Wall Street's Obligations to Main Street

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.

What a Difference a Day Makes!

Boy did the markets save Geithner's ass today.  How long they will kiss it remains an open question.

There are two poles to this "toxic trash" debate: those who believe the trash is worthless (Krugman) and those who think it undervalued (Geithner).  I side with Geithner and hope his plan works.  The worthless camp ignores the fact that the "subprime" CDOs  et al. are securitized by real property.  Surely this real property hasn't lost all it's value?   Granted, the underlying assets (homes) have dramatically dropped in value.  But they haven't dropped 100%.  And even in the case of CDOs with foreclosured mortgages  the  CDO owners generally are in the front of the line when it comes to disbursement of foreclosure proceeds.  Furthermore, the default rate in the bundles of mortgages (hundreds even thousands) that make up CDO's  is nowhere near 100%.  That means that CDOs still have some sort of revenue stream; it's just the uncertainty surrounding the future default rate that makes the CDO's  untradeable.     The level of uncertainty surrounding the return on any given CDO prevents investment.  Thus you are left with a CDO that has physical and monetary value but no price.  This is largely a problem of faith, and is not one necesarily rooted in the lack of any value in the securitized assets comprising the CDO.  

What Geithner has that Krugman lacks is faith in the ability of the market to work out the value of the underlying securitized assets.  Krugman thinks that the market cannot work out the value of CDOs even though they are securitized by physical property and revenue streams from current mortgages.  It is impossible for Krugman for there to be a market solution to the market's crash.  For Krugman derivative trading is discredited.  I disagree.  Properly regulated derivatives like CDO's are useful because they ameliorate risk and free up capital.  This crash is like most others, a product of excess and not the result of some innate flaw in derivatives.  No one blames the 1929 crash on innate flaws in the concept of stock shares.  While I don't know if Geithner's plan will pan out, I do think Geithner's right to have faith in capitalism's ability to scavenge itself.  Capitalism is first a predator but second a scavenger.