Perspectives on Exposure
There are several distinct areas that raise concern regarding investment bank exposure to the monoclines. Direct credit counterparty exposure related to hedges on ABS CDOs and CDS is the area that offers the obvious concern. Banks and broker dealers used mononlines, and Ambac in particular as CDS protection on a wide variety of other assets. Fitch writes that banks are thought to have actively engaged in ‘negative basis trades’ with CDS purchased from the financial guarantors. With the poor and increasingly deteriorating performance of underlying assets and securities upon which protection was purchased, substantial and material gains on CDO hedges have been booked by banks. These gains are likely reflected in the public reporting of banks as accounting profits. Referencing Why the Case Shiller Index, Although Showing Another Downturn Coming, is Overly Optimistic and Quite Misleading! and The Truth Goes Viral, Pt 1: Housing Prices, Economic Sales and the State of Depression you can get an idea of the depth and breadth of value destruction on a real, economic basis...
By perusing "The 3rd Quarter in Review, and More Importantly How the Shadow Inventory System in the US is Disguising the Equivalent of a Dozen Ambac Bankruptcies!" you can see that this problem will be persistent for the balance of this decade, at a minimum...
We estimate that it would take about 6.2 years to clear the shadow inventory if foreclosure sales account for 25% of sales (7.8 years and 5.2 years if foreclosure sales account for 20% and 30% of existing home sales, respectively).
It is important to note that these figures only encompass loans that are already delinquent and does not includes loans which are current now but will go delinquent in the future and REO’s held by banks.
All paying subscribers can download the full shadow inventory report here: Foreclosures & Shadow Inventory. Professional and Institutional subscribers should also download the accompanying data and analysis sheet in Excel – Shadow Inventory.
Now, with even the potential for the idea of residential real estate significantly rebounding any time soon empirically dismissed, we can revisit the concept of what happens when the financial wherewithal of one of the major CDS hedge counterparties in the monoline relationship is no longer simply questionable (see our warning in 2007 that Ambac was insolvent) but its insolvency is actually guaranteed and its ability to fulfill its obligation is unquestionably impaired if not totally eliminated. The result is that any accounting gains on these hedges would have to be reduced and reduced significantly – not merely reserved against, exposing banks and broker/dealers to real economic losses versus the accounting gains that they took against these relatively small companies with relatively (and literally/economically) huge and highly levered exposures.
Having said that, we have identified banks that have material exposure to monoline insurers, but far less that originally anticipated – at least on a direct basis.
Potential for direct investment bank losses
The AMBAC bankruptcy will have several repercussions on the financial markets
- It would hurt the ability of financial institutions and governments to issue new debt.
- Trigger wave of losses since now double-default protection is now effectively single-protection
- Increased mark-to-market losses
As implied in the previous page, we believe that investment bank’s securities investor exposure can and probably will translate into actual bank exposure upon loss due to the economic equivalent of warranty and representations clauses (if not directly from those clauses themselves). Ambac and MBIA has actually successfully sued many originators and issuers on this basis and the ability (as well as the impetus) to do so will easily fall into the investors lap with the collapse of the protection on these devalued securities which will invariably spur a multitude of realized and unrealized losses. If this is the case then investment bank’s exposure and liability is now very similar to commercial and mortgage banking originators known to be in the hot seat, ex. JP Morgan, Bank of America, Citibank, etc.
1. According to S&P, the top U.S. banks could face up to $31bn of losses from mortgages repurchases while the FBR Capital Markets expects Financial Institutions industry to face $44bn of total losses
2. According to FBR Capital, the five largest banks - Bank of America, JP Morgan, Citigroup, Wells Fargo, and Sun Trust Banks are expected to roughly 55% of total industry losses with Bank of America amongst the most exposed
3. Bank of America had sold $1.2 trillion of loans to Fannie Mae and Freddie Mac between 2004 and 2008 and has received repurchase requests on $18bn and has recorded $2.5bn of losses from mortgage repurchases. The implied loss rate on these repurchases is 13.88%. As of the time of the afore-referenced report, Fannie and Freddie have only requested repurchases of 1.5% of the loans sold by BofA. To put this into perspective, insiders at Citibank are on the record as saying that up to 80% of the Citibank loans were sold, knowingly containing defective underwriting criteria (BoomBustBlog is of the belief that B of A, through their Countrywide and Merrill Lynch acquisitions, has the worse loan book of size in the country, and this assumption is justified in linked anecdotal articles towards the end of this report).
