Ultra Trading: November 2010

Monday, November 29, 2010

COT Report - WE 11/23

Due to the Thanksgiving holiday the CFTC report came out today, versus Friday. Three charts I wanted to show that support the theory that this market is finally beginning to rollover relate to copper, crude and 30 year treasuries. Historically Copper and Crude have correlated very well with SPX. Looking at the commercial accounts in the CFTC weekly report for each commodity is yet another way of gauging a change in direction.

Chart 1 - Commercial Net Positions in Copper VS SPX: The past two weeks have seen a reversal in the net position after hitting a 2010 high and indicate a SPX reversal.

Chart 2 - Commercial Net Positions Crude (NYMEX) VS SPX: Similar to copper, net positions have reversed after matching 2010 highs and look to be rolling over.

Chart 3 - 30 Year Treasury Price (inverted) VS SPX: With yields coming back, the 30 year looks to be catching a bid once again. Based on this comparison fair value on SPX would be about 1025 today.

Sunday, November 21, 2010

Understanding “Mortgage-gate” Beyond the Headlines

“The ability to simplify means to eliminate the unnecessary so that the necessary may speak.” - Hans Hofmann
The mortgage back security (MBS) market is somewhat of a mystery to many, yet it serves an important role in financing the growth of housing within the US. In its most basic form, the MBS market is where a loan originator (a bank) can sell an existing loan to a private investor thus freeing up money to finance another home purchase. So the MBS market is in many ways a broker between those buying a home and those looking to invest money. Unfortunately as investors seek yield, this once simple product is now more complex.

Today it’s easy to read about mortgage-gate, the stories are plentiful. On the surface it sounds like a simple paperwork issue or delinquent homeowners trying to live for free. There is no denying that a vast majority of cases involve a homeowner who has failed to pay their mortgage. The investor has every right to foreclose and minimize their loss. Let’s dig a little deeper into the MBS market though and understand what is really going on.
When a home is purchased there are two important documents, a note and a mortgage. The note is the IOU, while the mortgage is the right to the house, the security interest. Each time the house is sold, the mortgage is assigned at the county so there is a public record of who owns what. As housing surged and in an effort to eliminate the cost associated with these mortgage assignments the larger banks joined forces and created MERS (Mortgage Electronic Registration Systems). The
initial mortgage assignment was made in the name of MERS and in all future assignments; MERS would continue to “own” the mortgage thus requiring no further action in the county.
Where are we currently?
All of the fifty attorneys general are investigating the home foreclosure process. MERS in many cases owns the mortgage but not the note. You cannot split the note and the mortgage. In splitting these two instruments an unsecured creditor has been created. The holder of the note cannot foreclose, as they have no security interest (they don’t own the mortgage). The holder of the mortgage has the security interest but since they don’t own the note the homeowner is never in default.
What is currently being investigated is who has the legal authority to initiate foreclosure? Was fraud perpetuated upon the legal system through false documentation and state notaries? Why have multiple foreclosures been brought on the same home?   Is there a need for a national moratorium on foreclosures on a state-by-state level?
Where do we go from here?
Foreclosures have all but stopped as many banks have issued self-imposed moratoriums pending internal investigations. Investors of MBS (pension funds, GSE, PIMCO, Federal Reserve) have also begun to inquire if they have recourse to put back (return) defaulted securities. The case being made by these investors is the trust which manages the MBS on behalf of the investor was never assigned the note and therefore the transaction was not completed within the allotted 90-day period.
The implications are massive and estimated in the hundreds of billions of dollars.   Unfortunately though, the way these securities were constructed 25% of the holders of an MBS are needed to initiate a put back. Without 25% the investor cannot proceed. In a recent BAC conference call, CEO Brian Moynihan was quoted, “our perspective on this, we're going to be quite diligent defending the interests of our shareholders. This really gets down to a loan-by-loan determination, and we have, we believe, the resources to deploy against that kind of a review.” The banks are ready to fight any put back by aggressive legal review, at least that is their current strategy.
Other current investigations
Reports of the same note being sold to multiple investors have surfaced. Did originators sell the same note multiple times, knowing they would default and each time take out insurance (credit default swap) on the transaction?
The chief underwriter for Citibank under deposition has stated that up to 80% of the MBS they bought for resale were defective. Did Citibank knowingly purchase these defective securities below par value and not disclose this information when selling to investors at par value?
Banks refusal to show loan documentation after repeated subpoenas have raised questions as to whether the original note was ever assigned to the trust, if not this would be the basis for a put back.   Others have questioned if these notes were destroyed.
The implications upon the housing market, securitization and the banking sector could be massive.   Banks are not capitalized to absorb put backs in the hundreds of billions. So in a worst-case scenario we would see either massive capital raises or restructuring. At a minimum the foreclosure process will remain stalled causing added expense to the banks and a continued reduction in state tax receipts from delinquent property taxes. Right now it’s hard to determine the exact outcome, many have said it’s no longer a matter of protecting bank capital structure but rather the integrity of our legal system. One thing for sure is the recent sign of a double dip in housing prices will put even more pressure on the financials.

