April 3, 2020|GSEs, Marketing & Sales, Mortgage Industry, Repurchases, Virus Response
Virus Driven Recourse Risk
The virus’ effects on the economy have the mortgage banking industry in convulsion. Funding sources, pricing models, secondary markets, MBS and whole loan investors, servicing agreements, etc., are all highly volatile and uncertain. It’s a fluid situation, but even if all that settles down, presently there is no relief to servicers to finance the GSE forbearance plan which allows borrowers to not pay their loans for up to 6 months. Rumors persist that relief to servicers still may come, but there is no talk of relief for originators who make loans to employed borrowers who later lose their job or income or who use the forbearance plan before the loan is sold.
The industry is still lending albeit with tightened guidelines, but those of us who still have PTSD (as one former colleague put it) from the repurchase battles arising from the meltdown era know what’s coming-Civil War. This time, we know exactly what is causing the problems. These job losses don’t reflect origination defects, yet the GSEs are still playing by the old “pass the recourse downstream” playbook and so will other investors.
Will the GSE’s Be Fair with Mortgage Bankers?
The job losses of today and resulting loan losses are virus effects. There is no “blame” to place on mortgage originators, servicers or aggregators for problems they didn’t cause and can’t control. It’s unjust to make those parties bear recourse due to contractual terms never intended to be used for this risk. However, remember the pivotal cave scene in The Fugitive. Harrison Ford, the fugitive, cries out to his pursuer, Tommy Lee Jones, “I didn’t kill my wife”. Just like Jones, the GSEs today, simply reply, “I don’t care”. Even though the GSEs (Fannie, Freddie and FHA) are wards of the state, presently they are saying it’s not their job to dispense justice. Just like the Jones character, the GSEs “don’t care” and are saying they will pass virus-related recourse back to originators. They are saying you can talk to a judge later about justice.
It Will Get Uglier
Despite the Fed pumping liquidity into financial markets, Congress offering $ trillions help to businesses and individuals and low interest rates fueling mortgage pipelines, the mortgage banking industry as we know it, is about to become a bloodbath without the GSEs addressing recourse risk. If any of my readers are mortgage company CPAs with a weak stomach you may want to stop reading this right now (or make sure your malpractice premiums are paid up and bone up quickly on FAS 166 recourse liability[1]).
In a nutshell, this is the mortgage industry’s dire situation beyond the virus: the GSEs offered every borrower up to 6 months forbearance with very little proof of need; even borrowers who just closed on their loans can get the relief. Moreover, the GSEs announced (rather quietly in FAQ #16 of 50) that loans in forbearance are not eligible for sale. The forbearance plan was also offered without relieving mortgage companies from liability for representations and warranties on employment, income continuity, ability to repay etc. All of that must still be true as of the date of transfer in an economy and job market on life support. Breach means the originator could be contractually liable for full recourse on the loan for the life of the loan. Accountants (in FAS 166) call that “standard reps and warrants” and don’t assign recourse, but (i) these are not standard times, (ii) moral hazard is a real thing, and (iii) recent repurchase history shows that servicers, investors (and/or their bankruptcy trustees) will hire armies of lawyers who claim recourse for any breach of a rep and warrant (regardless of fault or materiality) is for the life of the loan. The whole industry is pregnant with this problem already. Is it possible to cure an employment/income defect that existed at the time of sale? It would be helpful if they at least made that clear.
Responsibility for a Moral Hazard?
The GSEs (and other government actors) made it worse by creating a moral hazard. They enabled and encouraged consumers not to pay their loans. The GSEs could ameliorate the problem they helped create by assuming or limiting the recourse risk to downstream participants so losses could be spread to taxpayers fairly (the GSEs have been basically owned by the government for 10 years). Unfortunately for the mortgage industry, the GSEs seem to have doubled down on imposing recourse. Contrary to any public service role they occupy, on 3/23/20 GSE’s told originators to “practice additional due diligence” about disruptions to employment or income. To emphasize their position, GSEs used the word “ensure” 3 times in the same paragraph. So, it’s clear, these government wards are telling lenders to ensure the jobs and income of Americans amid stay at home orders and a raging pandemic.
The GSEs have been like opioids to the mortgage industry, but now is not the time to call the industry a junkie and withhold painkillers. Cold turkey withdrawal will kill this patient.
Blameless, but still headed for battle
Lenders haven’t stopped lending (and won’t), so unless a solution is worked out in advance, this will all be fought out as repurchase claims over contract terms designed to enforce underwriting discipline rather than assigning recourse liability due to unforeseen viral pandemics. Servicers could seek return loans to originators immediately when they go into forbearance (since they will otherwise have to front the payments not received to investors) and originators will, no doubt, refuse to comply with such demands. With memory of defending dozens of repurchase claims still quite fresh, I am not looking forward to the rancor and distrust such disputes cause for this formerly collegial and relationship-based industry. Absent addressing the fairness of any risk allocation in advance, however, I fear the battles to come will be even worse than the last time.
[1] I’ve been accused of wanting to be an accountant in the past, but I am not a CPA. You accusers know who you are.