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Beyond the Foreclosure Fiasco
10/19/2010 9:46 am EST
Banks' inattention to detail brought foreclosures to a halt across the nation. Was there a similar pattern in handing out mortgages that will come back to bite the industry?
Add another word to English as spoken on Wall Street: Robo-signers.
These are the folks at banks and mortgage service companies who signed hundreds of foreclosure documents a day. Frequently, they didn't read them at all. Even more frequently, they didn't bother to check that the financial information in the foreclosure documents was accurate or that the financial company bringing the foreclosure could even prove that it actually owned the mortgage in question and had the legal right to foreclose.
But the robo-signers signed away, putting their signatures on lines that said they had reviewed the documents for accuracy.
The result is a virtual national moratorium on mortgage foreclosures and an investigation by every state attorney general—yep, all 50 of them—into the mortgage servicing industry.
According to FBR Capital Markets, losses for banks and other mortgage servicing companies from the moratorium could run from $6 billion to $10 billion and stretch out for at least four years.
Ah, if only that were the biggest bill hanging over the US banking industry. But there's also this problem called put-backs, which could cost the industry a lot more than that $6 billion to $10 billion. No one knows how much more or who would get stuck with the costs. And that's a huge issue for investors, because we all know how much Wall Street likes uncertainty.
We do know that, as of the end of the third quarter, JPMorgan Chase (NYSE: JPM) had put $3 billion aside against potential losses from put-backs. (In the third quarter, the bank bought back $1.5 billion in loans from investors.) And that's just one bank.
So, Just What Is a Put-back?
OK, I know you're on the edge of your seats and can't wait to get into the arcane details of mortgages and mortgage-backed securities. So who am I to deny you?Put-backs have a certain similarity to the foreclosure problems that you've read so much about.
In a foreclosure, the bank or other mortgage service company is supposed to do what I'd call after-the-fact due diligence. Workers at the company and the officer who signs the paper are supposed to check to make sure that the homeowner is really behind in his or her payments (mistakes do happen), that all the required legal notices have been sent out at the required deadlines, that any required attempts to work out the debt have been completed, and that, most importantly, the company bringing the foreclosure actually owns the property in question.
The robo-signers at the heart of the mortgage moratorium and investigation signed without doing this critical due diligence. In some cases, they signed documents that didn't demonstrate a clear claim on the property in question.
(A mortgage service company, in case you're asking, is exactly what it sounds like: A company that services the mortgage by collecting payments, sending out notices of delinquency and foreclosure, and keeps the books on who's up to date and who's not. These mortgage services can be performed by the bank that issued the mortgage, but frequently, they're farmed out to companies that specialize in these back-office functions but that do not lend money themselves.)
At the least, banks and mortgage servicers will have to recheck their foreclosure paperwork, resubmit the legal work for the foreclosures (where they have the required legal work), and then try to figure out what to do with the mortgages for which they don't have the paperwork to foreclose. You can understand why some Wall Street analysts, such as Richard Bove at Rochdale Securities, estimate that it could take at least four years and maybe as long as a decade to work through this morass. Bove estimates that the problem will cost the industry as much as $1.5 billion a quarter in staff time, legal fees, and delays.
There's nothing like having to sit on a house where the owner isn't making mortgage payments to add to a bank's bottom line. And, of course, as JPMorgan Chase CEO Jamie Dimon said when his bank announced third-quarter earnings October 13, "If economic conditions worsen, mortgage credit losses could trend higher."
(If you don't think banks take this problem seriously, just look at what was innocuously called the Interstate Recognition of Notarizations Act, the bill that the industry and its allies on both sides of the aisle pushed through Congress. The bill would have made it more difficult to challenge foreclosures by shielding banks and mortgage service companies from liability for improperly prepared foreclosure documents. President Barack Obama killed the bill October 7. I expect to see a revised version after the November elections.)
NEXT: The Other End of This Problem|pagebreak|
Other End of the Problem
Put-backs involve due diligence near the front end of the mortgage process. Not at the very beginning, mind you, when a bank decides to approve or turn down a mortgage application from a homebuyer. The problem comes up later, when the bank decides that it wants to bundle a set of mortgages into a mortgage-backed security and sell it to investors. That way the bank can collect a fee for originating the mortgage and maybe keep a piece of the cash flow, too, yet recover most of its capital so that it can lend it out again in new mortgages.
In the creation and sale of those mortgage-backed securities, the banks that originated the mortgages made certain representations to the buyers of these securities about the quality of those mortgages. Specifically, they made representations that they had done their due diligence on those mortgages. Credit rating companies backed up those representations by giving these securities A, AA, or even AAA—good, better and best—ratings.
