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Home >USA >Corporate/Commercial Law
Last Updated: March 16 2011
NERA Economic Consulting
Uni t ed St at es: I s Mor t gage Under w r i t i ng To Bl ame For Subpr i me
Losses? Di sent angl i ng The Ef f ec t s Of Poor Under w r i t i ng Fr om The
Ec onomi c Dow nt ur n
Article by Paul Hinton and Dr. Ethan Cohen-Cole*
Introduction
The default of subprime mortgages has led to an array of litigation over losses allegedly resulting from failures in underwriting
and servicing practices. While mortgage loan underwriting and servicing failures have been widely reported, whether or to what
extent such shortcomings were responsible for losses is less evident.
1
The economic literature on the topic indicates that many
factors contributed to defaults, including the collapse of housing prices and rising unemployment. Although the Federal
Reserve Board's Senior Loan Officer Opinion Survey shows a net loosening of mortgage underwriting conditions overall in the
quarters prior to the summer of 2006 and subprime underwriting standards may have been loosened by some,
2
there is also
evidence that subprime underwriting was strengthened along some dimensions in the years preceding the credit crisis.
3
Careful economic analysis of loan performance is needed on a case-by-case basis to assess whether underwriting failures, to
the extent they are identified, contributed to losses. Indeed, such analysis may show that particular loans satisfied all stated
standards or, if not, that had all loans met the stated underwriting standards, loss development would not have been dissimilar.
The latter finding would establish that deviations from stated underwriting standards were not material and that subprime
mortgage losses mounted for other reasons. Analysis could also be used to assess whether, controlling for the characteristics
of borrowers, loan performance was consistent with expectations. Such a finding would preclude recovery of subprime investor
losses, given that the risks were known. While stricter underwriting standards could have improved the credit quality of loans
and potentially reduced losses, few investors in subprime mortgage-backed securities (MBS) could credibly claim they did not
know they were buying securities backed by mortgages made to the least creditworthy class of borrowers. Claims that
subprime losses were due to poor underwriting must account for the significant subprime losses that resulted even absent any
underwriting failure. In the words of Brian Moynihan, CEO of Bank of America,
4
investors who bought a Chevy Vega cannot
now claim they expected a Mercedes.
5
While useful analysis can be performed at the portfolio or company level, underwriting practices can be assessed most
precisely at the individual loan level. The opportunity to use loan-level data to investigate underwriting standards and controls
depends on getting access to loan underwriting files. Production of such data has already been authorized in several cases
and is likely to be demanded in others. Last May, production of loan origination files was ordered by J udge Bransten in the
Syncora v. Countrywide litigation. J udge Bransten also presides over similar monoline insurer cases brought by the Financial
Guaranty Insurance Company (FGIC) and MBIA.
6
In J uly, the Federal Housing Finance Agency, in its capacity as conservator
of Freddie Mac and Fannie Mae, used its subpoena power to request data from 64 issuers of private label subprime securities
to evaluate whether underwriting failures contributed to government-sponsored enterprise (GSE) subprime losses.
7
In this paper, we discuss the economic factors that may have influenced loan performance during the economic downturn,
explain the use of economic analysis of loan-level data to separate out the effects of underwriting performance, and identify
how such analysis might be relevant in current litigation.
The Elements of Underwriting
Underwriting is the procedure used to determine the eligibility of customers for specific products and to decide whether to
approve loans by assessing applicants' repayment ability, credit standing, and the value of collateral.
8
Customer eligibility may
depend both on the features of the product, e.g., the amount of collateral required, and the creditworthiness of the customer,
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typically measured using a credit score. Underwriting standards define eligibility in terms of a set of parameters, which may
include loan term, debt-to-income ratios, loan-to-collateral values, and minimum acceptable credit scores.
9
These factors have
been shown to be correlated with future loan performance. Collateral evaluation and appraisal standards, as well as carefully
calibrated credit scoring models,
10
are used to quantify these factors. Underwriters may also use controls, including loan
approval processes and documentation requirements, to ensure compliance with underwriting standards.
11
Claims attributing losses to underwriting practices may allege standards (or guidelines) were deficient or that controls were
inadequate or inadequately employed. However, some claims do not depend on an assessment of the adequacy of
underwriting standards or practices but instead simply allege that there was insufficient disclosure. Underwriting-related
misstatement claims allege that disclosed practices differed from those actually used. As described below, the principal
underwriting failures that are a focus of investigation and litigation are those that may have led to errors in measurement,
disclosure, or representation of borrower credit risk (i.e., FICO scores) and loan-to-value (LTV) ratios.
Economic Factors Influencing Underwriting Performance
Poor underwriting practices have been blamed for a wide array of credit crisis losses, in particular losses in subprime
residential MBS.
12
Allegations of a decline in underwriting standards commonly point to two facts: first, that the portion of
subprime mortgage origination increased in the years prior to the credit crisis (Figure 1); and second, that in each successive
year, subprime loan performance was worse than the last, i.e., the delinquency rate rose more quickly for each consecutive
loan vintage (Figure 3).
The subprime share of US residential mortgage originations increased to 20 percent in 2005 and remained at 20 percent in
2006. Since the creditworthiness of subprime borrowers is lower than prime borrowers by definition, a decline in average credit
quality of all originated loans, prime and subprime combined, would be expected from an increase in subprime lending even
absent any change in underwriting standards. However, maintaining credit quality while responding to growing demand prior to
2007 was challenging. According to former Citigroup CEO Chuck Prince, the growing demand for subprime MBS put pressure
on originators to increase supply while continuing to meet LTV and FICO score requirements of investors.
14
Many factors drove the growth in subprime lending, including the growth in demand for high-yielding triple A-rated subprime
MBS and collateralized debt obligations of subprime MBS. Many MBS issuers purchased pools of loans from third-party
originators to meet demand and commissioned due diligence, credit and compliance reviews of samples of these pools before
buying them. As described below, the results of some of this due diligence work show that success in controlling loan quality
was mixed.
Clayton Services Inc. (Clayton) reviewed 911,039 loans for its clients between 2006 and the end of the second quarter of 2007.
It reported the results of these reviews at the 23 September 2010 hearings before the Financial Crisis Inquiry Commission.
