An Elephant Stampede

An Elephant Stampede

Two and one-half years ago, we were talking about an “elephant in the room” for the mortgage banking business: loan repurchase obligations. In November 2005, the problem was primarily with respect to subprime mortgage loans. Today, according to The Wall Street Journal, the elephant is stomping throughout the house, smashing furniture in every room, and leaving a memento of his presence on every loan originator’s favorite sofa cushions.

Already burned by bad mortgages on their books, lenders now are feeling rising heat from loans they sold to investors.

Unhappy buyers of subprime mortgages, home-equity loans and other real-estate loans are trying to force banks and mortgage companies to repurchase a growing pile of troubled loans. The pressure is the result of provisions in many loan sales that require lenders to take back loans that default unusually fast or contained mistakes or fraud.

The potential liability from the growing number of disputed loans could reach billions of dollars, says Paul J. Miller Jr., an analyst with Friedman, Billings, Ramsey & Co. Some major lenders are setting aside large reserves to cover potential repurchases.

[…]

The fight over mortgages that lenders thought they had largely offloaded is another reminder of the deterioration of lending standards that helped contribute to the worst housing bust in decades.

Such disputes began to emerge publicly in 2006 as large numbers of subprime mortgages began going bad shortly after origination. In recent months, these skirmishes have expanded to include home-equity loans and mortgages made to borrowers with relatively good credit, as well as subprime loans that went bad after borrowers made several payments.

Many recent loan disputes involve allegations of bogus appraisals, inflated borrower incomes and other misrepresentations made at the time the loans were originated. Some of the disputes are spilling into the courtroom, and the potential liability is likely to hang over lenders for years.

The Wall Street Journal reports that Fannie Mae recently “said it is reviewing every loan that defaults — and seeking to force lenders to buy back loans that failed to meet promised quality standards.” Little bro’ Freddie Mac is also increasing the number of repurchase claims. That’s consistent with observations made two years ago. With those two GSE’s being positioned as the linchpins of the federal government’s “plan” (and we use that term loosely) to “save the mortgage market for the little guy,” it will be hard for any loan originator who wants to continue to play the mortgage banking game to get in a catfight with either of those big cats.  Expect “portfolio scrubbing” to be especially intense at both entities, given their history. As I’ve said previously, I represented clients on the wrong side of Fannie Mae during the last downturn, and it wasn’t pretty.

The WSJ also reports that repurchase pressure is coming from bond insurers, such as Ambac and PMI, and REITs, like Redwood Trust Inc. While most claims are settled out of court, it appears that trial lawyers will not be left out in the cold.

Repurchase claims often are resolved by negotiation or through arbitration, but a growing number of disputes are ending up in court. Since the start of 2007, roughly 20 such lawsuits involving repurchase requests of $4 million or more have been filed in federal courts, according to Navigant Consulting, a management and litigation consulting firm. The figures don’t include claims filed in state courts and smaller disputes involving a single loan or a handful of mortgages.

It’s always comforting to know that some good will result from all this suffering.

It will certainly be bad for originators, but while some mentioned in the WSJ article, including everybody’s favorite whipping boy, Countrywide, appear to have the financial wherewithal to fulfill their legitimate repurchase obligations (knock on wood), there are some who will not. Then, who gets stuck? I represented a lender that bought from the RTC a large block of servicing rights to loans originated by a failed savings bank. Unfortunately for the buyer, there were major problems with the loans, some dating from loan origination, and some as the result of incompetent servicing prior to the purchase, which wasn’t discovered during due diligence (the consequence of either poor sampling or bad luck). FNMA started putting loans back like they were radioactive and there was no one to turn to, since the RTC gave limited warranties on the junk assets it sold. You just never know who’s going to get stuck with the bill for loans that FNMA Mae buys, but it’s rarely FNMA if there’s any breathing body or inanimate object that Fannie can stick it to.

The WSJ also notes that many originators are increasing reserves to meet potential buyback liability.  Not increasing reserves by a conservative amount has its risks.

Lenders may feel pressure to boost reserves for such claims because of the fear they could be sued for not properly accounting for potential repurchases, says Laurence Platt, an attorney in Washington. At least three lawsuits have been filed by investors who allege that New Century Financial Corp. and other mortgage lenders understated their repurchase reserves, according to Navigant.

So, who wants to start a mortgage bank?

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