With new threats emerging to the housing and mortgage markets, investors have recently gotten jittery about bank stocks. I recently spoke to famed bank analyst Richard Bove to get his take on the mortgage mess.
What's foremost on Bove's mind these days? In a word, putbacks. "The putbacks are the critical issue," he said.
What exactly is a putback? A putback, in its simplest form, is a forced repurchase of a security — typically due to a claim of misrepresentation or fraud. In the domain of the mortgage market, what would an example of a putback look like? Let's take as an example a Government Sponsored Entity (GSE) like Fannie Mae or Freddie Mac.
These GSE's, of course, hold enormous quantities of mortgages on their books. If the GSE discovers that one of the mortgages they own has faulty underlying loan documentation they can demand that the originator repurchase the mortgage.
According to sources within the mortgage industry, there has been an uptick in this type of repurchase over the last several months. (Harry Terris, of American Banker, has written an excellent primer for Investment Dealer's Digest.)
Not surprisingly, analysts speculate that large scale implementation of putback demands between the GSE's and other institutions and the mortgage originators/aggregators could result in a litigation bonanza.
Bove thinks the litigation process is going to be both time consuming and costly. "The lawsuits are going to last 3-5 years," he says.
Bove maps out a three tiered litigation nightmare: The first wave of lawsuits will be to discover the mortgage documents which banks are not currently willing to disclose. The second wave of suits involves mortgages where the documents were fraudulently underwritten, or were fraudulently assigned to the pools. The third wave of litigation would be to decide which mortgages are going to be put back and to whom.
(My colleague John Carney has recently published a counterpoint article, arguing that the putback crisis will not be the apocalypse that has been projected.)
What's the magnitude of the litigation? Assigning a dollar value to the potential liabilities on this sort of case is notoriously difficult business — but Bove believes the potential liabilities may run over $150 billion mark.
Let's try to back out of that $150 billion number. Bove derives that assessment by looking at the mortgages issued between 2004 and 2007.
He takes a 14 percent industry-wide default rate as his base, and then applies a multiplier to adjust for the lower quality of the pooled mortgages — eventually arriving at a 35 percent default rate for the mortgages in the pools.
Based on the information he has seen so far, Bove assumes that 60 percent of those loans can be put back to the banks. And then, once the banks have had the mortgages putback to them, Bove assumes a 65 percent loss. That works out to a total of $164 billion in liabilities to the banks.
Bove points out that JPMorgan , for example, has only set aside $4 billion in total litigation reserves. And he believes the potential magnitude of putback litigation to be on par with tobacco and asbestos litigation.
Bove predicts the impact of the putbacks will spread more broadly, beyond the financial impact to banks. "There is going to be a contraction in mortgage credit," he said. This may in turn lead to a further deterioration in housing prices.
I also asked Bove about the ramifications of a broader foreclosure moratorium. With regard to the foreclosure moratorium, two questions have been troubling me:
First, isn't it likely that banks will exceed their loan loss reserves if they no longer can recover even a fractional portion of the bad mortgages on their books by liquidating the underlying real estate?
Second, isn't it likely that the number of delinquencies will increase rather dramatically in the event of a foreclosure moratorium — because home owners will be insulated from the consequences of the default.
Bove agreed on both points: "The answer to the first question is absolutely yes. If they can't grab the house, they've got nothing they can recover. The answer to the second question is yes as well — the incentive [for borrowers] to walk increases enormously"
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