Clayton noticed that third-party originator underwriting standards declined over the period and in response Clayton's clients
(the MBS issuers) imposed more of their own credit overlays in an attempt to prevent a decline in MBS collateral quality.
15
J ust
over half the third-party loans reviewed by Clayton initially met the issuers' underwriting guidelines.
16
An additional 18 percent
were accepted based on "compensating factors." Seventeen percent were rejected for failure to satisfy the guidelines and for
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having insufficient compensating factors. The remaining 11 percent were granted "waivers" from complying with the guidelines
or were approved for inclusion in the collateral pool conditional on the originator curing specified deficiencies within 30 days of
closing. Between the first quarter of 2006 and the second quarter of 2007, the decrease in third-party loans initially meeting the
guidelines was matched by a similar increase in the ultimate number of loans rejected. Thus, more low quality loans were
being originated by third parties but more were also being rejected through the due diligence review process. However, over
the same period the proportion of loans with compensating factors dropped and the proportion that were only accepted after
being granted waivers rose. Thus, assuming waiver loans did not have unreported compensating factors, and that deficiencies
for which waivers were granted were material, the mix of loans in the Clayton samples
17
passing the due diligence review
declined in relative credit quality.
Academic research has also developed evidence of trends in underwriting standards. Evidence that overall underwriting was
strengthened along some dimensions in the years preceding the credit crisis has been developed by Sengupta and Bhardwaj
(2010). They show that the percentage of relatively good FICO scores in low-documentation loans actually increased from
2002-2006which shows that underwriting standards, at least in terms of FICO scores in this loan category, were improving
over the period (see Figure 2).
The oft-cited observation that delinquency rates rose more quickly with each vintage of subprime loans, depicted in Figure 3,
does not prove a decline in underwriting performance. In fact, as illustrated in Figure 2 for low-doc and no-doc loans, a
reported measure of loan qualitythe FICO scoredid not decline over this period. Figure 3 shows that the delinquency rates
of underwriting vintages between 2005 and 2007 experienced similar levels of delinquency at the same point in time in 2008,
2009, and 2010. There was a jump in delinquencies that occurred at the same time across several vintages beginning in 2007,
indicating that changes in economic conditions in 2007 and subsequent years likely contributed to delinquencies.
In a lawsuit filed against Deutsche Bank, the FHLB of Seattle reports similar data and claims that increasing delinquencies in
consecutive vintages with similar average LTVs and FICO scores proves that underwriting practices were misrepresented.
19
According to the complaint "deterioration in the credit quality of the loans [early payment defaults] was caused not by the
disclosed facts [i.e. LTV and FICO scores], but rather by undisclosed factors [...] is strong evidence that the originator departed
from its underwriting standards in making the loan. [...] A higher-than-normal rate of delinquency at any time in a group of
mortgage loans is also evidence that the originators of those loans departed from their underwriting standards." However,
these claims ignore the contribution of changed economic conditions in explaining the observed decline in loan performance.
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A number of coincident behaviors have been identified in the economic literature that may have contributed to deterioration in
loan performance during the credit crisis. The importance of each of these factors in explaining the performance of a given
individual loan or group of loans requires detailed economic analysis. Among the possible explanations of the acceleration of
credit crisis subprime loan losses are:
Housing price declines may have triggered defaults by individuals because of the decline in the value of their
investment. This is a fully "rational" decision by individuals to trade off the impact of the consequences of default with the
financial benefit of a write-off.
21
1.
Economic conditions such as unemployment and health expenses may have led individuals to have short- or
medium-term liquidity needs independent of the price changes in their homes.
22
2.
Correlation in defaults across the country may have been greater than previously thought. In portfolios of
subprime mortgages such as those collateralizing residential MBS (RMBS), an increase in default correlation magnifies
the risk of loss to the portfolio as a whole. Economic analysis has revealed that default correlation was more substantial
in subprime lending than was realized prior to the crisis and was not a focus of risk management at that time.
23
Default
correlation among high risk borrowers was hidden by the ameliorating effects of rising home prices. However, when home
prices fell, this correlation was revealed and contributed to more extensive defaults than predicted by models developed
earlier.
3.
Changes in underwriting practices may have occurred to focus more narrowly on MBS collateral standards demanded
by investors. There is some evidence that, consistent with competitive market incentives, lenders gradually stopped using
variables not demanded by MBS investors and this may have reduced the accuracy of credit underwriting, particularly for
low documentation ("low doc") loans, even though nominal MBS collateral underwriting standards remained the same.
24
However, underestimation of credit risk may have resulted from not changing underwriting standards. Underwriting
models that were created using data from the earlier period of rising home prices could have underestimated later credit
risks once home prices began to fall.
4.
Servicers may have had adverse incentives that discouraged them from monitoring loan credit quality. Servicers are
typically paid a fraction of the performing loan volume and may have had lower incentives to monitor performance or
incur costs to engage in loss mitigation efforts (including modifications or foreclosures) as they would not suffer losses
from defaults. Servicing may also have been ineffective in detecting underwriting defects that could have triggered
repurchase obligations but instead contributed to higher rates of default.
5.
Securitization of loans may have provided incentives for underwriters to sell poor loans while keeping good ones
on their balance sheet.
25
While there is some empirical support in favor of this proposition, there remains profoundly
mixed evidence on the impact of securitization on loan performance. Existing economic studies that control for a wide
array of other factors, including the change in housing prices, collectively show that the impact is not clear.
26
6.
Credit risk of borrowers may have been disguised by rising prices. Individuals with poor credit that received loans
secured by property may historically have been able to show good loan performance because the price of their home was
increasing over time.
27
This could have been accomplished by using the rising value of homes to make payments (either
through negative amortizing mortgages or repeat refinancing). Once prices stop rising or fall, higher than expected credit
risk could have been revealed. Even properly and consistently underwritten subprime loans became more risky as
housing prices fell. Thus, losses due to the realization of higher default risk for such loans are attributable to changed
economic conditions, not changed underwriting practices.
7.
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The credit crisis has been characterized as a perfect storm brought on by a wide variety of problems including an increase in
personal financial distress.
28
Reported changes in underwriting practices immediately preceded the deterioration in economic
conditions, confounding the assessment of underwriting performance. Each of the factors above may have contributed
concomitantly to individual loan defaults. Academic studies investigating the importance of these potential factors have
reported mixed results,
29
suggesting that case-by-case analysis is required and that the results of econometric analysis of
specific mortgage pools could produce results that vary across cases.
