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The Mortgage Crisis Act II Is the Bleeding Over?
By Robert Pardes
June 24, 2008

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Potential Losses:  As noted above, the potential losses to be recognized may be quite substantial relative to the losses already realized. Factors that will weigh in on the scale of recourse exposure include (i) the aggregate balance of 2005-2007 private label securitizations; (ii) the cumulative default rate and its correlation to “defective” collateral; (iii) the expected loss severity; (iv) the securitization structure; and (v) the nature of the counterparties in terms of economic capacity (i.e. deep pockets).

Many of these securities are loaded with products susceptible to widespread abuse and intentional fraud (no down payment and no verification of income or assets). Mortgage professionals close to the issue have reported that more than 50% of the loans that have defaulted based on representative contain material breaches of the related representations and warranties (See,” Speculators may have accelerated Housing Downturn”, Wall Street Journal, February 6, 2008). With reported cumulative default rates ranging from the low 20s to 35% and loss severities of 40% - 50%, it is not difficult to arrive at an estimate that the total loss exposure to loan repurchases well exceeds $100 billion, before accrued interest and expenses. Major issuers and depositors with historical securitization activity in the range of several hundred billion dollars are likely to face an operating revenue and capital impact in the billions.

Timing of Losses: There is little clarity or consistency in the accounting rules and practices for recognizing the potential exposure to loan repurchases. Where there is a documented claim, a basis for establishing a reserve exists. The amount of the reserve, though, can be arrived at by a highly subjective determination of the probability of success in having the claim rescinded on substantive grounds and the expected loss or market value of the loan if repurchased. 

Where there is no documented claim, however, the accounting treatment becomes murkier, often relying on historical experience rather than the extraordinary circumstances that exemplify the current environment.  The relevance of historical experience as a basis for estimating future exposure should be a cause of concern, due to the perceived paucity of documented claims generated by outstanding private label securitizations in the context of elevated default rates that are multiples of historical defaults. To a large degree, the lack of documented claims is a function of flaws and impediments in the securitization structures, presenting novel legal and business issues for the secondary mortgage market.

Figure 1 depicts the basic structure of the securitization process. Warranties and representations flow to the Trust and the potential for repurchase claims flows from the Trust back to the loan originator or issuer. From a loss exposure point of view, mortgage related securities fall into one of three classes:

  • Standard representations and warranties are provided by the originator or securities firm having the economic capacity to honor repurchase obligations;
  • Representations and warranties flow from a party with the requisite balance sheet to support recovery, but the representation and warranties are diluted, resulting in considerable debate as to the merits of a demand by the Trustee to repurchase the related collateral
  • Representations and warranties flow from a party lacking economic capacity to honor repurchase demands and the potential for recovery for the Trust and investors based upon the structural obligations is remote.

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