These mortgage-backed assets were at the heart of the financial crisis that started in US real estate, spread to Wall Street, and eventually engulfed a good chunk of the developed world. As you might imagine, many of the buyers of these mortgage-backed securities looked at assets that were, at the height of the crisis, worth 40 cents or 60 cents on the dollar and figured that someone had lied to them. And some of those investors have tried to get all or part of their money back.
Those efforts haven't been particularly successful. The credit rating companies have hauled out their First Amendment protections (the "We've got a constitutional right to be wrong" defense). And mortgage originators have pulled out "Hey, we did our due diligence. We can't help it if a global financial crisis cost you money."
But the foreclosure debacle threatens to punch a hole in that defense big enough to drive billions in loan put-backs through. If banks didn't do solid due diligence on their foreclosures, what are the odds that they did the promised due diligence on those mortgages when they approved them before bundling them into mortgage-backed securities?
Is there another group of robo-signers out there—this time on the mortgage-origination end—that could rise up to bite banks right in their bottom lines?
Odds are pretty good.
Can You Call This Due Diligence?
Just take one year, 2006, near the height of the mortgage-origination boom. In that year, the industry cranked out $255 billion in option adjustable-rate mortgages. You remember option ARMs. These were mortgages with exotic wrinkles such as "pick-a-pay" designed to get more buyers to qualify for mortgages. Pick-a-pay allowed borrowers to pick a minimum rate—sometimes as low as 1%. They could even fix that low rate for up to five years. Or how about an interest-only payment? (Really fuddy-duddy borrowers could get a fully amortizing standard mortgage, of course.)
But there was something wrong with the way the industry was writing option ARMs, because they began to go bad at an alarming rate. By July 2008, Barclays Capital found, fully 18% of option ARMs originated in 2005 and 2006 were already 60 days past due or more.
Think there might have been something wrong with the due diligence on just a few of these mortgages?
The Great Unknown: Cost
If there was, that would offer big buyers of mortgage-backed securities such as Fannie Mae (OTC: FNMA) and Freddie Mac (OTC: FMCC) and every pension fund from Albany to Sacramento a chance to recover some of their losses. Somebody has already been going after the banks on this. We know that because JPMorgan Chase paid out $1.5 billion last quarter to buy back loans and because Bank of America (NYSE: BAC) told an investor conference last month that it had put aside adequate reserves to cover losses from repurchasing mortgages.
Adequate? When we don't know what the size of the losses might be? Estimates range from a few billion at the worst-hit bank to an astounding (and, frankly, not very believable) $70 billion calculated by hedge fund Branch Hill Capital for Bank of America. (By the way, Branch Hill is short Bank of America.)
We do know that big banks such as JPMorgan Chase, Bank of America, and Wells Fargo (NYSE: WFC) have the largest potential exposure because they bought the companies that were the biggest option ARM originators in the mortgage boom: Countrywide Financial, Washington Mutual, and Wachovia (which bought its exposure when it acquired Golden West Financial in 2006).
I think—and I stress "think"—that these big banks have enough capital strength to handle the potential liability under most estimates. I was reassured by JPMorgan Chase's talk of the size of its put-back losses and the size of its reserves in its third-quarter-earnings report. (For more on that report and banking in general, see my post "JPMorgan Chase earnings show US banks have a growth problem.") I'll be looking to see if Bank of America and Wells Fargo are similarly reassuring when they report October 19 and October 20, respectively.
I actually think the biggest dangers for investors are likely to lie with, first, companies that aren't recognized as having potential problems. H&R Block (NYSE: HRB), for example, originated mortgages until 2008. HSBC (NYSE: HBC), to take another example, has exited the US mortgage business it bought when it acquired HFC. But that doesn't mean HSBC has no exposure.
(I don't think the size of HSBC's potential exposure is a serious issue for a bank with its capital, but the stock could take a nasty short-term dip if investors, who aren't expecting a problem, suddenly discover one. Even if it is ultimately insignificant. I'm willing to hold the stock through any such dip, but I'd like to be prepared for the possibility of one. HSBC is in my Jubak's Picks portfolio.)
Second, watch out for smaller banks that did significant mortgage originations but don't have the capital strength of the big boys. Here, I'd keep my eye on regional banks such as SunTrust Banks (NYSE: STI), KeyCorp (NYSE: KEY), and Regions Financial (NYSE: RF). They report earnings on October 21, October 22, and October 26, respectively.
Even before this newest wrinkle, problems in the banking sector seemed to be concentrated in smaller banks. I think today's mortgage uncertainties just make that more so. (For more on the uneven nature of the banking recovery, see my post "A banking recovery for big banks only.")
At the time of publication, Jim Jubak did not own shares of any company mentioned in this column in his personal portfolio. His new mutual fund, Jubak Global Equity (JUBAX), may hold positions in these stocks, and positions may change at any time.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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