Potential paperwork errors on some of the $1.34 trillion of securitized home mortgages may give investors an opening to challenge the legality of deals, threatening to unnerve financial markets, according to Joshua Rosner, managing director at Graham Fisher & Co.
Some loans to borrowers with poor credit before 2007 may not have been transferred to mortgage trusts in the manner required by their pooling and servicing agreements. That raises questions about the ownership of the loans and may allow investors to force lenders to buy back the securities, Rosner wrote Tuesday in a note.
The failure to include MBS trust names on documents and to properly assign loans to the trust may encourage MBS holders to challenge the entire securitization, rather than press lenders to take back individual loans that were fraudulently issued, according to Rosner, whose firm advises investors and regulators. That could set off legal fights over almost all subprime MBS sold to investors.
"If plaintiffs bring suit it could rock the market," Rosner said in a telephone interview. "If courts allowed those suits to proceed it would well feel much like 2008," when the bankruptcy of Lehman Brothers Holdings Inc. led to the biggest market collapse since the Great Depression, he said.
Wall Street firms stopped selling almost all so-called private-label mortgage-backed securities in 2007 after defaults began to surge on loans to borrowers with poor credit. MBS values plunged as foreclosures climbed. More than 90% of mortgages are now issued by government-sponsored enterprises, such as Fannie Mae and Freddie Mac, or are insured by the federal government.
"We believe nearly every single loan transferred was transferred to the trust in 'blank' name," Rosner wrote. "That is to say the actual loans were apparently not, as of either the cut-off or closing dates, assigned to the trust" as required by many of the securitization agreements.
An unraveling of mortgage-backed securities could cripple a housing market already struggling with a freeze in foreclosures prompted by legal challenges to the documents mortgage servicers used to seize the homes of delinquent borrowers, said Jeffrey Gundlach, chief executive officer of DoubleLine Capital LP in Los Angeles.
"If people say that you cannot prove that you own the loan, it could be really cumbersome to untangle," said Gundlach, whose firm manages $5.5 billion of investments, mostly mortgage-backed securities.
"It has the potential to spiral into much, much more. There have been many twists and turns to the foreclosure process since the credit crisis started and this is one more turn of the wheel, and it can spin out of control."
There are three possible outcomes for the crisis, Josh Levin, a housing industry analyst with Citigroup Global Markets Inc. in New York, wrote Tuesday in a note to investors, citing an analysis by Adam Levitin, associate professor of law at Georgetown University.
The best scenario is that the disputes are deemed as legal technicalities, which would cause a one-year delay in foreclosures. In the medium case, years of litigation will ensue. In the worst case, the problem becomes systemic, causing "the mortgage market to grind to a halt as title insurers refuse to insure mortgages involving existing homes."
Bank of America Corp., the largest U.S. lender, has halted foreclosures in all 50 states amid allegations that home seizures are being based on faulty documents. JPMorgan Chase & Co. and Ally Financial Inc.'s GMAC Mortgage unit have stopped repossessions in the 23 states with judicial supervision over foreclosures.
"We're reviewing 115,000 plus or minus loan files that are currently in the foreclosure process," Doug Braunstein, JPMorgan Chase's chief financial officer, said Wednesday.
The critical question is whether misrepresentation is "material," which means it would be a fact that investors would reasonably want to know, said David Grais, a partner in the New York law firm Grais & Ellsworth LLP, who represents the federal Home Loan Banks of Seattle and San Francisco and Charles Schwab Corp. in litigation trying to force banks, including B of A and JPMorgan Chase, to repurchase mortgage-backed securities because they misrepresented the quality of the loans.