The second-quarter earnings for U.S. banks betrayed a divergence among the four major mortgage lenders in their approach to mortgage loan repurchase requests by GSEs (mostly Fannie Mae and Freddie Mac) due to allegedly faulty "representations and warranties". Some banks raised their provisions for such repurchased loans, referencing a more aggressive stance by the GSEs. Others, notably Bank of America Corporation (BAC), reduced them. Depending on how this issue plays out, there could be some catch-up on provisioning later in the year.
Logically, one would think that, as time went on, and borrowers continued to make regular payments on loans, it would be harder for the GSEs to make the case that any defaults were the result of faulty underwriting . But it appears that the GSEs have become more aggressive in claiming faulty "reps and warranties" for loans that have been paying since 2007. Bank of America has taken up the gauntlet on the issue on behalf of the industry, as is natural for the bank that has the most to lose.
Bank of America has refused to settle on those claims. Therefore, its provisions for "reps and warranties" have dropped down to a mere $395 million for the quarter versus $14 billion a year earlier. Its backlog of outstanding claims has skyrocketed, doubling to $22.7 billion of loans in the past three quarters. Its reserves for claims on "reps and warranties," or "liabilities," has stayed relatively flat at $15.9 billion in that time. Given the impasse with the GSEs, write-offs and resolutions have also stalled.
If Bank of America's gamble does not pay off, it could face a sudden requirement to add perhaps $2 billion to its liabilities. In the tussle with the GSEs, it is hard to see how the banks could win, given that pushing the potential losses back onto the GSEs means pushing them back onto the taxpayer. In this political environment, that does not seem likely.
Wells Fargo & Co. (WFC) also alluded to the GSE stance, but it chose to raise its "reps and warranties" charges to $669 million in the quarter, from $242 million a year ago. Pnc Financial Services Group,The (PNC), a much smaller player, noted similar reasons and bumped its provisions up to $438 million in the quarter, up from a run rate in the range of the low $30 millions.
The other major mortgage players did not acknowledge any change in behavior on the part of the GSEs. JPMorgan Chase & Co. (JPM) reduced its "reps and warranties" charges to just $10 million from a run rate of $302-$319 million in the past few quarters, and its stock of outstanding claims did not rise. That certainly helped offset some of the losses from its "London whale" trades. Citigroup Inc. (C) also recorded substantially lower "reps and warranties" charges of $242 million versus $335 million in the previous quarter.
It appears that just as investors may have been feeling that this particular issue of "reps and warranties" may be under control, another chapter is opening.