Banks Face Two-Front War on Mortgages, Foreclosures
Shoddy mortgage lending has led bankers into a two-front war, pitting them against U.S. homeowners challenging the right to foreclose and mortgage-bond investors demanding refunds that could approach $200 billion.
While federal regulators and state attorneys general have focused on flawed foreclosures, a bigger threat may be the cost to buy back faulty loans that banks bundled into securities. JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), Wells Fargo & Co. (WFC) and Citigroup (C) Inc. have set aside just $10 billion in reserves to cover future buybacks. Bank of America alone said this week that pending claims jumped 71 percent from a year ago to $12.9 billion of loans.
Investors such as Bill Gross’s Pacific Investment Management Co. contend that sellers are obligated to repurchase some mortgages because of misrepresentations such as overstatements of borrowers’ income or inflated appraisals. Their case may be bolstered by probes in 50 states into whether banks used documents that were also flawed to conduct foreclosures. Neither dispute is likely to be resolved quickly.
“It’s going to be trench warfare with years of lawyering,” Christopher Whalen, managing director of Institutional Risk Analytics, said in a telephone interview from White Plains, New York. “The banks can’t afford to lose.”
The biggest risks for banks may be loans packaged into mortgage-backed securities during the housing bubble, of which $1.3 trillion remain. The aggrieved bondholders include government-controlled firms Fannie Mae and Freddie Mac, bond insurers and private investors.
Fannie Mae and Freddie Mac, the largest mortgage-finance companies, may be owed as much as $42 billion just on loans they bought directly from lenders, according to Fitch Ratings. On top of that, investors in private mortgage bonds, including them, may collect as much as $179.2 billion, Christopher Gamaitoni, vice president of research at Compass Point Research & Trading LLC in Washington, said in an August report. That brings the total to more than $220 billion.
Pimco, BlackRock Inc. (BLK), MetLife Inc. and the Federal Reserve Bank of New York are seeking to force Bank of America to repurchase mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit. In a letter to the bank, the group cited alleged failures by Countrywide to service the loans properly.
“It enhances the likelihood of claims coming to fruition,” said Gamaitoni, a former senior financial analyst at Fannie Mae.
Bank of America, which acquired Countrywide, the biggest U.S. mortgage lender, in 2008, faces potential repurchase obligations of $74 billion, according to an August report by Branch Hill Capital, a San Francisco hedge fund, which is betting against the Charlotte, North Carolina-based company’s shares. Potential claims consist of $21.8 billion to Fannie Mae and Freddie Mac, $45 billion for investors in mortgage bonds and $7.2 billion for insurance companies, Branch Hill said.
Bank of America has $4.4 billion in reserves for claims on $12.9 billion of loans, the company reported Oct. 19, and has already resolved claims on more than $14 billion of loans.
The company will “defend our shareholders” by disputing any unjustified demands that it repurchase mortgages, Chief Executive Officer Brian T. Moynihan said in an interview on Bloomberg Television. Most claims “don’t have the defects that people allege.”
JPMorgan took a $1 billion third-quarter expense to increase its mortgage-repurchase reserves to about $3 billion. Citigroup raised its reserves to $952 million in the third quarter, from $727 million in the previous period. Wells Fargo reduced its repurchase reserves to $1.3 billion, from $1.4 billion in the second quarter.
“These issues have been somewhat overstated and to a certain extent, misrepresented in the marketplace,” Wells Fargo Chief Financial Officer Howard Atkins said yesterday on the bank’s third-quarter earnings call. “Our experience continues to be different than some of our peers in that our unresolved repurchase demands outstanding are actually down.”
So far, most lenders have resisted large-scale settlements, agreeing only to paybacks after defects are discovered in individual loans. Investors have in some cases been stymied in their efforts to examine individual loan files by mortgage-bond trustees, which administer the securities.
In July, the Federal Housing Finance Agency, the government conservator of Fannie Mae and Freddie Mac, issued 64 subpoenas demanding loan files to assess the possibility of breaches in representations and warranties by securities issuers. The regulator said companies had 30 days to produce the documents.
“As the requested information comes to FHFA, it will be analyzed,” Stefanie Mullin, a spokesman, said. “No decisions for future action have been made.”
The most common issues found with the mortgages bundled into securities are borrowers who didn’t occupy the homes and inflated appraisals that distorted the loan-to-value ratio, according to lawsuits filed by the Federal Home Loan Banks in Seattle and San Francisco. A sampling of 6,533 loans in 12 securitizations by Countrywide found 97 percent failed to conform to underwriting guidelines, according to a lawsuit filed Sept. 29 by Ambac Assurance Corp. in New York state Supreme Court.