Sad Times in the US

The DXY is pennies from testing key support going back to 2008 at about 76.25. The AUD/USD is at a 28 year high as the RBA raised rates to combat inflation while the US Fed is going to flood the world with USD that no one wants as they have less and less value each day. All in the name of higher inflation? Margins are being squeezed in corporate America and consumers are getting squeezed. Meanwhile the equity markets are catching bids, not because the patient is improving. No the patient is more sick but the nurse is bringing more morphine. Makes no sense but whoever said markets were rational in the short term. The BOJ appears to have lost all ability to contend with a 15 year high in the JPY and meanwhile the EUR catches bids each day while the PIIGS are seeing higher CDS, higher yields and run on bank deposits.

Topping Signs Are There

Groundhog day is showing signs of tiring. Quite the reversal today as traders took risk off the table ahead of a very eventful week ahead. Here a few a few things to consider from a directional standpoint:
AAII investor sentiment (WE 10/27) showed the highest % bulls in well over a year at 51.2%, contrasted with the lowest % bears at 21.6%. There are currently 2.73 investors expecting markets to rise over the next 6 months for every investor expecting contraction. Comparing AAII to SPX shows some very tight correlations with SPX responding about a week after a high is registered. Contrast that to Investor Intelligence which seems to be far more out of phase from a timing standpoint. The VIX looks to be bottoming on a daily chart

USD looks to be finally catching a bid. The DXY bounced off support going back to March 08 at 76.144
Insider selling has been extremely high for the past few months now. This past week alone it was nearly 500 to 1. Money also continues to flow out of mutual funds now in an unprecedented 25 weeks straight without a net inflow.
Funds managers have record low cash on hand, another contrarian sign with plenty of history to support it's "signal quality."
In 2007, financials were weak for 5 months prior to the indices beginning their leg down. BAC was a $20 stock in April, today it sits at $11.
Barton Biggs is bullish, and calling for another 10% move higher in risk assets. need I say more?

ISM Behind The Headlines

Bulls are celebrating ISM Manufacturing and Services reports showing expanded growth (above 50 is expansion, below contraction). Looking inside the report shows some troubling signs though, primarily prices paid. As the USD has continued to get slammed the past few months, input costs have continued to rise. In this current economy, producers do not have pricing power on non essentials to pass along those higher prices. The result is their margins have been and will continue to get squeezed. To combat tighter margins, employers will begin laying off "non-essential" employees. New Orders in both reports have shown increased strength which is certainly a good sign for future ISM reads but is this solely due to the weak USD helping exports? Just like the EUR/USD was going to parity back in the summer, everyone is talking the end of the USD right now as the reserve currency. At some point that may very well be true but a reversal in the USD will put pressure on future ISM reads. Sovereign debt concerns have not passed, just kicked a little further down the road. Dec. 7 is national run on the bank day in France, which has now spread to a handful of other countries all as a result of austerity and another form of protest (important to remember EU banks are leveraged 10 times US banks). Don't be so quick to favor the EUR over the USD. Both currencies are bad but it's a lesser of two evils scenario right now.
So the ISM manufacturing and services both were positive signs for future growth of the US economy but need to be taken in context of what is driving them.

