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Repurchase demands on the rise-but why? Understanding what's driving the surge in repurchase requests first requires an understanding of the reps and warranties made by loan sellers.

Everyone in the secondary mortgage market has by now noticed the huge increase in demands for sellers to repurchase mortgage loans under loan purchase agreements. [??] What is fueling this increase? Do the loans originated and sold most recently include many more that don't satisfy the loan-level representations than in the past? Has there been a significant increase in credit losses? Have the representations given by sellers become more stringent than in the past? [??] The answer to all of these questions is "probably a little bit." But sloppy selling practices, payment defaults and tougher standards account for only a small part of the current phenomenon. By far the bigger source of repurchase demands is a concern by the buyers about the overall financial health of their sellers and the prospects for their staying in business. Buyers simply want out, or want to diminish their perceived risk in any way possible. The "deserting the ship" metaphor comes to mind.

What are these repurchase demands based on?

Loan sale agreements have always included various representations and warranties about the characteristics of the individual loans. The extent to which the loans actually met all of these characteristics was never 100 percent. There are many reasons for this. Some of the characteristics simply could not be known at the time of sale, so the function of these representations was to allocate the risk as between buyer and seller. Others could be known and generally were satisfied, but might occasionally be incorrect due to the large number of loans involved and because of simple mistakes.

The buyers typically did not immediately "scrub" the portfolios, because that would have been very costly. As long as loans were performing, they had no reason to go looking for the occasional breach of a representation and warranty.

Buyers would typically just wait until a loan got into trouble, and then look to see if it breached any representation that had been given. As a practical matter, sellers were only asked to repurchase the subset of breaching loans that actually became collection problems. The buyers happily continued to hold all the performing loans, without bothering to check if they did or did not conform.

Recently, however, with some of the loan originators in fragile financial condition, buyers are not waiting that long. It has become more cost-effective to send due-diligence teams to look at the loans and find those that do not fit all the representations and warranties now, even if the loans are performing.

What has changed?

The fragile financial condition of sellers, generally speaking, has little to do with the quality of the loans or declines in the real estate markets. It is mainly due to the decline in the volume of originations from the levels experienced in the overheated markets of a few years ago. Business boomed for the better part of the last decade, because escalating real estate prices and declining interest rates created incentives for homeowners to trade up or refinance.

The loan originators built up their platforms to accommodate this volume. When these factors abated, loan originators did not contract as fast as would be ideal, even as the market shrunk back to more normal levels. Business costs remained high while income contracted. Predictably, the effect was shrinking earnings, followed (recently) by periods of net loss.

That the mortgage banking business is a roller coaster of boom years and bust years is not news; it is a cyclical business. But as companies suffer even modest losses, they may trip financial triggers in their warehouse borrowing documents (or other financial contracts) that, if not waived, might cause other contracts to cross-default, leading to the potential of being unable to continue in business.

So what's beginning to happen is that financial covenants imposed on sellers are not being met, leading to a snowball effect on what would otherwise be a normal cyclical decline in the size of the industry.

For some individual companies, accounting or regulatory problems--or even just questions--have added to the sense that some counterparties may have of an uncertain corporate future. All of this has made the buyers of loans anxious to have loans repurchased now, rather than waiting for those same loans to go bad.

Additionally, the turmoil in the subprime industry has caused a generalized uncertainty that has led to reduced prices for mortgage loans in general. Even performing mortgage loans have lost value as collateral or for use in securitizations, compared with when the loans were initially purchased.

Whenever market prices fall significantly, buyers have an incentive to find loans that are eligible to be put back. In the current environment, this inclination compounds the other reasons for returning performing loans, where representation breaches can be found.

Is repurchase of performing loans such a bad thing?

In theory, the repurchase of loans that are still performing should not be a problem for originators. If the loans are still performing, they should be saleable to a new buyer, with accurate representations and warranties. But the reality is that right now the secondary market is a buyer's market.

Bad press and business uncertainties have affected the price at which mortgage loans can be sold. Buyers are demanding wider spreads (i.e., pay lower prices) than they would have a year ago, even after adjusting for interest-rate changes. And seasoned loans don't fetch the same premiums as brand-new loans, even if they are performing.

