Moneybox

My House Is Your House

Don’t count on banks buying back those bum mortgages.

Will banks have to buy back bad mortgages they issued?

Last week several large investors and the New York Federal Reserve sent a threatening letter to Countrywide, the mortgage giant that is now part of Bank of America. The investors were objecting to the way Countrywide was handling $47 billion in mortgage-backed securities that they owned. (The New York Fed is involved because it owns Bear Stearns and AIG securities as part of the rescue of those firms.) Arguing, among other things, that these mortgages didn’t meet Countrywide’s purported underwriting standards, the investors want Countrywide to buy them back.

Kathy Patrick, the Gibbs & Bruns lawyer who represents the investors in this case, said in an earlier letter that “our clients will pursue all contractual remedies available to them in these and … many other Countrywide [mortgage-backed-security] deals.” The Federal Home Loan Bank system has filed lawsuits seeking to get banks to buy back a combined $25.6 billion * in mortgage-backed securities, according to Compass Point Research and Trading in Washington, D.C. The foreclosure mess is getting most of the headlines right now, but the related prospect that banks might be forced to repurchase bad mortgages is another reason bank stocks have been sliding during the last few weeks. Chris Gamaitoni of Compass Point estimates that the 11 biggest banks, including JP Morgan, Bank of America, and Goldman Sachs, could end up losing almost $200 billion thanks to mortgage repurchases.

That is a stunning and (given banks’ well-publicized misbehavior in creating the housing mess) supremely satisfying number. Forcing mortgage bankers to buy back those bad loans seems like perfect retribution. But investors probably can’t make it happen.

The key idea is that the “representations and warranties”—the legal promises that both the originators of the loans and the underwriters of the securities made to buyers about the quality of the loans—were false. A former Citigroup loan underwriter named Richard Bowen told the Financial Crisis Inquiry Commission last spring that more than 60 percent of the mortgages he looked at that Citi sold violated the reps and warranties. The government-owned mortgage giants, Fannie Mae and Freddie Mac, have with some success been pushing banks to buy back mortgages. In addition, bond insurers like MBIA and Ambac, which insured pools of mortgages against default, have been embroiled in lawsuits with both those who made the mortgages (most notably Countrywide) and the investment banks who packaged up the securities.

But investors in “private-label” securities—meaning those that didn’t pass through Fannie and Freddie—were mostly quiet until now. One reason is that the recent foreclosure scandal spotlighted just how sloppy the banks’ bookkeeping really was. In last week’s letter, Gibbs & Bruns’ Patrick noted that although there were tens of thousands of mortgages underlying the bonds, Countrywide had never told the investors about the discovery of even one—not one!—mortgage that violated the reps and warranties. How could that be possible?

The other thing that changed is that Talcott Franklin, a former equity partner at D.C.’s Patton Boggs, created what he calls an “Investor Clearing House” that banded investor groups together to facilitate lawsuits. Joint action is necessary because the investors need to own 25 percent, and sometimes more, of the bonds in order to force servicers such as Countrywide to take any action. This summer, Franklin announced that he had signed up investors holding 25 percent or more of $500 billion in mortgage-backed securities. “The phone doesn’t stop ringing,” says Franklin.

Inevitably, this activity has bred speculation. Several sources tell me that hedge funds are talking about buying up soured mortgage-backed securities with the express intent of forcing the banks to buy them back. Investors are also betting against the banks themselves.  In August, Ron Beller, a former Goldman Sachs partner who ran a hedge fund called Peloton that blew up in the early innings of the housing crash, helped put together a presentation under the name of his new fund, Branch Hill Capital. The presentation noted that Branch Hill had a short position in Bank of America’s stock and noted that B of A might lose as much as $74 billion in mortgage repurchases and, as a result, could see its stock sink to around $6. * (B of A is everyone’s favorite whipping boy because of its purchases of both Countrywide and Merrill Lynch.) One slide reads, “The math for Bank of America = A BIG PROBLEM.”

But private-label investors won’t have an easy time forcing the banks to repurchase crappy mortgages. Legal uncertainties abound. Does the liability belong to the originator of the mortgages or to the underwriter of the securities? If the originator is liable but out of business—as is often the case—who can pay? Many investors who possess the legal right to see the banks’ files will nonetheless face multiple obstacles. In a case MBIA is currently litigating against Countrywide, MBIA complained that the loan files Countrywide had produced were an incomplete mess. And they have been litigating the case since 2008!

Even if you can cut through enough legal tape to get your hands on the data, some investors are starting to realize that proving fraud won’t be as easy as the numbers might suggest. For instance, in the MBIA case, there are 386,000 underlying loans. Can you take a sample of the underlying loans to prove that there was fraud, or do you have to check each and every loan? (Good luck with that.) And the legal view of a material violation of the reps and warranties is often different than the common sense view. Let’s say a borrower states her income at $200,000 and says she holds a Ph.D. from Stanford. Actually, she makes $15,000 as a maid. That’s fraud, right? But if the loan was sold as a “stated income” loan, then the bank probably can’t be held responsible. And actual dollar amounts lost because of fraud could be a lot smaller than they appear. If a borrower can’t pay her mortgage because she lost her job, for instance, that isn’t fraud—just bad luck. (The Web site Naked Capitalism has more about the difficulties here.)

The banks are preparing to fight, and fight hard. In the past quarter, JP Morgan (which could be on the hook because of its acquisitions of Washington Mutual and Bear Stearns) added $1 billion in reserves for mortgage-related litigation. On a recent conference call, Bank of America executives told investors that “this really gets down to a loan-by-loan determination, and we have, we believe, the resources to deploy against that kind of a review.” One investor who has already tried to get banks to repurchase bad mortgages describes it as “hand to hand combat.” After digging through each and every loan, he found problems in only about 10 percent of the loans, and only about half of those problems were material. After fighting for over a year, he got paid on what he describes as a “handful” of loans. “Anyone who is going to try this strategy … good luck,” he says.

These investors aren’t stupid. So why are they pursuing a legal strategy that will likely fail? Possibly to put enough downward pressure on bank stocks that the banks cry uncle and settle. Some of the money would go to investors who got burned. But much of it would go to others who bought these securities at distressed prices or to hedge funds that swooped in to take advantage of this situation. In the meantime, investors shorting the banks would also benefit from the hue and cry. Of course, not a penny would go to homeowners. This is yet another reminder, if any were needed, that financial markets are just about the last place you should go looking for moral uplift.

Corrections, Oct. 27, 2010: This article originally gave the incorrect figure of $25.6 million in mortgage-backed securities. ( Return to the corrected sentence.) This article also incorrectly stated that Bank of America might have to repurchase as much as $74 billion in mortgages; the company could lose $74 billion in mortgage repurchases. ( Return to the corrected sentence.)

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