4. If Freddie and Fannie were to simply attempt to put back half of that amount (40% x $1.2 trillion), and succeed on only half of those demands (20% of $1.2 trillion), we are talking over $33 billion of losses for B of A alone. Now, of course, this is a gross oversimplification of the matter, but we believe the logic is sound and ratings agencies (as has been customary over the last decade or so) have materially and significantly underestimated the extent, depth and breadth of the problems at hand.
5. Testimony of Richard Bowen, Senior Vice President and Chief Underwriter for Correspondent Acquisitions for Citigroup Mortgage, in front of the Financial Crisis Inquiry Commission. In early 2006, he was promoted to Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group.
The delegated flow channel purchased approximately $50 billion of prime mortgages annually... In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets. This situation represented a large potential risk to the shareholders of Citigroup...I started issuing warnings in June of 2006 and attempted to get management to address these critical risk issues. These warnings continued through 2007 and went to all levels of the Consumer Lending Group...We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.
6. All interested in this space should investigate the accounting and economic treatment of liabilities arising from warranties and representations, as well as the legal treatment as such, for there is significant potential for fraud in creating securitizations. The SEC, as demonstrated by their actions with Goldman Sachs, has a point to prove and word has it that FHFA is issuing subpoenas, powers unavailable to private concerns (ex. the monolines) who have to sue and access such information through discovery. FHFA and similar government entities will undoubtedly seek to recover and maximize any amounts available to reduce taxpayer losses in an election year.
Additional observations on investment bank Ambac Exposure through Reps and Warranties
From the Ambac 3rd quarter 2010 conference call:
Total incurred losses for the quarter were $459.2 million, primarily related to a handful of asset-backed securitization credits and a public finance transportation transaction. All the transactions had been previously reserved but had deteriorated over the past few months.
The RMBS incurred losses were negative $259 million during the quarter, favorably impacted by increased estimates for remediation recoveries in the second lien portfolio, partially offset by additional deterioration noted in certain segments of portfolio.
While initial delinquency rolls are steadying somewhat, large later stage buckets are driving continued poor performance especially in loss severities across both first and second lien transactions. Ambac increased its estimate of remediation recoveries on RMBS transactions due to breaches of representations and warranties by approximately $738 million during the third quarter.
As of September 30th, RMBS reserves are net of approximately of $1.9 billion of estimated remediation recoveries. The increase in the estimate of remediation recoveries is a result of additional breaches discovered during the quarter, the addition of two more transactions to the scope of our review and an enhancement to our estimation process of certain transactions to include an extrapolation of breaches across the population that is based on a statistically significant sampling of loan files.
Given the scale of the losses in the RMBS portfolio, the evidence of pervasive breaches noted to date and recent performance addressing these contractual breaches, Ambac believes limiting remediation credit to the loan amounts where actual breaches have been discovered under-staged the amount Ambac is expected to recover from institutional sponsors.
As a result, the number of transactions where random samples were extrapolated to estimate the amount of subrogation recovery increased from one as of June 30, 2009 to seven as of September 2009. Correspondingly, the number of transactions where an adverse sample was used decreased from ten to six. We are actively working these transactions to resolve these breaches through litigation or otherwise and continue to believe our assumed recovery time of three years is appropriate.
Although Ambac’s management is not the most disinterested party through which to get unbiased information, it is evident that they are more confident, and probably justifiably so, in their ability to ramp up recoveries by putting losses back to the originators. They have been at this since before 2008.
As excerpted from the Subprime Shakeout blog: AMBAC Sues Bear Stearns Subsidiary For Shoddy Underwriting November 17, 2008
Mortgage insurance company Ambac Assurance Corp. has become the latest plaintiff to bring a lawsuit against a mortgage originator for improper underwriting, suing Bear Stearns subsidiary EMC Mortgage Corp. in the United States District Court for the Southern District of New York. The lawsuit (available here) alleges that mortgage originator and "aggregator" EMC, under the control and behest of Bear Stearns, made loans that it knew borrowers could not afford to repay and sponsored securitizations that created a market for such defective loans. It further alleges that EMC made specific representations to Ambac to induce it to provide insurance for four separate securitizations, maintaining that the loans were underwritten without fraud, errors or omissions and that EMC would repurchase any loans that were found to be defective. Interestingly, while Ambac brings several claims based on EMC's eventual breach of these representations and warranties, it does not bring a claim for fraud or negligent misrepresentation.
This has a direct correlation with investment banks’ exposure, of which we have illustrated potentially $31 billion worth in the accompanying model for professional subscribers, complete with CUSIP numbers (I-bank Ambac-MBIA Insured Model).
