Oct. 13 (Bloomberg) -- Potential paperwork errors on some of the $1.34 trillion of securitized home mortgages may give investors an opening to challenge the legality of deals, threatening to unnerve financial markets, according to Joshua Rosner, managing director at Graham Fisher & Co.
Some loans to borrowers with poor credit before 2007 may not have been transferred to mortgage trusts in the manner required by their pooling and servicing agreements. That raises questions about the ownership of the loans and may allow investors to force lenders to buy back the securities, Rosner wrote yesterday in a note to clients.
The failure to include MBS trust names on documents and to properly assign loans to the trust may encourage MBS holders to challenge the entire securitization, rather than press lenders to take back individual loans that were fraudulently issued, according to Rosner, whose firm advises investors and regulators. That could set off legal fights over almost all subprime MBS sold to investors.
“If plaintiffs bring suit it could rock the market,” Rosner, 44, said in a telephone interview. “If courts allowed those suits to proceed it would well feel much like 2008,” when the bankruptcy of Lehman Brothers Holdings Inc. led to the biggest market collapse since the Great Depression, he said.
Wall Street firms stopped selling almost all so-called private-label mortgage-backed securities in 2007 after defaults began to surge on loans to borrowers with poor credit. MBS values plunged as foreclosures climbed. More than 90 percent of mortgages are now issued by government sponsored enterprises, such as Fannie Mae and Freddie Mac, or are insured by the federal government.
“We believe nearly every single loan transferred was transferred to the trust in ‘blank’ name,” Rosner wrote in the note. “That is to say the actual loans were apparently not, as of either the cut-off or closing dates, assigned to the trust” as required by many of the securitization agreements.
The extent to which there’s a documentation problem is unknown to investors, Jeffrey Gundlach, chief executive officer of DoubleLine Capital LP in Los Angeles, said in an interview. If widespread flaws are found in the paperwork for mortgage-backed securities, it could roil a housing market already struggling with a freeze in foreclosures prompted by legal challenges to the documents mortgage servicers used to seize homes of delinquent borrowers, he said.
‘Potential to Spiral’
“If people say that you cannot prove that you own the loan, it could be really cumbersome to untangle,” said Gundlach, whose firm manages $5.5 billion in investments, mostly mortgage-backed securities. “It has the potential to spiral into much, much more. There have been many twists and turns to the foreclosure process since the credit crisis started and this is one more turn of the wheel, and it can spin out of control.”
Gundlach said his firm has “built in cushions of safety” when buying non-agency mortgage-backed securities that are trading at a discount, and has assumed high default rates and low recovery rates.
There are three possible outcomes for the crisis, Josh Levin, a housing industry analyst with Citigroup Global Markets Inc. in New York, wrote yesterday in a note to investors, citing an analysis by Adam Levitin, associate professor of law at Georgetown University in Washington.
The best scenario is that the disputes are deemed as legal technicalities, which would cause a one-year delay in foreclosures. In the medium case, years of litigation will ensue. In the worst case, the problem becomes systemic, causing “the mortgage market to grind to a halt as title insurers refuse to insure mortgages involving existing homes.”
Bank of America Corp., the largest U.S. lender, has halted foreclosures in all 50 states amid allegations that home seizures are being based on faulty documents. JPMorgan Chase & Co. and Ally Financial Inc.’s GMAC Mortgage unit have stopped repossessions in the 23 states with judicial supervision over foreclosures.
“We’re reviewing 115,000 plus or minus loan files that are currently in the foreclosure process,” Doug Braunstein, JPMorgan’s chief financial officer, said during a conference call today. “We really believe the proper approach and response here is to go loan by loan, file by file, customer by customer, and if mistakes have been made, then we need to address them individually.”
Top legal officers of all 50 states opened a joint investigation into home foreclosures today, saying they will seek an immediate halt to any improper practices at banks and mortgage companies.
Lawsuits over the assignment of the mortgages have ”that Armageddon possibility,” said Katherine Porter, a visiting professor at Harvard Law School who has studied banks’ foreclosure practices. “I think if you press hard, the transfers from the depositor to the sponsor and that sort of stuff were often flubbed.”
Few lawyers can bring those suits successfully, because they are so complex, Porter added
“All litigation in this arena is a tough slog because there’s a lot of money at stake,” said David Grais, a partner in the New York law firm Grais & Ellsworth LLP.
In Florida, the state with the third-highest foreclosure rate, homeowner challenges to bank documentation threaten to slow the process to a crawl, derailing the state’s efforts to streamline it.
The critical question is whether misrepresentation is “material,” which means it would be a fact that investors would reasonably want to know, said Grais, who currently represents the federal Home Loan Banks of Seattle and San Francisco and Charles Schwab Corp. in litigation trying to force banks including Bank of America and JPMorgan to repurchase mortgage-backed securities because they misrepresented the quality of the loans.
Not all investment analysts expect financial chaos. The controversy may cause a six-month delay in foreclosures and “have a muted effect on valuation” of about $154 billion of mortgage-backed securities, Laurie Goodman, senior managing director of Amherst Securities Group LP in New York, wrote in a note to investors yesterday.
“Servicers will incur high costs both from re-processing loans that are in the process of foreclosure as well as from defending themselves in litigations,” Goodman wrote. “And investors definitely need to question the cash flows they are receiving on private-label MBS, to ascertain that they are not paying for expenses that rightfully belong to servicers.”
To contact the reporter on this story: John Gittelsohn in New York at email@example.com
To contact the editor responsible for this story: Kara Wetzel at firstname.lastname@example.org.