Mirabile Dictu! SEC Prods Banks Over Mortgage Litigation Reserves

When the SEC wakes up and starts acting like a regulator, you know something serious is afoot.

The Wall Street Journal reports that the securities agency, spooked by Bank of America setting aside over $20 billion for mortgage-related liability, has sent letters to “a number of banks” asking them to do a better job of disclosing what their legal liability is (the elephant in the room is of course the mortgage mess) and making adequate reserves. Per their story:

The SEC is focusing on whether banks are doing enough to disclose the “reasonably possible” category of losses. Officials in the agency’s corporation finance division are reviewing banks’ regular filings to determine whether shareholders have been given fair warning of the mounting future liabilities, according to people familiar with the matter.

One can have a teeny bit of sympathy for the banks. Structured credit and chain of title litigation are cutting edge areas of the law. We are in a better position than the banks to be candid about what is afoot, and even so, we’ve gotten a few calls wrong. But it’s also true that many of the key elements of the law are being sorted out in court, and certain issues are too early to call.

But I wouldn’t go beyond being a teeny bit sympathetic. The industry has gone into a defensive posture, trying to rely on PR and aggressive salvos by stanch allies, like the American Securitization Forum, or fellow members of the mortgage industrial complex who have as much to lose as they do (like the securitization law firms that have liability on past opinion letters). The problem is in this arena, mastering the spin is going to have limited effect on outcomes. There are enough judges that are not beholden to banks and were appalled by the massive fraud on the court perpetrated in the robosigning scandal that the banks can’t expect to get a break simply by being presumed to be credible.

The banks simply can’t admit how bad things are. Between eventually needing to take large writedowns on their second lien portfolios (roughly $400 billion among the four biggest banks plus Ally Financial) and their mortgage-related liability, the largest banks have severely impaired if not negative equity.

And investors have not yet roused themselves. This is where the potential meteor wiping out the dinosaurs events lie. Bondholders seem to be badly behind the curve on the implications of the mortgage train wreck in the nation’s courtrooms. The latest data I have seen suggests that loss severities on foreclosures (usually expressed as losses as a % of the original mortgage amount) are roughy 50% on prime mortgages and 75% on subprime. But these losses are certain to escalate. This is by e-mail from Tom Adams; I’d be curious to get informed reader input:

My very rough back of the envelope calculation is that each month of foreclosure delay is adding about 0.75% in accrued costs to the loan, which has a corresponding increase in severity. Plus, the legal and administrative cost of foreclosing loans is skyrocketing – I would estimate refiling and redoing foreclosures, assuming they ever go through, is a cost of at least $20-40k, even if they don’t go to trial. These costs will ultimately cause substantial increase in severities.

As a result, I think loans that have experienced substantial foreclosure delays (which is probably a sign of documentation problems) could experience loss severities 10-20% higher than originally estimated, and some could come in even higher.

I think this means investors that bought MBS in the past year probably overpaid by a fair amount and any investor that marked their portfolio of MBS up due to the large gains MBS experienced over the past year are probably carrying these bonds at values that are too high. As the foreclosure crisis drags on, the losses will eventually be realized, and at these higher severity levels. This means a large number of investors will have to write the binds back down. I’m sure this will include many of the large banks. In theory, if they are writing down their first lien mortgages, they will also have to write down their large second lien exposures as well.

Banks and hedge funds will experience higher losses on the holdings, reducing earnings. The BofA settlement may reflect a growing awareness of these coming losses, but I expect this will have other effects, including a sell off of other higher value bonds to cover the losses and an attempt by some to push the realization of the losses into the new year to preserve this year’s bonuses. Another implication could be that principal mods start to look like a much better deal.

Notice that Tom did not allow for the cost of more borrowers fighting foreclosures, due to greater awareness of chain of title issues and banks’ continued unwillingness to do much in the way of principal mods. I don’t have a lot of data points here, but as I mentioned, one Alabama case on a $100,000 mortgage (house now worth only $50,000-$60,000 due to the plunge in housing prices) had produced legal fees of $250,000 to the foreclosure mill partway through the litigation. That case is also being appealed. It doesn’t take too many foreclosures like that to notch up loss severities further.

As investors face losses, they will increasingly want banks to do principal mods for viable borrowers rather than foreclose (as we’ve said repeatedly, a 40% principal mod beats a 75+% loss on foreclosure all day). Their best tool to bring banks to heel is to threaten litigation on chain of title issues (that the banks failed to fulfill the duties they specified in the pooling and servicing agreements). Whether any lawsuits will see the light of day is an open question, but forces are in motion that will make it far more difficult for banks to engage in extend and pretend as far as their mortgage exposures are concerned.

