RMBS holders in court battle over breaches of reps and warranties

The private label RMBS market in the US has been hit in recent months by the threat of legal action from investors, demanding that banks take back loans included in RMBS deals that have breached reps and warranties. Do investors have a case, and what could be the lasting implications for the RMBS market?

Courting trouble: US RMBS investors are pushing for put-backs

Some battles are harder to win than others. In the case of attempts by bondholders to force put-backs of private label US residential mortgage-backed securities to bank originators, the battle is all relentlessly uphill. Despite that, investors are continuing to join forces in a bid to recoup losses on their RMBS investments, with growing numbers of bondholders adding their names to action groups.

Their case rests on showing that mortgage originators violated representations and warranties when selling mortgages into securitisation trusts; which they claim has materially and adversely affected their investments. Alternatively, proof of material documentation errors also provides grounds for mortgage put-backs, which involve originators buying back loans from securitisation trusts at par.

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On the face of it, arguing that poor underwriting standards at the height of the US housing bubble damaged RMBS investors – in other words, reps and warranties about the quality of mortgage loans were false – might seem like a no-brainer. In reality, private label investors, or buyers in the non-agency RMBS market, are far from being on a sound legal footing.

A securitisation lawyer at a New York-based law firm, who preferred to speak anonymously, says: “Arguing over whether an alleged breach of reps and warranties is material and adverse will take an enormous amount of effort if fighting loan-by-loan and won’t have a high success rate. Did a breach of the reps and warranties cause the loss to RMBS investors, or did the decline in US property values cause the harm? It’s the sort of legal issue that could go back and forth for years.”

Looming liabilities

Such a cautious assessment contrasts with the most bearish estimates of the losses that might fall to banks and other mortgage originators as a result of put-backs. Some estimates have suggested that mortgage repurchases in relation to private label RMBS could exceed $200 billion. But Tom Deutsch, New York-based executive director of trade body, the American Securitization Forum, refutes those figures. “There is little credibility in those estimates,” he says. “It is trying to blend economics skill with legal skill, with questionable results.”

However, bondholders are ready for a prolonged fight, with support growing for two key initiatives. First, a consortium that is seeking to pressurise Bank of America into paying back RMBS losses has recently grown to at least 17 in number, including some of the biggest asset managers in the world. An initial group of eight investors, including BlackRock, Pimco and agency lender Freddie Mac wrote to Bank of America last October, seeking to recoup losses on $26 billion of RMBS originated by Countrywide, which Bank of America acquired in 2008.

“From an investor’s perspective, it’s a small issue now, but one with a very large tail. If you are able to go through the hoops and prove there were not only some warranty violations but there was fraud, it could really open up the floodgates,” says a senior portfolio manager specialising in securitisation at one of the US’s biggest asset managers. “We are just peeling back the onion right now. What’s fascinating is looking at the individual loans that were being underwritten at the time. There was a higher percentage of no-doc loans and Alt-A loans with Fico scores. But it wouldn’t give you any indication of what we see today because of the economic downturn.

“There’s a missing piece of the puzzle, which centres on whether much of what was underwritten in 2006 and 2007 was fraudulent. Fraud is very difficult to prove, either against the broker that originated the loan or the bank that bought the loan from the broker and included it in a securitisation,” he adds.

In addition to the consortium against Bank of America, Dallas-based law firm Talcott Franklin has established a facility called the RMBS Investor Clearing House, which allows private label investors to pool their holdings without disclosing their portfolios. By the end of last year, more than $600 billion of RMBS had been pooled, or two-fifths of the total private label RMBS market. At the latest count, the facility accounted for 25% of the voting rights in at least 3,000 securitisation deals. The facility had pooled voting rights of 50% or more in 1,350 trusts.

The intention of both initiatives is to have large enough blocks of voting rights in securitisations to try and make changes at servicers, or to otherwise pressurise originators. Securitisation servicers are responsible for putting back mortgages, but are often also the originator of the loans or affiliated to one, meaning there is little incentive to act on behalf of investors. Servicers can simply block access to the loan files that bondholders need to scrutinise when trying to show that breaches have occurred.

The weak hand dealt to private label investors contrasts with the government-supported RMBS market, where agencies have strong rights to insist on put-backs. In addition, agencies can exercise considerable muscle in relation to their private label investments. Monoline insurers are also in a stronger position with respect to their RMBS portfolios, as they can exercise control rights over servicing.

“Financial guarantors can change the servicer with little or no discussion with other investors,” says Deutsch. “Historically they have exercised that a fair bit.”

Majority rule

The problem for other private label investors is that it may require a large majority of voting rights to have any influence over recalcitrant servicers. “Investors have been more organised over the last year or two regarding put-backs, but it is diverse individuals against an individual seller. It is challenging,” says Deutsch.

