Kumar Palghat is Kapstream managing director.

Everyone is well aware by now that the sub-prime market in the US was one of the key causes of the global financial crisis. While the headlines around the US mortgage market had gone relatively quiet, it has recently come back into focus following speculation of fraud in the foreclosure process and the potential of forced buy backs of securitised mortgage products by US banks. This has led to recent underperformance in both bonds and equities and will remain a significant driver of financials performance.

The US mortgage market is large and complex. It’s estimated the mortgage market totals approximately $10.6 trillion, of which $6.6 trillion has been sold to investors through structured securities in special purpose vehicles. The largest mortgage originators in the US are Wells Fargo, Bank of America, JP Morgan and Citigroup.

Historically, when these banks originated a mortgage they would keep it on their balance sheet, sell it to a government sponsored entity (GSE), or package them into their own private label vehicles. Given the growth of GSEs Fannie Mae and Freddie Mac, banks eventually found it was most efficient to originate non-conforming (read sub-prime, Alt-A and jumbo prime) mortgages and package them into private label securities to be sold to investors. The resulting surge in credit availability allowed for a greater percentage of home ownership, higher home prices and eventually greater consumer leverage.

This process led to an increase in financially volatile teaser floating-rate and option-adjustable rate loans, thus increasing the leverage risk to homeowners.

Chart 1: Foreclosure rates

(Source: BNP)

As Chart 1 above indicates, greater leverage has its downside in the form of higher delinquency and foreclosure rates. The US mortgage market remains a long way from being stable. While delinquencies have largely stabilised in the prime and Alt-A part of the markets and improved in sub-prime, they remain significantly elevated. It’s estimated 2.5 million foreclosures have been completed since 2005, 3.1 million are currently in the foreclosure pipeline and another 3.4 million are seriously delinquent and may be headed for foreclosure. According to BNP estimates, this equates to 4 per cent of serviced loans in foreclosure and approximately 10 per cent being seriously delinquent.

Some observers argue that these delinquency rates remain artificially low due to banks’ reservation to crystalise losses. This makes the bank balance sheets look artificially more secure than they should. This picture is only expected to get worse due to the mortgage resets taking place over the next two years.

The recent market attention on the US mortgage market relates not only to potential fraud in origination, but also to poor foreclosure document administration. The first issue is that of robo-signing. There have been multiple documented cases of banks or other groups charged with executing mortgage foreclosures having not followed proper legal procedures. This is somewhat understandable given the volume of foreclosures being processed, however the legal requirements must be met. For example, in many states, an affidavit needs to be signed by someone saying they have personal knowledge of the terms of the loan. Bank personnel are admitting to having signed off on thousands of foreclosures without personal knowledge of the deals. Some firms were foreclosing on 20,000 loans a month while attesting to the fact that they had personally reviewed the files.

Foreclosure firms and departments were paid largely on a volume basis, which meant some of the finer details were certainly missed. Some of the biggest mortgage lenders in the country, including government-owned Fannie Mae, were so keen to get mortgages off their books they imposed penalties on contractors that were too slow to process foreclosures. Law firms, loan servicers, and document processing companies all made more money the quicker they were at evicting people from their homes. Many unqualified and untrained people were hired to handle the significant volumes of foreclosures.

As a result of the recent scrutiny, a number of banks suspended foreclosures during the month as they reviewed their procedures. It’s likely that the vast majority of foreclosures are valid but clearly some could be open to challenge.

The second and perhaps bigger issue relates to the documentation surrounding mortgages that were sold into special purpose vehicles (SPVs). During the glory days of the asset-backed securitisations, the incentive was for mortgage originators to generate, securitize and distribute as many mortgage loans as possible and collect origination fees. Due diligence on the borrowers and documentation was not a top priority. Clearly, the quality of the due diligence was compromised by the incentive to collect origination fees.

The issue of negligence arises if underwriters allowed mortgages with incomplete paperwork, fraudulent paperwork or non-performing mortgages into these SPVs.

If this is proven to be the case it might allow investors holding these instruments to put them back to the issuers to recoup losses. This is a structural feature of residential mortgage-backed securities (RMBS) securities in the US, which is not common to the Australian market. Loans were only supposed to be placed in the vehicles if they met very strict underwriting criteria relating to items such as loan-to-value ratio and borrower income and credit score. In addition, the loans needed to be transferred to the trust vehicle in such a way that investors would have full rights to the loan. It is currently in dispute as to whether shortcuts in the mortgage assignment process were performed legally, and if not, how liable the banks may be.

What does all this mean for US banks? In simple terms, they could be liable for billions of dollars if they are forced to repurchase some of the questionable securities, not to mention their legal fees. A number of investors have already filed suits claiming banks are required to repurchase some of these securities, so called put-backs. It is very difficult to estimate what the ultimate liability could be for the US banks but various sources estimate this could cost the industry $30-$70 billion over the next three to four years. However, that figure could potentially be much larger.

Chart 2: US bank credit default swap

(Source: Bloomberg)

Chart 2 looks at the credit default swap of six large US banks over the last three months. Spreads clearly widened early in the month following news of suits filed by certain RMBS investors, however spreads recovered later in the month as the broader market tightened and investors digested the potential implications of these disclosures. The two largest mortgage underwriters, Bank of America and Wells Fargo, saw the widest spikes during the month.

Ultimately, banks should be entitled to foreclose on loans where the borrower is not meeting their obligations, however the letter of the law should be followed in that process and borrowers should have their rights protected in the process. While these disclosures have highlighted clear weaknesses and lax procedures in many circumstances, they appear more likely to be a case of one-offs rather than systemic issues.

How does the US fix this mess? That is a difficult question to answer, but obviously it will take time. Any solution will likely involve prudent writedowns by the banks, losses to be absorbed by RMBS investors, and some level of government involvement. There has been talk of a moratorium on foreclosures, but there does not appear to be substantial government support for this approach. In fact, a moratorium would likely prolong the US housing crisis as the foreclosure process could be dragged out for many years.

The federal government may need to subsidise the borrowers, but that could be costly and difficult to implement if it required additional taxpayer funds. However, like it or not, US government officials know how important a strong banking sector is to credit creation and ultimately growth. With near double-digit unemployment in the US, they are not going to do anything that would severely hamper growth in the near term.

Approximately 28 per cent of mortgages in the US are in negative equity and may be difficult to refinance due to high loan-to-value ratios. No matter how low the Fed’s quantative easing program can push bond yields, it’s not going to provide a significant help to those mortgage holders if they cannot refinance their loans. One option might be for the government to provide some form of guarantee that would entice banks to refinance these mortgages. The government could also buy back the RMBS securities from investors rather than forcing the banks to do so. This would prevent any material deterioration in banks’ balance sheets or lending ability.

The Fed could also redirect some of their asset purchase towards more mortgages rather than treasuries. What does all this mean for investors? Firstly, it could have ratings implications for a number of the larger mortgage lenders in the US, particularly if the liabilities end up being larger than the market is currently estimating. Secondly, while it shouldn’t create any solvency issues for the banks, it could certainly be a drag on earnings. Thirdly, these issues may take quite some time to resolve and could lead to more negative headline and mark-to-market risk until there is more certainty of outcomes.

Finally, this could potentially delay foreclosures and slow the required repair of bank balance sheets. Kapstream has exposure to select US banks that we believe have more limited exposure to the ongoing mortgage uncertainty. In terms of credit, we believe there continues to be good value in financial paper in general and remain overweight the sector. Australian AAA RMBS securities remain attractive as do Australian corporates relative to other countries given the attractive risk/return characteristics.

This report appeared on www.morningstar.com.au

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