Last week I argued that the worst fears about devastating put-back exposures at banks were overblown. Regardless of violations of representations and warranties banks made when they sold mortgage bonds, I think it is unlikely that banks will suddenly find themselves liable for financially-crippling levels of mortgage repurchases.
The reason: Put-back exposure—where investors in a mortgage-backed security demand that the banks that issued the security buy it back at par—is a legal issue instead of an economic issue.
Note, most analysts think that fears of a put back apocalypse are overstated. In a report issued late last week, JPMorgan estimates that the total liability across the banking sector will be $55 billion spread over several years. Morgan Stanley arrived at the same number, noting that we’re unlikely to see a repeat of 2008’s financial crisis due to this issue. Even the guy who wrote the report that sparked fears of enormous liabilities at Bank of America—largely because it acquired Countrywide and Merrill Lynch—doesn’t think its solvency will be threatened by put-backs.
What happens if put-back exposure is worse than expected?
But it is clearly early days on this issue, and there are plenty of unanswered questions. Are the 'fauxclosures' and robo-signers covering up a deeper problem with the mortgage market? What are the legal rights of investors to require repurchases of mortgage bonds if it turns out that banks never properly perfected title in the underlying home loans? Did the banks commit fraud by not revealing the results of their own due diligence on the mortgage pools? How many of the mortgage pools were filled with mortgages that didn’t live up to promised underwriting standards?
Even if the exposure of large banks to put-backs ends up far higher than analysts expect, it is unlikely that lawmakers will allow put-backs to blow gigantic holes in the balance sheets of Bank of America, JPMorgan Chase, Wells Fargo or Citigroup. If the problem becomes large enough to threaten the financial stability of our largest banks, lawmakers will probably opt to retroactively approve the legal flaws that may have accompanied the securitization process.
The Financial Devastation of 2008
In 2008, banks faced an entirely different problem. Many of their mortgage related assets were underperforming expectations. Mortgage bonds on their balance sheets were dropping in value on the expectation that mortgage defaults would lower the revenue they would generate. No legal or regulatory change could alter the facts on the ground: Many financial institutions risked being unable to fund their own operations without new capital.
The 2008 problem was far more than most banking analysts—even bearish analysts—expected. Many thought banks would find that the balance sheet losses would push capital levels below regulatory requirements—which would require shareholder dilution and dividend reductions. The cure for this would simply have been regulatory forbearance. Regulators could allow banks to temporarily dip into loss reserve cushions. Alternatively, they could have suspended accounting rules that required banks to mark assets to market prices, allowing them to base the value of assets on their balance sheets based on internal projections of future revenue rather than current tradable values.
Both of these regulatory cures more or less happened, but they turned out to be inadequate. Largely, they were inadequate because they were seen as concealing the financial instability of financial institutions. Each of the world’s largest financial institutions became worried about the credit risk of every other financial institution—worried that despite all the regulatory forbearance and accounting chicanery, some banks would simply fail because the loans on their balance sheets were of such low quality that they wouldn’t produce revenues to meet their obligations.
The market was basically pronouncing several large financial companies dead in the water. The only way to revive their fortunes was to inject new capital—either by substituting cash for the toxic assets on the balance sheets or by purchasing equity stakes. (Of course, the failed companies could have been allowed to fail. But the Bush administration and Capitol Hill lawmakers were convinced this would bring about the second Great Depression, so they wouldn’t let this happen.)
A Zero-Sum Game in 2010
When Joe Weisenthal argued over the weekend that this is an economic issue, because it is about who is on the hook for bad mortgages, I realized I hadn’t made my point clearly enough. So let’s put it slightly differently. In 2008, it became evident that the economic pie had shrunk and that many major financial institutions would fail unless the pie somehow grew again. The TARP and the Fed’s policies were how we grew the pie again—with taxpayer dollars.
The put-back problem is not about the pie shrinking. Instead, it is about how the pie is divided up. It is a zero-sum game, as they say. The legal battle over put-backs will divide money between banks and aggrieved investors who have taken losses on mortgage bonds, but it won’t directly increase or decrease the overall amount of wealth in the financial system.
In short, it’s an issue of legal rights rather than underlying economic reality. And that means it will be far more manageable than the problem of 2008.
In the first instance, this will take much longer to play out than the financial crisis of 2008. It will depend on litigation, much of which will turn on untested legal theories and unexplored factual inquiries. This will take years, which will mean banks will have a long time to build reserves to meet any payouts.
More importantly, banks will no doubt attempt to use their influence on Capitol Hill to win favorable legislation that will reduce their liabilities. To the extent that put-back liability arises from failure to meet technical requirements related to the perfection or assignment of security interests during the securitization process, lawmakers will likely be able to easily paper over the problem. Even put-back liability from outright fraud by banks in the mortgage pools can be limited by legislation. Recall, for instance, that oil drillers are protected by law from unlimited liability stemming from oil spills.
Although many are skeptical that Congress would bail out bankers again, I think this resistance is over-rated. After November, we’ll be two years away from the next election. Lawmakers will be far more frightened by a collapse of the banking system and its effects on the economy than they are of public outrage against another bailout lasting until 2012. What’s more, this can be done on the cheap. No government funds need to be appropriated to accomplish the bailout. It’s not TARP II, it’s “financial modernization.”
In short, the put-back apocalypse won’t happen. Either the problem will be small enough to be manageable by our big financial institutions, or the logic of “Too Big To Fail” will kick in and lawmakers will bail them out with regulatory and legal changes.
(Note: If you are going to send an angry email about this, please take note that I’m not advocating that lawmakers pass legislation letting banks off the hook. In fact, I’m far from convinced that this is a good idea. It stinks of moral hazard and legislative interference with contractual rights. I’m just saying that I expect this is what Washington, DC, would do if it fears the banking system—or any Too Big To Bail bank—is threatened by put-back exposure.)
Companies mentioned in this post
Bank of America
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