Banking Law

I'm not the only blogger bleating about loan repurchase risks.

Francine McKenna has been pounding the large audit firms for several years about their failure to catch the repurchase risk inherent in the business operations of large mortgage bankers like the defunct New Century and the merged-out-of-existence Countrywide Financial. She recently discussed the fact that although KPMG has settled litigation over the failures of New Century and Countrywide, it still faces litigation over Citigroup and Wells Fargo/Wachovia.She also mentions that Price Waterhouse Coopers faces similar risk with respect to its audits of Bank of America and JPMorgan Chase, both under heavy buyback pressure from Fannie and Freddie.

Francine's gone back and parsed previous public reports that estimate the potential buyback risk to banks like JPMorgan Chase and the quarterly reports that contain reserves for such losses, and thinks she smells the stench of a gross mismatch.

I went back and looked at the JPM Chase and Bank of America (BAC) 2009 Annual Reports for more clues.

From JPMorgan Chase:

Page 241: At December 31, 2009 and 2008, the Firm had recorded repurchase liabilities of $1.7 billion and $1.1 billion, respectively. The repurchase liabilities are intended to reflect the likelihood that JPMorgan Chase will have to perform under these representations and warranties and is based on information available at the reporting date. The estimate incorporates both presented demands and probable future demands and is the product of an estimated cure rate, an estimated loss severity and an estimated recovery rate from third parties, where applicable. The liabilities have been reported net of probable recoveries from third-parties and predominately as a reduction of mortgage fees and related income.

2009 compared to 2008, page 66: Noninterest revenue was $12.2 billion, up by $2.8 billion, or 30%, driven by the impact of the Washington Mutual transaction, wider margins on mortgage originations and higher net mortgage servicing revenue, partially offset by $1.6 billion in estimated losses related to the repurchase of previously sold loans.

A reserve of $1.7 billion is much less than the $23.9 billion Compass Point Research and Trading estimated form the Wall Street Journal as JPM?s potential liability to the Federal Home Loan Banks alone, not including claims by Fannie Mae and Freddie Mac.

From Bank of America:

The Corporation records its liability for representations and warranties, and corporate guarantees in accrued expenses and other liabilities and records the related expense in mortgage banking income. During 2009 and 2008, the Corporation recorded representations and warranties expense of $1.9 billion and $246 million. During 2009 and 2008, the Corporation repurchased $1.5 billion and $448 million of loans from first lien securitization trusts under the Corporation?s representations and warranties and corporate guarantees and paid $730 million and $77 million to indemnify the investors or insurers. In addition, during 2009, the Corporation repurchased $13.1 billion of loans from first lien securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls.

Bank of American admits ?representations and warranties expense? as well as losses of $1.5 billion for repurchases of loans from first lien securitization trusts under their representations and warranties and corporate guarantees.  In addition, they?d already repurchased an additional $13.1 billion based on mods, delinquencies and other ?clean-up?.

However, I can?t easily see anywhere in either bank what the actual reserves are for estimated future liabilities and how they come up with a number given the total loans sold by type and the current claims by various parties. I think it?s time for someone, perhaps the SEC, to demand more detailed disclosure about reserves for repurchase risk.

She also wonders how Deloitte can sign off on entities who are involved in both sides of the buy-back controversies.

Can PwC, in good faith, honestly sign off on financial statements on both sides of the disputes between the FHLBs and Freddie Mac and several PwC bank clients where completely different estimates of these liabilities are submitted?

I can understand judgment and leave some room for disagreement in a legal dispute as opposed to the valuation of an individual security. But, in the end, the quality of the documentation, the quality of the underwriting, the level of potential fraudulent documentation and the collectibility of the loan based on accuracy of the borrower ratings assigned at origination must all be relatively easy to ascertain on a comparable basis. These factors ultimately drive the value of the asset.

A loan doc is what it is. If it exists, that is.

The auditors have been helping the banks pull rabbits out of their hats for some time now.  But isn?t it about time we jump on the issue of audit firms behaving like Switzerland to protect their own self-interests? There are hundreds of millions of reasons in New York alone for PwC to stay neutral and to allow balance sheet ?window dressing? via manipulation of reserves. But what does that say about the integrity of the financial information published by these banks?

Shareholders and other stakeholders will suffer greatly when the the banks eventually ?surprise? us with the huge losses.

Strong stuff. Good stuff. Definitely worth a read.

Where a the federal banking regulators on these issues? Oh, that's right, we're talking about too-big-to-fail banks and audit firms. Similar facts involving a community bank and regional or local audit form would have had serious adverse supervisory consequences for them both long before this point.