Thursday, August 22, 2013

A Proliferating "Putback" Problemo

Several media outlets have focused of late on the ongoing litigation costs being incurred by JPMorgan (and suffered by its shareholders) pertaining to crisis-era loans and structured products, and post-crisis concerns, like investigations into the "London Whale" trade and allegations into potential manipulations of LIBOR and the energy market manipulations.  (See for example the FT's "JPMorgan pledges to clean up legal woes.")

We're closing in on 5 years since Lehman filed for bankruptcy protection but, of course, the problematic mortgage loans originated between 2005 and 2008 haven't completely left the system.  In some ways the problems they're causing the banks are increasing.  We'll explore the headaches one particular aspect – mortgage repurchases – could be causing at Deutsche Bank, and how a couple of recent court rulings could exacerbate the pain.

The WSJ recently reported "Deutsche Bank Net Profit Halves on Charge for Potential Legal Costs." After absorbing the charge, the Journal reports, Deutsche Bank had litigation reserves of EUR 3.0 billion; as of June-end, DB had cordoned off $534 million in provisions against outstanding mortgage repurchase demands - or "putbacks."

We went back and took a look at DB's reserves historical against put-backs.  Since year-end, they have increased their reserves roughly 20%, from EUR 341 mm to $534 mm (applying a 1.3x exchange rate from EUR to USD at both year-end '12 and mid-year '13).  These are provisions against outstanding demands that grew roughly 28% from $4.6 bn as of YE to $5.9 bn as of June-end.

Will repurchase demands continue to grow, requiring the posting of additional reserves?

First, let's discuss mortgage put-backs.

Mortgage Put-backs

According to Deutsche, from 2005 through 2008, as part of its U.S. residential mortgage loan business, it sold "approximately U.S. $ 84 billion of private label securities and U.S. $ 71 billion of loans through whole loan sales, including to U.S. government-sponsored entities such as the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association."

To keep this simple, Deutsche essentially sells or transfers or conveys residential mortgages into securitization vehicles, or trusts: it "puts" them into the trust.  Thousands of loans can be transferred or deposited into a single trust. If any of the loans is later found to be, let's say, problematic, or in violation of agreed-upon representations made, a trust's trustee would ideally be able to put 'em back to Deutsche at cost: the "put-back". (Keep in mind that DB may not have made representations on all of the loans transferred into trust vehicles for which DB acted as the securitization sponsor.)

In DB's words now, "Deutsche Bank has been presented with demands to repurchase loans or indemnify purchasers, other investors or financial insurers with respect to losses allegedly caused by material breaches of representations and warranties. Deutsche Bank’s general practice is to process valid repurchase demands that are presented in compliance with contractual rights. Where Deutsche Bank believes no such valid basis for repurchase demands exists, Deutsche Bank rejects them." (emphasis added)

Importantly, two parties don't always agree with the validity of a repurchase request.  The question becomes, then, whether DB's disclosed $5.9 billion of repurchase demands outstanding constitute those that are "agreeable" to Deutsche, or whether DB might reject some of them?  And if they are all agreeable, how large is DB's exposure to other repurchase demands that it has previously rejected, but that may become contentious or the subject of litigation.

We can't be sure, but we do know that DB's disclosure changed in this regard between Sept-end 2012 and YE 2012.

From: "As of September 30, 2012, Deutsche Bank has approximately U.S. $ 3.3 billion of outstanding mortgage repurchase demands (based on original principal balance of the loans and excluding demands rejected by Deutsche Bank)." (emphasis added)

To: "As of December 31, 2012, Deutsche Bank has approximately U.S. $ 4.6 billion of outstanding mortgage repurchase demands (based on original principal balance of the loans)."

Since then the description hasn't changed. In their YE earnings call transcript, they mention there having been an increase from $3.3bn to $4.6bn, "attributable to demands made by RMBS investors." This seems to suggest that the change in description is incidental to, rather than the cause of, the increase.

They also intimate on the call that the improving market conditions – probably home prices – understandably translate into lower losses on the repurchased loans.  Could this be one reason why the repurchase demands are growing or outpacing settlements – or that Deutsche is postponing, slowing, or opting against the repurchase or settlement of these loans, as indicated by the slow growth in the third row of the table?

Mortgage Put-back Litigation 

As mentioned above, parties don't always agree as to the viability of a put-back claim.  Deutsche Bank unit DB Structured Products is on the receiving end of a number of lawsuits in which indenture trustees, on behalf of the mortgage-backed securities trusts themselves, claim that DBSP has failed to repurchase some or all of the violating loans presented to them.

Last week, District Judge Harold Baer added to a recent string of decisions in favor of securitization trusts’ ability to “put-back” non-complying mortgage loans to the conveyor – in that instance UBS Real Estate Securities Inc. (“UBS”).  Like many related complaints, the argument was that UBS had breached its contractual obligation under the relevant Pooling and Servicing Agreements (“PSAs”) to repurchase certain mortgage loans that did not conform to its representations and warranties.