Econometric Analysis of Loan Portfolios
Economic models estimated using regression analysis (i.e., econometric analysis) allow the performance of large numbers of
individual loans to be used to estimate the effects of competing factors, including borrower and loan characteristics, and
alleged loan deficiencies.
The effect of changing market conditions may be separated out either by estimating calendar year effects or by measuring
performance relative to a benchmark. If the effect of changing market conditions on the loans of interest is the same as on the
benchmark loans, then the market effects can be eliminated in any relative performance measure. Benchmarking can also be
used to analyze the effects of factors that are difficult to quantify. The effect of differences that are not captured by specific
parameters is measured by any residual differential performance. For example, if a representative fraction of a loan portfolio (or
a different similar portfolio of loans) did not share the same alleged underwriting defects, a comparison with these loans could
be used to estimate the effect of defects not already reflected in the underwriting parameters.
To assess whether the defaults in a particular portfolio of loans were caused by poor underwriting, the features of a group of
benchmark loans need not match the loans of interest exactly, nor do the loans need to have the same combinations of
characteristics. As long as the characteristics of the loans of interest are represented among the benchmark loans, it should be
possible to compare and control for the effects of each quantifiable characteristic and reveal any residual differential
performance.
Examples of the application of this approach can be found in J iang et al (2010), Demyanyk and Van Hemert (2010), Sengupta
and Bhardwaj (2010), and many others.
30
Sengupta and Bhardwaj (2010) show that relative default rates increased over time
even for loans of higher credit quality (See Figure 4.) Loans with higher FICO scores have lower probability of default,
measured relative to loans with FICO scores below 540 (the lowest credit quality group),
31
but default rates in every credit
score category rose between 2003 and 2007. The rising slope of the lines shows that the default risk of high FICO score loans
increased relative to the lowest quality loans. An important feature of these findings is that they control for the change in
composition of subprime lending (including LTV, FICO, occupancy status, documentation level, refinancing, and other features)
and separate out the effects of credit quality from changes in market conditions.
32
Thus, while Figure 3 shows that
delinquencies of loans overall were higher in 2007 than in prior years,
33
Figure 4 refutes the theory that this increase was
caused entirely by a decline in underwriting standards, since loans with the same credit underwriting characteristics in the 2007
vintage performed worse than loans from the prior few vintages.
The research of Rajan, Seru, and Vig (2010) provides one reason why default risk in high FICO score loans rose over the
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period prior to the credit crisis. They find that the statistical credit models calibrated to historical data became less effective at
predicting defaults in part because the mix of loans changed in dimensions not captured by the model parameters. The authors
claim that standardization of underwriting criteria demanded by the securitization industry created unanticipated systematic
risk. MBS investors acted as if they could control the credit risk of mortgage loan collateral using underwriting criteria that were
calibrated from a statistical model of defaults based on data that reflected historical underwriting practices. But the act of
creating industry-wide underwriting standards for MBS collateral and the commercial success of private label securitization
meant that underwriting practices changed. Practices become more homogeneous, invalidating the statistical model upon
which the underwriting standards were based. As a consequence, the underwriting criteria set by MBS investors systematically
underestimated credit risk. This limitation in the use econometric models to make policy decisions is known as the Lucas
critique, after the economist Robert Lucas, who articulated the problem in a 1976 paper.
35
Ironically, changes in underwriting practices were made to comply more closely with criteria demanded by MBS investors. As
private label securitization volumes increased, underwriters became more focused on originating loans that met the standards
demanded by MBS investors. The minimal risk retention associated with MBS origination meant that there was little incentive
to invest in developing additional costly variables to refine credit risk estimates beyond what MBS investors required.
36
Furthermore, if a lender did impose additional credit enhancing underwriting criteria, it would restrict the supply of loans it could
otherwise sell profitably to MBS investors.
In its J une 2010 amended complaint against the banks from which it bought private label RMBS, the FHLB of San Francisco
makes a similar observation about the deterioration in the ability of underwriting parameters to predict default rates. However,
the FLHB asserts that this is "evidence that the deterioration in the credit quality of those loans was caused by departures from
its underwriting standards."
37
Their chart shows that even though LTVs and credit scores of borrowers remained nearly
constant for mortgages originated by Countrywide from 2004 through 2007, delinquencies six months after origination rose
dramatically starting in 2006. However, this evidence provides an insufficient basis for their claim. As described above, while
deterioration in the credit quality of the loans is evidently not explained by LTV and FICO score, no deviation from underwriting
standards is necessary to observe an increase in the default rate. The deterioration in performance of underwriting models at
predicting defaults was also in part a consequence of the end of rising housing prices that had lowered defaults among
borrowers with higher credit risk.
38
The FHLB apparently does not consider this effect. Credit risk parameters estimated during
a period of rising home prices that did not explicitly account for the effect on refinancing behavior would underestimate default
rates once housing prices declined.
Accounting for Consumer Decision-Making on Default Rates
The microeconomics of loan performance modeled above treats individuals' behavior as effectively fully defined by their credit
characteristics. However, analysis that accounts for the predictable response of consumers to their more broadly defined
financial circumstances can provide more accurate and detailed understanding of the causes of different levels of loan
performance.
Economic research has shown that consumer behavior may be hard to predict and is often apparently inconsistent with simple
economic models. As a result, a second method of determining whether a set of defaults is consistent with changes in housing
prices or underwriting standards comes from a careful modeling of consumer behavior using additional information about the
individual context of default decisions.
To explicitly account for consumer behavior, additional factors can be developed to describe how consumers make loan
repayment decisions. These factors may include liquidity constraints or the role of a neighbor's or colleague's decision.
Cohen-Cole and Duygan-Bump (2009) find, for example, that the decision to file for bankruptcy and fail to pay on one's debt is
a function of the decisions of people close to them.
39
Another factor may include the presence of sufficient cash liquidity for
daily expenses. Cohen-Cole and Morse (2010) find that many individuals default on their houses to protect very small amounts
of liquidity that they use for daily expenses. Paying a mortgage can put simple expenses such as food, medicine, and
commuting costs at risk.
40
Agarwal et al (2009) find that financial counseling also matters.
