Yes, Virginia, Servicers Lie to Investors Too: $175 Billion in Loan Losses Not Allocated to Mortgage Backed Securities (and Another $300 Billion on the Way)

The structured credit analytics/research firm R&R Consulting released a bombshell today, and it strongly suggests that prevailing prices on non-GSE (non Freddie and Fannie) residential mortgage backed securities, which are typically referred to as “private label” are considerably overvalued.

R&R Consulting described how the reports presented to RMBS investors show losses at the loan level (which is super eye-numbing detail in the investor reports) that have NOT been allocated to the bonds (boldface ours):

On the securities performing at December 2011, a universe of approximately $1.42 trillion, R&R estimate the amount of additional losses likely to materialize is $300 billion, with one-third concentrated in ten arranger names, including Countrywide, Morgan Stanley and JP Morgan. About 17,000 tranches, or 34% of the universe analyzed by R&R, may lose up to 83% of their remaining principal.

In addition, R&R estimates that approximately $175 billion of losses already incurred on the loans have not yet been allocated to the bonds in the related transactions. Failure to allocate realized loan losses could distort the valuation of related RMBS tranches.

In the course of conducting valuations on RMBS, the R&R analytics team discovered widespread, serious, repeated data discrepancies. Ann Rutledge, a founding principal, asked the team to measure the magnitude of the discrepancy on the RMBS universe. To do this, R&R subtracted cumulative losses allocated to the tranches from unallocated, expected losses, calculated as the sum of defaults, bankruptcies, foreclosures and REOs minus recoveries. “The results were very disturbing: $175 billion of unallocated current losses and $300 billion of imminent losses,” Rutledge said.

Now you might say, how can investors NOT know this is happening? Have you ever looked at an investor report on MBS? They are really really nerdy. Summary stuff up front, tons of pages of detail. Now bond fund managers are presumably paid to care about nerdy stuff like this, but I have spoken to some MBS lifers who have gone to the buy side, and they tell me that the level of expertise among MBS investors is not high.

But, but, but….some of you are protesting….surely these errors are just innocent mistakes? That’s a nice theory, but the numbers are huge, and the “mistakes” happen to line up with more profit for servicers:

The implication for bond holders in RMBS is significant with respect to both estimates. Subordinated securities in the RMBS with probable future losses ought to be written down by such losses but instead may be continuing to receive interest owed to more senior tranches. It could also mean that servicers are earning fees against loans that have already been liquidated, which also reduces the amount of cash to pay senior bond holders. For example, in one month, servicers could generate $75 million or more in inappropriate fees against the $175 billion in unallocated losses.

Translation: when the servicers don’t write down the bonds in a securitization to allow for ACTUAL and pretty certain losses, the effect is that junior tranches show artificially high balances (remember, as losses occur, the effect is to wipe out tranches from the bottom of the securitization up. The riskiest tranche fails first, then the next riskiest, and so on).

Servicers ALSO advance principal and interest to bondholders when borrowers quit paying, in theory up to the mortgage balance (we’ve seen cases where advances exceeded the mortgage balance). Then when they foreclose and liquidate the loan, the servicer reimburses himself for the advances and his fees and foreclosure costs first.

So, if they report artificially high balances in junior tranches, they are paying interest to investors who don’t deserve it. The result, when the foreclosure occurs and the real estate is sold, is that the interest overpayment to the junior bondholders reduces the monies that should have gone to the senior bondholders. Oh, and those junior bondholders are more likely to be hedgies, and those senior bondholders are more likely to be pension funds, bond fund (the sort that you might hold in your 401 (k) and insurers. The costs to the insurance industry alone means that this is not a fat cat investor issue but affects all of us (losses to insurers eventually lead to higher insurance premiums to compensate for the shortfall in investment income).

Reports like this are why I am cynical about talk of mortgage “investigations”. The evidence of servicer misconduct is rife. I’ve gotten numerous reports about various types of servicer scams, not just ones that hurt borrowers, but tons that impact investors (for instance, it is common, and it may be pervasive, that servicers delay reporting the liquidation of a loan to the investors. Why? The longer a loan appears to be in the pool, the longer they can collect servicing fees).

To my knowledge, the R&R report is the first effort to place a dollar figure on one type of mortgage-investor-related abuses. I’m not surprised it is so large. What I am surprised at is that no investor seems to have noticed this type of pilfering.

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  1. bob

    They can also hide in there the fact that a lot of the loans simply doo not exist. Clearing this up would lay this problem bare. Can’t have that.

    1. Bridget

      Sooo,Bob. Have you figured out yet who is gonna get hurt if Joe Blow, squatting in a house on which he paid little or nothing down, gets a free house because of problems (mostly curable) created by originators and servicers? That’s not a free house. It’s coming out of your ver own hide if you pay taxes, have a pension plan, a 401k, or rely on insurance to protect you in the event of disaster.