AAII Sentiment - Week Ending 11/3

The AAII data for the week is out and shows still very high % bulls of 48.2 (down 3% from prior week but still above historical average of 39%) versus % bears of 29.8% (up 8.2% and close to the historical average of 30%). In the prior week there were 2.3 bulls for every bear, the current data has 1.62 bulls for every bear. AAII data seems to be highly correlated to SPX as shown on the chart below. The data for AAII as graphed is shifted forward one week to better correlate.

EU (PIIGS) Bond Spreads

Bonds spreads continue to reach new highs per the chart below (courtesy of Calculated Risk and the Atlanta Fed)

Riots in Greece and Ireland and don't forget those "rumors" of Berlusconi having yet another affair with a 17 year old apparently moving up Italian CDS rates. In the dash for trash the EUR v USD perhaps it's time to start selling the EUR.

Bonds or Equities – Who Is Right?

The 30 year treasury has correlated very well with the SPX as shown on the chart below (note the 30 year price is inverted). Perhaps I should say it did correlate well into the summer time frame and then diverged when QE2 was first discussed. If you assume the bond market is correct, fair value on the SPX would be about 1,000 right now. One could argue though that the bond market has it wrong this time (at least the 30 year) based on where QE2 purchases will focus their attention (the middle of the yield curve). In the dash for yield though, relative to other maturities the 30 year should begin to draw further bids.

The next chart is the weekly Commitment of Traders report for Commercial Net Positions (US Long Bond) versus 30 year price. Commercial traders went aggressively short relative to prior positions in October and then reversed those positions pretty aggressively as well. The question then is do they continue increasing their net position or follow the YTD trend and reverse and short into strength? Friday's CFTC report should be very telling.

Non Farm Payroll Beats Estimates

On the surface, sure, all looks well. To even talk about a double dip right now will get you banned from CNBC (which isn't a bad thing for your credibility). Before people go ahead and call mortgage gate a non issue, bank health a non issue, macro economics as rebounding, check out the headline from October 5, 2007 (yes 2007).
Nonfarm payrolls rose by 110,000 last month -- including 73,000 in the private sector -- very close to expectations of a 113,000 gain in total payrolls.
The S&P 500 highs were on October 8, 2007. What happened after that? Subprime was NOT contained. Financials having declined for 5 months were a leading indicator of the indices. The economy was not doing a goldilocks dance as Kudlow so proudly declared each night. This is all in the back drop of a weakening dollar and rising commodity prices. Seems quite familiar to our current environment.

AAII Weekly Sentiment - Week Ending 11/10

The weekly data is out and the % bulls climbed to it's second highest level in 5 years. The weekly data shows % bulls currently stands at 57.60 (highest in 5 years was 58.96). This is an increase of 9.4% over last week's reading of 48.20. The % bears dropped from 29.80 to 28.50 over the past week. There are currently 2.02 bulls for every bear. Sentiment is based on a six month view of markets and has correlated very well with the SPX as shown below. It correlates far better than Investor Intelligence data in my view.

So if anyone tells you the markets are too pessimistic just smile at them politely and say OK.

Commitment of Trader Report - WE 11/9

Due to the Veteran's Day holiday the COT report was delayed from Friday to today. After crunching the data, one interesting data point relates to the 30 year treasury. The chart below shows the price of the 30 year treasury (right axis with price inverted) versus the net position (left axis, positive is net long) of commercial traders.

Throughout the year the commercial traders regularly decreased their net long position as the treasury continued to catch a bid. Then just a few weeks ago they reversed hard. Last week it was unclear whether the trend would continue or if they would revert back to increasing their net short position. Well they have not let up. They are at a pretty neutral position right now and it looks like weakness in the 30 year will continue.