41
When more detailed data are available about the borrowers, this research shows how modeling consumer behavior can better
explain defaults. Better explaining defaults allows more reliable determination of whether and to what extent a set of loan
defaults may have been related to changes in underwriting standards or practices.
Using Sampling Strategies to Evaluate Underwriting Performance
The ability to prove underwriting defect claims using a sample offers considerable cost advantages by reducing the number of
loan underwriting files that have to be reviewed and coded. But sampling increases the uncertainty of estimates and may make
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it difficult to detect relatively smaller effects. In practice, sample sizes are adjusted to minimize costs while ensuring the
analysis will be able to measure statistically significant effects of a critical size or greater.
Selecting for review only those loans that defaulted may help identify candidate characteristics to investigate as potential
causes of underwriting deficiencies. However, without reviewing performing loans, too, the effect, if any, of possible deficiencies
cannot be measured or even shown to matter. A fully representative sample is needed to compare loans with and without
deficiencies while controlling for other important features that affect performance.
The use of sampling techniques is well established in litigation as "scientifically accepted, valid and reliable."
42
The use of
sampling techniques in litigation of mortgage loan underwriting failures was recently upheld in the MBIA v. Countrywide
matter.
43
MBIA proposed to take 400 mortgage loan samples to develop evidence of liability and damages for each of 15
securitizations, which together pool cash flows from 286,000 mortgages.
44
Under this proposal, each 400-loan sample would
on average represent 1.6 percent of the securitized loans. J udge Bransten ruled "that Plaintiff's proposed methodology to
extrapolate results from the proposed sample to prove liability and damages" could be used at trial. She stated that
Defendant's objections to the methodology were "not without merit" but pertained "to the weight, rather than acceptability of the
[sampling] evidence." Their arguments could be employed at trial to challenge the adequacy of Plaintiff's proofs.
Challenges to the adequacy of sampling evidence include technical criticisms of sampling methodology used to assure
representativeness, the size of the sample, and the ability to classify consistently certain subjective elements of credit
assessments.
45
However, careful implementation of any sample should preempt such arguments. The more likely focus of
evidentiary challenges relates to the reliability of econometric analysis produced using samples of loans. Arguments over the
relative merit of competing models of loan performance and the ability of these models to measure reliable effects of
underwriting practices and market conditions will turn on issues of economics, mortgage finance, and econometrics.
Relevance of Loan Level Analysis to Current Litigation
The investors who purchased subprime MBS and the insurers who guaranteed payments to investors assert they relied on
representations from underwriters concerning their mortgage lending practices and the quality of the loans that were
contributed to collateral pools. Their claims include fraudulent misrepresentations in connection with the sale of securities and
contractual reps and warranty claims resulting from the obligations of underwriters and servicers under mortgage pooling and
service agreements (PSAs).
46
Insurers also have contract claims in connection with their Insurance and Indemnity
Agreements.
Alleged underwriting failures include non-qualifying loans in collateral pools, loans underwritten on the basis of erroneous
applications, and bias in appraisals (or other underwriting parameters). Another allegation is that even though stated criteria for
asset selection did not change, underwriters materially changed their practices in other ways ("latent underwriting criteria") and
should have disclosed these changes.
47
Liability for underwriting failures depends on proving the materiality of failures in terms
of their effect on loan losses. In their various complaints, plaintiffs argue that the materiality of certain underwriting failures is
self-evident from the fact that to investors, "LTV [and other elements of underwriting criteria] is one of the most crucial
measures of the risk of a mortgage loan."
48
However this is insufficient to establish that underwriting failures caused losses.
Loan-level review is necessary to identify defective loans in MBS collateral pools and loan-level analysis is needed to prove
that loan defects caused losses. Identifying deficiencies in low-doc loans may be particularly challenging because low-doc
guidelines require judgment, for example "about the reasonableness of the income stated on the application in relation to the
[borrower's] occupation and credit information."
49
However, systematic assessments that were made of the ability to repay and
even contemporaneous subjective judgments could be coded from loan underwriting files and their economic significance
analyzed alongside other underwriting parameters.
Access to loan underwriting files is necessary to allow full loan-level review and has become a focus of litigation. As mentioned
above, the production of loan files has been ordered in some cases, but not yet in others. In advance of accessing loan
underwriting files, claimants have had to be creative to develop an empirical basis for their complaints. For example:
In its 28 September 2010 complaint against Countrywide, Ambac Assurance Corp. reports results of its review of the 6,533
defaulted loans from 12 different transactions with a principal balance of $658 million. It has data on these loans as a
consequence of the claims made against the policies it wrote. This sample is clearly not representative of the entire
collateral pool, however, Ambac reports that it found that 97 percent of these loans failed to conform to Countrywide's own
underwriting guidelines and many "were made to borrowers with little or no ability to repay their loans."
50
The list of the
alleged deviations from underwriting guidelines includes: inflated borrower income, fraudulent appraisals, predatory
lending, and qualifying non-conforming loans without strong compensating factors. However no assessment of the relative
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materiality of these various defects was reported.
The FHLB of San Francisco used summary loan level information it was provided at the time each deal was closed to
perform some independent checks of loan LTVs, presence of undisclosed liens, early payment default experience, and
owner occupancy.
51
Other FHLBs have performed similar analyses to support their separate claims.
52
Independent
property valuations were performed using an Automated Valuation Model (AVM). AVMs use characteristics of each
property and actual property sales data to match comparable property sales in each location. The proportion of loans for
which the stated property valuations were more than 105 percent of the AVM values was computed for each of the 78
securitizations in which the FHLB of San Francisco participated.
53
FHLB considered the defendants to have materially
misstated the LTV in each case. A smaller number of properties were estimated to have values less than 95 percent of the
AVM values. The higher number of alleged overvaluations than undervaluations is presented as evidence of bias.
However, this ignores the possibility that the AVM failed to capture certain valuable attributes of the properties.
54
A review
of tax records for the properties was performed to check whether each was owner occupied. Public land records reportedly
revealed evidence of undisclosed second liens. The FHLB also identified all those loans that became delinquent within six
months of origination and asserted that these loans must have resulted from deviations from underwriting standards. As
an example, for the first of the 78 securitizations listed in the complaint, the proportion of loans with each type of alleged
misrepresentation is reported as follows:
40 percent had LTVs that were understated because property values were overstated by more than 105 percent;
12 percent were not owner occupied;
6 percent were delinquent within six months of origination (allegedly due to underwriting deviations); and,
5 percent had additional liens which reduced owner's equity by 5 percent or more.
