Formerly beleaguered bond insurer MBIA (MBI) reported earnings Nov. 9 after the close, a generally accepted accounting principle (GAAP) loss of $1.06. Non-GAAP adjusted book value (ABV) increased slightly, to $36.11. Market reaction was muted, with the stock trading in the $11.50 area, somewhat below its 52-week high of $13.17.
Over the past several months the mortgage putback issue has finally attracted the attention it deserves. There is a growing consensus that banks will be forced to repurchase meaningful amounts of ineligible mortgages under contractual obligations imposed by representations and warranties. MBIA, as a beneficiary of this development, has rallied strongly. This article focuses on issues surrounding the enforcement of putback rights.
Putbacks and Contractual Interpretation
Because the company has booked substantial amounts for expected putback recoveries, and anticipates booking and receiving additional recoveries, this area is critical to assessing MBIA's future value. It is important to note that the representations and warranties made in connection with private label, non-government sponsored entity (GSE) securitizations do not have standard wordings and are in some respects more lenient than the GSE requirements. Briefly, some of the banks have taken the approach that there is enough wiggle room in the weasel words to get them off the hook.
From Bank of America's (BAC) 3Q 2010 10-Q:
Subject to the requirements and limitations of the applicable agreements, these representations and warranties can be enforced by the trustee or the investor as governed by the agreements or, in certain first-lien and home equity securitizations where monolines have insured all or some of the related bonds issued, by the insurer at any time over the life of the loan. Importantly, the contractual liability to repurchase arises if there is a breach of the representations and warranties that materially and adversely affects the interest of all investors in the case of non-GSE loans, or if there is a breach of other standards established by the terms of the related sale agreement. The Corporation believes that the longer a loan performs prior to default the less likely it is that an alleged underwriting breach of representations and warranties had a material impact on the loan’s performance. Historically, most demands for repurchase have occurred within the first few years after origination, generally after a loan has defaulted. However, in recent periods the time horizon has lengthened due to increased repurchase request activity across all vintages.
BAC is hanging their hat on materiality, and taking the position that materiality declines rapidly as time to default increases.
From JP Morgan's (JPM) 3Q 2010 10-Q:
From 2005 to 2008, the Firm and certain acquired entities sold or deposited approximately $450 billion of residential mortgage loans to securitization trusts in private-label securitizations they sponsored and, in connection therewith, made certain representations and warranties related to these loans. While the terms of the transactions vary, they generally differ from loan sales to GSEs in that, among other things: (i) in order to direct the trustee to investigate loan files, the security holders must make a formal request for the trustee to do so, and typically, this requires agreement of the holders of a specified percentage of the outstanding securities; (ii) generally, the mortgage loans are not required to meet all GSE eligibility criteria; and (iii) in many cases, the party demanding repurchase is required to demonstrate that a loan-level breach of a representation or warranty has materially and adversely affected the value of the loan.
Again, JPM finds that the materiality issue is important enough to require mention in their financials. The meaning of the word "material" is material to the financial results of the big banks, and even more material to the financial results of MBIA.
It's worth noting that JPM refers to the fact that a specific percentage of of security holders must unite in order to compel the investigation of loan files. That same issue is of concern to BAC, as noted from the same 10-Q call:
Recently, Countrywide Home Loans Servicing LP (which changed its name to BAC Home Loans Servicing, LP), which is a wholly-owned subsidiary of the Corporation, received a letter, as master servicer under certain pooling and servicing agreements, for 115 private-label RMBS transactions, from eight investors purportedly owning interests in RMBS issued in the transactions. The RMBS issued in the transactions have an original and current principal balance of approximately $104 billion and $46 billion, respectively. The letter asserts breaches of certain servicing obligations, including an alleged failure to provide notice to the trustee and the other parties to the pooling and servicing agreements of breaches of representations and warranties with respect to mortgage loans included in the transactions, and states that a failure to remedy the alleged servicing breaches will constitute an event of default if not remedied within 60 days of the date of the letter. The master servicer intends to challenge these assertions and fully enforce its rights under the pooling and servicing agreements. We believe these purported investors may, in the future, attempt to obtain loan files and submit claims for breaches of representations and warranties on private-label RMBS issued in those transactions. Successful efforts by these and other private-label RMBS investors asserting similar claims could result in significant repurchase obligation.
BAC is concerned that purported investors will obtain access to loan files and submit claims. Clearly, the big banks don't want anyone looking at the files. To the extent these files exist, and contain the proper paperwork, they will increase the risk of claims from purported and/or disgruntled investors, particularly when subjected to a forensic review. While BAC is to be commended for their determination to enforce their rights, I would suggest they develop a similar and reciprocal determination to perform their obligations and duties.
MBIA CEO Jay Brown, from the transcript of the 3Q 2010 earnings conference call:
I would say from our perspective nothing has really changed in the put back area. We believe our contractual rights are the same; nothing significant has been decided in the quarter. But we are 90 days closer to the trial. We have two significant trials scheduled for next year. The trials really are over the interpretation of the contracts and a disagreement between ourselves and the originators about the process of reps and warranties
It's about the interpretation of the contracts, and the key is materiality. It's also about the process, which logically can't start until the files have been made available for review.
BAC's views on the process of reps and warranties are curious. When presenting at the BancAnalysts of Boston Conference, among their accomplishments in responding to putback demands we find the following: Rescinded $1.9B claims.