The next chart is of the 30 year price and it is sitting right on the 200MA. It should find some support here for a brief bounce but looking at the COT data that's all it may be. Considering how municipal funds have been selling off lately as is the rest of the yield curve, fixed income investors are sending a very strong message about inflation expectations and QE2. Today's rumor by Moody's to cut the US AAA rating should the Bush tax cuts be made permanent was the "stated reason" for the sell off but this move across all fixed income would imply there is far more to the sell off.

Mortgage-gate - Recent Developments

Anyone watching the financials around 3:45 (EST) on 11/16 noticed a big spike (and subsequent sell off right before the closing bell) on the news of an imminent deal between those involved in robo signing and the 50 attorneys general. The media put a quick spin as did a few "uninformed" blog sites about how all was well, time to go long the banks.
It's important to understand all aspects of the mortgage problems right now and the various fronts being fought. There are a few key issues that this big issue can be broken into:
Issue 1: Robo signing
Plain and simple, this was fraud committed by those appearing before a judge stating their paperwork was all in order and followed necessary legal process. Under deposition these "robo signers" stated they used false titles such as VP of MERS when in fact they never received a paycheck from MERS, didn't even know anything about the company. The best of all deposed quotes has to be from the person saying "I know nothing about mortgages, my country does not have mortgages."
The news that broke yesterday about a settlement, which did not include terms of a settlement and the fund that would be created would address this issue.
HR3808, a bill stealthily passed and later pocket vetoed by President Obama is back for vote today. If passed, the presidential veto would be overridden and states would have to accept another state's notary.
Issue 2: Representations and Warranties
Did sellers of MBS knowing sell investors securities that failed to meet basic requirements such as LTV, income, credit quality and more. Under deposition a Citi executive stated they knowing did such. One of the top due diligence firms in the country was hired by Citi and others to evaluate the quality of credits to be purchased. The analysis clearly showed the poor credit quality which Citi and others used to negotiate from the seller a price below par. Citi and others then did not disclose the finding of Clayton in selling at par to investors of MBS.
Equally if not more damaging is the question of put backs. Securities were sold to investors yet never conveyed to the MBS. Data has surfaced lately showing two years after the demise of Countrywide or Lehman for example that the transfer of note/mortgage was made from such non existent entities. For investors to begin a put back process they need break the 25% threshold of investors of such securities before the issue can be investigated. A few reports have surfaced stating that such thresholds have been reached.
This is the worst case scenario for banks which have no where near reserved for such losses. Nor have they reserved for the hundreds of billions in second liens that have far less value than currently booked.
Issue 3: Foreclosing moving forward
Rumors have surfaced of another bill being attached during the lame duck session of congress (attached to a larger bill) to basically acknowledge the legitimacy of MERS. Federal law would override years of State law and would allow MERS (retroactively and moving forward) to not be required to assign mortgage transfer at the state level. California is suing for billions to recoup lost fees associated with MERS bypassing the system. Right now when a servicer (hired by the trust on behalf of the investors to service the MBS) goes to court for foreclosure proceeding the question being raised is do they have the legal authority to do this. MERS holds the mortgage (the security lien, the right to the asset) yet the servicer holds the note (which could be questioned as stated above) and therefore has a default trigger but does not have a security lien and therefore no recourse.
So those are three totally different issues, all requiring fights on different fronts. So yesterday's news of a deal, if true address one of the three but not all. And then there is a little detail of home prices double dipping and rising foreclosures all in the face of rising unemployment. Not a pretty picture for the banking industry right now.

AAII Survey - WE 11/17

Quite the reversal on the sentiment survey this week. Bulls reversed down from last week's reading of 57.6% bullish to now 40% bullish. The prior week's reading was the second highest in five years so a reversal should have been expected. Bearish sentiment increased to 32.5% from 28.5 the prior week. We now have 1.3 bulls for every bear, a more neutral level.

Looking at the correlation of the SPX to the AAII report the question now is did SPX just put in a significant top? There is evidence from this chart that it in fact did. Investor Intelligence also just registered a very bullish reading but I must admit I find the correlation of Investor Intelligence to be less reliable to the SPX.