In the case of the consortium pursuing Bank of America, the initial eight-strong bondholder group accounted for at least 25% of the voting rights. However, a recent settlement agreed by the bank with Freddie Mac may have put a fly in the ointment, by reducing the amount of voting rights accumulated by the consortium. Bank of America announced at the start of January it will pay Freddie Mac $1.28 billion for repurchase claims, and has also paid Fannie Mae a $1.34 billion net cash settlement. The agreements resolve claims in relation to Countrywide loans sold to the agencies up to the end of 2008.

“These actions resolve substantial legacy issues in the best interest of our shareholders,” said Bank of America’s chief executive officer Brian Moynihan. “Our goals remain the same: put these issues behind us; focus on serving customers and clients; and continue to help distressed homeowners facing difficult times.”

The agreement with Freddie Mac extinguishes all outstanding and potential mortgage repurchase and make-whole claims arising out of any alleged breaches of selling representations and warranties related to loans sold by Countrywide to Freddie Mac to the end of 2008.

It seems reasonable to assume that, having negotiated a settlement with agency investors, Bank of America might be prepared to come to a similar arrangement with private investors. An ABS portfolio manager at a large New York investment firm certainly holds that view, believing that all bondholders should receive the same treatment.

“There are distinctions to be made between a loan that goes bad – which is nobody’s fault – fraudulent loans, and loans that didn’t meet the reps and warranties. Any issue with the reps and warranties means the bank has to purchase the loan back. But we all have to take responsibility for loans that go bad because the economic environment isn’t what it was three years ago,” he says.

“The genesis of this case is that the mortgage insurers, as well as the agencies, have had some success in getting access to the individual loans and putting them back to the originators. Non-agency investors have not had the opportunity to do that, until now. Large institutional investors are pooling their resources; they are saying ‘if the mortgage insurers and Fannie and Freddie are finding loans that didn’t meet the underwriting standards, why isn’t the trustee providing that same information to the investors?’”

But market participants are realistic about the chances of a positive outcome for private investors. “The likelihood of success [over repurchase requests] is high for the agencies, lower but still significant for the monolines, and very low for investors,” says Paul Jablansky, securitisation strategist at RBS in New York.

Agencies are at an advantage, not least because securitisation sellers are in effect negotiating with the government. “There is some moral suasion, which gives the agencies an even bigger advantage,” he adds. Under securitisation pooling and servicing agreements, a 25% threshold enables private label investors to direct the securitisation trustee to request loan files from the servicer. Whether the servicer complies or not is another question. The 25% threshold also gives investors the power to call an event of default, but such a declaration could well be an empty gesture.

“Investors can declare a servicer event of default if they have 25% of the investor interest, but the subtlety is that they may not be able to replace the servicer,” says Jablansky. “They may need 50% or two-thirds of the investor interest in order to do that.”

The investor group in dispute with Bank of America last month delayed a deadline to declare a servicer event of default, perhaps in recognition of the upcoming settlement with Freddie Mac, or because they realise they have nothing to lose by delaying. Meanwhile, Bank of America has softened its stance, saying that it is in “constructive discussions”. Previously, the bank said it would engage in “hand-to-hand combat” to protect shareholders.

Terms and conditions

Negotiated settlement is the obvious option for private label investors to pursue, rather than litigation. However, such negotiations are likely to include some unpalatable conditions for bondholders. “There may be the possibility for meaningful investors to negotiate something, but it will be hard to accomplish,” says the securitisation specialist at the New York law firm. “For example, I’m sure Bank of America would want to stipulate that investors give up all future claims, otherwise anybody who buys the bonds might sue. They’ll want investors to hold the bonds or transfer agreement on future rights along with the sale of the bond. That makes it difficult for investors. It reduces the liquidity in the bonds as it is unlikely there would be purchasers.”

Bank of America has by far the largest exposure to put-backs among US mortgage originators. “Bank of America’s existing repurchase reserves should cover the costs associated with the GSE put-backs,” says David Hendler, head of US financial services at research firm CreditSights in New York. “This leaves the majority of monoline and private label repurchases as potential earnings headwinds.”

CreditSights estimates that losses resulting from put-backs on private label RMBS could cost Bank of America between $4 billion and $10.4 billion. According to analysts, private label investors have the best chance of clawing money back from Bank of America and other originators where they can show significant documentation errors have occurred. Such errors could include failing to include the original signed mortgage note from the house purchaser in the loan file. However, such file exceptions are likely to be found in only a small proportion of non-agency RMBS.

RBS calculates that up to 5% of outstanding non-agency RMBS originated by the big US money center banks – Bank of America, JP Morgan, Citi and Wells Fargo – could have a fatally missing piece of information.

“We estimate that the banks could have potential obligations totalling $25 billion due to incomplete loan files,” says Jablansky. That is not an insignificant number, but well below the most bearish estimates.