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  1. mike m.

    Yves- I’m in the r.e. business,I rep investors.Tom’s close enough on the additional carry for foreclosure delays.I look at about a 72% loss severity on agency & non-agency reo.I have seen the lower end property,if priced correctly,have no accounting value or at best salvage value.Note,I said priced correctly.
    What lawyer in their right mind is going to mess with known chain-of-title issues on existing reo? Damage is done,you can’t just go back and re-file non-existant paperwork at any price. Well,on second thought…I really see no other viable plan other than some sort of principal modification.Even with a loan mod there are going to be folks that are so underwater it will make no difference.
    What concerns me the most is how are all the chain of title issues will be corrected.We can’t just say “King’s X” and start over.

    1. grandiosity

      @mike m.

      Yeah that is what worries me too.

      Yves: Is anyone thinking about what happens if the chain of title is so bad on MM of properties that ownership cannot be resolved?

      1. Just Tired

        I am not a lawyer but have developed RE in many states. To my knowledge, every state has procedures to quite title (and title issues are generally solely left to the states). In my experience (mostly in CA) quiet title actions move quite quickly through the system and since the laws derive from common law, a judge can determine ownership based on equitable principles. Based on my personal experience and knowledge most of the title problems raised in the judicial foreclosure or bankruptcy forums would be eliminated by filing a quiet title action where recording formalities can be ignored in favor of determining who actually is the owner of the property. For example, I owned a property (the former site of Oakland Raiders pre-season training facilities) where the recorded documents indicated a claim by the heirs of the original land grant from Mexico in the 1800s. It was cleared up in less than three months.

        1. Cedric Regula

          I’d like to hear from someone that knows the title insurance biz. When I worked at Fidelity National as a programmer sometimes I would hear them say “we fixup little title problems” during the title search/issueing title policy procedure they go thru when you are in escrow.

          But I was too busy with other things to learn what they meant by that.

        2. ToivoS

          Just tired wrote:

          I owned a property (the former site of Oakland Raiders pre-season training facilities) where the recorded documents indicated a claim by the heirs of the original land grant from Mexico in the 1800s. It was cleared up in less than three months.

          It is for reasons like this that I don’t think the courts are going to be too hard on the banks — they do not challenge the power structure. Even if title transfers violated state laws, the courts will likely come up with some way to not punish any banks.

          Those Mexican land grant cases result from the fact that American settlers to California simply stole the land from the Mexican owners, in many cases killing any who tried to work their land. The US courts negated those land grants. I know descendants have refiled cases over the last 40 years but I never recall any winning.

    2. Jim A

      That’s why “forgive us our past sins, this time we won’t lose the paperwork” will be part of every mod, short sale, and keys for cash deal. In many cases the borrower can be persuaded to agree, because they really don’t have an expectation that they’re going to get the house for free. IMHO the real problem will be whether they can keep the bond holders from realizing that there’s a chance that they can force the originator to take the non-performing loan back. And that’s why the piece the other day about BoNY boning bondholders instead of going after BA was so important.

      1. grandiosity

        Wow. So Pandit’s music hasn’t stopped — they haven’t really decided how stick US with the bill.

  2. TC

    “…this will have other effects, including a sell off of other higher value bonds to cover the losses and an attempt by some to push the realization of the losses into the new year to preserve this year’s bonuses.” Which means common stocks are bound to be trashed en masse in this postponement attempt higher up in the capital structure, no?

  3. TraderGreg

    If they broke the chain of title, then they cannot re-issue the note. Once they lost the note, it is over – it doesn’t matter what happens afterwards. How can they transfer something that they don’t have? If they cannot properly foreclose, then they cannot properly do the mod – no?

    It looks , they are trying to pile up more errors, to confuse everyone.

  4. Jean paul Marat

    But JP Morgan posted record earnings.JPMorgan said on Thursday its second-quarter profit and revenue outpaced estimates, pushing its shares higher, as sales rose 7 percent.
    Nothing to see here… move along.

  5. Naples Retreat

    Sad attrition, then an awakening from deep slumber:

    “There are enough judges that are not beholden to banks and were appalled by the massive fraud on the court perpetrated in the robo signing scandal that the banks can’t expect to get a break simply by being presumed to be credible.”