Any one of the defects was considered by the FHLB as evidence of a misrepresentation. Across all 78 securitizations, the
proportion of loans with any alleged misrepresentation was 43 percent.
55
However, no empirical assessment of materiality
of these alleged breaches was reported.
Mortgage Repurchase Litigation
Reps and warranties provide investors a contractual remedy in requiring the repurchase of defective loans for the amount of
unpaid principal and accrued interest so neither damages nor loss causation need be proven.
56
However, since any
representation or warranty found to be inaccurate must materially and adversely affect the value of a related mortgage loan,
the materiality of alleged defects is likely to be disputed.
57
Loan-level analysis of alleged defects may be useful in assessing
materiality.
On 3 J anuary 2011, Bank of America (BofA) announced a $2.8 billion settlement of all its remaining repurchase claims for
residential mortgages sold directly to Fannie Mae and Freddie Mac (the GSEs).
58
The BofA stock price rose 5.6 percent,
reflecting a favorable reaction of market participants to the news that BofA had made a significant step towards resolving
repurchase claims against it.
59
However, the repurchase obligations of institutions that sold conforming mortgages to the GSEs
are distinct from the repurchase liabilities arising from the sale of subprime MBS, which are the subject of private litigation. It is
not clear that the BofA-GSE settlement will influence the prospects of subprime repurchase litigation, or even possible
forthcoming litigation in relation to the historical GSE subprime MBS purchases.
Repurchase claims made by the GSEs on loans that collateralized agency MBS are a routine part of the GSEs' continuing
mortgage finance business and are only made on a small fraction of loans. In the case of BofA, about 2 percent of the $1.1
trillion loans sold directly to the GSEs from 2004 to 2008 were the subject of repurchase claims.
60
These disputes are not
being litigated but instead the banks and agencies are "working together to mutually resolve repurchase requests as quickly as
possible."
61
This collaborative approach is made possible by "deep experience" of the banks in responding to reps and
warranty claims
62
and by the continuing relationships of the banks with the agencies, who are the almost exclusive buyers of
the new mortgages they continue to originate.
By contrast, BofA sold $910 billion in residential mortgages to private investors as whole loans and via private label subprime
securitizations, giving rise to actual and further potential repurchase claims from many different parties. The proportion of these
loans with the potential to give rise to repurchase claims is much higher than 2 percent. Repurchase liability could arise from as
many as half these loans based on the defect rate alleged by the FHLB of San Francisco for the collateral backing the
subprime securities they bought.
63
The rate of serious delinquencies and defaults on these loans provides another benchmark
of potential repurchase exposure given investors' incentives to use repurchase claims to mitigate their losses.
64
For 2006 and
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2007 vintage subprime loans, the serious delinquency rate was close to 40 percent as of November 2009.
65
These numbers
make clear how repurchase exposure from private investors in subprime MBS has been estimated to greatly exceed GSE
exposure.
66
While ongoing repurchase requests made by Fannie and Freddie are being resolved based on "mutual understanding of what
represents a valid defect,"
67
repurchase requests made by investors in private litigation are unlikely to get the same
treatment.
68
Of the $2.7 billion in repurchase claims reviewed by BofA through the third quarter of 2010 (related to its private
label securities wrapped by monolines), it approved $550 million for repurchase, leaving 80 percent of the loan "defects" in
dispute.
69
BofA is reportedly in settlement discussions with a syndicate of investors, including BlackRock and the Federal
Reserve Bank of New York
70
(the Greenwich syndicate),
71
in an attempt to resolve a $16.5 billion repurchase claim.
72
These
discussions, initially set to run through J anuary 2011, provide a test of whether differences of opinion over banks' reps and
warranty obligations to subprime investors can be bridged without proceeding in the litigation requiring further loan-level
discovery, underwriting loan file review, and expert economic analysis.
The States Attorneys General and Federal Housing Finance Agency are assessing whether to make repurchase claims in
relation to the private label subprime MBS bought by Fannie and Freddie. As of May 2010 they reportedly held $255 billion.
73
The Federal Housing Finance Agency, in its role as conservator of Freddie Mac and Fannie Mae, has issued subpoenas to
obtain loan-level underwriting and performance data, side-stepping the normal litigation discovery process. The subpoenaed
data were obtained to "assess whether contractual violations or other breaches have taken place leading to losses for the
[companies] and thus taxpayers."
74
The FHFA is investigating both underwriting quality as well as servicing, which could result
in repurchase demands in addition to claims for economic damages.
Talcott Franklin, a Dallas attorney, is spearheading another syndicate of investors representing over $500 billion in MBS
holdings, which would account for over one-third of the $1.5 trillion private-label MBS market.
75
As a syndicate, investors can
collectively meet the 25 percent or 50 percent ownership thresholds required by the trust agreements to petition the trustees of
particular deals to pursue repurchase, underwriting fraud, or servicer misconduct claims. Mr. Franklin has stated that the
syndicate owns bonds with at least 25 percent of "voting rights" in over 2,300 deals. Once trustees are made aware of specific
instances of misconduct, also known as "defaults," the trustees have a responsibility to take steps to remedy those defaults.
76
To read this article and its footnotes in full please click here.
Footnotes
* Mr. Hinton is a Vice President and Dr. Cohen-Cole is a Special Consultant with NERA Economic Consulting. The authors express thanks to their
colleagues Andrew Carron, Denise Martin, Timothy McKenna, Oksana Kitaychik, and Carl Vogel for their helpful comments and Caroline Wu for research
assistance.
1. See e.g. Audit Report, "Safety and Soundness: Material Loss Review of IndyMac Bank, FSB," Office of Inspector General, Department of the Treasury,
OIG-09-032, 26 February 2009; "OIG IndyMac Report, February 26, 2009"; "IndyMac: What Went Wrong? How an "Alt-A" Leader Fueled its Growth with
Unsound and Abusive Mortgage Lending," Center for Responsible Lending, 30 J une 2008 ("CRL IndyMac Report, J une 30,2008"); Testimony of Chris
Mayer, "Housing, Subprime Mortgages, and Securitization: How did we go wrong and what can we learn so this doesn't happen again?" Financial Crisis
Inquiry Commission, Forum to Explore the Causes of the Financial Crisis, Day 2, 27 February 2010.