It's a strange use of the word. The typical usage is, insurance companies have the right to rescind coverage, typically where fraud is involved. BAC, it seems, regards its warranties and representations as insurance policies. If you present a claim, it's fraudulent, and the bank rescinds their warranty? That's their process. See you in court.
What is the meaning of the word "material?"
Former President Bill Clinton was a lawyer, and inspired wonder and awe among his listeners by saying "That depends on what the meaning of the word 'is' is". For the purposes of this essay, the concern about the concept of materiality is more pragmatic than linguistic. What does the word "material" mean in practice: specifically, what does it mean when enforcing putbacks under warranties and representations?
When is a breach of warranty or a misrepresentation material? Materiality can lead into debates about proximate cause.
One line of thinking holds that if a loan breached warranties and representations when it was included in the portfolio, that any subsequent loss was caused by the breach. The point is, if the loan had not been included in the portfolio, there would have been no loss.
If a portfolio has minimal losses, but is known to contain numerous loans that breach warranties and representations, the value of that portfolio is seriously diminished, since it is illiquid and trades for less than if would if the collateral were pristine. Consequently, the breaches have caused a material loss.
An alternate line of thinking, fueled by the concept of proximate cause, would see the housing bust as an intervening cause. As an example, a hamburger flipper stated his income was 120,000 and that he intended to occupy a residence upraised at 600,000 as his homestead, when in reality he intended to flip it, just like a hamburger, and just as fast, as soon as it could be upraised at 750,000. Clearly, the housing bust was an intervening event, since otherwise there would have been no loss and no harm. As such, the breaches of warranty and representation inherent in letting this mortgage into the pool are not material.
Under this line of thinking, the fact that a portfolio contains 80% defective collateral is not material, since no losses would have occurred if only the housing market had continued its parabolic trajectory. While this may seem like an untenable position, illogical and indeed ridiculous, it should be noted that the CEOs of major banks testified before Congress, with straight faces, that no one could have foreseen the housing bust. It was like a meteor, completely unexpected, almost an act of God, a bolt from the blue.
Putback Recoveries May Increase
During the conference call, management discussed the development of estimated recoveries. The remarks presented here are forward looking statements.
Darin Arita - Deutsche Bank
Two questions here, one on the mortgage put backs. So you did $2 billion that have been recognized thus far. I believe that reflects only about 30% of ultimate recoveries. What do you need to see to increase this percentage?
Chuck Chaplin (MBIA President and CFO)
The $2 billion that we've recognized on a statutory basis relates to about a $4.3 billion of incurred loss on the deals for which we are reflecting those put backs. And we have a scenario-based approach to valuing the put backs that takes into account things like the estimated time to receipt of payment, the risk associated with litigation, the potential that counterparts might be unable to take judgments against them because of the value of all liabilities that they would carry at that time.
And so, all of those factors result in a discount on the amount of our contract claim relative to that which we are recording to the balance sheet. Over time, Darin, we would expect that as we have more information, as we have reviewed additional files, as we have gotten specifically significant valid samples on the cases, and as the court process proceeds, we would expect to see the probability associated with all recovery to increase.
And in fact that's the driver of a part of the increase in put back value that we're recognizing in the third quarter. So over time it's our expectation that that value will rise until the receivable is settled and paid.
Jay Brown (MBIA CEO)
So you'd see a modest change perhaps each quarter of anywhere from $50 million or $100 million, but you're not going to see a significant closing of the gap, as Chuck would say from the $2 billion or so to the $4 billion until we get out towards late 2011, early 2012.
If recoveries increase by $2 billion, and if that flows to ABV, the effect is $10 per share.
Implications for Valuation of MBIA
There are numerous issues surrounding the valuation of MBIA that are not discussed in this article, such as: the transformation litigation; suits MBIA has filed that rely on claims of fraud rather than putbacks; the quality and loss potential of insured CMBS; the potential for a liquidity accident, etc.
However, after reviewing progress on the putbacks issue, the overall odds that MBIA will survive and eventually resume writing meaningful amounts of insurance continue to improve. And the odds that the company will eventually achieve a market value roughly equal to its ABV continue to improve.
If putback recoveries are in line with management's expectations, the transformation issue becomes moot: MBIA can pay its claims and there is no valid reason to question the allocation of financial resources among its subsidiaries. After all, the company guarantees payment of interest and principal when due, not a triple A rating and/or a high market price for the insured bond.
The cases involving outright fraud by the originator differ from cases seeking to enforce putbacks. The legal outcomes are less certain. However, the SEC's action against Goldman Sachs (GS) over the Abacus case has reaffirmed that the bar is quite high for conduct in creating securities. As such, there may be additional commutations, with no names revealed. During the past quarter, over $4 billion of CDO^2 exposure went away, at an after tax cost of $35 million.
Importantly, the company continues to create value for shareholders by other, less conspicuous means. As an example, during the third quarter they spent $13.7 million buying back their own shares, increasing ABV by $58.8 million.
Putting all of this through the blender, I am now investing on the basis that MBIA shares will eventually reach ABV, currently $36.11. It takes time, a lot of time. No doubt there will be setbacks. It's a game of inches and fractions of an inch, played to close tolerances. And then there are big gains and losses - legal victories and defeats.
Allowing four years for the stock to reach a target of $36, the annualized return is 35%. As such, MBIA continues to be a very attractive speculative investment.
Disclosure: Long MBI, no position in other companies mentioned