Fed Governor Warns of Bank Liabilities From Mortgage Repurchases

This morning Federal Reserve Governor Daniel Tarullo testified in front of the Senate Banking Committee.  He spoke at great length about foreclosures, mortgage servicers, and mortgage modification.  However, we have covered those topics at great length on this blog, and there are very few new revelations in the testimony.  I thought the more interesting portion of the testimony was regarding the risks that mortgage repurchases (or putbacks) pose to major lenders.

Mortgage repurchase agreements are indemnification clauses that purchasers of mortgage backed securities put in purchase contracts.  These clauses stipulate that the buyer can force the seller to buyback the securities in the event that the underwriting (or other origination processes) for the underlying mortgages was defective and the mortgages defaulted.  Many investors in mortgage backed securities are currently looking into the possibility of pursuing mortgage buybacks against major lenders for violating purchase agreements.

According to Tarullo:

“During the third quarter of 2010, Fannie Mae collected $1.6 billion in unpaid principal balance (UPB) from originators, and currently has $7.7 billion UPB in outstanding repurchase requests, $2.8 billion of which has been outstanding for more than 120 days. Freddie Mac has $5.6 billion UPB in outstanding repurchase requests, $1.8 billion of which has been outstanding for more than 120 days. As of the third quarter of 2010, the four largest banks held $9.7 billion in repurchase reserves, most of which is intended for GSE put backs”.

The estimates of the liabilities that mortgage repurchases pose to banks vary greatly depending upon the source.  Most recently, Paul Miller of FBR Capital Markets estimated that putback liability could range between $54-106 billion.  Still others think repurchase liability could be far greater.  This presentation from Christopher Whalen, while not addressing putbacks specifically, raises some interesting points regarding bank solvency.  Tarullo continued:

“While the full extent of put back exposure is for this reason hard to specify with precision, the risk has been known for some time and has been an ongoing focus of supervisory oversight at some institutions. However, in light of recent increased investor activity, the Federal Reserve has been conducting a detailed evaluation of put back risk to financial institutions. We are asking institutions that originated large numbers of mortgages or sponsored significant MBS to assess and provide for these risks as part of their overall capital planning process”.

It would be very illuminating to see what kind of capital the banks are putting aside in the event many of these repurchases come to fruition, but I suspect we will not be privy to that information.  Between bad second mortgages, putbacks, and foreclosure lawsuits, major lenders are facing potentially massive liabilities.  It will probably take years and reams of litigation to sort this whole mess out, but it will be interesting to see what ends up happening.

About Michael Kraus

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