  2. Enzica

    I’m guessing there are a lot of people in this boat: Related to the article above, what are the best options for a homeowner with a first and second, let’s say both of roughly the same amount, the total of both being well over the current market value of the house, the 2nd owned by the same bank that services the first for Fannie Mae, and the homeowner does not have enough income to service them both, and has few assets to sell to raise money to pay off the house or hire a lawyer? How does one navigate to get the best outcome?

      1. Bridget

        Even if you’re in a recourse state, threaten bankruptcy, offer a deed in lieu of foreclosure in return for forgiveness of the debt and walk away with a fresh start. There’s no way the lenders can pursue all the deficiencies they are dealing with. They’ll end up selling the debt to vultures for pennies on the dollar. Might as well make a deal with you in hopes you won’t strip the place and knock holes all over the walls on your way out.

        One caveat. Debt forgiveness usually results in taxable income. Special rules were put in place at the start of the crisis to benefit defaulting homeowners. Make sure they are still in place and that you qualify.

    1. Not advise

      Stop making payments, and build up a cash reserve.

      First thing would be to stop direct deposit, if you have it. Request a paper check. This part could take a while.

      Cash those checks at a bank not associated with the mortgage. Leave only the amount you need in any kind of bank account. Hold NOTHING at the bank with the mortgage. Hide the rest as cash, not at a bank. Try not to make it too obvious what you are doing.

      This may or may not get you into more trouble, but cash seems to cure most problems these days.

      1. Smellslikechapter11

        Really bad advice this would expose u to multiple bank And bankruptcy crimes
        Can’t fix this in bk until they let u cram down a home

        1. SmellsBad

          What? Chapter 13 is excellent advice, stripping a 2nd lien is a perfect example, discovery another.

        2. Sam Durst

          “multiple bank crimes” Hahaa! That’s funny, family loses house, life savings yet the Justice Department will come get ’em for declaring bankruptcy. Even though that sounds insane, it may very well be that the same Justice Department/FBI that hasn’t gone after any mountain of white collar Bank criminality may find lower hanging fruit with the alleged “borrowers”.

      2. John Dear

        Banks don’t like consumers declaring Bankruptcy, it’s still one of the most powerful options for victims. For example, it will stop an auction in it’s tracks giving the victim more time. In a recourse state, the predator can go fuck themselves after they steal a house as far as the borrower is concerned.

      3. Charles Gall

        If more homeowners would simply fight back, Banks might be more willing to attempt to work with them By all means, after a Chapter 7 petition sue the “lender” as conditions warrant.

  3. psychohistorian

    One would think that by now that one of these 1/2 trillion (300 + 175) dollar scandal/oversight situations would effect the stability of one or more of the cards at the bottom of this house of cards and ……..major disruptions would occur.

    Is that what happens, coming in March? I keep reading about all sort of gloom and doom for March, 2012. I thought the gloom and doom was supposed to be later in the year.

    I wonder if Eric Schneiderman will be looking into these allegations as well?

    1. ambrit

      Dear psychohistorian;
      I too have moticed a trend toward apprehension of the month of March. There are some major Eurozone debt roll overs, I know. Are they big enough to cause a Panic if they fall short?

  4. 4D

    Hmm, what about if the servicers and investors are in cahoots holding out until the Fed suckers come along to bail them out! Is that feasible?

    1. Yves Smith Post author

      No. Buy side exists, in the mind of the sell side, to be picked clean by the sell side. They are not in cahoots on this one. The investors don’t benefit in any way, and to the extent they realize they are being abused (and some do), they are fearful about suing the banks. I had an attorney for investors say that if Jamie Dimon killed the children of some of his clients, they’d be afraid to call the police.

      Similarly, one of my former clients had JPM steal (and I mean steal via stuffing it with toxic dreck at inflated prices) $100 million (and they now think the losses are worse) from a money market fund set up with very conservative investment guidelines. This is one of the richest men in the world. He is still careful about not wanting to be seen as an enemy of banks since he uses them a lot for financing of his deals.

      1. ambrit

        So, are we looking at ‘willful negligence’ on the part of fund managers, or simple incompetence?

        1. ambrit

          Sorry about that. I’ve just learned that your comments can be added to as you go along. I responded to the first paragraph above before the second paragraph appeared. (The writing on the wall?)

        2. Yves Smith Post author

          Both, as in it varies by fund. Remember also that Doing Something involves hiring lawyers, and fund managers in bigger fund complexes don’t have permission to do that, and they have to fight the bureaucracy and not get any rewards. These funds (whether in small boutiques or bigger firms). have such low margins that suing is not really attractive (as in helping the end investors does not get them the brownie points that it ought to and takes time and energy away from managing money and nicing up clients).

      2. skippy

        остаток в чью-л. пользу

        Which is it… kindness, office, service or grace.

        Skippy… oh how it would be to know.

      3. 4D

        Sorry Yves, bit late back to this but I’m not sure you understood what I was implying.

        I am not aufait with the full detail of the Fed’s MBS purchases, but is there not some incentive for investors to take the abuse and pretend all is ok in the hope/belief the Fed will bail them out of these losses by purchasing the MBS at elevated prices?

