One important aspect of the foreclosure fraud scandal are the increasing number of "put-backs," cases where investors who own failing mortgage-backed securities are discovering just how bad the paperwork is behind these instruments and legally forcing the banks that constructed them to buy them back. It could amount to as much as $120 billion, if not more. This presents a serious risk to the financial system but also an opportunity for regulators to force banks to help troubled borrowers.
It's instructive to look at how the financial sector is coming up with those numbers. They're taking the value of the total mortgage market -- generally loans issued between 2005 and 2007 -- figuring out what percent of those loans will default, factoring in how severe the average default loss is, and then taking a guess at how many of those securities the investor will attempt to return and how often they'll be successful. Running these numbers, J.P. Morgan came up with a cost of $50 billion to $120 billion over five years.
There are two key points to be made. One is to look at how often they expect investors and agencies to attempt put-backs -- in the worst-case scenario, J.P. Morgan analysts estimate investors will do this for about twenty-five percent of the failing securities. Given the current concerns about problems with these instruments, we can expect that attempt number to rise, especially if agencies like Fannie Mae and Freddie Mac have an incentive to shift their losses onto the private sector. The other issue is that these estimates are mainly focused on put-backs for problems with conforming loans, not on the burgeoning issues around fraud in the securitization chain, which adds another wrinkle. The point is this: These early cost-estimates are conservative and reflect uncertainty up and down the line, but this problem is likely to get larger, not smaller.
-- Tim Fernholz