Burden of proof

Not all investors are convinced the issue is worth pursuing in the courts, either. “The reps and warranties are never meant to cover the economic loss brought about by negative equity; they are to protect the efficiency of the stated underwriting process,” says Alessandro Pagani, a vice-president at Boston-based asset manager Loomis Sayles, and co-portfolio manager of its Securitized Asset Fund and Securitized Asset Credit Fund.

“The process for agency paper is pretty clear: it is well defined and there is supposed to be full documentation, so the standard of proof for any violation in the underwriting process is a lot lower. In non-agency RMBS, the investors need to prove there was fraud in the underwriting process. Granted there was a huge spike in origination in 2005–2007. In catching up with the rising volumes, the banks needed to compensate for lower margins and I am sure a certain amount of sloppy underwriting went on. The amount of economic loss that we see is enormous, but in our view it is primarily due to negative equity, not fraudulent underwriting. You could argue that a no-income, no-asset loan is poor underwriting, but that is what investors were buying,” says Pagani.

There has also been speculation that bondholders could launch challenges by arguing that mortgage loans have been improperly assigned. Attention has focused on whether the transfer of loans to securitisation trusts in ‘blank name’ (the trustee’s name isn’t stated so there is no explicit endorsement) constitutes a true sale. However, ASF’s Deutsch believes this line of argument can largely be dismissed.

“We could see one-off cases on a very detailed level [where transfer of ownership is brought into doubt], but we do not see a systemic issue here,” he says. “Loans are transferred in accordance with the law and contracts. It is very clear it is an unbroken chain of title from the originator all the way to the securitiser, in full compliance with the pooling and servicing agreement.”

In US law, mortgage loans are recognised as promissory notes, meaning there is an unconditional promise to pay. By extension, ownership of mortgage loans is transferred even by way of endorsement ‘in blank’. In Europe, contagion from put-back issues and from the broader crisis in the US over faulty foreclosure practices has been limited.

“Unlike the US non-agency mortgage market, the origination and, in some cases, underwriting of European mortgages are largely regulated so the risk of any systemic, industry-wide flaws in this regard should be minimal,” says Ganesh Rajendra, asset-backed strategist at RBS in London. “However in distressed mortgage markets, certain aspects of lending or funding are likely to be tested, such as claims of mis-selling, but we think documentation issues in Europe are likely to be isolated compared with the US.”

With investors and originators embroiled in put-back disputes, the question of the future of the US private label RMBS market might seem like an irrelevance. It remains to be seen whether investors will be willing to return to non-agency MBS, which has been at a standstill for the past three years. Properly constructed reforms as part of the US’s financial legislative overhaul are clearly part of the solution to reviving the market. But for now, GSEs continue to dominate the mortgage origination business, after the maximum size of loans that agencies can purchase was raised at the height of the credit crisis.

“There has only been one new issue of newly originated collateral [in the private label market] in the last three years,” says ASF’s Deutsch. “The GSE loan limits are so high that it is very difficult to find collateral originated outside of that sector. The private label market can’t compete with the government-guaranteed market. Market dynamics and regulatory uncertainty are stopping the private label market from reviving.”

GSE loan limits are set to fall by $100,000 later this year, but an element of Catch 22 is involved. “Who is to say that high loan limits won’t be extended? The private label market isn’t functioning, which leaves the GSEs,” says a trader at a New York-based MBS dealer, who wished to remain anonymous.

Agency for change

Quite apart from the question of investor appetite, the non-agency MBS market’s future is dependent on the extent and pace of GSE reform. Political wrangling suggests the omens are not good. The Republican party, with the power to block due to its House of Representatives majority, is arguing for a complete phasing out of GSEs, while the Democrats favour less sweeping changes. “Ultimately we will see a revival of the private label RMBS market but that change is coming slowly,” says RBS’s Jablansky. “The question is whether there is the prospect of any progress on the future of Fannie Mae and Freddie Mac, or whether there is legislative gridlock. That will have a large impact on whether the private label market makes a rapid recovery or not. Our expectation is that legislative gridlock is quite possible given the change in majority in the House of Representatives to the Republicans.”

Pagani argues that the ongoing legal wrangling over the put-back issue is working against efforts to revive the private label RMBS market.

“The mortgage origination business has consolidated pretty significantly with the fall away of some of the independents and buyouts of some of the banks. To have four large banks represent the majority of the market is putting tremendous pressure on them. You are trying to sue them, impose extra costs because of the servicers, but at the same time want them to originate as much as possible,” he says.

“We were too busy as an industry fighting over the distribution of economic losses for past deals to think about reigniting the non-agency market. It is vital for the country to come up with a framework that promotes the healthy origination of mortgage products, but we don’t have that. The originate-to-distribute model didn’t work very well in the mortgage market; there is no question that needs to be addressed, and regulators are honing in on this issue. We are really far from laying the groundwork for a healthy securitisation market, and the efforts to put the economic loss back with the banks is not constructive for the restoration of the market. Whoever invests needs to be very mindful of where this [legal action] takes us,” he adds.