters have not yet been made available, as the group appears to be continuing to closely guard the identity of the investors involved.

Franklin would only say that the members of the Syndicate are investors representing over $500 billion in mortgage-backed securities (MBS) holdings, which would account for over one-third of the $1.5 trillion private-label MBS market.  Franklin was formerly with the lobbying group of the Washington, D.C.-based law firm, Patton Boggs, that was involved in bondholders’ lobbying efforts over the Servicer Safe Harbor, but reportedly left the firm this year to head up the Investor Syndicate.

As discussed in prior posts (here and here), the Syndicate’s initial goal was to amass enough representation in a material number of securitizations to meet the 25% or 50% ownership thresholds imposed by the trust agreements, thereby acquiring the right to petition the trustees of those deals to take action.  From Franklin’s statements, it appears that this first step has been accomplished, as he has represented that the Syndicate owns bonds giving them 25% of “voting rights” in over 2,300 deals, 50% in more than 900 deals, and 66% of the bonds in more than 450 deals.

Assuming this is true, the letters sent on behalf of the Syndicate this week should be viewed as merely an opening salvo.  It is only a matter of time before the Syndicate begins issuing communications to trustees identifying specific instances of servicer misconduct or defects in the underwriting with respect to particular loans.  These instances of misconduct, also known as “defaults,” will change the responsibilities and incentives of the parties dramatically.  Once trustees are made aware of specific defaults by bondholders owning the requisite percentage of voting rights, the trustees become essentially fiduciaries of the bondholders, and acquire obligations to take steps to remedy those defaults.  Should they fail to do so, they may be fired or sued.

To those invested in the Big Four banks, which originated and now service huge percentages of the loans underlying these private-label securities, this next step will be the equivalent of yelling “fire” in a crowded movie theater.  Up to now, banks have been able to drag their collective feet in recognizing losses associated with the profligate lending practices of 2005-2007.  When banks originated mortgages and sold them into securitizations, they made representations and warranties regarding the quality of the underwriting and the guidelines they followed.  Should the Investor Syndicate be able to acquire the servicing and loan files associated with these mortgages and find breaches in those reps and warranties (as Freddie and Fannie are trying to do now through their subpoena powers), banks will be inundated with repurchase requests.  And as the media and government officials have only recently begun to recognize, banks have consistently under-reserved for the losses they will likely face from investor buyback obligations.

Further, in their role as servicers, these same banks have been slow to foreclose on hopelessly delinquent borrowers, as they were rife with conflicts of interest based on their second lien holdings.  Servicers have instead been content to rack up late fees while investors remained unorganized and the normally passive securitization trustees had no incentive to act.  Without active trustee enforcement of servicing obligations, the banks have also been able to modify loans as they pleased, irrespective of whether such workouts were in the best interests of bondholders, because trustees would not enforce servicer obligations to obtain the approval of the investors (see articles on the Greenwich Financial lawsuit against Countrywide for more background on this issue).  However, once trustees are compelled to go after these servicing breaches (or are fired and replaced by friendly trustees if they don’t), the banks will be liable for additional losses caused by their failure to service loans in accordance with bondholder wishes.

All this is to say that the financial landscape will change drastically in the coming month as the Investor Syndicate moves forward with its plans.  To drop a shameless Counting Crows reference, the MBS world may look very different in “August and Everything After.”

Posted in fiduciary duties, firing servicers, Investor Syndicate, irresponsible lending, private label MBS, repurchase, reserve reporting, securitization, servicer defaults, Servicer Safe Harbor, Trustees | 13 Comments

Loan File Issue Brought to Forefront By FHFA Subpoena

Posted on July 14, 2010 by Isaac Gradman

The battle being waged by bondholders over access to the loan files underlying their investments was brought into the national spotlight earlier this week, when the Federal Housing Finance Agency (FHFA), the regulator in charge of overseeing Fannie Mae and Freddie Mac, issued 64 subpoenas seeking documents related to the mortgage-backed securities (MBS) in which Freddie and Fannie had invested.  The FHFA has been in charge of overseeing Freddie and Fannie since they were placed into conservatorship in 2008.

Freddie and Fannie are two of the largest investors in privately issued bonds–those secured by subprime and Alt-A loans that were often originated by the mortgage arms of Wall St. firms and then packaged and sold by those same firms to investors–and held nearly $255 billion of these securities as of the end of May.  The FHFA said Monday that it is seeking to determine whether issuers of these so-called “private label” MBS misled Freddie and Fannie into making the investments, which have performed abysmally so far, and are expected to result in another $46 billion in unrealized losses to the Government Sponsored Entities (GSE).

