The foreclosure crisis has brought the issue of buybacks to the forefront of discussions once again. Jaded investors are looking to get some compensation from the mortgage market fiasco that has seen RMBS delinquency rates soar.

"In the past few weeks, 'robo-signing' has rapidly snowballed into broader questions about the entire foreclosure process," said securitization analysts at JPMorgan Securities in a conference call last month. "In the extreme, some market pundits have even suggested that securitizations were fundamentally flawed, and that loans were not assigned properly to securitization trusts. Unfortunately, many of the news reports have not been accurate and confuse the issues and potential outcomes for the market."

For securitization bondholders, the issue of foreclosures means that defaulted homeowners will stay in homes up to a year longer without making any payments, which, in turn, will increase liquidation timelines. As a result, the market could see a higher number of negative rating actions particularly on the subordinate tranches because of the larger losses.

There is a significant interest among ABS players around this issue because of its impact on a significant number of transactions. Most of these deals have high delinquencies already, so it is uncertain what impact an extended foreclosure timeframe might have on their performance. The foreclosure problem is affecting all borrowers regardless of product type. While foreclosures are more predominant in subprime loans, they represent only about 20% of the loans in the market today with the rest of the loans being prime and Alt-A.

For the RMBS market, the foreclosure crisis should really present only operational risks. Depending on how long the foreclosures are stalled, securitization trusts will face higher loss severities, lower recovery and less principal to pass on to the trust. "The effect, however, could be significant," a Moody's Investor Service analyst said.

The delayed foreclosure process is expected to have a minimal impact on the senior bonds with them performing marginally worse in the long run as a result of the slower prepayments, said Kathleen Tillwitz, senior vice president at DBRS.

"The largest impact will be on the subordinate bonds," she said. "In the short term, the subordinate bonds will be paid more interest because they will be outstanding longer before losses ultimately hit. However, eventually these bonds will suffer larger write-downs due to the higher loss levels."

These investors face longer losses because loans that were about to be foreclosed on suddenly had to be pulled because of incorrectly filed documents. Foreclosures have always taken a considerable amount of time.

Joe Mason, a professor of finance at Louisiana State University, said that the different states have varying foreclosure rates, whether dictated specifically by law or through a myriad of time-consuming procedures to which adherence is mandatory. In Texas, for instance the law allows for a near immediate foreclosure upon exceeding 120 days past due while New York requires procedures that commonly result in delays of more than 18 months.

DBRS' Tillwitz believes that the even greater backlog created by the recent foreclosure moratorium could add, in certain cases, another six months to a year to the lag time, depending on the state in which it is filed in.

According to the Mortgage Bankers Association's National Delinquency Survey, some 12% of delinquent subprime loans are 30 days past due, followed by just under 6% of loans that are 60 days past due.

"With seeming alarm, many view the fact that, only weeks into the foreclosure documentation problems, more than 21% of delinquent loans are 90 days past due but not yet in foreclosure, and another 22% are already in the foreclosure pipeline, for a seriously delinquent rate (90+ past due and in foreclosure) of just under 43% of delinquent loans," Mason said.

The situation, he said, is worse for securitized loans and, therefore, their investors.

Among current delinquencies reported for all securitized deals, some 17% of loans are 30 days past due, followed by just under 8% of loans that are 60 days past due. For securitized loans, however, more than 30% of delinquent loans are 90 days past due but are not yet in foreclosure, with another 26% in the foreclosure pipeline, for a seriously delinquent rate of just under 56% of delinquent loans.

On the agency mortgage side, timely interest and principal payments are guaranteed for and defaulted loans are bought out of pools long before they reach the foreclosure process. From this perspective, agency MBS should not be affected by foreclosure problems and moratoria.

"But once servicers get foreclosures moving again we are likely to see an increase in foreclosures, showing you that the loan mod programs have run their course," said Scott Buchta, head of investment strategy at Braver Stern Securities. "The fallout is that foreclosure numbers will be much higher and banks will have to deal with this."


The Put-back Issue

Within the foreclosure crisis, more fundamental issues have been raised challenging both the validity of the procedures used to convey mortgage loans into securitization trusts and the qualification of the securitization trusts as a real estate mortgage investment conduit (REMIC) at the time those trusts were formed. According to securitization industry players, these statements are false and misguided.

"There is no question whether the contracts each party signed were valid," Mason said. "The borrower owes the money they used to buy the property. The lender has a claim to that money. Mere delays in providing the right documentation of a perfected collateral claim will not change the situation. Hence, a foreclosure moratorium would only turn an unpleasant inconvenience (albeit one of banks' own making) into a source of considerable additional loss and unnecessary policy uncertainty for the entire industry."

The big picture, according to Mason, is that investors are jumping at any opportunity to put loans back to the seller. "If you as the trustee are not able to demonstrate possession of the note that gives you the legal right to foreclose on a property, then investors are going to jump on this deficiency - even though it could be fixed," he said.