Richard M. Bowen, former chief underwriter for Citigroup’s consumer-lending group, said he warned his superiors of concerns that some types of loans in securities didn’t conform with representations and warranties in 2006 and 2007.
“In mid-2006, I discovered that over 60 percent of these mortgages purchased and sold were defective,” Bowen testified on April 7 before the Financial Crisis Inquiry Commission created by Congress. “Defective mortgages increased during 2007 to over 80 percent of production.”
Some analysts say that the losses will be manageable by the banks. Last week, Mike Mayo, an analyst at Credit Agricole Securities USA in New York, estimated a cost of $20 billion for repurchases. Future expenses may total $30 billion to $70 billion, Nomura Securities International Inc. analysts including Ohmsatya Ravi said in a report today. Goldman Sachs Group Inc.’s Richard Ramsden said a worst-case scenario would be $84 billion.
U.S. Representative Brad Miller, a North Carolina Democrat on the House Financial Services Committee, says he asked Treasury Secretary Timothy Geithner in a recent hearing whether the government included mortgage-repurchase losses in the so-called stress tests of banks conducted last year, because he was expects that they will be growing. Geithner couldn’t immediately answer, and Miller assumes they weren’t.
“It appears the banks have contractually promised the mortgages met specific requirements, and also it certainly appears not all of them did,” Miller said. “In all likelihood a great many of them didn’t.”
The Second Front
The other front in the battle is the potential cost to banks of improper documentation used in foreclosures. Attorneys general in all 50 states are jointly investigating foreclosure procedures, including the use of so-called robo-signers who didn’t check the material they were signing. Litigation costs for such cases may reach $4 billion, while a three-month delay in foreclosures would add an additional $6 billion to industry expenses, FBR Capital Markets estimated in an Oct. 19 report.
Foreclosure document errors also can be used to push for repurchases.
The total amount of loans that the four biggest banks may need to buy back because of flawed paperwork could be “on the order of” about $25 billion, said Paul Jablansky, a senior debt strategist at Stamford, Connecticut-based RBS Securities Inc. With these demands to investigate breaches of contracts, “it’s relatively objective, the loan files are either complete or not, and the missing files are either material and adverse, or not.”
To settle disputes with homeowners about attempts to foreclose, banks may offer borrowers more generous loan modifications, potentially including principal reductions, said Frank Pallotta, managing partner of Loan Value Group, a mortgage-consulting firm in Rumson, New Jersey.
‘Going to Cost Them’
“The potential for owners to challenge lenders on foreclosure improprieties certainly is there,” Pallotta said. “Even if it turns out that the banks were right in 99 percent of these foreclosures, the additional diligence on their part, going forward, is going to cost them more money.”
Reducing principal would be complicated by an “elephant in the room,” about $175 billion of home-equity loans owned by the four biggest banks in which the borrowers’ debt exceeds the value of the property, New York-based research firm CreditSights Inc. said in an Oct. 18 report titled “Foreclosure Freak Out!” The government may force banks to forgive some of that debt in a settlement, the firm said.
The litigation over buybacks, also known as putbacks, can also pit big banks against each other. Last month, Deutsche Bank AG, acting as a trustee, refiled a lawsuit over misrepresented mortgages in $34 billion of Washington Mutual Inc. mortgage securities, with $165 billion in original balances.
The new suit in the U.S. District Court for the District of Columbia included JPMorgan as a defendant, after the Federal Deposit Insurance Corp. said that JPMorgan was wrongly claiming its insurance fund had agreed to cover the liabilities, according to the amended complaint.
JPMorgan, which bought most of WaMu after it failed in 2008, is balking at turning over loan files to the trustee, according to the suit. “Based on the limited information available to” Deutsche Bank, including evidence of WaMu’s shoddy practices found in internal documents released in a Senate investigation, either JPMorgan or the FDIC owes investors $6 billion to $10 billion, according to the complaint.
About 26 percent of mortgages underlying securities without government backing are at least 60 days late, in foreclosure proceedings or already backed by seized homes, according to data compiled by Bloomberg. Typical prices for the most-senior bonds tied to so-called Alt-A mortgages, whose borrowers often failed to document their pay or plan to live in properties, fell to as low as 33 cents on the dollar in March 2009, before rallying to 64 cents last week, according to Barclays Capital Inc. data.
Like WaMu, many lenders that originated the mortgages have gone out of business, making litigation more complex, said Kurt Eggert, professor of law at Chapman University in Orange, California. And top executives at the surviving companies, such as the CEOs of Bank of America and Citigroup, have been replaced.
“It’s troubling that the people who caused the problem have walked away and left everybody else to fight over who gets stuck with the tab,” Eggert said in a telephone interview. “It’s like a massive game of dine and dash.”
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