Amid mounting defaults in the market for subprime mortgages, some big banks and mortgage companies are striking out in their efforts to wrest compensation from originators of those high-risk, high-return loans.
Led by HSBC Holdings PLC, banks and others are trying to force small mortgage lenders to buy back some of the same loans the banks eagerly bought in 2005 and 2006, by enforcing what the industry calls repurchase agreements. Squeezed by the onslaught of defaults, many originators are saying they can't afford to buy back their loans or are pursuing bankruptcy protection.
This is a standard part of the securitization industry. Here's how it generally works.
1.) Subprime company makes loan.
2.) Subprime company sells loan to larger bank.
3.) Larger bank pools loan with other, similar loans (same interest rate, same maturity etc....) and then sell pools to various investment groups (insurance companies, mutual funds etc...).
As part of step 2, the subprime originator agrees it will repurchase a loan under certain conditions, one of which is usually a specific delinquency rate.
Although the specifics vary from deal to deal, repurchase agreements obligate the mortgage originator, under some circumstances, to buy back a troubled loan sold to a bank or investor. That obligation sometimes kicks in if the borrower fails to make payments on the loan within the first few months or if there was fraud involved in obtaining the original mortgage. The total volume of mortgages nationwide that might meet those criteria isn't known, but such agreements cover billions of dollars in mortgages.
When a large number of loans go into delinquency early, the larger banks can flood the subprime originator with repurchase requests. This can bankrupt the subprime originator which is exactly what is happening right now.
This is why there have been so many problems in the subprime originators for the last few months.
New Century said yesterday that, starting last Wednesday, it had received a wave of default notices from its major Wall Street creditors, and may owe creditors a combined $8.4 billion for mortgage repurchases. It said if all its lenders demand repurchases, it can't afford to pay. That could force the company into bankruptcy proceedings, where it would join scores of others hurt by the industry meltdown.
That's a a whole lot of money. Considering New Century relies on lines of credit from the same large investment banks to finance its operations, New Century is obviously in a world of hurt.
Robert Napoli at Piper Jaffray said assuming a 20% loss rate on loans it is forced to buy back from its creditors, New Century "would have to absorb $1.6 billion of losses, essentially wiping out shareholders equity." As of Sept. 30, the company listed $25 billion in assets, about $23 billion in liabilities and $2 billion in shareholders' equity.
From a balance sheet perspective, this is a huge deal. Essentially, the owners/stockholders see their actual ownership interest wiped out overnight. Imagine if you were part owner of a company and you just woke up to discover your ownership interest -- which was pretty decent yesterday, is now worth nothing 24 hours later.
Loose credit standards are a prime culprit in the problems:
HSBC's borrowers included people who couldn't make their first mortgage payments as well as people who misrepresented their income or employment on their mortgage applications, interviews and HSBC's court filings show.
There's also a large amount of "whose left holding the bag" going on -- as in, who is being stuck with the loss.
When it is unable to claim its money or believes it will be unable to, HSBC must write off the loans. In 2006, the bank said the loan-impairment cost totaled $6.68 billion for its main U.S. consumer finance business. That was 34% higher than in 2005. The bank has said it may take two to three years to work through its problem loans.
HSBC's top finance chief acknowledges the difficulties in trying to enforce repurchase agreements. "It's proving quite difficult in the sense that many of the parties...don't have the wherewithal" to repurchase the loans, said HSBC Finance Director Douglas Flint.
Short version of all this -- it's a big damn mess.