Allonhill CEO Sue Allon said that there are reasons to believe that many of the claims won't go anywhere. For starters, the servicing issue likely will go down as a matter of procedure where the servicer, not the originator of the loan is held culpable.

"It's also a very expensive process and the fundamental question behind these repurchase claims is whether or not these loans went bad because of a bad economy or because of some negligence on behalf of the issuer?," Allon said.

Bill Fricke, a senior credit officer and vice president at Moody's Investors Service, agreed and said that because the foreclosure issue is likely to be viewed more as a servicing problem, it would not likely lead to loan repurchases. "If there is a breach the servicer is responsible for damages, but that doesn't mean they necessarily have to repurchase the loans," he said.

There is sufficient documentation for the transfer of ownership, but since the foreclosure issue will potentially be handled on a state by state basis, it is possible that there are documentation problems that could delay foreclosures for a longer term. "Even if someone owns a mortgage note, he may not be the 'record owner' of the mortgage and thus may not have the right to exercise the remedy of foreclosure unless he has complied with all of the details the state law requires," said Yehudah Forster, a vice president and senior analyst at Moody's.

There is nonetheless a strong likelihood that many of these loans will be repurchased out of the transaction as a result of breaches of representation and warranties if they were not serviced according to applicable guidelines and state laws.

"Put-backs have been talked about and have been out there for a long, long time but when you start putting names like Pimco, Blackrock and NY Fed all in one sentence; this will start to get others' attention," said Jesse Litvak, a mortgage trader at Jefferies & Co. "There is a ton of psychology that exists in (the non-agency) space (and it is) very much a herd mentality. So when everything goes one way [ie selling or buying] the sheep tend to follow. If other investors start to pile on and add more CUSIPs to the list, rest assured I think the optionality (especially on the tail) is very large."

Servicers are supposed to follow the laws in each state when servicing a mortgage loan. If a court determines that a borrower's home was taken from him or her - regardless of the delinquency level - through a process that did not comply with the law, that borrower would be entitled to compensation.

The form of compensation would need to be determined on a case-by-case basis by a judge and would likely include a financial settlement. Tillwitz said she expects that some sort of fund will be set up by banks for this process.

On the RMBS side, if it is proven in court that a loan was not serviced in accordance with applicable laws, that would be considered a breach of the reps and warranties in an RMBS transaction and subject to any buyback provisions in the transaction.

The investor in a security can find out if a loan was initially submitted with an incorrect affidavit by asking the servicer for a list of active and completed foreclosures in the 23 judicial states in the transactions that they own where the erroneous submission procedure was in place.

"Some servicers will provide the information (usually without the address due to privacy laws) others will tell them they are not entitled to receive anything more than the remittance reports," Tillwitz said. "If the servicer is unwilling to provide the data to an investor they will need to sue the servicer to obtain the information. If an investor is able to obtain partial information on a loan they may be able to work with the title company to find out if there are any title perfection issues due to faulty foreclosure documents."

It is the route that bondholders of more than 25% of the voting rights in more than $47 billion of Countrywide Financial-issued RMBS have taken. The group of investors sent a notice of non-performance to Countrywide Home Loans, identifying specific covenants in 115 pooling and servicing agreements (PSAs) that the holders allege Countrywide Servicing has failed to perform.

In the notice, the bondholders allege that each of these failures has materially affected the rights of the certificate holders under the relevant PSAs.

Under Section 7.01 of the PSAs, if any of the cited failures "continues unremedied for a period of 60 days after the date on which written notice of such failure has been given ... to the Master Servicer and the Trustee by the Holders of Certificates evidencing not less than 25% of the Voting Rights evidenced by the Certificates," that failure constitutes an Event of Default under the PSAs.

In a previous notice, the bondholders emphasized their intent to invoke all contractual remedies available to them to recover their losses and to protect their rights.

Kathy Patrick, a securities litigator from Gibbs & Bruns and lead counsel for the holders, emphasized that the holders' notice does not seek to halt loan modifications for troubled borrowers. Instead, it urges the trustee to enforce Countrywide Servicing's obligations to service loans prudently by maintaining accurate loan records, demanding the repurchase of loans that were originated in violation of underwriting guidelines, and compelling the sellers of ineligible or predatory mortgages to bear the costs of modifying them for homeowners or repurchasing them from the trusts' collateral pools.

Patrick also noted that the group of holders that tendered the second notice of nonperformance is larger, and encompasses more Countrywide-issued RMBS deals, than were included in the first letter issued on Aug. 20. "Ours is a large, determined, and cohesive group of bondholders," Patrick said. "We have a clearly defined strategy. We plan to vigorously pursue this initiative to enforce holders' rights."

However, in some cases, the statute of limitation on representations and warranties may be running out and this will likely present a problem for investors, Braver Stern's Buchta said.


How Big Is the Problem?

What's certain is that the put-back issue is likely to be spread out over a number of years because of the complexity and cost of implementing put-backs, especially in non-agency securitizations. Royal Bank of Scotland analysts anticipate that, in the next several months, the banks will agree on a financial settlement with the state Attorney General's in the range of $1.3 billion to $4.3 billion.