Trading The Financial Sector

As the SPX has powered higher and higher each day, the financial sector has done the complete opposite. The financials simply have not participated in the rally. In 2007 prior to the SPX highs, the financials lagged for five months until the entire market finally rolled over. The ultimate bullish signal would be a financial sector rally.
Well, we have seen such a rally recently with the XLF up 6%, BAC 11%, JPM 10%, WFC 11% all in the past six trading days. Is this move the start of a true bull leg up in the sector or an extremely oversold bounce?
The financials clearly were due for a bounce as shown by the XLF below with an 18% drop from its April 15 high (tax day nonetheless) to its September low.

When QE 2 was announced the 30-year treasury sold off as the Fed said they would not be buying the long end of the curve. The result was a favorable yield curve for the financials combined with news the following day that the Fed would soon allow “strong” banks to increase their dividend. I take issue with the notion of an increased dividend anytime soon. If cash was so plentiful then why is BAC talking about paying bonuses in company stock this year? There is no way dividends are increasing anytime soon.
When I look at financials all I see is a business model that is struggling with an unfamiliar task of turning a growing REO inventory. I see vast headwinds, questions of the industry’s ability to generate positive cash flow, years of litigation and a balance sheet where value is questionable at best and ready to experience another contraction.
Home prices are double dipping:
Read any report, even the out of phase Case Schiller Index and prices have clearly begun a new leg down. Zillow’s recently presented the following chart:

There is currently a shadow inventory that would take over six years to deplete. Six years! That’s assuming no more homes are foreclosed. Not a very good assumption. Amherst’s Laurie Goodman has put out a report calling for 20% of homes to eventually be foreclosed, without government intervention. Assume limited impact due to foreclosure concerns and mortgage put backs (again not a safe assumption), this REO increase alone will crush the bank’s capital structure. High unemployment is here for many years (once discouraged workers come back unemployment should easily exceed 10%) and with supply far exceeding demand, bank REO inventory will be moving in a very unfavorable direction.
Mortgage-gate / Robo Signing:
When this news first broke the media reported this as a simple technical issue with no repercussion to the banks. Over the past few months it has grown into a far larger issue that goes beyond a simple moral issue of failing to pay one’s mortgage for years. What have developed are clear signs of fraud, improper documentation and failure to meet simple warranties and representations. From originator to servicer to trust, the entire MBS process is now being called into question. There is no question that the vast majority of foreclosed homes will and should result in the person living for years without payment being removed. The problem is the process the servicer (hired by the trust) has used to initiate foreclosure.
Just recently an AZ judge ruled that Bank of NY Mellon (servicer) must produce the custodial records in a case against an AZ homeowner, thereby producing the note and mortgage. The judge refused a transfer in bearer paper, and demanded endorsement specific to the trust. Will we sacrifice the integrity of our legal system to maintain the capital structure of the banking industry?
What the above case highlights in addition to a flawed foreclosure process is also failure of conveyance of the note and mortgage to the trust. This is the very basis for investors to demand a put back to the originator.
Lawyers on both sides will argue possibly for years security put backs on a note-by-note basis. This is the process the banks want as referenced by BAC on a recent conference call. Worst case the banking sector is looking at hundreds of billions in put backs at par plus interest. Best case, banks will incur vast legal expenses, a far more expensive MBS process (if one remains as currently defined) and increased reserves for both legal and put back exposure.
Generating Cash Flow:
Banks simply are not creating new credit as shown below. Recent reports show bank lending standards are loosening but there is simply no demand. Surveys of business owners continually show that lack of customers is their biggest issue, not lack of credit. The most recent bank earnings missed on the revenue side and only beat on the bottom line due to reversing reserves. Even during the prior quarter conference call Jamie Dimon said this type of earnings beat was not good.