Though the FHFA has not disclosed the targets of its subpoenas, the top issuers of private label MBS include familiar names such as Countrywide and Merrill Lynch (now part of BofA), Bear Stearns and Washington Mutual (now part of JP Morgan Chase), Deutsche Bank and Morgan Stanley.  David Reilly of the Wall Street Journal has written an article urging banks to come forward and disclose whether they have received subpoenas from the FHFA, but I’m not holding my breath.

The FHFA issued a press release on Monday regarding the subpoenas (available here).  The statement I found most interesting in the release discusses that, before and after conservatorship, the GSEs had been attempting to acquire loan files to assess their rights and determine whether there were misrepresentations and/or breaches of representations and warranties by the issuers of the private label MBS, but that, “difficulty in obtaining the loan documents has presented a challenge to the [GSEs’] efforts.  FHFA has therefore issued these subpoenas for various loan files and transaction documents pertaining to loans securing the [private label MBS] to trustees and servicers controlling or holding that documentation.”

The FHFA’s Acting Director, Edward DeMarco, is then quoted as saying ““FHFA is taking this action consistent with our responsibilities as Conservator of each Enterprise.  By obtaining these documents we can assess whether contractual violations or other breaches have taken place leading to losses for the Enterprises and thus taxpayers. If so, we will then make decisions regarding appropriate actions.”  Sounds like these subpoenas are just the precursor to additional legal action.

The fact that servicers and trustees have been stonewalling even these powerful agencies on loan files should come as no surprise based on the legal battles private investors have had to wage thus far to force banks to produce these documents.  And yet, I’m still amazed by the bald intransigence displayed by these financial institutions.  After all, they generally have clear contractual obligations requiring them to give investors access to the files (which describe the very assets backing the securities), not to mention the implicit discovery rights these private institutions would have should the dispute wind up in court, as it has in MBIA v. Countrywide and scores of other investor suits.

At this point, it should be clear to everyone–servicers and investors alike–that the loan files will have to be produced eventually, so the only purpose I can fathom for the banks’ obduracy is delay.  The loan files should, as I’ve said in the past, reveal the depths of mortgage originator depravity, demonstrating convincingly that the loans never should have been issued in the first place.  This, in turn, will force banks to immediately reserve for potential losses associated with buying back these defective mortgages.  Perhaps banks are hoping that they can ward off this inevitability long enough to spread their losses out over several years, thereby weathering the storm caused (in part) by their irresponsible lending practices.  But certainly the FHFA’s announcement will make that more difficult, as the FHFA’s inherent authority to subpoena these documents (stemming from the Housing and Economic Recovery Act of 2008) should compel disclosure without the need for litigation, and potentially provide sufficient evidence of repurchase obligations to compel the banks to reserve right away.  For more on this issue, see the fascinating recent guest post by Manal Mehta on The Subprime Shakeout regarding the SEC’s investigation into banks’ processes for allocating loss reserves.

Meanwhile, the investor lawsuits continue to rain down on banks, with suits by the Charles Schwab Corp. against Merrill Lynch and UBS, by the Oregon Public Employee Retirement Fund against Countrywide, and by Cambridge Place Investment Management against Goldman Sachs, Citigroup and dozens of other banks and brokerages being announced this week.  If the congealing investor syndicate was looking for political cover before staging a full frontal attack on banks, this should provide ample protection. Much more to follow on these and other developments in the coming days…

Posted in Alt-A, Countrywide, Fannie Mae, FHFA, Freddie Mac, Investor Syndicate, irresponsible lending, loan files, MBIA, private label MBS, repurchase, reserve reporting, subpoenas, subprime, Wall St. | 1 Comment

When Fed Bailed Out A.I.G., Banks Were Given Immunity

Posted on June 30, 2010 by Isaac Gradman

The story just keeps getting worse as more details about Credit Default Swaps (CDS) emerge daily.  CDS were essentially side bets on the performance of other mortgage derivatives, such as mortgage backed securities (MBS) and collateralized debt obligations (CDO).

From Michael Lewis’ The Big Short and other commentary, it was already well documented that A.I.G. was the counterparty on much of the CDS issued by Wall St., being one of the few large companies willing to take the long side of the bet on mortgage default risk.  Those selling mortgage default risk to A.I.G. had several risks to consider: 1) that mortgages would perform better than expected, 2) that mortgages would underperform but the counterparty on the trades (e.g., A.I.G.) would become insolvent and not be able to make good on the trades, and 3) that the counterparty would sue the bank issuing the CDS or underlying mortgage securities for fraud and misrepresentation in the creation of the instruments.

