Add another word to English as spoken on Wall Street: robo signer.
These are the folks at banks and mortgage servicing 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 had actually owned the mortgage in question and had the legal right to foreclosure.
But the robo signers signed away putting their signatures on a line that said they had reviewed the documents for accuracy.
The result is a virtual national moratorium on mortgage foreclosures and an investigation by every single 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 to $6 billion to $10 billion and stretch out for at least four or five years.
Ah, if only that was the biggest bill hanging over the U.S. banking industry. But it’s not. Potentially. There’s this little problem called “put-backs.” That could be much bigger. No one knows how much bigger or who owns how much of it. And that’s a huge issue for investors since we all know how much Wall Street likes uncertainty.
How much bigger? Well, we know that, as of the end of the third quarter, JPMorgan Chase (JPM) has put $3 billion aside against potential losses from “put-backs.” (In the third quarter the bank had to buy back $1.5 billion in loans from investors.) And that’s just one bank.
Okay, 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 your wishes?
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 finally the officer who signs the paper are supposed to check to make sure that the home owner 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 ever doing this critical due diligence. In some cases they signed a set of 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 never lend out money themselves.)
At the least, banks and mortgage servicers will have to go back, recheck their foreclosure paperwork, resubmit the legal work for the foreclosures where they have the correct legal work, and then try to figure out what to do with the mortgages where 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 to five years and maybe, in his estimation, 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.
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 2010 earnings on 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 the bill, innocuously called the Interstate Recognition of Notarizations Act, that the industry and its allies on both sides of the aisle tried to push 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 on October 7. I expect to see a revised version after the November elections.)
Put backs involve due diligence at the other end of the mortgage process. Not at the very beginning, mind you, when a bank decides to grant or turn down a mortgage from a home buyer. The problem comes up slightly after that, when the bank decides that it wants to bundle those mortgages into a mortgage-backed security and sell them to investors. That way the bank can collect a fee for originating the mortgage and maybe keep a piece of the cash flow too, and yet recover most of its capital (from the sale of the mortgage-backed security) so that it can lend it out again in new mortgages.
In the creation and sale of those mortgage-backed securities the bank that originated the mortgages made certain representations to the buyers of these mortgage-backed securities about the quality of those mortgages. And specifically they’d made representations that they had done their due diligence on those mortgages. Credit ratings companies backed up those representations by giving these mortgage-backed securities A or AA or even AAA credit ratings.
These mortgage-backed assets turned out to be at the heart of the financial crisis that started in U.S real estate, spread to Wall Street, and finally engulfed a good chunk of the developed world. And 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 their “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 then approved them before bundling them into those mortgage-backed securities?
Is there another tranche 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.
Just take one year, 2006, near the height of the mortgage origination boom. In that one year the industry cranked out $255 billion in option ARMS mortgages. You remember option ARMS. These were adjustable rate mortgages with exotic wrinkles such as Pick A Pay designed to get more buyers to qualify for mortgages. Pick A Pay gave the borrower options each month on their payments. They could pick a minimum rate for 12 to 60 month—sometimes as low as 1%. They could even fix that low rate for 5 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 quickly 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 be something wrong with the due diligence on just a few of these mortgages?
And if there is that would offer big buyers of mortgage-backed securities such as Fannie Mae and Freddie Mac and every pension fund from Albany to Harrisburg 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 (BAC) has 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 billions 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.) On October 15, Goldman Sachs came out with an estimate of $44 billion for the banking sector. The Federal Home Loan Banks of Pittsburgh, Seattle, and San Francisco have sued for a combined $26 billion, according to Compass Point.
We do know that big banks such as JPMorgan Chase, Bank of America, and Wells Fargo (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 on October 13. (For more on that report and banking in general see my post http://jubakpicks.com/2010/10/15/jpmorgan-chase-earning-show-u-s-banks-have-a-growth-problem/ ) I’ll be looking to see if Bank of America and Wells Fargo are similarly reassuring when they report on 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 a potential problem. H&R Block (HRB), for example, originated mortgages until 2008. HSBC (HBC), to take another example, has exited the U.S. mortgage business it bought when it acquired HFC But that doesn’t mean the company 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 discovery 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 a member of my Jubak’s Picks portfolio http://jubakpicks.com/the-jubak-picks/ )
Second, watch out for smaller banks that did significant mortgage originations but that don’t have the capital strength of the big boys. Here I’d keep my eye on regional banks such as SunTrust (STI), Keycorp (KEY) and Regions Financial (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 http://jubakpicks.com/2010/09/08/a-banking-recovery-for-big-banks-only/ )
Full disclosure: I don’t own shares of any company mentioned in this post in my personal portfolio. JPMorgan Chase and HSBC are both members of my Jubak’s Picks portfolio.