Citigroup shares rallied following a third quarter earnings report that beat analysts expectations this morning, gaining back most the ground it lost in last week’s panic over put-back exposure.
Citi is the first big financial institution to report earnings since the panic ensued. JP Morgan Chase’s earnings last week came before many investors were focused on the issue.
Citi did not shy away from the put-back issue. Chief financial officer John Gerspach addressed it directly in his introductory discussion. Two slides of the bank’s presentation were devoted to the issue. He addressed analyst question on put-backs directly and forthrightly.
That’s good news. The bad news: there still is a lot of room for uncertainty in Citi’s potential liability for repurchasing mortgage backed securities.
Let’s start with Gerspach’s strongest point. He said Citi had reviewed its foreclosure documentation process and concluded it was “sound.” Apparently, Citi is not worried that its process is inflicted with robo-signing problems that have frozen foreclosures at JP Morgan and Bank of America . As long as Gerspach is right about this—it looks like Citi is in good shape, especially compared to competitors. If it turns out that Citi’s foreclosure program is more problematic than Gerspach let on, however, investors will likely be furious.
Gerspach pretty much dismissed the concern that has been at the forefront of much of the put-back panic: that the mortgage securitization process may have not validly transferred rights in the underlying loans, which would give investors in mortgage bonds the right to force banks to buy back all the securitized loans. He said that “the well-established securitization loan transfer processes are an effective means to transfer ownership in mortgage loans.” He pointed out that on Friday the American Securitization Forum defended the financial sector’s processes.
This won’t satisfy the fiercest critics, of course. They argue that many of the traditional requirements for loan transfers were legally binding and ignored during the securitization process. They can point to court decisions that have found that flawed securitization can result in banks failing to obtain a viable security interest that would give the banks the right to foreclose in the event of a default.
The truth is that no one really knows, at this point, how this will turn out. Both sides have strong arguments. The critics of banks can point to long-standing rules about property and mortgage transfers, as well as the letter of the law in many jurisdictions. The defenders of the securitization can argue that it’s unlikely and unfair for courts to vitiate standard business practices. Courts have been known to be flexible when it comes to areas where widespread business practices depart from formal legal requirements (to the great annoyance of legal formalists).
Gerspach sounded far less confident (or confidence inspiring) when it came to the liabilities Citi might face for violations of representations and warranties in mortgage securities it underwrote. He used the $504 billion loan portfolio that Citi services as a proxy for the total universe of loans it securitized, although its far from clear that these are the same thing. Does Citi service every single mortgage-backed security it underwrote?
Even if we assume the servicing portfolio is equivalent to the loans securitized by Citi, investors might be wary about some of Gerspach’s answers about put-back liability. We can categorize his answers into three categories: indemnification, history, and hand-waving.
- Indemnification: Gerspach pointed out that 22% of the loan servicing portfolio was subject to third-party indemnifications. Basically, these are loans that Citi bought from other lenders. As part of the sale, those lenders agreed to indemnify Citi against possible breaches of representations and warranties regarding loan quality. Unfortunately, without any information about who the counter-parties are to those indemnifications, it’s hard to judge what level of confidence Citi should have in them. Who is on the other side of these deals? Can they afford to pay off the indemnifications?
- History: Gerspach said that of the 2.5 million loans for which Citi is not indemnified, it had only received repurchase claims on 17,500 of those loans through the third quarter of this year. Most of the actual repurchase payouts went to Fannie and Freddie. Apparently, private buyers of mortgage-backed securities have not been making claims.
This is where Gerspach’s comments faltered. When asked why private claims had been so low despite evidence of flawed mortgage pools and huge default rates, he could not really offer a reassuring answer. “Maybe it takes them awhile,” was what his answer amounted to.
That implies that historical repurchase claims could far understate future claims, which is exactly what the critics of the banks have been arguing. If we get a put-back request explosion, the reserve numbers could skyrocket.
- Hand-waving: Toward the end of the call, Gerspach was asked about the idea that entire securitizations could be contested based on flawed pools. In theory, this would require banks to buy back entire pools rather than just a few flawed mortgages in the pools.
“I couldn’t find anyone who would say there was a big red button that gets pushed and blows up the securitization. But I’ll leave that to all the lawyers in the world to figure out,” Gerspach said.
That’s way too dismissive for my taste. There’s been a lot of serious work done by hedge funds, banking analysts and financial bloggers (the papers and magazines so far have been MIA on this issue) suggesting that the “big red button” might really exist. Having the CFO of Citi say he’s leaving it to the lawyers means the company is not considering this a serious risk to the business. After all we’ve been through—hello Chuck Prince!—I think Citi should have a rule of not leaving anything to the lawyers.
So did Citi flunk the first Push Back Apocalypse conference call? Not entirely. But it definitely did not score better than a gentleman’s C.
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