Up to now, Lewis and others, including the New York Times, had focused primarily on the second risk above in pointing out that the Fed’s bailout of A.I.G. had the primary effect of ensuring the solvency of the trading partner of big banks, so that they could collect on their bets against the mortgage market.  However, there is now a spotlight on the third risk above, after the House Committee on Oversight and Government Reform released 250,000 pages of largely undisclosed documents showing that A.I.G. was forced to agree to waive its rights to sue several banks – including Goldman Sachs, Societe Generale, Deutsche Bank and Merrill Lynch – over irregularities in the mortgage securities it insured.  This fact is only made more appalling by the fact that many of the primary decisionmakers at the New York Fed (which oversees A.I.G. and presided over the bailout) were alumni of the banks that would benefit from this forfeiture, and some even still held stock in those financial institutions.

Sources indicate that this waiver prevents A.I.G. from suing to recover claims it paid on $62 billion worth of mortgage securities that it insured.

For more information, read the article published yesterday in the New York Times, entitled “In U.S. Bailout of A.I.G., Forgiveness for Big Banks.” It pretty much says it all, and if you are not shocked and outraged by what you read, you may want to have your pulse checked.

[Thanks to Manal Mehta for being the first to bring this story to my attention – IMG]
Posted in bailout, Uncategorized | Leave a comment

SEC Demands More Disclosure From JP Morgan on Repurchase Liabilities

Posted on June 24, 2010 by Isaac Gradman

By Manal Mehta, Guest Blogger
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.
Due to findings of mortgage fraud and underwriting deficiencies in the mortgage origination process and  misrepresentation in the packaging of mortgages, banks have been experiencing a drastic increase in the number of repurchase demands they are receiving, including from Government-Sponsored Entities (“GSE”), monoline and mortgage insurers and other end purchasers of RMBS securitizations, such as the Federal Home Loan Banks.  Banks have responded by taking on additional reserves, which have had the effect of reducing mortgage income in the corresponding period.  Now, however, in a letter dated January 29, 2010, the SEC has asked JP Morgan to clarify its reserving methodology for mortgage put-backs—a process that has historically been opaque and difficult for outsiders to evaluate.
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.

Posted in balance sheets, BofA, Citigroup, Countrywide, Federal Home Loan Banks, guest posts, investors, JPMorgan, lawsuits, litigation, mortgage insurers, repurchase, reserve reporting, SEC | 1 Comment

Investor Syndicate At Hundreds of Billions And Growing

Posted on June 16, 2010 by Isaac Gradman

Heard on this Street this week: the super-secret Syndicate of MBS Investors discussed previously is gaining momentum.  A confidential source has informed me that some of the largest institutional investors in mortgage-backed securities have now joined the group, bringing the amount under management to “hundreds of billions of dollars in MBS investments.”  The source further informed me that this number is expected to swell to a “jaw-dropping dollar figure.”

As discussed before, the Syndicate hopes to amass enough representation in enough securitizations throughout the country to take over those trusts pursuant to the terms of the respective Pooling and Servicing Agreements (PSAs).  These contracts often require 25% class ownership to petition the Trustee to take action and 50% ownership to fire the Trustee or Master Servicer.

Once the Syndicate has reached critical mass, it reportedly will approach the Trustees of a number of deals to present evidence of Servicer misconduct and request the Trustee to take action to remedy Servicer breaches (including firing the Servicer).  If the Trustee does not comply, the Syndicate plans to fire the Trustee and Servicer, and install friendly institutions in their place.
At that point, the Syndicate would likely pursue two major courses of action: 1) take over the servicing of the deals and begin servicing the loans in the trust in accordance with bondholder wishes (including liquidating or modifying loans in default, depending on which option makes the most economic sense over the long term) and 2) pursue remedies against originators for losses caused to the pool.  This second prong would involve pouring over loan files obtained from the prior servicer to look for breaches of reps and warranties in the origination and underwriting of the loans.  This will almost certainly lead to a jump in mortgage litigation seeking to compel originators to buy back or repurchase loans that were improperly originated (to the extent these originators are still solvent).
Again, loan files are critical, because they reveal the fundamental characteristics of each loan and the underwriting determinations made in the approval of such loans.  Though certain plaintiffs have recently made strides towards forcing servicers like Countrywide to turn over loan files (see also Order Granting Motion to Compel in Syncora v. Countrywide), the acquisition of these all-important documents remains a difficult proposition.  Investors are increasingly coming around to the idea that the only way they will be able to obtain these files is by force–namely, firing Servicers and taking over their duties and documents.
I will continue to provide updates on this fascinating development as they become available, and expect that we’ll begin to hear more about the Investor Syndicate in the mainstream media in the coming months.  Stay tuned…
Posted in Countrywide, firing servicers, Investor Syndicate, investors, irresponsible lending, litigation, loan files, MBS, repurchase, servicers | 2 Comments