I may not be an expert on the law, but I do own shares of Wells Fargo (NYSE: WFC ) . So when news broke out earlier this month that a Massachusetts court decision was pummeling my stock, I had to find out more. Especially when news outlets kept reporting that it could have far-reaching consequences. (The news does like to do that.)
Jim Cramer telling me to buy bank stocks on the dip just wasn't reassuring enough for me. I want to really know what this decision is all about and what it means for the major banks. So dig your heels in, because we're about to tackle 40 pages of case documents.
Two families were given subprime mortgages in 2005 to buy homes in Massachusetts. Both loans were made by Option One and its affiliates. These loans were then sold to Lehman Brothers and Bank of America (NYSE: BAC ) , respectively. These firms packaged them into mortgage-backed securities, sold them to the public, and appointed Wells Fargo and U.S. Bancorp (NYSE: USB ) as their respective trustees to make sure that the assets were properly managed.
Both families stopped making their payments and both saw their homes foreclosed on in 2007, but when the trustees went to court to affirm their title, a problem arose.
Massachusetts law requires that any foreclosure sale be initiated by the party holding the mortgage, or an agent of that party. In these two cases, the judge ruled that there wasn't adequate evidence that the mortgage was properly transferred to the trustees before the foreclosure occurred. (There was plenty of evidence to show that it at least occurred several months afterward.) Because Wells Fargo and U.S. Bancorp announced themselves as the mortgage holders in their foreclosure notices, and because everyone is entitled to know the proper party foreclosing on them, the judges ruled that the foreclosure sales should be voided.
What this means
Investors usually aren't well-versed in real estate law, and I can't say I am particularly either. But after reading up on the matter, here are my opinions on some of the major concerns.
First, the homeowners' debts in this case have not been wiped clear, nor have they gotten free title to their properties. As the judge admits, there are clear records of mortgage transfer occurring about one year after their foreclosure sales. In the worst scenario, the trustees would just have to reinitiate foreclosure and spend a greater sum of money to get the thing done.
Second, I don't believe there will be an avalanche of new lawsuits following from this. Remember that these are not cases of people being mistakenly foreclosed on, but rather errors in proper documentation. It is hard to say what kind of damages someone can claim when the economic substance of the process is still found to be just. And even the homeowners who wanted to try would still have to prove to the judge why this is so material as to cause a ruckus.
But if there is liability, who is going to pay? For the sake of being thorough, I will go into this.
Normally, the mortgages in a trust are managed for the benefit of the mortgage-backed security holders, and the expenses incurred usually eat away at only their returns. But investors may try to push some of these losses back to the sellers and trustees. After all, sellers like Bank of America were responsible for making sure the loans in this case were all properly transferred. And trustees like Wells Fargo and U.S. Bancorp were responsible for making sure the seller provided the proper documents.
Generally speaking, trustees aren't really held accountable for much. They can be liable if they are found guilty of gross negligence or willful misfeasance, but from a historical perspective, they are free from most blame. Both U.S. Bancorp and Wells Fargo have issued statements saying, in effect, they don't see themselves responsible in any of this. This time may be different, but it's too early to tell if they did anything so extreme as to deserve penalties.
Investors may find some recourse from the sellers. They certainly are liable for any breaches in representations and warranties, but the seller bank usually has the opportunity to cure any breaches. That will be costly, but not nearly as much as some of the loss estimates which I've seen flying around.
The Foolish bottom line
If widespread deficiencies are found in the securitization process, then there would be a period of elevated costs for the largest issuers of mortgage-backed securities, like Bank of America, Barclays Capital (NYSE: BCS ) , JPMorgan Chase (NYSE: JPM ) , and Credit Suisse (NYSE: CS ) .
But think about this: If your bank started with $100 billion in securitized loan exposure, your liability from this decision would first be limited based on how many of those loans were in Massachusetts, foreclosed on, and also improperly documented. Of that pool, only some will choose to actually pursue litigation for what is as of now a very unclear possibility of rewards. Only a handful will find enough proof to even bring their case, and even then the liability is likely to be only a fraction of the loan amount.
Don't even get me started on insurance coverage. It seems pretty clear to me that this situation is hardly apocalyptic for the major U.S. banks.
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