Thus, the liquidity burden of these repurchase obligations can be daunting or impossible to meet for all but the best-capitalized loan originators, regardless of the resale opportunities. Sellers had come to expect a particular level of repurchase demands, based on the practices of most buyers of requesting repurchase only when loans became delinquent. The liquidity pressure adds to concerns about the financial viability of sellers, exacerbating buyers' instincts to demand repurchases now, rather than waiting.

It is a vicious cycle, and it genuinely does threaten many companies that have done nothing wrong and that might otherwise have a bright future were it not for this liquidity challenge.

What is the appropriate seller response?

In their frenzy to get loans repurchased, buyers are not always reading their contracts with care. An attentive seller can often reduce the volume of repurchases simply by matching up loans with the documents under which they were sold.

Loan sale documents are not all the same (even though a quick look might suggest that they are identical). The loan-level representations and warranties, in particular, are parts of the agreements that differ quite a bit. They have evolved over time, and even within a single time frame, differ depending on the concerns of the particular parties and their relative bargaining power. The following are a few of the more common variations that will affect the repurchase obligation.

* Time limits: Some agreements say that the buyer must assert a breach of representations within a stated period after the loan sale (or within a stated period after the buyer knew or should have known of the breach). These are no longer common, except in discount sales of nonperforming or subperforming loans. Still, they are worth checking for.

* Knowledge qualification: Some representations are given to the best knowledge of the seller. If the seller did not actually know (or, under some of these agreements, have reason to know) that a loan breached a representation, the seller might not be responsible even if the loan actually did breach that representation. This qualification might apply to all of the loan-level representations or to just some of them. (Remember, some representations were included in agreements as a way of allocating risk, not confirming their truth.)

Some agreements that have a knowledge qualification on some or all representations also have what is sometimes called a "notwithstanding" clause. This is a statement--usually in the text immediately following the list of loan-level representations--saying that, notwithstanding a knowledge qualification, the seller still must repurchase the loan if the underlying fact of a representation proves to be inaccurate. This provision, if present in the document, effectively wipes out the knowledge qualification.

* Early payment default (EPD) provisions: The contractual provisions regarding early payment default have an especially wide variation, due to their history. EPD provisions grew out of the fraud representation. Before the mid-1990s, loan sale agreements did not include any representation about EPD. These agreements did include a representation that the loan was originated without any fraud on the part of the borrower or any broker, appraiser or other participant in the origination process.

The fraud representation is one that is given for the purpose of allocating the risk to the seller. A seller is not really expected to know with certainty at the time of the loan sale that there was no fraud, but the seller is in the better position (as between the seller and the buyer) to undertake practices and procedures to avoid fraud. The fraud representation was intended to put pressure on loan originators to follow practices that would minimize the chance of fraud. If it turns out that fraud occurred in the origination, the seller would be the entity to bear the loss.

After operating for some time with these types of fraud representations, buyers came to realize that it can be costly and time-consuming to prove fraud. They realized that in many of the worst kinds of fraud cases, the first indication of fraud is that the borrower does not make the very first payment. This does not always signal fraud, but it strongly correlates with some kinds of fraud.

As a proxy for the representation that there was actually no fraud, parties started including EPD clauses that said, in effect, that the seller represents that the borrower timely made the first payment on the loan that was due following origination. This first payment was taken to be an indicator that at least the most blatant types of fraud had not occurred.

For seasoned loans, the first payment would have already occurred before the loan sale, and so the EPD representation was really about something that had happened in the past. For brand-new originations, the EPD representation was about something that was yet to occur, which is an odd sort of thing to include in the representations and warranties. Notwithstanding this oddity, most EPD provisions were included in the representation and warranty section of the agreement. Some parties made it a separate section, part of the covenants. In any case, as originally conceived, EPD provisions were about the very first payment on the loan.

A later development was to have the EPD provision apply to the first payment due after the loan sale, regardless of whether it is also the first payment after origination. Within the last year or two, EPD provisions have routinely been extended to several payments instead of just one. Loans that do not experience timely collection of two, three or four payments after the transaction are allowed to be put back by the buyer.

Knowing which version of the EPD clause applies to each loan sale can save a seller from having to make some requested repurchases.

What part does servicing play?

If the representation breach can be traced to the performance of a servicer hired by the buyer, there may be a defense to repurchase. This might happen in relation to several types of representations, such as a representation as to the completeness of the loan files (if the servicer lost some records). It is particularly likely in the context of EPD provisions. Recall that the EPD relates to whether the borrower paid on time. A loan that is in good standing would nevertheless be tagged with an EPD violation forever if the relevant payment was not on time.