2. IndyMac loosened its underwriting standards in 2008. See description of Shareholder Litigation below.
3. An example of this economic evidence is presented later in this paper in Figure 3.
4. BofA is one of the principal targets of this litigation by virtue of its acquisition of Countrywide.
5. "'If you think about people who come back and say, "I bought a Vega, a Chevy Vega, but I want it to be a Mercedes with a 12-cylinder," we're not putting
up with that,' said Brian Moynihan, BofA's chief executive." J ustin Baer and Francesco Guerrera, "Institutional investors join forces in bond losses fight,"
Financial Times, 20 October 2010.
6. Chris Gamaitoni, J ason Stewart, Mike Turner, "Mortgage Repurchases Part II: Private Label RBMS Investors Take AimQuantifying the Risks," Compass
Point Research & Trading, LLC, 17 August 2010.
7. "Subpoenas Over MBS Could be Prelude to Major Lawsuits Against Banks," American Banker, 13 J uly 2010.
8. See, for example, the description of Countrywide's underwriting process in its MBS prospectus supplements, Ambac Assurance Corp. et al. v.
Countrywide Home Loans Inc. et al., (New York State Supreme Court, case number 651612/2010, at 14).
9. "Interagency Guidance of Subprime Lending," Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the
Comptroller of the Currency, Office of Thrift Supervision, 1 March 1999.
10. According to Interagency Guidance, "the scoring model should be based on a development population that captures the behavioral and credit
characteristics of the subprime population targeted for the products offered. Because of the significant variance in characteristics between the subprime and
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prime populations, institutions should not rely on models developed solely for products offered to prime borrowers. Further, the model should be reviewed
frequently and updated as necessary to ensure that assumptions remain valid."
11. Interagency Guidance of Subprime Lending mentions the following controls: credit file documentation requirements (such as applications, offering
sheets, loan and collateral documents, financial statements, credit reports, and credit memoranda to support the loan decision); and loan approval
processes, that ensure loans meet underwriting standards; and tracking and monitoring of loans approved as exceptions to stated policy guidelines.
12. Underwriting failures have also been alleged to have caused losses on commercial real estate, and construction and development loans held by failed
banks. See, e.g., Paul J . Hinton, "Failed Bank Litigation: The economics of recent bank failures, comparisons with the S&L crisis, and implications for
litigation against directors and officers," NERA Economic Consulting, 16 August 2010.
13. The 2010 Mortgage Market Statistical Annual - Volume I: The Primary Market, Inside Mortgage Finance Publications, 2010, p. 4.
14. See e.g. Testimony of Chuck Prince, Former Chairman and CEO of CitiGroup, Inc. Before the Financial Crisis Inquiry Commission, 8 April 2010.
15. United States Of America, Financial Crisis Inquiry Commission Hearing on "The Financial Crisis at the Community Level Sacramento, CA" Thursday,
23 September 2010, 9:00 am, Official Transcript pp. 167-173.
16. In testimony before the Financial Crisis Inquiry Commission, Vicki Beal, a Senior Vice President at Clayton Holdings, LLC, a mortgage services
outsourcing, analytics, and consulting company, presented "trending reports," which reported the quarterly results of underwriting reviews they performed
over six quarters starting in the first quarter of 2006. Financial Crisis Inquiry Commission, 23 September 2010.
17. These included representative and adversely selected samples and so in aggregate were not representative of all third-party originated loans.
18. Bhardwaj, G., and Sengupta, R., "Where's the Smoking Gun? A Study of Underwriting Standards for US Subprime Mortgages," ("Where's the Smoking
Gun?") Research Division Federal Reserve Bank of St. Louis, Table 1, Revised March 2010, SSRN abstract 1286106.
19 .FHLB of Seattle v. Deutsche Bank, Amended Complaint, No. 2:10-cv-00140-RSM, 10 J une 2010.
20. Moody's Home Equity Indexes, FRM03-FRM08, Moody's Investor Service, as of February 2010.
21. See e.g., Chris Foote and Kris Gerardi and Paul Willen, "Negative Equity and Foreclosure: Theory and Evidence," Journal of Urban Economics,
64(2):234-245, 2008.
22. Cohen-Cole, Ethan and Morse, J onathan, "Your House or Your Credit Card, Which Would You Choose? Personal Delinquency Tradeoffs and
Precautionary Liquidity Motives," 28 J anuary 2010.
23. See, e.g., Adrian M. Cowan and Charles D. Cowan, "Default correlation: An empirical investigation of a subprime lender," Journal of Banking & Finance,
Volume 28, Issue 4, April 2004, Pages 753-771.
24. Uday Rajan, Amit Seru, and Vikrant Vig, "The Failure of Models That Predict Failure: Distance, Incentives and Defaults," 2 August 2010, SSRN abstract
1296982.
25. Empirical evidence of this incentive problem is developed by Keys et al (2010), who find that low doc securitized loans are more likely to default. Keys,
Benjamin J ., Tanmoy Mukherjee, Amit Seru, and Vikrant Vig, "Did Securitization Lead To Lax Screening? Evidence From Subprime Loans," The Quarterly
Journal of Economics, February 2010. A principle finding was that "[T]he role of soft information is crucial to understanding what worked and what did not in
the existing securitized subprime loan market [and] that by relying entirely on hard information variables like FICO scores, these models ignore essential
elements of strategic behavior on part of lenders which are likely to be important. (p. 4, p. 29)
26. See Piskorski, Tomasz, Seru, Amit, and Vig, Vikrant, "Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis,"
15 April 2010. Keys, Benjamin J ., Mukherjee, Tanmoy K., Seru, Amit, and Vig, Vikrant, "Did Securitization Lead to Lax Screening? Evidence from Subprime
Loans," 25 December 2008. Ashcraft, Adam B. and Schuermann, Til, "Understanding the Securitization of Subprime Mortgage Credit," March 2008,Wharton
Financial Institutions Center Working Paper No. 07-43. Krainer and Laderman (2009) "Mortgage Loan Securitization and Relative Loan Performance"
http://www.frbsf.org/publications/economics/papers/2009/wp09-22bk.pdf.
