Bank Regulators Agree: The Mortgage Mess Poses Massive Risk

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The Senate Banking Committee held its second hearing on problems in mortgage servicing today, and the news is grim.

One key focus of these panels was the risks posed to banks that sold mortgage-backed securities if investors in those securities were able to force the banks to buy them back (also called putbacks). That risk arises from two parallel scenarios that have been explained by the Congressional Oversight panel and elsewhere. The first is that the mortgages put into the securities didn't meet the level of quality that investors were promised. The second is that the securitizations themselves were faulty because the mortgages never got into the securities in the first place.

In his oral testimony, Federal Reserve Board Governor Daniel Tarullo wouldn't quantify the risk to banks posed by forced buybacks, but he said for at least some institutions, particularly "big servicers," it could be "significant." He later hedged on how big the systemic risk would be because the Fed's goal is to find institutions with big problems and help them avoid triggering systemic risks by "reserving more" and doing "capital preservation."

Real Money Is at Stake

Government-sponsored enterprises Fannie Mae and Freddie Mac are both "aggressively" pursuing putbacks, Acting Director of the Federal Housing Finance Agency Edward DeMarco testified:
"During 2009, the Enterprises' lenders repurchased $8.7 billion of single-family mortgages, and slightly higher volumes are being repurchased in 2010. However, as of the end of the third quarter 2010, Fannie Mae had $7.7 billion in outstanding repurchase requests, and Freddie Mac had $5.6 billion in outstanding repurchase requests.
More than one-third of these repurchase requests have been outstanding for more than 90 days. Many of the lenders with aged, outstanding repurchase requests are among the largest financial institutions in the United States. . . . FHFA is examining its options should these requests not be resolved in the normal course of business."
Sounds like Fannie and Freddie are getting ready to sue. Nor have they made all the claims they hope to make. Last July, DeMarco said, the FHFA sent out 64 subpoenas seeking the information it would need to put back more securities. Nor are Fannie and Freddie the only investors looking to force banks to repurchase mortgage-backed securities. While such efforts face logistical hurdles, they are moving forward. Real money is at stake, after all: Some $7 trillion of mortgages are securitized.

"A Cloud of Uncertainty"


The Fed's Tarullo isn't the only regulator who believes buybacks pose a serious risk. The head of the Office of the Comptroller of the Currency, John Walsh, acknowledged "the systemic risk" posed by buybacks in his oral testimony. Similarly, Sheila Bair, the head of the Federal Deposit Insurance Corp., testified that "the mortgage documentation problems cast a cloud of uncertainty over the ownership rights and obligations of mortgage borrowers and investors. Further, there are numerous private parties and government entities that may have significant claims against firms central to the mortgage markets. While we do not see immediate systemic risk, the clear potential is there."

Despite regulators' unanimity that investors' efforts to force banks to buy back mortgage securities pose major, potentially systemic risks, one witness rejected the idea that a big problem exists: Tom Deutsch, the executive director of the American Securitization Forum. More specifically, Deutsch dismissed concerns that securitizations had been fundamentally flawed such that mortgages never made it into the trusts that issued the mortgage-backed securities. He didn't address the idea that the loans in the securities were so lousy that investors could force the banks to buy them back on that basis.

Pushing back against concerns that the notes secured by the mortgages had not been properly endorsed and so had not been transferred into the trust, Deutsch cited a white paper put out by his group a couple of weeks ago, which was critiqued at the blog Credit Slips by Georgetown Law Professor Adam Letvin. Deutsch responded directly to Letvin's critique, but in doing so assumed two "facts" that have been challenged recently.

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First, Deutsch presumes the notes were delivered as required, although a recent bankruptcy case involving Bank of America (BAC) and anecdotal evidence suggest that didn't happen on a wide scale. Second, Deutsch presumes the notes were endorsed in a way he claims is proper. But again, the BofA case calls into question whether notes were endorsed at all.

Similarly, the foreclosure document problems exposed to date have included notes with mysteriously changing endorsements. In short, assuming Deutsch's arguments win the day, his testimony should reassure no one. At least not yet.

If the notes were never delivered, or never endorsed at all -- as a matter of routine practice, not just as isolated incidents -- Deutsch's arguments are irrelevant, all those securities aren't backed by mortgages and more buybacks are extremely likely.


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