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Here's the Second Shoe
A new US mortgage meltdown?Karen Maley
Published 6:56 PM, 21 Oct 2010 Last update 10:08 AM, 22 Oct 2010
Fears that the US banking system is about to be engulfed in 'subprime crisis part two' have been fuelled by recent media reports that a group of powerful institutional investors is seeking to force Bank of America to repurchase soured mortgages.
According to the reports, a group including PIMCO (the world’s largest bond fund), BlackRock (the world’s largest money manager), and the Federal Reserve of New York (which acquired its bonds as a result of its 2008 bailout of Bear Stearns and AIG) have written a legal letter to the Bank of America, objecting to the handling of 115 bond deals issued by the California-based lender Countrywide (which was acquired by Bank of America in 2008). The investors reportedly claim to hold about $16.5 billion, or more than 25 per cent of the $47 billion of mortgage-backed securities created by these deals.
The letter alleges that Countrywide, which was the servicer of the bonds, has failed to inform investors that various mortgages backing their bonds are in breach of representations and warranties made when the bonds were first sold. And the originator of the bonds – again Countrywide – has not been required to buy back the problem mortgages, even though it is obliged to do so when their quality of the mortgages falls short.
Now, this is an interesting development in the sub-prime saga, because it demonstrates that the big institutional investors are extremely keen to try and shift losses from their mortgage bonds back onto the banks. And it puts Bank of America in a somewhat tricky situation, because some of these huge institutional investors undoubtedly rank among its top clients.
Still, faced with the prospect that they will be flooded with demands to buy-back defaulted mortgages, the big US banks have little choice but to strenuously fight investor claims.
The banks are arguing that they are only required to buy back mortgages that didn’t meet the representations and warranties that they provided when they sold the loans. They’re not required to buy back mortgages that soured because borrowers lost their jobs in the economic downturn, and stopped meeting their mortgage payments. This makes it much harder for investors to put back large numbers of defaulted mortgages to the banks.
In addition, investors have to demonstrate breaches on a loan-by-loan case, which means they’ll have to spend huge amounts of money hiring experts to comb through the loan files, in an endeavour to uncover the faulty mortgages.
At this stage, no-one knows just how big a problem this is going to be for the banks.
Some argue that the standard of mortgages packaged into MBS frequently failed to meet the banks' warranties, either because the values of the properties were over-stated, or else the borrowers didn’t have the income that was claimed. As a result, they predict banks will incur heavy losses as a result of having to buy back large numbers of problem mortgages. And they’ll also run up huge legal costs because they’ll have to spend years in the courts fighting claims of breaches from investors.
Others estimate that the problems for the US banking sector will be much less severe – amounting to several tens of billions of dollars, which can be spread over a number of years.
Whatever the outcome, the latest flurry of fear demonstrates that US investors are all too aware that the banks did not fully shed their risk when they bundled up all their low doc mortgages and flogged them to investors.
As a result, the big banks continue to be haunted by the spectre of lurking sub-prime losses.
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