Big Banks May Be Forced to Buy Back Bad Mortgage Loans

by: Money Morning

by Don Miller

Major U.S. banks are under pressure from government officials, as well as groups of investors and insurers, to repurchase or modify bad mortgage loans they pooled into securities and sold to unwitting buyers.

In the latest effort, a group of investors with roughly $500 billion invested in 2,300 mortgage securities is trying to force the large banks that originated or are now servicing faulty subprime-mortgage loans to repurchase or modify them, The Wall Street Journal reported.

Some investors "had no idea that their money was being invested in mortgage-backed securities," Dallas-based attorney Talcott Franklin told The Journal. "And yet somehow these people are now the ones being punished, and that's just not right."

Many bond and mortgage insurers accuse lenders and banks of sticking them with bad loans flawed by poor underwriting and faulty appraisals.

Federal Home Loan Banks in Pittsburgh, Seattle and San Francisco have sued several banks, in an effort to force them into buying back mortgage-backed bonds. In July, the Federal Housing Finance Agency issued 64 subpoenas to obtain information about loans backing securities sold to mortgage giants Fannie Mae (NYSE: OTCQB:FNMA) and Freddie Mac (NYSE: OTCQB:FMCC).

Edward DeMarco, the acting director for the Federal Housing Finance Agency last week said big banks have an obligation to pay some of the cost for bailing out the government-backed mortgage buyers because they sold the bad mortgages.

The banks have refused to take back $11 billion in bad loans, Demarco said in written testimony submitted for a House subcommittee hearing. The government may take new steps to force those buybacks if "discussions do not yield reasonable outcomes soon."

Wall Street is worried that big banks could be forced to cover the costs of bailing out Fannie and Freddie. Fitch Ratings Inc. said last month that the four largest U.S. banks - JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Wells Fargo & Co. (NYSE: WFC) - could be on the hook for $42 billion in troubled mortgages they made to Fannie and Freddie.

Fannie and Freddie have a legal right to return bad loans if they later discover fraudulent statements on applications. Any money they recover offsets their losses.

The two mortgage giants nearly collapsed two years ago when the housing market went bust. The government program to rescue them has cost taxpayers about $148 billion. The bailout is the most expensive piece of the effort to stabilize the financial system.

Lenders say Fannie and Freddie are trying to return too many loans and are pushing back loans where it's not clear fraud was committed.

"The industry believes that the pendulum has swung far beyond what is reasonable," mortgage industry consultant Brian Chappelle told the Associated Press, noting that many of theloans met the mortgage buyers' guidelines at the time.

In another case, bond insurer MBIA Inc. (NYSE: MBI) in December sued Credit Suisse Group AG (NYSE ADR: CS) over a $900 million loan pool, a large portion of which MBIA agreed to cover. MBIA said it had relied on Credit Suisse to vet the quality of the loans.

In January, Ambac Assurance Corp., the bond-insurance unit of Ambac Financial Group Inc. (NYSE: ABK), sued a Credit Suisse unit in New York state court, alleging that it made "false and misleading" representations about home-equity lines of credit backing bonds that the insurer guaranteed in 2007.

A Credit Suisse spokesman said the claims are without merit and the bank will defend itself.

How the battle will end up is unclear and will no doubt hinge on contentious negotiations and litigation that could last for years.

The legal actions focus on the contractual duties of lenders known as "representations and warranties," which require them to repurchase faulty loans or modify them so borrowers can keep paying monthly mortgages. Those payments maintain the value for mortgage securities tied to the loans.

If a borrower lied when getting a loan, a bank trustee is responsible for forcing the originating bank to repurchase the loan on behalf of mortgage investors. Trustees enforce warranties made by banks when they sell loans and oversee loan-servicing firms that decide whether to modify the terms of a loan.

As part of the legal process, banks may be forced to disclose confidential information about the loans, including faulty appraisals or lack of documentation.
That data could be used to force banks to repurchase as much as $133 billion in bad home loans, according to Compass Point Research & Trading Inc., a Washington, D.C., boutique investment bank.

Disclosure: None

Disclaimer: Money Morning and Stansberry & Associates Investment Research are separate companies, and entirely distinct. Their only common thread is a shared parent company, Agora Inc. Agora Inc. was named in the suit by the SEC and was exonerated by the court, and thus dropped from the case. Stansberry & Associates was found civilly liable for a matter that dealt with one writer’s report on a company. The action was not a criminal matter. The case is still on appeal, and no final decision has been made.

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