Many commentators, and not a few big banks, believe that once a mortgage has been sold into securitization, the originator and sponsor are off the hook, and do not have to answer for the quality of the product.
Nothing could be further from the truth. When banks sold mortgages, they almost always made warranties and representations as to the quality thereof, obligating themselves to repurchase those that did not meet specific standards. And when issuing MBS or CDOs, banks must conform to legal standards which make them responsible to buyers for fraud and misrepresentation.
Banks have uniformly resisted accepting responsibility for their actions in creating the toxic assets that debilitated the financial system and brought the economy to the brink of a Depression. The result has been first a steady drumbeat of litigation and now the beginnings of regulatory action. Finally, reality is beginning to sink in, and a few of the larger banks are starting to grudgingly talk about the issues, put up litigation reserves, and book liabilities for repurchase obligations.
Bank of America (NYSE:BAC) has changed its tune. When questioned about warranties and representations during the 1Q 10 earnings conference call, then CFO Joe Price offered the following pearls of wisdom:
Few and far between. If you think about the hierarchy of reps and warranties, think of them as quite frankly, they are probably the clearest in GSEs, monolines and in private sales the reps and warranties generally by this time are somewhat unenforceable, not from a data standpoint but just from a lack of time and they have run out. I wouldn’t put that one on your radar screen.
His successor, Chuck Noski, had this to say during the 2Q 10 call:
... we increased our reps and warranties expense by $722 million to $1.2 billion as a result of our continued evaluation of exposure to repurchases including our exposure to repurchase demands from certain monoline insurers.
Possibly he is referring to MBIA (NYSE:MBI). CEO Jay Brown has been outspoken in his determination to enforce all contractual and legal rights against those who harmed shareholder interests by fraud and dishonesty. He even went so far as to accuse the banks of stonewalling and recalcitrance. Under further questioning, Noski discussed some communication issues:
...there is a real variability in the degree of dialog between us and the various monolines. In some cases, we’re in a very constructive discussion where we have an ability to understand our exposure and measure it and accrue for it. In other cases, there is litigation involved and a lack of communication because of the condition and the circumstances of those monolines. So, what we’ve tried to do, as we would each quarter, is make our best judgment and our best estimate around that exposure.
Last quarter, we told you that as it related to monolines, we didn’t have enough information to make an accrual. We have more information this quarter to make an accrual. It will depend upon the dialog with the monolines or the lack of dialogue and the kind of work we do to see if we change our estimates.
The point is, over the quarter the attitude changed from one of cavalier dismissal to a desire to have constructive dialog. Warranties and liabilities made the radar screen. There were reserves posted – and there will be payment made. Bear in mind, BAC bought Merrill Lynch and Countrywide, neither of which earned high marks for ethical conduct.
FHFA as Conservator for the GSEs – From Joe Price's comment, it appeared that the banks were treating the demands of Freddie Mac (FRE) and Fannie Mae (FNM) with more respect. They were, at least for mortgages that were sold directly to the GSEs, for the simple fact that otherwise they would be shut off and would not have a pipeline to dispose of future production.
However, with regard to PLS (private label securities, non-agency MBS) that the GSEs bought and held as assets, the banks were less cooperative. Apparently they continued the stonewalling and intransigence, thwarting efforts at remediation.
In any event, FHFA issued 64 subpoenas, hitting all the broker-dealers, in an effort to develop information, including access to mortgage files, that is needed in order to determine their rights to put back mortgages from within PLS. The monolines don't have the privilege of issuing subpoenas, and are forced to sue first and await discovery.
It appears BAC and others were not able to open constructive dialogs with the GSEs either.
JP Morgan (NYSE:JPM) bought Bear Stearns and WaMu, picking up liabilities for what it calls “heritage” companies. CEO Jamie Dimon has an artful way of answering questions: he is in no way evasive, yet he does not overload anybody with facts and figures.
By way of background, JPM's 1st quarter 10-Q provided a dollar amount for litigation reserves – 2.3 billion, not chump change. With that figure in mind, please consider the following from the 2nd quarter earnings conference call:
Chris Kotowski – Oppenheimer & Co.