        I guess it would hinge on the transparency and nature of the Fed MBS programme, but just as they have bailed out the banks in the past three years, perhaps the Fed is happy to do the same for pension funds?

  5. ambrit

    It is entirely concievable that the personalities running the pension funds, 401k funds, etc are ‘cut from the same cloth’ as those initiating the fraud. 4D’s comment above is quite reasonable. This ‘universe’ of control fraud could well be an artifact of the ‘culture’ inculcated into the present generation of managers and traders in ‘elite’ business schools. Take a Calvanist world view, mix in some Hedonism, and some Short Termerism, shake well, and pop in the oven. Voila! The cake you advised them to eat in the first place!
    This is going to end badly.

    1. James Cole

      You could say that NFL players are all “cut from the same cloth” but that doesn’t mean my team doesn’t want to win. Similarly, funds have no reason to be complicit in their own looting.

  6. keepon

    Now: will the New Presidential Task Force “discover” what you’ve uncovered here? Have they already and that’s why there’s been no investigation: ’cause they know precisely what s_ _ t hole this all winds up in?

    What ‘bill o’ goods will these investigators try to sell us this time? More like Obama’s SOTU speech: the People are to blame for ‘taking out loans they knew they couldn’t afford?’ What a pisser!!

    Why would Obama need another mega-bucks sooper investigation task force (lol) when he has ‘Yves & Company?’

    God bless you all from the People!!! Keep on ‘shovin’ it higher’ for the People Yves!!!

    1. Foreclosureblues

      Couple of Points…

      You can bet that “investors” are not holding the lower tranches benefiting from the servicer misallocation, just take a guess who

      you might be able to figure out which trading desks either bought or sold any outstanding tranches that could suddenly have ‘value’ when they previously did not…lol

      and servicer advances are financed in large part by either FNMA or a bailed out bank, well, actually, YOU…so

      this is basically a stealth conduit of funds…it’s a beauty

  7. Richard

    There is no area of finance that is fighting disclosure harder than structured finance.

    One of the ways they promote opacity is by making servicer reports as user unfriendly as possible. Of course, this helps Wall Street’s bottom line.

    In one of the great ironies of the financial crisis, even the Paulson Treasury recognized the need to create a central database with all of the supporting loan-level performance data. This would make it easy to value the securities.

    Naturally, Wall Street objected and to date the database that needs to be created still does not exist.

    1. Foreclosureblues

      of course servicers are making advances, BUT ONLY with someone else’s money and ONLY when they WANT to (or have lined up all the Tranches that were already zeroed out or bought for pennies first)

      then they will turn around and sell them!! lol and then suddenly find another uh allocation (misallocation)

      and start over again…traders need trades

  8. Eric

    The real bombshell in this report is the admission that servicers continue to make the payments to the owners of the debt. This is an admission that the Notes are not in fact in default. If the Notes are not in default there can be no foreclosure. Every foreclosure stating a default and an amount in default is fraudulent and the foreclosure judgments are void for lack of standing since there is no default.

    It’s a very very important admission that must not be overlooked in defending a foreclosure suit.

    1. Walter Wit Man

      That’s interesting. I haven’t heard this before. Is there a citation or has this argument been successful before?

      Would you use this report to demand they show a default on the Note?

    2. Yves Smith Post author

      No, that is not at all correct. It’s in the PSA that the servicer advances interest and principal on delinquent and defaulted loans up to the mortgage balance.

      1. Foreclosureblues

        sosa says…”yep, it’s in the PSA, that’s why we do it.”

        just like we complied with the rest of the PSA requirements.


  9. Vijay

    Really dumb question, can someone explain the math? Seems like losses are just differed. Ignoring time value of money, why does that effect payout? Is this RMBS trust indenture specific?

    1. Foreclosureblues

      they dont care about “trust indentures”

      that is for use only against investors lol


      “payout” is determined by who and where its going.

  10. Up the Ante

    The entitled in the Banana Republic are protecting their livelihood.

    “.. the “mistakes” happen to line up with more profit for servicers: “

  11. LeonovaBalletRusse

    YVES, Bernanke ought to shift everything TOXIC to TBTF banks, free up good money for We the People, and become a hero thereby.

  12. steelhead23

    Yves, thank you for dogging this story. I am not a MBS investor, but if I were, and was investing in senior tranches and the servicer was undermining the principal of MY investment by gaming fees and paying undeserved equity tranchers, I would be hopping mad. Doesn’t a PSA mean something? Frankly, I consider this to be theft. Doesn’t the SEC have some oversight authority over MBS servicers? Seriously, this seems criminal, not just a civil matter. And the fact that many of the MBS’s at one time had AAA ratings, were fed to pension funds as as good as treasuries, makes me want to punch somebody in the mouth. Damn.

  13. Donnie Duvania

    God, this sounds a lot like check-kiting. I see that I could’ve been successful as an investment banker.

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