The Wall Street Journal, in an article entitled "Bad Loans Draw Bad Blood" (paid subscription required), asks a question that we've been asking for the last year:
As the housing sector cools, the mortgage market faces an awkward question: Who takes the hit when loans go bad?
As we've noted (most recently here), the answer is, in many cases, the loan originator (assuming it's solvent).
Under contracts that govern the exchange of mortgages, lenders often must take back loans that default very early in their lives or that come with underwriting mistakes, such as flawed property appraisals. As the housing boom fizzles, cases of bad underwriting are popping up and more mortgages are defaulting early. That has investment banks and other mortgage buyers invoking these contract provisions and pressing lenders to repurchase mortgages that get sold to third parties, creating big losses for some lenders.
In response, some of the loan originators are tightening their underwriting standards. Investors and lenders also are doing more financial sleuthing to sniff out problems in loans.
As attorneys who have represented mortgage bankers in tough times know very well, when the going gets tough, the tough look for loopholes. There's nothing like a laundry list of loan seller warranties to peruse on a balmy Sunday afternoon, gin and tonic in hand. Sooner or later you'll find several breaches, some of them actually supportable.
How bad will this get? At the moment, according to the "experts" cited by the WSJ, bad but maybe not horrendous.
While "not serious" at this point, the buybacks are the first real test
of the modern mortgage market, said Christopher Mayer, director of the
Paul Milstein Center for Real Estate at Columbia Business School. "This
will continue to be an issue even in the case of a soft landing" in
real estate, he said.
[...]
The current round of loan buybacks began in late 2005 and picked up
steam in 2006. It probably will continue for several more quarters if
mortgage delinquencies keep rising. "When you see foreclosures rise,
you often see buybacks rise," said Doug Duncan, the Mortgage Bankers
Association's chief economist. He expects a modest increase in
delinquencies in the next year or two.
[...]
Investment banks and others are showing an unwillingness to wait for
loans to default before taking action. Some are turning to companies
such as Clayton Holdings
Inc., which uses computer-driven risk models to find troubling
patterns, such as brokers that sold lots of bad loans. Mortgage
investors and lenders are "sharpening their pencils and using a thicker
magnifying glass," said Keith Johnson, Clayton's president.
Great! Computer driven models designed to find more loans where repurchases can be forced. Just what every originator wants to hear. Obviously, this is another downside to technological innovation.
Don't kid yourselves: loan purchasers are not only sharpening their pencils, they're also sharpening their axes.
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