  6. DP

    Yves, the latest loss severity rates according to a presentation on Tuesday by Jeff Gundlach of DoubleLine Capital are 44.8% for prime, 58.9% for Alt-A and 72.5% for subprime. He has long projected that they are headed higher. He says they have seen some subprime mortgages, particularly ones under $100K, with loss severities over 100% due to legal fees, payments advanced by the servicer, etc. He would disagree with your assessment that all MBS buyers in the last several months have overpaid, as he claims the MBS in his portfolios have a significant further decline in housing prices and loss severities baked into the prices. But he is very bearish on subprime MBS, owns virtually none of it and thinks much of it will be close to worthless with both default rates and severity approaching 100%.

    If you email me I’d be happy to send you a PDF of the slides from his presentation, which includes charts on the mortgage market trends as well as many very good charts on the macroeconomic situation. If you have the time, I’d recommend listening to the replay of his webcast which runs about 60-70 minutes and should be up in the next day or two if it’s not already. He does not sugarcoat the economic mess we’re in and has plenty of charts to illustrate it.

  7. Bravo

    One would like to think that the banks will eventually have to identify those loans that do in fact have chain of title/note conveyance issues associated with them. Then, rather than incur the loss severities that more foreclosures will bring, they choose to approach those borrowers where their documentation is suspect, and propose modifications that represent a fair compromise between the positions of all primary parties to the boondoggle: a borrower that bought and borrowed too much on an ill-timed investment, the MBS investors who never contemplated a drop in housing values of the magnitude we’ve seen, the trustees who failed to properly secure mortgages for the MBS investors, and the servicers who were incented and ill-equipped to do anything other than foreclose. Simple and rational modifications to credit worthy borrowers, led by Freddie and Fannie, should include 1) a reduction of loan balance to the property’s current market value, 2) a 50/50 borrower/lender split of appreciation of the property over a reset 10 yr loan term (30 yr amort), 3) a reset of the interest rate to a fixed current market interest rate over the new 10 year loan term, and 4) the borrower must refinance the lender out at the end of 10 years or sell the property outright before the end of the 10th year, or agree to deed the property to the lender at the end of the 10th year. To address chain of title issues, the banks would be required to go back to the last party that truly owned the note (assuming it is not the trust), and get that party’s release of claim on title prior to proceeding with the mod and putting a whole new set of documents in place. Investors should be motivated to agree to such terms. Borrowers should be incented to take the terms rather than take their chances in an overwhelmed court system, ruin their credit, potentially lose their house if they were to draw a pro-bank judge, and finally be able to walk away with a clear conscience on reaching a settlement on debt they in fact were responsible for taking on in the first place. If borrower/lender can’t come together on terms, then the investors and homeowners are left to take their chances in court.

    The Obama administration seems to being looking for ideas on what to do….what’s wrong with this? How the banks account for the resulting substantial losses on their second mortgage HELOC’s would seem to be the only impediment to this approach? The banks can surely use their influence with FASB to get whatever accounting treatment is needed to soften the blow by amortizing the losses over the 10 year period of the modified loans?

    1. House This

      A reduction of loan balance to the property’s value in 2000, Bank of America shuttered, etc.
      Yes good ideas.

  8. Foreclose on Yves

    “for viable borrowers rather than foreclose ” You still don’t get it, shelter is a human right. I’d suggest the un-viable consider revenge, or gaining the upper hand on dice rolling terrorists. (investors who knew exactly what they were doing)
    How many millions of un-viable unemployed are there in this country, by the way?

    1. Terra Tremuit

      Good point. As soon as you call them borrowers, most of the PR effort is achieved. We could call them civilians, as the military does when they kill them in foreign countries. (that’s very profitable too)

    2. liberal

      Why should someone who bought a house they couldn’t afford during the bubble have access to cheap shelter any more than the millions of renters who didn’t buy during the bubble?

      1. hermanas

        If shelter is cheap make it so.
        “Liberty and Justice for All”
        This train has gone off the rail.

  9. Bravo


    Those very renters you reference are in the catbird seat today, are they not? Clean credit, no prospective mortgage deficiencies hanging over their head, and the ability to buy at 2000 price levels at record low interest rates? Seems to me, their clairvoyance has had its rewards? Meanwhile, the proposed modifications stop the flood of housing inventory, the market begins to stabilize, and the fortuitious renters, turned homeowners at the bottom of the cycle, reap their rewards as the market tightens over time?
    Am not feeling too sorry for the renters at this juncture my friend.

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