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Real Problem versus Many Perspectives 
The perspectives reported on the Mortgage Mess varies very widely. From the political right is the Wall Street editorial “We’re not aware of a single case so far of a substantive error” to the political left Congressman Alan Grayson’s “the easiest way to make a buck is to steal it”. This one really shocked me, financial institutions and their mortgage servicing departments hired hair stylists, Walmart floor workers and people who had worked on assembly lines and installed them in “foreclosure expert” jobs with no formal training.

In my opinion these are details that subtract from the big picture. Without understanding the big picture we would not have a context in which to address this Mortgage Mess.

What is the big picture? It is, is our fiduciary responsibility to our shareholders or is our fiduciary responsibility to our customers? Correct picture but wrong perspective.

Our fiduciary responsibility is to our shareholders and that this fiduciary responsibility is derived from our fiduciary responsibility to our customers. We’ll discuss each perspective below.

Residential Mortgage Industry is Shrinking
First some context to this discussion. From the Wall Street reported data I estimate that 15.4% or about 1 in every 6 US homes are in foreclosure, and this does not include recent past foreclosures. That is a huge amount and bank troubles pale in comparison to this number. What does this number tell us?

It says that the mortgage market size will shrink by 15% as foreclosures are executed because foreclosed home owners will be barred for at least 7 years from participating in this market. The lowest estimate I was able to find was 10%. Therefore to remain profitable banks will have to lay off at least 15% of their residential mortgage staff.

Further, as reported in the New York Times, if title companies shy away from insuring foreclosed properties because they think those properties are vulnerable to claims, this will further depress the market, as investors too will shy away. 

Looking at the CMBS industry for clues, even though the reported commercial property appraisals are hovering in the 55% range, the anecdotal prices I have heard suggest purchase prices averaging between 10 to 20 cents on the dollar, and there are no reported foreclosure problems. Therefore, we can infer that the residential mortgage industry will experience similar appraisal versus selling price discrepancies and is therefore not out of the woods, yet.

Good News for Banks?
The Florida attorney general’s office says it doesn’t have the power to investigate banks but it has started an investigation into the law practices. To complicate matters, one needs to be aware that there is a difference between industry practice and actual mortgage regulation. There are also enormous variations from state to state with respect to foreclosure procedures. I found that in one state banks can start foreclosures on day 2 (1 day delinquent). This means that even though the 50 State Attorney General’s offices have launched investigations into the mortgage industry, in my opinion the banks don’t have to worry about them as these offices have no teeth. But some how this does not sound like good news, right?

First Fiduciary Responsibility
This Bloomberg article very nicely summarizes the current Mortgage Mess. That there are two fronts, “against U.S. homeowners challenging the right to foreclose and mortgage-bond investors demanding refunds that could approach $200 billion”. Of course this is an evolving situation and it is very likely many more fronts will open up.

The first fiduciary responsibility is to your customer. This is very clear in the many securities regulations since 1933. Of course banks are governed by banking regulations and in many instances are exempt from securities regulations as these exemptions are covered in the banking regulations.  Therefore I wonder if the banking regulations are any where nearly as concerned about protecting bank customers as the securities regulations require of investment advisors and broker-dealers?

Though the individual contracts appear to be in favor of the banks, investors are using every means possible to force banks to buy back bad mortgages. The final outcome, however, may play out in terms of power of buyers versus power of sellers, and not through legal means. That is investors in the future will seek assets from players who are amenable to buy backs than from those who are not.

This may be a good thing for the economy as insufficient principal protection may cause investors to seek alternative investments such as manufacturing, R&D driven technology licensing, and new materials, to name a few. Why? Because residential mortgages are no more safer than R&D.

Therefore, why did the residential mortgage market develop to the size it did? I can only conjecture that the existence of GSEs led to the mistaken belief that residential mortgages were one of the safest forms of investments.

Second Fiduciary Responsibility

The second fiduciary responsibility is to shareholders as this is a derivative of the fiduciary responsibility to customers. It is in this context that one would ask the question, how did this Mortgage Mess come to be?

In this context, given the Wall St. crash of 2008 and in the light of the Goldman Sachs hearings, the Wall Street editorial opinion that “We’re not aware of a single case so far of a substantive error” is difficult to justify as this would raise other questions.

As a general rule organizational seniority and salaries increase with fiduciary responsibility to shareholders. Therefore the questions, why did we did not have in place the systems and procedures to detect “substantive error”? Why were we paying managers so much if they did not know what was happening? What were these managers thinking?

Quite obviously operational risk and credit risk methodologies were insufficient. And may be they were ignored? A rethink of these methodologies and how risk committees are staffed and to whom they report to is in order.

Some Likely Future Outcomes

In the context of the First Fiduciary Requirement we can infer some future outcomes. 

Firstly, if there genuinely were mistakes in the foreclosure process, the second lien holder should now have a claim to the funds recovered from the sale of the property as the first lien holder did not conduct his fiduciary responsibility correctly. (Check this with your attorney as he may disagree.)

Second, title insurance fees may increase. Title insurers have two options either do not insure the title or substantially increase the fact checking required. The latter will increase title insurance fees. Assuming that Congressman Alan Grayson’s findings are correct, I believe that title insurance firms will choose not to insure as it would be more expedient to not insure than to dig up bad documents. Therefore, don’t expect title insurance for foreclosed homes unless the bank owns the title insurance firm, but this should raise questions of bias. My guess is that the title insurance problem is only going to get more complicated.

Third, future bank purchases will be structured more like an asset sale than an acquisition or merger. Why? First you don’t absorb the bad management team. Second by insisting only on asset purchases you put into place a screening process that substantially ensures that you are not purchasing a barrel of bad apples. Sure its a lot of work but that comes back to the banks’ fiduciary responsibility to its shareholders. An asset sale would allow the purchaser to include a clause that any future claims due to fraud, misstatement or omissions are the liability of the seller’s management team. Therefore one can infer that Bank of America’s purchase of Countrywide as a single company was not a good strategy, and that any subsequent M&A activity in the banking sector would require a rethink.

Fourth, further changes to securities regulation. Dodd-Frank indeed may turnout to be insufficient or in the worst case irrelevant as private action against mortgage industry participants further tighten regulation. For example if we assume that the alleged wrong doings were conducted by a handful of employees and not an issue of management culture, checks and controls, then we can expect changes to portions of the securities and banking regulations that would provide investors more time to seek recourse. For example Securities Act of 1934, Section 10(b), investors have two years from discovery of the fraud or five years from when it occurred to file their claim, while Sections 11 and 12(a)(2) claims against misstatements or omissions must be brought within one year of discovery and three years of the securities filing. These timing could be changed to 10 years or simply no statue of limitations for any fraud, misstatements or omissions.

Fifth, we would expect bond investors require,
1) A buy back clause in any future securitization, and that buy back clause is automatically transferrable to any and all future bond holders. At the very least in the event of the failure of the insurance provider.

2) That any third party providing a fee based opinion about a or soon to be securitized deal state that they have fully examined the collateral backing the deal.

Summary
This downside risk assessment of the residential mortgage industry suggest that an end to the industry turmoil is not in sight. Further, we can expect substantial private sector initiated changes to investment contracts that will provide both investors and home owners with better uniform protection.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational / educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk
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