Mortgage-backed securities are sort of conceptually simple - put mortgages in a pot, stir, sell layers of resulting goop - but complex in execution; they have not only economic but also legal and accounting and bankruptcy purposes and so their offering documents are long and boring and filled with dotted and dashed lines and arrows and boxes and originators selling to sponsors selling to depositors selling to trustees selling to underwriters selling to investors. All those arrows serve as a finely calibrated series of one-way gates; each link in that chain is meant to shield the person before the link from something, some real or imaginary claim from the people coming after the link, allowing originators/sponsors/etc. to tell themselves "I never need to worry about those mortgages again!"
Hahahaha no they totally do. Today the Journal and the FT have stories about a possible JPMorgan SEC settlement on some Bear Stearns mortgage practices, specifically (per JPM's filings) "potential claims against Bear Stearns entities, JPMorgan Chase & Co. and J.P. Morgan Securities LLC relating to settlements of claims against originators involving loans included in a number of Bear Stearns securitizations". If you're keeping score these are:
- not the thing where Bear maybe did a shoddy job underwriting mortgages, and
- not the New York state lawsuit involving, besides the shoddy underwriting, Bear Stearns' settlements of claims against originators, but rather
- the SEC's investigation of what seem to be those same settlements of claims against originators.1
This is how the FT describes it:
The SEC is investigating the bank’s alleged failure to pass on proceeds recovered from loan originators for soured mortgage loans to a trust managing residential mortgage-backed securities, according to people familiar with the matter.
The SEC investigation is also focused on disclosures made to investors concerning the renegotiated loans.
As noted, New York AG Eric Schneiderman did his own investigation - or, um, sat in on the SEC's investigation? - and has already sued over it; here is his take on this issue from the complaint:
76. Although loan originators were contractually required to buy back defective loans at an agreed-upon repurchase price, Defendants [i.e. Bear] routinely permitted them to avoid this obligation by extending cheaper or otherwise more appealing alternatives. Specifically, Defendants offered substantial concessions to originators in order to preserve Defendants’ relationships with them and to ensure the continued flow of loans.
77. For example, “in lieu of repurchasing the defective loans,” originators were permitted by Defendants to confidentially settle EPD and other claims by making cash payments that were a fraction of the contractual repurchase price. Defendants’ other concessions included agreements to cancel or waive entire claims against originators, and the creation of “reserve programs” under which Defendants used funds collected from these originators towards future loan purchases. ...
79. Defendants were contractually obligated to give prompt notification to investors of any breach that materially and adversely affected investors, such as fraud in connection with loan origination or the failure to underwrite a loan in accordance with underwriting guidelines. Defendants were also required to repurchase defective loans from securitizations. Defendants not only failed to fulfill their contractual obligations; according to the testimony of one senior Bear Stearns manager, Defendants collected and retained the recoveries they obtained from their undisclosed settlements with originators.
That seems shady! Bear's lawyers and accountants eventually told them to knock it off, which also suggests it really was shady. Still, it warms my heart a little as a former lawyer and a guy who appreciates clever shadiness wherever I can find it. The documents - here is a Bear securitization at issue in the DOJ case, obviously there are others - do certainly create the impression that if mortgages are in serious breach someone will repurchase them. That's sort of a gestalt impression more than it is a clear and definitive flow of mortgages back to originators / funds back to investors. For instance:
The only obligations of the depositor with respect to a trust fund or the related securities would result from a breach of the representations and warranties that the depositor may make concerning the trust assets. However, because of the depositor’s very limited assets, even if the depositor should be required to repurchase a loan from a particular trust fund because of the breach of a representation or warranty, its sole source of funds for the repurchase would be:
- funds obtained from enforcing any similar obligation of the originator of the loan, or
- monies from any reserve fund established to pay for loan repurchases.
"You can make one link in the chain buy back the mortgages, but that link is just a nonsense accounting entity, so good luck with that!" Presumably, as New York's Schneiderman argues and the SEC seems to also think, there is some chain of obligations that actually link up here - somewhere else in the document the depositor is obligated to enforce etc. etc. etc. all the way back to the originator. But the chain is more fractured and obscured when it works in reverse than it is when it works forward. There's no flowchart in the front of the prospectus for getting your money back.
In some ways this is obvious. To be only slightly inaccurate, the flow of mortgages in the securitization really was originators -> sponsor -> depositor -> trustee -> underwriter -> investors; this flow was greased in part by thousands of pages of legal documents but also in larger part by the fact that everyone wanted things to flow in that direction. Investors wanted mortgages, everyone else wanted to be rid of them, so everyone worked together to get each other what they wanted. The putbacks of breaching mortgages were greased by the same legal documents, but not by any particular desire. I mean, yes, each link in the chain wants the link before them to pay them for selling early-defaulting mortgages with false representations - but the previous link doesn't want to pay.2 Legal documents are a lot more fragile than coincident economic desires.
That's particularly true because (1) the banks wrote the documents and (2) the investors didn't read them, so, y'know, vagueness will go in the banks' favor. The trick, if you can work it, is to make the product look as mechanical as possible - mortgages go in, securities come out, and the process for rejecting defective mortgages is as automatic as the process that brought them to you in the first place - while still creating little pockets of optionality at important points along the chain. Bear finds a breach in the mortgage reps? Why not take some money from the originator, but decide the breach isn't material enough to trouble the investors which? You win both ways: you get less than the full putback value from the originator, but you don't have to pass on any of it to investors.
Until they - or someone - sue you and you do! Then I guess you feel bad because you settled your claims against originators at pennies on the dollar, but you owe the full dollar to the investors? Hahahaha no you don't; at a guess, I'd say you get some sort of settlement with the SEC where you settle this putback liability for somewhat more than you pocketed from the originators, but less than you actually should have passed along to investors. Depending on your probability of getting sued in the first place, that can look like a pretty attractive strategy. Especially if you're not expecting to get sued over and over again for the same stuff.
1.A while back we discussed the fact that Bank of America seems to be getting sued multiple times for some Countrywide loans; I found that sort of amusing and anomalous but obviously I am a dope. Here we have parallel state and federal investigations about ... this repurchase-obligation thing is at least a little obscure isn't it? Yesterday Breakingviews had a funny column that went like this:
Recycled legal claims are beginning to make banks look like victims. Wells Fargo is saying the U.S. Justice Department sued it twice over the same dodgy mortgage practices. If true, that's unfair as well as a waste. Yes, Wall Street still must answer for the financial crisis. But duplicative suits from state and federal watchdogs promote resentment, not deterrence.
Why can't it be both? I dunno. It's sort of churlish to be all "yes we committed fraud on mortgage securitizations, but only eight million times, so it's totally unfair that we're being sued twelve million times." Tiniest violin etc.
2.For most of the links that's independent of whether they've recovered from people even further back in the chain. If the sponsor gets money from the originators, why would they want to hand it over to the investors? They don't, that's why.