Looks like the banks are making it tough for Fannie & Freddie Mac to exercise their rights under their Master Loan Purchase Agreements ("MLPAs") requiring the big banks buy back any bad loans the big banks sold to Fannie & Freddie. And with good reason, as the big bank repurchase liabilities could be massive.
To understand what's going on here, and how the big banks' repurchase obligations potentially represent large off balance sheet liabilities for these banks, you need a little background on how loans are bundled into Mortgage Backed Securities, or "securitized." First, there's the originator of the actual mortgage loan. The originator is the entity that gives a mortgage to an individual or business. The originator decides if an applicant meets its loan criteria and handles the paperwork for the original loan. The originator then bundles any given number of mortgages together and then sells them, usually to a special purpose vehicle, known as the "sponsor/seller," of a mortgage backed securitization. The sponsor/seller then sells the loans to what is known as the "Depositor" who then sets up a common law trust that issue certificates sold by an underwriter to investors. The certificates generally entitle the holder to a share of the interest and principal payments in the loans underlying the trust. Sound complicated? It is. But you don't need to understand the intricacies of mortgage backed securitization to understand the massive liabilities involved, you just need to know a few simple things.
First, because the originators were selling the loans they originated they had little incentive to issue creditworthy loans because after the loan was sold the originator no longer carried the loan liability on its books. This allegedly resulted in fraudulent or negligent loan originations to mortgagors unable to actually meet their loan obligations unless property values continued to climb. And as we all know, property values fell off a cliff and people were stuck with homes they couldn't sell except for less than what they paid for them and a tsunami of defaults occurred.
Second, the sponsor/sellers often originated loans themselves, or repackaged loans purchased from originators, and sold them to other entities like Freddie and Fannie Mac.
Third, Fannie and Freddie Mac are government sponsored entities, guaranteed by U.S. taxpayers, that massively, some say foolishly, buy mortgages and MBS in order to provide liquidity to the mortgage market in a government directed effort to promote home ownership.
Fourth, every major investment bank set up entities along the whole mortgage securitization spectrum to capitalize on this market.
Fifth, when bundle of loans are sold between these entities, they are usually governed by MLPAs, which contain a repurchase obligation on the part of the seller to the buyer if there is a breach of the specified representations or warranties in the MLPA.
It's these repurchase obligations that give rise to the potentially massive liability. If banks were issuing as many bad loans as some people say and the data seems to indicate, then it stands to reason that Fannie and Freddie, and by extension the American taxpayer, bought a lot of bad loans from the big banks. And the big banks are likely required under the terms of their MLPAs to buy them back from Fannie or Freddie. But then the big banks would take a massive hit to their balance sheets. So they're lawyering up instead, because it's probably cheaper to spend a millions of dollars on lawyers then it is to buy back the loans. So once again America saves Wall Street, and Wall Street thumbs its nose at America.