I see no argument beyond a trade for a long-term investment in the financials right now. Banks need to clean up their balance sheets, improve their operational efficiency and address their vast legal problems. Everyday a class action suit is brought against a major bank, self-imposed foreclosure moratoriums are still in place and even JPM is facing RICO charges for silver manipulation.
For the sake of full disclosure I am short banks via short calls and have been for the past six months.

Mortgage Gate Just Took A Big Step Forward

Call me naive, but perhaps, just for a change the tide is in fact turning in this country. Perhaps fraud can only be hidden for so long before it is finally exposed. Ten House Democrats have sent the following letter to the Financial Stability Oversight Council demanding stress tests and further evaluation of bank exposure relative to recent MBS findings. The big piece is the question of second lien credit values currently at 85%.

Members of the Financial Stability Oversight Committee
c/o Secretary Geithner, Chairman of the FSOC
1500 Pennsylvania Avenue NW
Washington DC, 20220
In light of the recent report from the Congressional Oversight Panel regarding mortgage irregularities, we are writing to support the panel’s call for a new round of stress tests to examine stability issues arising from residential mortgages held in securitized pools. Stability issues that have not been included in previous stress tests include liabilities for breaches of representations and warranties in Pooling and Servicing Agreements, liabilities arising from systemic mortgage documentation irregularities, and conflict of interests for servicers affiliated with firms that hold significant portfolios of second liens. We urge the council to recommend that its members conduct specific, thorough reviews of the potential effects of these issues on the risk profiles of the institutions they regulate and also that the Federal Reserve incorporate these potential liabilities into the new round of stress tests it announced earlier this week. We urge that the Financial Stability Oversight Council consider, in light of those stress tests, requiring that some financial companies divest affiliates involved in servicing securitized mortgages.
First, we urge that the members of the Council examine a representative sample of collateral loan files of each major servicer to determine if the files contain all the documents required by contract or by law, including the note; mortgage, deed of trust or equivalent document; and all documents evidencing or constituting the necessary assignment, delivery and recording of those documents. The Council should determine if the documents satisfy contractual representations and warranties in the pooling and servicing agreement or other governing instrument for the mortgages in question, and if not, any potential liability that may result. The collateral loan files examined should be selected at random, not by the servicers.
Questions about the documentation of securitized mortgages have received much recent attention. The financial institutions involved in securitization, including sponsors, trustees and servicers, have said publicly that any problems are isolated, technical in nature and easily cured. Others contend that the problems are pervasive, incapable of cure, and may ultimately require financial institutions involved in the securitization of residential mortgages to repurchase at face value hundreds of billions of dollars of mortgages, many of which are now non-performing. Many of the financial companies with potential liability to repurchase those mortgages are on any list of systemically significant firms.
Second, we urge the Council to examine the servicing of first mortgages by servicers that hold second liens or are affiliated with firms that hold second liens. The largest servicers hold almost half a trillion dollars in second liens, which are valued for accounting purposes at approximately 85 percent of face value. Those servicers, also systemically significant firms, assert that the second liens are performing, as are the first mortgages on the same property, and thus the second liens are accurately valued. The servicers contend that any interest the servicers may hold in second liens has not affected their servicing of securitized first mortgages. Others contend that there is an indefensible conflict of interest for servicers of securitized first mortgages to hold second liens on the same property, that servicers have acted contrary to the interest of the beneficial owners of first mortgages to avoid accounting losses on second liens, and that servicers face significant unrealized losses on those second liens.
An important purpose of the Dodd-Frank Act is to identify risks to the financial system as early as possible, so that regulators can take corrective action or minimize the disruption to the financial system that results from the insolvency of systemically significant financial companies. It is also a purpose of the Act to make risk to our nation’s financial system transparent in order to restore the confidence of the American people in the financial system and in their government. It would serve those purposes to examine these issues and make the result of that examination public.
Finally, we urge that the Council consider use the authority under the Dodd-Frank Act to require that financial companies divest affiliates or other holdings involved in servicing securitized mortgages. There is no apparent advantage in having financial companies that securitized mortgages also act as trustees or servicers, and there is an obvious conflict of interest. The uncertainty about the extent of the risk to our nation’s financial stability posed by the mortgage irregularities is largely the result of the control of critical information by financial companies at risk of insolvency from potential legal liability to mortgage investors and others. The control of critical information by financial companies with a possible motive to conceal systemic risks is incompatible with the intent of the Dodd-Frank Act, and is a grave threat to our nation’s financial stability.
Thank you for your attention to this matter.
Andre Carson (IN)
Stephen Lynch (MA)
Joe Baca (CA)
Jackie Speier (CA)
Danny K. Davis (IL)
Laura Richardson (CA)
Barney Frank (MA)
John Conyers (MI)
Luis Gutierrez (IL)