Yes. Standing back and looking big picture, I guess, given the revenue environment, the total revenues came in right about where we were looking for, but expenses were about – if you back out the U.K. bonus tax and back out the $2.3 billion charge last quarter, I mean it was – the expenses were – was off a bit and if I look at it, again sort of linked-quarter revenues are down 9%, but excluding the two special items, linked-quarter expenses are up about 2%. So I'm curious, do you have a – is there a reason for that? Is that investing in future growth? Is that the drag of higher credit costs currently or –?
Paul, I think Mike mentioned this. It was higher litigation costs this quarter. We are in a litigious society and a litigious time. So that was – that will be one number. I think expenses are generally in some of the businesses as we are adding some people and adding branches and things like that. And then – but of course we continue to run higher costs in default and higher costs in foreclosed assets. I don't know the year-over-year on that, managing foreclosed assets. So it's a variety of factors.
Yes Jamie we are indeed in a litigious society and a litigious time. The reason is, we have a dishonest and a deceitful band of banksters defrauding society, and people want to do the right thing, so they sue. At least we're talking about it, communication and dialog.
SEC as Cop on the Beat – The SEC, mirabile dictu, arose from its slumber and smote Goldman Sachs (NYSE:GS) with 550 million in fines and disgorgement over missing information in the Abacus transaction. The case was intricate and curious, featuring minimal malfeasance by the fabulous Fabrice, as well as a cameo role for John Paulson, famed for the Big Short. There has been quite a bit of debate as to whether Goldman won or lost on the settlement. Many Wall Street denizens do not believe Goldman did anything wrong. I see a blow struck against Financialism, and look for more to come.
One thing is clear – the bar has been raised for strict, complete and literal disclosures when issuing securities, whether ordinary MBS or more complicated confections such as CDOs of synthetic ABS, stuffed with adverse selected CDS. That can only strengthen the hand of those who seek legal redress for fraud and misrepresentation around the issuance and sale of MBS and CDOs.
Certain Monolines - Assured Guaranty (NYSE:AGO) when last I checked, was taking a thorough and methodical approach to warranties and representations, negotiating patiently with banks that seem to see endless shades of very pale gray where others see black and white. MBIA has been very active in asserting its legal rights and suing to enforce them. Ambac (ABK) received the assistance of its regulator, negotiating settlements while under conservation, and with its Structured Finance liabilities walled off from its municipal bond liabilities.
Bruce Berkowitz – Not to change the subject, but the famed value investor's Fairholme Fund has taken up a position totaling 11% of MBIA's outstanding shares. It should be noted that Berkowitz was an original investor in the Fireman's Fund ipo in 1985 when Jay Brown was CFO and earned huge profits for his investors. As such, he respects Brown's abilities and that will be a factor in his investment thinking.
Berkowitz has a tendency to make concentrated investments in companies where he sees exceptional management and a cheap share price, especially if a catalyst is likely within a reasonable time frame.
Investment Implications – Those who are long investment banks will want to inquire carefully as to the accounting treatment of liabilities arising from warranties and representations, as well as potential fraud in creating securitizations. The SEC is on the warpath, and may count coup on others besides Goldman Sachs. FHFA is issuing subpoenas, and will undoubtedly recover any amounts available to reduce taxpayer losses in an election year.
BAC has a lot of goodwill to write off. Disregarding that and looking at tangible book value, the stock doesn't look that underpriced, particularly when there are liabilities that may not have been fully booked. JPM has been quietly booking litigation reserves and netting put-backs as they occur: however, as of the 1Q 10-K they were unable to estimate future warranties and representations and had not booked anything. Dimon strikes me as a pragmatic type who does well under difficult conditions and I don't think JPM will experience major difficulties as this plays out.
MBIA stands to benefit from these developments. NonGAAP adjusted book value stood at 36.05 as of the end of the 1st quarter, and with shares trading in the 7 area recently, there is ample room for appreciation if the legal issues continue to develop favorably.
Disclosure: Author is long MBI, no position in other companies mentioned