How the mortgage mess could spread beyond sub-prime
By Julian Fisher
Bank of America shares have been rocked by news that a consortium of mortgage bond investors is demanding it repurchase billions in soured mortgages, amplifying the effects of the recent “robo-signing” debacle.
Industry proponents are downplaying the risk that these so-called “putbacks” will impact more than a small number of financial institutions, but the evidence increasingly points to substantial and widespread breakdowns in controls along the mortgage origination and securitization chain.
What’s more, the impetus for putbacks appears to be shifting from lapses in documentation to ones involving possible fraud and misrepresentation.
The potentially fraudulent activity has come to light through data gleaned from reports and FDIIC hearings involving third party re-underwiter Clayton Holdings, as reported by Reuters.com blogger Felix Salmon.
Unlike the documentary issues at the heart of the “robo-signing” debacle, these findings point to a banking-industry wide epidemic of bundling loans which failed the originators’ underwriting standards into pools sold to investors.
Faulty underwriting appears to be prevalent across the board, with originators complicit in overvaluing both the lender and the collateral at the point of underwriting — and doing so systematically.
If this turns out to be the case investors have redress under a “Fair Consideration” clause in the contracts between loan originators, lenders, and investors.
This clause says that if the originator knew the loan was overpriced, having negotiated with the loan underwriter a lesser price, then this could be primae facie evidence that the price paid was not fair.
As the underwriting controls are investigated further, any evidence that originators failed to inform both the ratings agencies and investors about the quality of the underlying loans will lead to an increasing number of claims of fraud and misrepresentation.
Had rating agencies known of non-compliance, it would have adversely affected loan pool ratings and, subsequently, their price, due to increased likelihood of default.
Another wild card in the equation: losses related to putbacks on mortgage-backed CDOs which contain similar warranties and representations as mortgage-backed securities (MBS). Mortgage losses for originators could rise exponentially as CDOs can reference each mortgage pool multiple times. In the worst case the effects of CDOs putbacks and litigation could be catastrophic, by provoking a spate of legal suits, both justified and opportunistic.
At this time of increasing scrutiny there is a sea change in the way investors are forcing putbacks. The entities most active in putbacks had been Fannie Mae and Freddie Mac. Now, MBS investors such as PIMCO and the NY Fed are banding together to force servicers and their associated partners to comply with the terms of their trusts and enforce putbacks. Expect to see this group interest to grow. With originators having seen an increase of up to 300 percent in putbacks from 2008 to 2009, and reserves held by banks appreciating by a similar amount, there’s little doubt where this trend should be heading.
As more and more evidence surfaces around defects, fraud and misrepresentation in the loan origination and securitization process, it will become increasingly easy for investors to prove a breach in warranties and representations. This raises the risk that the mortgage industry contagion will spread from one centered on the sub-prime space to Alt-A, Prime and mortgage derivative products.
Fasten your seat belts; it’s going to be a bumpy ride.
Julian Fisher is Managing Director of Crestrider, LLC, a boutique capital markets consulting firm. He has more than 15 years of experience in risk, governance and trading systems for banks including Bank of America, AIG, WaMu and Deutsche Bank. The opinions expressed are his own. At the time of writing, he held put options on the Dow. He did not hold any investments in banks.