27. "When low foreclosure rates are observed in a portfolio over time, it is unclear whether these rates are low because the inherent default risk of the pool
is low or because a prepayment rate for certain types of loans or borrowers allowed risky borrowers to prepay before they would have defaulted." Ashish
Das and Roger M. Stein, "Underwriting versus economy: a new approach to decomposing mortgage losses," The Journal of Credit Risk, Volume 5, Number
2, Summer 2009.
28. The combination of events contributing to the financial crisis have been characterized as a perfect storm by The Chairman of the Financial Crisis Inquiry
Commission Mr. Angelides. Official Transcript, First Public Hearing of the Financial Crisis Inquiry Commission, 13 J anuary 2010.
29. For example, Bhardwaj and Sengupta find that while underwriting may have weakened along some dimensions, it certainly strengthened along others;
they also find that any deterioration post-2004 cannot be the explanation for the collapse of the subprime market.
30. J iang, W., Nelson, A., and Vytlacil, E., "Securitization and Loan Performance: A Contrast of Ex Ante and Ex Post Relations in the Mortgage Market,"
(J iang et al, "Securitization and Loan Performance") J uly 2010, SSRN abstract 1571300; Demyanyk, Y. and Van Hemert, O., "Understanding the Subprime
Mortgage Crisis," Review of Financial Studies, December 2008, SSRN abstract 1020396; Bhardwaj, G., and Sengupta, R. "Where's the Smoking Gun?"
Revised 2010.
31. For example, a default rate of 0.2 indicates a loan that is 20 percent as likely to default a as the same loan with a FICO score of 540.
32. J iang, Wei, Nelson, Ashlyn Aiko, and Vytlacil, Edward J ., "Securitization and Loan Performance," J uly 2010. Demyanyk, Y. and Van Hemert, O.,
"Understanding the Subprime Mortgage Crisis," Review of Financial Studies. Bhardwaj, G., and Sengupta, R. "Where's the Smoking Gun?" Revised 2010.
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33. Specifically for loans underwritten in 2005 and 2006.
34. Relative default rates are estimated using Cox proportional hazard rate regressions that account for borrower characteristics and the closing rate spread
(difference between closing rate on the origination and the 30-year conventional mortgage rate). These hazard ratios are a measure of the probability of
delinquency within 90 days of underwriting for each FICO group as compared to the base group (FICO scores less than 540). Bhardwaj, G., and Sengupta,
R, "Where's the Smoking Gun?" Revised 2010, Table 10b.
35. Lucas, Robert (1976), "Econometric Policy Evaluation: A Critique", in Brunner, K.; Meltzer, A., The Phillips Curve and Labor Markets, Carnegie-
Rochester Conference Series on Public Policy, 1, New York: American Elsevier, pp. 1946, ISBN 0444110070.
36. Uday Rajan, Amit Seru and Vikrant Vig, "The Failure of Models That Predict Failure: Distance, Incentives and Defaults," 2 August 2010, SSRN abstract
1296982.
37. FHLB of San Francisco vs. Credit Suisse Securities (USA) LLC, Superior Court of California, County of San Francisco, No. CGC.10.497840, Amended
Complaint, 10 J une 2010 ("FHLB of San Francisco Amended Complaint"), p.34.
38. See, e.g., Dennis R. Capozza and Robert Van Order, "The Great Surge In Mortgage Defaults 2006-2009: The Comparative Roles of Economic
Conditions, Underwriting and Moral Hazard," J une 2010.
39. Cohen-Cole, Ethan and Duygan-Bump, Burcu, "Social Influence and Bankruptcy: Why do so Many Leave so Much on the Table?" 10 December 2009.
SSRN: abstract 1423964. This theory is supported by Scholnick, Barry, "Consumption Smoothing After the Final Mortgage Payment: Testing the Magnitude
Hypothesis," May 2010, SSRN: abstract 1358457.
40. Cohen-Cole, Ethan and Morse, J onathan, "Your House or Your Credit Card, Which Would You Choose? Personal Delinquency Tradeoffs and
Precautionary Liquidity Motives," 28 J anuary 2010. SSRN: abstract 1411291.
41. Agarwal, Sumit, Amromin, Gene, Ben-David, Itzhak, Chomsisengphet, Souphala, and Evanoff, Douglas D., "Do Financial Counseling Mandates Improve
Mortgage Choice and Performance? Evidence from a Legislative Experiment," 1 J une 2009.
42. MBIA Insurance Corporation v Countrywide home Loans Inc. et al., Supreme Court of the State of New York, (Index No. 602825/08) decision on in limine
motion on use of statistical sampling, Hon Eileen Bransten, 22 December 2010.
43. Ibid.
44. Isaac Gradman, "MBIA Sampling Order Signals Shorter Path to RMBS Putbacks," Subprime Shakeout Blog, 29 December 2010.
45. These were among the arguments presented by Defendants in the MBIA v Countrywide matter.
46. PSAs generally state that repurchase of defective loans is the "sole remedy" available to the parties for breach of reps and warranties. However, in the
recent decision on a motion to dismiss in the FHLB of Pittsburgh case against J P Morgan, the judge ruled that the repurchase remedy was only available to
the Trustee and not to investors who had their own right to bring claims for fraud, negligent misrepresentation, and other torts. Isaac Gradman, "Federal
Home Loan Bank of Pittsburgh Scores Important Early Victory in Pennsylvania Lawsuit," Subprime Shakeout Blog, 7 December 2010.
47. See, e.g., Ambac Assurance Corporation v. Countrywide Home Loans, Inc., Supreme Court of the State of New York, New York County, Index No.
651612/2010, Complaint, 28 September 2010 ("Ambac v. Countrywide complaint").
48. FHLB of Seattle v. Deutsche Bank, Amended Complaint for Rescission, 10 J une 2010, p.31.
49. Ambac Assurance Corp. et al. v. Countrywide Home Loans Inc. et al., (New York State Supreme Court, case number 651612/2010, at 18.
50. Ambac Assurance Corp. et al. v. Countrywide Home Loans Inc. et al., (New York State Supreme Court, case number 651612/2010, at 6.
