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.