Since the housing bubble burst more than three years ago, lenders have been fending off legal challenges from homeowners who say they were duped by bad mortgages. Now the industry faces a potentially more formidable adversary: investors who bought bonds backed by those bad loans.
Citibank became the latest lender to disclose that it faces legal challenges from investors demanding a refund on billions of dollars lost on bonds backed by faulty loans. On Friday, Citibank disclosed in a regulatory filling that Charles Schwab, the Federal Home Loan Banks of Chicago and Indianapolis and a hedge fund have filed lawsuits claiming the bank misled them when it sold bonds backed by pools of home mortgages.
The key issue: Who will take the losses for billions of dollars worth of failing mortgages written during the height of the housing boom?
Investors are pursuing several strategies, but they generally center on a promise made in the documents that created bonds backed by mortgages. These so-called “representations and warranties” assured investors that certain underwriting standards would be followed.
Yet underwriting was often lax during the boom years, with lapses including inflated appraisals, overstated incomes and false assurances that a borrower would live in the house he was buying.
“If you tell my bondholders that this is an owner-occupied property and it's not owner-occupied, that's an incorrect fact," said Kathy Patrick, a Houston-based attorney representing investors who want Bank of America to buy back bad mortgages. "And an owner of occupied property has very different credit qualities than an investment property where somebody has 20 properties and may default strategically."
Patrick is representing a high-powered investor group that includes Freddie Mac, Pimco Investment Management, Blackrock Financial Management and the Federal Reserve Bank of New York, which took over mortgage-backed investments held by American International Group.
Lenders have vowed to put up a vigorous defense against the claims, arguing that investors who bought mortgage-backed bonds knew they were taking a risk. Just because those bets aren’t paying off, lenders say, investors shouldn't expect to get their money back.
"If you think about people who come back and say, 'I bought a Chevy Vega but I want it to be a Mercedes with a 12-cylinder,' we're not putting up with that,” Bank of America CEO Brian Moynihan told analysts and shareholders in a conference call with last month. “We're protecting the shareholders' money."
Lawyers representing mortgage bondholders don’t see it that way.
“That argument is just dead wrong,” said Alcott Franklin, a Texas attorney who is helping investors take on lenders. “These are warranty claims. Whether we bought a Vega or a Mercedes, it was under a warranty. And they violated the warranty."
In many of these cases, investors are invoking language in the bond offering that allows them to force the lender to buy back a bad loan, a process known as a “put back.”
At the height of the housing boom, rising home prices allowed mortgage originators to replace failed loans with freshly-written performing mortgages. Lenders, originators, investors and borrowers all assumed that there was little risk in churning out new mortgages because even if a loan defaulted, the rising value of the home securing it would minimize any potential losses.
But when home prices began falling, many of those bad loans came back to haunt the companies that had underwritten them. With demand for new mortgages drying up, there weren’t enough new loans to replace the ones that were going bad.
With home prices still falling and mortgage defaults rising, losses on foreclosed homes are hitting even those investors holding top-rated bonds. By some estimates, at least as many homeowners are currently at risk of foreclosure as have already lost their homes.
“It took a while for the losses to eat through and start to affect the majority of investors,” said Franklin, the Texas attorney. “Now that that’s happening, there’s going to be more interest" in these loss claims.
The claims are complicated by restrictions that require a minimum number of investors from a given pool of mortgages – often 25 percent – to file a claim. That has been difficult because many mortgage pools were sold off to dozens or hundreds of different investors.
To overcome that hurdle, Franklin has set up a clearinghouse for investors to find each other. He estimates his database has grown to holders representing more than a third of the $1.5 trillion market in mortgage-backed securities – “and it's growing every day by leaps and bounds.”
The potential cost of these claims will depend on how many more homes are lost to foreclosure, how much further home prices fall, how far the value of those properties will have to be written down when those foreclosed homes are sold.
“This could be a large hit for the entire industry,” said Brian Maillian, CEO of Whitestone Capital Group, which advises investors. "When you look at the scope of the problem, it's a very, very large problem. We really don't know how deep the hole is."
Goldman Sachs recently estimated that “put backs” could cost the four largest lenders - Bank of America, JP Morgan Chase, Wells Fargo and Citibank – a combined $26 billion. Goldman Sachs estimates more than 12,800 put back claims had been filed cumulatively as of the third quarter – up from 7,500 claims a year earlier.
Working through those claims – in some cases loan by loan – could take years. As long as lenders continue to post healthy profits, that lengthy process would work in lenders' favor. By spreading the losses over several years, lenders hope to pay most of the tab with future profits.
That could hurt shareholders as fears of future losses weigh on lenders' share prices, which have declined as the pace of claims has quickened. But it would help lenders avoid a sudden hit to their balance sheets.
Because mortgage-backed bonds are widely held by insurance companies, endowments, pensions and mutual funds, the impact could be widespread, said Franklin.
“Where you’re really going to see the hit is off in the future a few years, when there’s no money to pay your life insurance policy or when your pension is gone or when your mutual fund is unable to pay you the interest rate they promised you," Franklin said.