Until recently, much of the attention surrounding "put-back risk" has focused on the legal aspect, notably whether judges will require lenders to repurchase loans they sold to securitizers.
But bankers are now starting to wonder about the potential regulatory costs of this risk, as observers predict it could cause the banking agencies to raise a firm's capital, reserve and liquidity requirements.
The agencies are "going to have to look bank by bank and try and make some assessment of how that legal risk is going to manifest itself and to what degree in financial risk," said Kevin Jacques, the Boynton D. Murch chair in finance at Baldwin-Wallace College in Ohio. "Because this is going to be determined by the legal system, that creates an unknown or a wild card as to what amount of that risk is going to be put back to the bank."
The Federal Reserve Board is now leading an examination of put-back risk at the largest banks, asking institutions to include their exposure to repurchases in reports to the central bank about their capital strength. Many see this as a first step toward higher regulatory requirements.
Excluding potential put-back claims from private-label investors, Fed Gov. Dan Tarullo said in testimony to the Senate Banking Committee last week that outstanding repurchase requests from mortgage giants Fannie Mae and Freddie Mac exceed $13 billion, well above the nearly $10 billion of reserves for potential put-backs at the four largest banks.
"This liability could be quite significant for some firms, although particularly with respect to private-label securitizations, the losses may well be spread over a considerable period of time as litigation ensues," he said. When pressed by Jeff Merkley, D-Ore., to measure the risk "on a scale of 1 to 10," Tarullo said it was still hard to gauge.
Investors can attempt to force a repurchase on claims that the quality of a security does not meet the so-called "representations and warranties" outlined in the original contract.
For example, investors can claim a bank attested to sound underwriting for the underlying loans, which did not actually turn out to be true. But the claimant would have to prove the misrepresented statement was directly related to a significant loss by the investor.