…But, what's most interesting about this action is the lengths to which Ambac goes to create a distinction between the poor performance of the loans stemming from the downturn in the housing market and the overall financial crisis, and the poor performance engendered by EMC's irresponsible lending. For example, in paragraph 25, Ambac alleges that "EMC assumed the risk that the loans did not conform to its representations and warranties, while the insurers agreed to assume the risk that loan pools conforming to EMC's representations did not perform as anticipated." (emphasis in original) Ambac explains this concept further in paragraph 58:
The ability to evaluate the risk of the Transactions and adequacy of structural protections therefore depended on the ability to assess and control for the risk of default on the securitized loans. Certain default risk - e.g., due to changes in interest rates, changes in borrowers' creditworthiness over time, adverse macroeconomic developments, and geographic concentration - is not subject to the control of the originator or sponsor, is measurable and quantifiable to an acceptable degree, and is the type of risk that Ambac knowingly assumes when it insures these types of transactions in exchange for a premium. Other default risk - e.g., due to misrepresented loan attributes, fraud or abject failures in origination and underwriting practices - depends directly on the controls, protocols, and practices of the originators and sponsor, and is not reasonably measurable or quantifiable by their counterparties.
Of course, the story gets worse. Let’s fast forward to this past September: Ambac sues BofA over fraudulent mortgages issued by Countrywide September 30th, 2010
Ambac Assurance Corporation, the guarantor of structured finance obligations for Ambac Financial Group Inc., is suing Bank of America Corporation over losses associated with fraudulent mortgages allegedly originated and sold as securities by Countrywide Financial.
Ambac claims it was mislead about the quality of loans the monoline insured as securities between 2004 and 2006. Bank of America took over Countrywide in 2009.
According to the Ambac complaint filed on Tuesday, the firm engaged in 12 transactions with Countrywide consisting of more than 268,000 loans, which served a total collateral of about $16.7 billion.
…Ambac has so far reviewed 6,533 Countrywide loans, 97% of which it found did not comply with the failed institution's representations and warranties.
Just so this is not lost on anybody, Ambac is alleging (and I certainly do believe them) that nearly ALL (yes, 97% is just about ALL) of the loans pledged as securities behind the B of A securitizations though Countrywide financial were bogus! The Countrywide portfolio makes the 80% claim from the Citibank official look downright rosy in comparison! Think about all of the potential repercussions if this statement were just remotely accurate.
"Countrywide's loans did not bear the represented attributes or conform to Countrywide's own underwriting guidelines," the filing said, "And in many cases were made to borrowers with little or no ability to repay their loans."
…Managing director for investor relations at Ambac, Peter Poillon, said he couldn't directly attribute Ambac's bankruptcy to the deals with Countrywide. He told HousingWire "because of our exposure to those transactions and others, Ambac Assurance is no longer able to issue those cash dividends to holding company."
Ambac Assurance Corp, a unit of Ambac Financial Group Inc has sued Credit Suisse Group, alleging the company misrepresented the risks of mortgage-backed securities in a deal Ambac insured in 2007. Ambac claimed that many of the loans involved were fraudulent, based on misstatements of income or occupancy.
… Ambac Credit Products in a lawsuit against Citigroup and Credit Suisse related to $2 billion of credit protection that Citigroup obtained from Ambac on the super-senior tranches of a CDO named Ridgeway Court Funding II Ltd. that was structured by Citigroup during the first half of 2007. Credit Suisse was hired by Citigroup to manage the CDO and was responsible for selecting the collateral in which it invested. In order to induce Ambac to provide credit protection on the deal, Citigroup and Credit Suisse made specific false representations with respect to the value, nature and credit quality of the collateral that was included in Ridgeway II’s portfolio, which, in fact, included substantially deteriorated subprime mortgage backed securities that Citigroup sold to Ridgeway II in order to get off its own books. In August 2009, Ambac filed its action in New York state court, asserting claims for fraud, negligent misrepresentation, breach of fiduciary duty, and fraudulent conveyance. Ambac seeks to rescind the credit default swaps or, in the alternative, obtain damages.
While it is clear that Ambac will have limited resources to aggressively pursue certain litigation, those entities that purchased the insured securities from the investment banks now have significant impetus to start looking under rocks and into dark crevices. With a 97% fraudulent or misrepresented loan rated, I see the buyers of said securities getting very rough with the investment banks, particularly with the guaranteed losses in the pipeline due to a lack of CDS coverage. You never know regulatory capture may even be damned in this election year teeter tottering on the brink of a recession - see More on Lehman Brothers Dies While Getting Away with Murder: Introducing Regulatory Capture for more on this topic.