Over the next year, banks will likely satisfy objective loan file exception repurchase obligations of approximately $25 billion; over the longer term, satisfy a relatively small percentage of massively sized claims for breaches of representations and warranties as the result of litigation or negotiated settlements with investors; and, over the next several years, repurchase approximately $13 billion of loans from the GSEs.

JPMorgan analysts estimated that put-back risk will be approximately $23 billion to $35 billion for agency mortgages, $40 billion to $80 billion in non-agency and roughly $20 billion to $30 billion for second liens and HELOCs.

And when it comes to repurchase agreements HELOCs and second liens backed by monoline insurance have had a higher repurchase rate, JPMorgan analysts said. The success rate is as high as 60%.

According to the Association of Financial Guaranty Insurers (AFGI), Bank of America repurchase obligation for paper insured by members fall in the area of $10 billion to $20 billion. AFGI members estimated that more than half of the 2005, 2006 and 2007 vintage nonperforming HELOCs and first- and second-lien residential mortgage securitizations reviewed or sampled, that have been insured by them qualify for repurchase by BofA.

"Well it will hit bank earnings," Mason said. "The big banks will get investor lawsuits and repurchase claims if not actual put backs. The losses will continue to concentrate around these banks because, as we discussed years ago, we really were not selling risk. The banks do have skin in the game in the form of retained risk on securitizations. The risk transfer was never complete because the sale was never complete and the losses keep trickling back to the banks. We could see some sort of [Troubled Asset Relief Program] Part II for the mortgage sector with blanket coverage of risk by the Treasury. All of the future losses on housing would go to the Treasury."


Better Structuring Down the Line

One positive outcome that will result from these unsettling days is that investors will get better representation in future structures.

Allon said that an upside to this mess is that investors looking to buy into future securitizations will be investing in the safest products around. Sure, the extra due diligence that will go into the deals will make all-in costs more expensive, but the security that results from these procedural changes is likely to ensure a near failsafe product, one that investors can trust.

"Everyone is paying attention to every detail and then double checking it. Our clients want to keep deals 100% clean and they are dramatically concerned about getting things right," she said. "All this contributes to a degree of assurance that you didn't have before."

The issue is forcing servicers to examine all areas of their companies and they will come out stronger in the long run as a result. None of these servicers wants to delay their processes due to errors or face losses due to expensive litigation and class action lawsuits.

Peter Swire, a law professor at Ohio State University who served as a top adviser on housing-finance issues in the White House, has proposed a system where the bank and senior banker would be essentially making a stronger set of "reps and warranties" about the banks' systems. If a senior officer is not willing to sign, then the regulators and the public have good reason to remain skeptical. If and when the senior officer does sign, the officer and the bank are taking responsibility - something many feel has not happened enough since the financial crisis began.

The certification can also bring increased certainty back to a portion of the housing market - the portion covered by that bank's activities. More banks will sign over time, and this will create a path forward to leaving this portion of the mortgage mess behind us.

"These servicers have hired hundreds of people and they are moving quickly to assess this problem. There is no question that in the end servicers will come out better," Tillwitz said.

But any changes made to servicing procedures means an increase in the costs of mortgage servicing, which would then likely be passed on to the borrower. This would result in an increased primary-secondary mortgage spread. Moody's has already put GMAC on watch because of the liquidity concerns that might result from increased litigation risks. The firm is, in fact, already facing claims from the Ohio Attorney General.


Foreclosure Pipeline Grows

The foreclosure issue will also push down home sale prices, which will, in turn, cause larger write-downs in deals. In the near term, banks may increasingly look to cut back credit for marginal borrowers to avoid any future potential problems in future deals. This means a further restriction on the housing market.

"For the past year or more, mortgage servicers have struggled with selling properties taken back in foreclosures," Mason said. "Such disposition delays have cost the industry dearly, and will continue to do so. In response, some in the industry delayed foreclosures. Some banks allowed greater time for borrowers to affect short sales. Others took more time to modify loans, hoping to avoid foreclosure."

Moody's analysts said that holding up foreclosures just pushed the trough further out, and this short delay means that prices will decline more sharply in 2011. Until mortgage ownership issues have been clarified, it's likely that mortgage insurers may be hesitant to insure or may desire extra time to perform their own due diligence.

Citigroup Global Markets analysts said that if mortgage insurers begin to exhibit hesitancy, mortgage originations could be slowed.

"I do think this mess is going to take a very long time to sort out," Jefferies' Litvak said. "But when you have the likes of the biggest players in the space pushing for put-backs that will get the attention of others - let's not forget that most of the non-agency space trades at a discount dollar price - even a marginal amount of put-backs could create significant upside to these bonds. Also keep in mind that last week we were seeing selling of $1 billion a day. We have yet to crack the $1 billion number this week yet and last time I checked there are no new mortgages getting done ."



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