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The Mortgage Crisis Act II Is the Bleeding Over?
By Robert Pardes
June 24, 2008
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Robert M. Pardes is a CPA and attorney with over 20 year’s management experience in banking, real estate finance and the mortgage capital markets. He can be contacted at robert@pardesconsultants.com.


Advisor Perspectives welcomes guest contributions.  The views presented here do not necessarily represent those of Advisor Perspectives.

 

 

Is the bleeding over for the Mortgage Crisis?

With the inventory of foreclosed properties and resulting loss severities continuing to increase, it hardly seems so… Looking at only our major financial institutions, most of the press would have us believe these losses have been largely accounted for and investors should shift attention to visible cracks in other areas of consumer finance (prime home equity lines, auto loans and leases, marine and RV financing, etc.). 

But, on a macro basis, the bleeding is not over.  An important issue, largely overlooked and not fully appreciated, will continue to adversely impact the performance of financial institutions.

Investors are beginning to exert pressure to enforce the contractual rights embedded in most mortgage securities. These rights represent Act II of the Mortgage Crisis and will continue to create financial stress for many players in the housing finance arena as the related exposure is unlikely to be adequately reflected in existing loss reserves.

These institutions may well be reminded of the iconic Al Pacino line from the Godfather, Part III, “Just when I thought I was out, they pull me back in.”

Generally, the referenced contractual rights relate to the obligation to require the issuer (often referred to as the “Depositor” in the securitization structure) or some other party to repurchase loans that support the securitization to the extent that the loan can be documented as “defective..”  Typically a defective loan is one that does not meet the contractual representations and warranties that accompanied the transfer of the pool of loans to the securitization, which is generally sliced into tranches that are beneficial interests in a Trust. The Trust, in turn is managed pursuant to the trust agreement by a Trustee. The obligation to buy back defective collateral is referred to as a “repurchase” and, for purposes of this discussion, the overall contingent liability to repurchase loans is “recourse exposure”.

To date, major financial institutions have reported aggregate losses in the range of $350 billion associated with holdings in private label MBS and related transactions. These reported losses overwhelmingly relate to write downs or cash losses for items reflected on the balance sheet. Recourse exposure, however, is the potential losses relating to loans previously securitized and therefore not reflected on the balance sheet. The realization of these losses is not a mere transfer of already recognized losses between investors and counterparties, despite what many believe to the contrary.   In light of total private label securitizations for the years 2005-2007 in the range of two trillion, losses relating to non recourse exposure could total hundreds of billions. These losses will increase over time as delays in identifying and reporting the exposure has only increased the severity of loss associated with each potential repurchase, as interest and default related expenses continue to accrue.

In light of the above, the seminal issues that should be of concern to the financial community, including investors and analysts are:

  • The scale of exposure by institution and in the sector;
  • The timing for recognizing the related exposures


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