Maxine Waters (CA)we urge that the members of the Council examine a representative sample of collateral loan files of each major servicer to determine if the files contain all the documents required by contract or by law, including the note; mortgage, deed of trust or equivalent document; and all documents evidencing or constituting the necessary assignment, delivery and recording of those documents. The Council should determine if the documents satisfy contractual representations and warranties in the pooling and servicing agreement or other governing instrument for the mortgages in question, and if not, any potential liability that may result. The collateral loan files examined should be selected at random, not by the servicers.
Questions about the documentation of securitized mortgages have received much recent attention. The financial institutions involved in securitization, including sponsors, trustees and servicers, have said publicly that any problems are isolated, technical in nature and easily cured. Others contend that the problems are pervasive, incapable of cure, and may ultimately require financial institutions involved in the securitization of residential mortgages to repurchase at face value hundreds of billions of dollars of mortgages, many of which are now non-performing. Many of the financial companies with potential liability to repurchase those mortgages are on any list of systemically significant firms.
Second, we urge the Council to examine the servicing of first mortgages by servicers that hold second liens or are affiliated with firms that hold second liens. The largest servicers hold almost half a trillion dollars in second liens, which are valued for accounting purposes at approximately 85 percent of face value. Those servicers, also systemically significant firms, assert that the second liens are performing, as are the first mortgages on the same property, and thus the second liens are accurately valued. The servicers contend that any interest the servicers may hold in second liens has not affected their servicing of securitized first mortgages. Others contend that there is an indefensible conflict of interest for servicers of securitized first mortgages to hold second liens on the same property, that servicers have acted contrary to the interest of the beneficial owners of first mortgages to avoid accounting losses on second liens, and that servicers face significant unrealized losses on those second liens.
An important purpose of the Dodd-Frank Act is to identify risks to the financial system as early as possible, so that regulators can take corrective action or minimize the disruption to the financial system that results from the insolvency of systemically significant financial companies. It is also a purpose of the Act to make risk to our nation’s financial system transparent in order to restore the confidence of the American people in the financial system and in their government. It would serve those purposes to examine these issues and make the result of that examination public.
Finally, we urge that the Council consider use the authority under the Dodd-Frank Act to require that financial companies divest affiliates or other holdings involved in servicing securitized mortgages. There is no apparent advantage in having financial companies that securitized mortgages also act as trustees or servicers, and there is an obvious conflict of interest. The uncertainty about the extent of the risk to our nation’s financial stability posed by the mortgage irregularities is largely the result of the control of critical information by financial companies at risk of insolvency from potential legal liability to mortgage investors and others. The control of critical information by financial companies with a possible motive to conceal systemic risks is incompatible with the intent of the Dodd-Frank Act, and is a grave threat to our nation’s financial stability.
Thank you for your attention to this matter.
Andre Carson (IN)
Stephen Lynch (MA)
Joe Baca (CA)
Jackie Speier (CA)
Danny K. Davis (IL)
Laura Richardson (CA)
Barney Frank (MA)
John Conyers (MI)
Luis Gutierrez (IL)

Maxine Waters (CA)ong before it is finally exposed. Ten House Democrats have sent the following letter to the Financial Stability Oversight Council demanding stress tests and further evaluation of bank exposure relative to recent MBS findings. The big piece is the question of second lien credit values currently at 85%.