When servicing is transferred from one servicer to another, the timing of payments can get messed up. Borrowers may be confused about where to send their payments. Some borrowers may take advantage of the situation. The new servicer may require time to get all the records created on its computer system. In the course of these processes, some payments may end up with a posting date that is later than it should be. This is not because the borrower was fraudulent (remember the historical basis of EPD clauses), and doesn't portend a chronic problem loan. It can be useful to check the facts behind the records when a servicing transfer has occurred.

What is a practical approach?

Conceptually, there are two approaches that may make sense for a company that is on the receiving end of a repurchase demand. One is to focus on the details. Review each loan and the specific agreement under which it was sold. Insist that the alleged breach be one that is really in the agreement, and for which there is evidence. Check if any conduct of the parties might be construed to have waived the breach. Check if a servicer or other third party engaged in wrongful conduct and should be held responsible. And so on.

At the opposite extreme, there may be an opportunity to negotiate a global settlement that is strictly "big picture." Recognizing that the real concern of the buyer is not the quality of individual loans, but the financial strength of the seller, the parties may both be better off if the buyer keeps the loans and the seller pays some money in exchange for a full release from its repurchase obligation. To get to the point of having that negotiation, however, the parties may need to do at least some of the loan-by-loan evaluation, so as to size the settlement.

What can we learn?

People in the mortgage industry may be too busy right now coping with the immediate demands to sit back and take stock. Some in the industry, though, are already revisiting their loan sale agreements with a view toward doing things differently the next time around.

Sellers would be well-served to try to negotiate the loan-level representations and warranties more knowledgeably and more carefully.

But the parties to an agreement will not always have the bargaining power to control the outcome of those negotiations, even if they are attentive to these concerns. If sellers are unable to alter burdensome representations, the next best thing is for the accounting and loan-packaging people in the seller's organization to understand the contractual risks and prepare for them.

For the accountants, this means setting up adequate reserves. For the secondary market people it means organizing loan-level data with reference to the contractual terms of the sale contracts. In the end, it all ties back to understanding the terms of the agreements and integrating that understanding into the fabric of the business. There are no shortcuts.

Ellen R. Marshall is a partner with the national law firm Manatt, Phelps & Phillips LLP in the Orange County office, in Costa Mesa, California. She specializes in business transactions, including capital markets, finance, mergers and acquisitions, and securitization. She can be reached at emarshall@manatt.com.

RELATED ARTICLE: Repurchase Requests--Not Repos

Readers should not confuse the repurchase obligations that are the subject of this article with repurchase agreements (also called "repos"). Repos are a form of financing essentially equivalent to a secured loan. The borrower "sells" assets to the lender and makes a binding promise to repurchase those same assets for a higher price on a specific date in the future. The price differential is calculated in a way that makes it equivalent to interest on a loan.

A repo is accounted for as a loan rather than a sale. The "seller" bears the entire risk of loss on the assets, because it is contractually bound to buy all the assets back at the specified date in the future. Many mortgage warehouse lending arrangements are actually repos that are renewed every month.

In the recent crisis, some of the lender-buyers under these arrangements have refused to renew their repos because of financial concerns about the borrower-sellers. This is the process that the warehouse lenders use to withdraw their lines of credit, and it is hitting some of the subprime lenders hard. But it is fundamentally different from the limited obligation of a seller under a mortgage loan purchase and sale agreements (MLPAs) to repurchase loans that do not comply with representations and warranties that were given at the time of sale.

Once a loan is sold under an MLPA, the risk of loss passes to the buyer. A seller of loans under an MLPA has truly sold the loan and is obligated to repurchase that loan only if, in effect, it misrepresented the characteristics of the loan at the time of sale. This limited repurchase obligation under an MLPA does not turn it into a repo, and should not be referred to as a repurchase agreement. Understandably, some press accounts of the current events in the subprime market confuse these two concepts.
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Title Annotation:Cover Report: Secondary Market
Comment:Repurchase demands on the rise-but why? Understanding what's driving the surge in repurchase requests first requires an understanding of the reps and warranties made by loan sellers.(Cover Report: Secondary Market)
Author:Marshall, Ellen R.
Publication:Mortgage Banking
Geographic Code:1USA
Date:May 1, 2007
Words:2809
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