Tag Archives: warranties

Frannie Reps and Warranties Crisis Brewing

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The Inspector General of the Federal Housing Finance Agency released an audit, FHFA’s Representation and Warranty Framework. Reps and warranties are a risk-shifting device that sophisticated commercial parties use in transactions. If a party makes a representation or warranty that turns out to be false, they other party may have some remedy — maybe the ability to return something or to get some kind of payment to make up for the failure to live up to the promise.

For instance, a lender may sell a bunch of mortgages to a securitizer and represent that all of the borrowers have FICO (credit) scores of 620 or higher. If it turns out that some of the borrowers had scores of less than 620, the securitizer may be able to make the lender buy back those mortgages pursuant to a rep and warranty clause. The IG undertook this audit because of recent changes to the reps and warranties framework for Fannie and Freddie. Before these changes were implemented,

the Enterprises’ risk management model primarily relied on reviewing loans for underwriting deficiencies after they defaulted as the representations and warranties were effective for the life of the loans. In contrast, the new framework transfers responsibility to the Enterprises to review loans upfront for eligible representation and warranty deficiencies that may trigger repurchase requests. If the Enterprises fail to do so within the applicable period, their ability to pursue a repurchase request expires if it is based upon a representation and warranty that qualifies for repurchase relief. (2)

The IG’s findings are disturbing. It “found that FHFA mandated a new framework despite significant unresolved operational risks to the Enterprises.” (3) It also found that

FHFA mandated a 36-month sunset period for representation and warranty relief without validating the Enterprises’ analysis or performing sufficient additional analysis to determine whether financial risks were appropriately balanced between the Enterprises and sellers. Freddie Mac, in contrast to Fannie Mae which provided analysis limited to a 36-month period, provided FHFA with the results of an internal analysis of loans that indicated loans with a 48-month clean payment history were significantly less likely to exhibit repurchaseable defects than loans with a 36-month clean payment history. Thus, losses to the Enterprise could be less with a longer sunset period. Therefore, FHFA cannot support that the sunset period selected does not unduly benefit sellers at the Enterprises’ expense. (3)

This is all very technical stuff, obviously. But it is of great significance. Basically, the IG is warning that the FHFA has not properly evaluated the credit risk posed by changes to the agreements that Fannie and Freddie enter into with the lenders who convey mortgages to them. It also implies that this new framework “unduly” benefits the lenders.

The FHFA’s response is unsettling — it effectively rejects the IG’s concern without providing a reasoned basis for doing so. Its express rationale for doing so is to avoid “adverse market effects” and because addressing the IG’s concern “may not align with the FHFA objective of increased lending to consumes . . ..” (32)

Whenever federal regulators place increased lending as a priority over safety and soundness, warning bells should start ringing. Crises at Fannie and Freddie (and the FHA, for that matter) begin with this kind of thinking. Increased lending may be important today, but it should not be done at the expense of safety and soundness tomorrow. We are too close to our last housing finance crisis to forget that lesson.

FHFA Wins on “Actual Knowledge”

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Judge Cote issued an Opinion and Order in Federal Housing Finance Agency v. HSBC North America Holdings Inc., et al. (11-cv-06189 July 25, 2014). The opinion and order granted the FHFA’s motion for partial summary judgment concerning whether Fannie and Freddie knew of the falsity of various representations contained in offering documents for residential mortgage-backed securities (RMBS) issued by the remaining defendants in the case.

I found there to be three notable aspects of this lengthy opinion. First, it provides a detailed exposition of the process by which Fannie and Freddie purchased mortgages from the defendants (who included most of the major Wall Street firms, although many of them have settled out of the case by now). it goes into great length about how loans were underwritten and how originators and aggregators reviewed them as they were evaluated  as potential collateral for RMBS issuances.

Second, it goes into great detail about the discovery battle in a high, high-stakes dispute with very well funded parties. While not of primary interest to readers of this blog, it is amazing to see just how much of a slog discovery can be in a complex matter like this.

Finally, it demonstrates the importance of litigating with common sense in mind. Judge Cote was clearly put off by the inconsistent arguments of the defendants. She writes, with clear frustration,

It bears emphasis that at this late stage — long after the close of fact discovery and as the parties prepare their Pretrial Orders for three of these four cases — Defendants continue to argue both that their representations were true and that underwriting defects, inflated appraisals and borrower fraud were so endemic as to render their representations obviously false to the GSEs. Using the example just given, Goldman Sachs argues both that Fannie Mae knew that the percentage of loans with an LTV ratio below 80% was not 67%, but also that the true figure was, in fact, 67%. (65)

S&P on Risky Reps and Warranties

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Standard & Poor’s posted New Players In The RMBS Market Could Present Unique Representations And Warranties Risks. It opens, S&P

believes that new entrants into the residential mortgage-backed securitization (RMBS) market that make loan-level representations and warranties (R&Ws) may present additional risks not present with more established market players. Many of these new entrants not only lack historical loan performance data, but have not yet established track records for remedying any R&W breaches. This can call into question their ability or willingness to repurchase under R&W provisions. In light of this, mitigating factors may exist that could alleviate the risk of a potential R&W breach. (1)

This all sounds pretty serious, but I am not so sure that it is.

S&P explains its concerns further:

We believe it is important for investors and other market participants to evaluate the quality and depth of various factors that mitigate the risk of R&W breaches occurring in U.S. RMBS transactions, including those that would be remedied by new entities with limited histories and the risk that comes with their willingness or ability to do so. Specifically, we believe the quality and scale of third-party due diligence, the depth of operational reviews, and a transaction’s overall expected losses, are critical for assessing the risk of a breach and if a new entity would be remedying it. We consider all of these aspects in our assessment of the credit characteristics of loans that are securitized in U.S. RMBS deals. (1)

One assumes that every party to every transaction would consider the counterparty risk — the risk that the other side of a deal won’t or can’t make good on its obligations. Regular readers of this blog also know that many well-known companies have attempted to avoid their responsibilities pursuant to reps and warranties clauses. So, when S&P states that “the quality and scale of third-party due diligence, the depth of operational reviews, and a transaction’s overall expected losses, are critical for assessing the risk of a breach and if a new entity would be remedying it,” one wonders why this is more true for new players than it is for existing ones.

Further undercutting itself, this report notes that “post-2008 issuers have been addressing many of these potential R&W risks, including newer players. The level of third-party due diligence in recently issued U.S. RMBS for example has been more comprehensive from a historical (pre-2008) perspective in terms of the number of loans reviewed and the scope of the reviews.” (1)

So I am left wondering what S&P is trying to achieve with this report. Are they really worried about new entrants to the market? Are they signalling that they will take a tough stance on lowering due diligence standards as the market heats up? Are they favoring the big players in the market over the upstarts? I don’t think that this analysis stands up on its own legs, so I am guessing that there is something else going on.  If anyone has a inkling as to what it is, please share it with the rest of us.