51. FHLB of San Francisco Amended Complaint.
52 .For example, the FHLB of Seattle developed a sample of 2,578 loans, representing 58 percent of the collateral pool, for which it independently estimated
LTVs. Overall the average of the AVM valuations were 8 percent higher than the weighted average reported in the pool prospectus. J onathan Laing, "Banks
Face Another Mortgage Crisis," Barrons, 20 November 2010.
53. FHLB of San Francisco Amended Complaint, p.19.
54. FHLB of San Francisco Amended Complaint, pp.24-25.
55. This is the weighted average across all securitizations listed on pages 3-5.
56. For example, the Countrywide PSA states: "With respect to any Mortgage Loan required to be purchased by a Seller pursuant to Section 2.02 or 2.03
hereof or purchased at the option of the Master Servicer pursuant to Section 3.11, an amount equal to the sum of (i) 100% of the unpaid principal balance of
the Mortgage Loan on the date of such purchase, (ii) accrued interest thereon at the applicable Mortgage Rate [...] from the date through which interest was
last paid by the Mortgagor to the Due Date in the month in which the Purchase Price is to be distributed to Certificateholders and (iii) costs and damages
incurred by the Trust Fund in connection with a repurchase pursuant to Section 2.03 hereof that arises out of a violation of any predatory or abusive lending
law with respect to the related Mortgage Loan." See definition of Purchase Price in Article I of the Countrywide PSA - Pooling and Servicing Agreement,
Alternative Loan Trust 2005-35CB Mortgage Pass-Through Certificates, Series 2005-35CB, CWALT, Inc., Depositor; Countrywide Home Loans, Inc., Seller;
Park Granada LLC, Seller; Park Monaco Inc., Seller; Park Sienna LLC, Seller; Countrywide Home Loans Servicing LP, Master Servicer; and the Bank of
New York, Trustee; Dated as of J uly 2005 ("Countrywide PSA").
57. As stated in the Countrywide PSA: "With respect to the representations and warranties described in this Section which are made to the best of a Seller's
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knowledge, if it is discovered by either the Depositor, a Seller or the Trustee that the substance of such representation and warranty is inaccurate and such
inaccuracy materially and adversely affects the value of the related Mortgage Loan or the interests of the Certificateholders therein, notwithstanding that
Seller's lack of knowledge with respect to the substance of such representation or warranty, such inaccuracy shall be deemed a breach of the applicable
representation or warranty." Section 2.03. Representations, Warranties and Covenants of the Sellers and Master Servicer; Countrywide PSA.
58. "Bank of America Announces Fourth-Quarter Actions With Respect to Its Home Loans and Insurance Business," Bank of America Press Release, 3
J anuary 2011.
59. Hugh Son and Dawn Kopecki, "BofA Resolves Fannie Mae, Freddie Mac Loan-Putback Dispute," Bloomberg, 3 J anuary 2011.
60 "Bank of America Announces Fourth-Quarter Actions With Respect to Its Home Loans and Insurance Business," Bank of America Press Release, 3
J anuary 2011.
61. Nick Timiraos and Aparajita Saha-Bubna, "Banks face fight over mortgage-loan buybacks," The Wall Street Journal, 18 August 2010.
62. "Bank of America, 3Q10 Earnings Results," presentation materials accompanying company press release, 19 October 2010, p. 23.
63. See, e.g., FHLB of San Francisco Amended Complaint.
64. This assumption is used by Compass Point to develop their base case estimate of repurchase exposure. Chris Gamaitoni, J ason Stewart, and Mike
Turner, "Mortgage Finance, Mortgage Repurchases Part II: Private Label RMBS Investors Take Aim - Quantifying the Risks," Compass Point Research &
Trading LLC, 17 August 2010.
65. See, e.g., Federal Reserve Bank of New York, US Credit Conditions, "Serious Delinquency, Subprime First-Lien." This chart shows serious delinquency
estimates by vintage for subprime first-lien mortgage loans at the national level. Serious delinquencies are defined as loans that are one of the following: 90
or more days delinquent, in foreclosure, real estate-owned, in bankruptcy, or prepaid with loss. This report uses a 2 percent random sample of securitized
nonprime mortgage loans from First American CoreLogic's Loan Performance data set. http://data.newyorkfed.org/creditconditions/.
66. Nick Timiraos and Aparajita Saha-Bubna, "Banks face fight over mortgage-loan buybacks," The Wall Street Journal, 18 August 2010.
67. Ibid.
68. At least one monoline is reportedly having some success in a negotiating strategy. Assured Guaranty has reportedly adopted the strategy of negotiating
directly on a loan-by loan basis with the banks whose mortgage-backed pools it insured. Its executives have stated that they have already won over $400
million in recoveries. (J onathan Laing, "Banks Face Another Mortgage Crisis," Barrons, 20 November 2010.)
69. BofA, 19 October 2010, 3Q10 Earnings presentation, p.24.
70. The Federal Reserve Bank of New York is also involved in the litigation as a member of the investor syndicate behind the Greenwich Financial action
against Bank of America in relation to investments in Countrywide mortgage pass-through certificates. The Fed's exposure resulted from investments it
inherited through its rescue of Bear Stearns Cos. and Amercian International Group Inc. Other members of the syndicate include Neuberger Berman Group
LLC, Blackrock Inc., MetLife Inc.,Western Asset Management Co., and Pimco. Dan Fitzpatrick, "BofA Resists Rebuying Bad Loans," The Wall Street
Journal, 20 October 2010; J ohn Gittelsohn and J ody Shenn, "Banks face two-front war on bad mortgages, flawed foreclosures," Bloomberg BusinessWeek,
21 October 2010.
71. Greenwich Financial Services Distressed Mortgage Fund 3, LLC, and QED LLC v. Countrywide Financial Corporation, Countrywide Home Loans, Inc.
and Coutrywide Home Loans Servicing LP, Supreme Court of the State of New York County of New York, Index No. 650474/08, D.
72. Ruth Simon, "Bondholders Pick a Fight With Banks," The Wall Street Journal, 19 October 2010.
73. Nick Timiraos, "U.S. Queries 64 Issuers of Mortgage Securities, Others," The Wall Street Journal, 13 J uly 2010.
74. Ibid.
75. Isaac Gradman, "Investor Syndicate Fires Warning Shot Across Trustee Bows," The Subprime Shakeout Blog, 23 J uly 2010.
76. Ibid.
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