In denying UBS’ motion to dismiss the case, Judge Baer explicitly disagreed with an earlier decision, more favorable to the defendants, made by US District Judge John Tunheim in MASTR Asset Backed Sec. Trust 2006-HE3 ex rel. U.S. Bank Nat. Ass'n v. WMC Mortgage Corp. – taking rather the stance consistent with a 2002 First Circuit decision and referencing other recent decisions more favorable to trust investors, including that of Judge Rakoff in Assured Guar. Mun. Corp. v. Flagstar Bank, FSB, No. 11 Civ. 2375.

One such matter of Deutsche's, before Justice Kornreich of the Supreme Court of the State of New York, concerns a trust that originally contained 8,815 home loans, according to the complaint.  The trustee-plaintiff put forward in the complaint that "[in] total, 1,642 repurchase demands have been submitted to DBSP thus far," and contended that "[the] Trust has suffered over $330 million of losses on non-performing Mortgage Loans to date, and will continue to suffer damages as a result of DBSP’s failure and refusal to comply with its express contractual obligations."

According to the complaint, a significant portion of mortgage loans tested has failed to comply with the representations made:
"A loan-level investigation performed by an independent forensic mortgage loan review firm (the “Forensic Review Firm”) has, thus far, revealed breaches of the Representations and Warranties with respect to 696 Mortgage Loans in the Trust out of the 697 Mortgage Loan files that were analyzed. Furthermore, an analysis of publicly-available data regarding the Mortgage Loans in the Trust uncovered breaches of the Representations and Warranties with respect to 946 Mortgage Loans."
In mid-May 2013, Justice Kornreich decided to let the case continue, denying defendant DBSP's motion to dismiss the complaint.  ACE Securities Corp. v. DB Structured Products, 650980/2012, NYLJ 1202604071610, at *1 (Sup., NY, Decided May 13, 2013).

Our investigation came up with 17 such unique, current, put-back lawsuits filed against DB Structured Products since March of last year (and there may well be others) by trusts holding an aggregate of roughly $15bn in loans at origination. (In some of the cases, parties other than the trustee have sued DB Structured Products, purportedly on behalf of the trust or trustee.)

The trusts have since declined in size, but it is worth noting that even some loans backed by homes which have foreclosed upon, may still be put-back to the transferor: in this case DB Structured Products. Justice Kornreich maintained that DBSP ought still be responsible for repurchasing such non-complying loans, finding the defendant's argument to be, in her words, "unconvincing." 
"If DBSP were correct, it would be perversely incentivized to fill the Trust with junk mortgages that would expeditiously default so that they could be Released, Charged Off, or Liquidated before a repurchase claim is made. Indeed, if DBSP learned that loans were non-conforming and played a crafty game of accounting by moving them off the Trust's books to their own to evade their repurchase obligations, such actions would be a breach of the duty of good faith and fair dealing. Consequently, it is to no avail to contend that the nonconforming loans are long gone and the Trustee's repurchase rights have been extinguished by DBSP's actions."

Thursday, August 15, 2013

Richmond's Million Dollar Eminent Domain Homes

Three of the mortgages Richmond, California is threatening to acquire through eminent domain have balances in excess of $880,000 - suggesting that the underlying properties were worth over $1 million at the peak of the housing boom. Public records show that two of the three properties did, in fact, change hands at prices in excess of $1 million several years ago. (On the 624 loans up for acquisition, the median and average outstanding balances are roughly $380,000.)

The three homes are all in the tony Point Richmond neighborhood. The accompanying picture, taken from Google maps, shows the house carrying the third largest mortgage in the eminent domain pool. The other two homes were apparently too far back from the road for Google’s van to photograph.

The biggest mortgage, with a balance of slightly over $1.1 million, is on a property that sold for $1.4 million in 2001 - well before the housing boom crested in 2006. The property currently has an assessed value of about $750,000 and Richmond is proposing to buy the mortgage for $680,000. The three bedroom waterfront home is 2500 square feet and sits on a 17,000 square foot lot - quite large by San Francisco Bay Area standards.

While this particular homeowner appears to be underwater, appraisals for such unique homes are prone to both error and volatility given the lack of recent comparables. Thus, the city’s “offer” to mortgage backed security holders may be significantly less than the homeowner could receive on the open market.

More importantly, the fact that such expensive homes are included in Richmond’s eminent domain initiative raises the question of what public interest is being served. Point Richmond is not a blighted neighborhood and any foreclosed home would likely sell very quickly. Further, anyone in a million dollar home is probably not poor - at least not by any conventional definition of the word poor.

Proponents of the use of eminent domain to resolve underwater mortgages see this as a way for the little guy to “take it” to Wall Street. While it is true that Wall Street made substantial profits packaging up pools of dodgy mortgages, Richmond’s action does not address that injustice. Those profits have already been taken: what remains are mortgage borrowers and MBS investors, many of whom are public employee pension funds.

So the question really is: Should the city of Richmond use eminent domain to transfer wealth from public employees (and the taxpayers that fund their pensions) to affluent homeowners who took on more mortgage debt than they should have?

For an update on this, visit the Wall Street Journal's coverage or the San Francisco Chronicle's coverage.

Tuesday, August 6, 2013

Are Moody's and S&P Growing Apart?

Leading up to the November 2012 announcement that McGraw Hill would sell its education division – and become more of a rating agency/financial institution like Moody's Corp. – the two companies' stocks moved in tandem, with a correlation of over 90%. Since then, the correlation has gone way down, into the 70-80% region.