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(Bloomberg) - Shoddy mortgage lending has led bankers into a two-front war. On one front, U.S. homeowners are challenging the banks' right to foreclose because of sloppy paperwork. On the other, investors who bought mortgage bonds are demanding refunds that could approach $200 billion because the underlying loans are flawed.

The cost of buying back faulty loans that banks bundled into securities may actually be a more costly problem for banks than dealing with foreclosure mistakes. 

JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co. and Citigroup Inc. have set aside just $10 billion in reserves to cover future buybacks. Bank of America alone said this week that pending claims jumped 71 percent from a year ago to $12.9 billion of loans.

Investors such as Bill Gross's Pacific Investment Management Co. (PIMCO), contend that sellers are obligated to repurchase some mortgages because of misrepresentations such as overstatements of borrowers' income or inflated home appraisals. 

Fannie Mae and Freddie Mac, the largest mortgage-finance companies, may be owed as much as $42 billion just on loans they bought directly from lenders, according to Fitch Ratings.

"It's going to be trench warfare with years of lawyering," Christopher Whalen, managing director of Institutional Risk Analytics, said in a telephone interview from White Plains, New York. "The banks can't afford to lose."

The biggest risks for banks may be loans packaged into mortgage-backed securities during the housing bubble, of which $1.3 trillion remain. The aggrieved bondholders include Fannie Mae and Freddie Mac, bond insurers and private investors.

An August report from Christopher Gamaitoni, a former senior financial analyst at Fannie Mae, now vice president of research at Compass Point Research & Trading LLC in Washington said investors that bought private mortgage bonds may collect as much as $179.2 billion.

If so, that brings the total liability to more than $220 billion.

Pimco, BlackRock Inc., MetLife Inc. and the Federal Reserve Bank of New York are trying to force Bank of America to repurchase mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit. In a letter to the bank, the group cited alleged failures by Countrywide to service the loans properly.

Bank of America faces additional claims as well.  The bank, which acquired Countrywide, the biggest U.S. mortgage lender, in 2008, faces potential repurchase obligations of $74 billion, according to an August report by Branch Hill Capital.  The San Francisco hedge fund is betting the Charlotte, North Carolina-based company's shares will drop in value. 

Bank of America has $4.4 billion in reserves for claims on $12.9 billion of loans, the company reported Oct. 19, and has already resolved claims on more than $14 billion of loans.

The company will "defend our shareholders" by disputing any unjustified demands that it repurchase mortgages, Chief Executive Officer Brian T. Moynihan said in an interview on Bloomberg Television. Most claims "don't have the defects that people allege."

Other firms are setting aside additional money to deal with mortgage-related claims.

JPMorgan took a $1 billion third-quarter expense to increase its mortgage-repurchase reserves to about $3 billion. Citigroup raised its reserves to $952 million in the third quarter, from $727 million in the previous period. 

Wells Fargo, on the other hand, reduced its repurchase reserves to $1.3 billion, from $1.4 billion in the second quarter.  The San Francisco bank is a major employer in Minnesota.

 
"These issues have been somewhat overstated and to a certain extent, misrepresented in the marketplace," Wells Fargo Chief Financial Officer Howard Atkins said yesterday on the bank's third-quarter earnings call. "Our experience continues to be different than some of our peers in that our unresolved repurchase demands outstanding are actually down."

So far, most lenders have resisted large-scale settlements, agreeing only to paybacks after defects are discovered in individual loans. Investors have in some cases been stymied in their efforts to examine individual loan files by mortgage-bond trustees, which administer the securities.

In July, the Federal Housing Finance Agency, the government conservator of Fannie Mae and Freddie Mac, issued 64 subpoenas demanding loan files to assess the possibility of breaches in representations and warranties by securities issuers.

Lawsuits allege problems can be widespread and share similarities. The most common underlying concerns involve borrowers who didn't occupy the homes and inflated appraisals that distorted the loan-to-value ratio, according to lawsuits filed by the Federal Home Loan Banks in Seattle and San Francisco.


A sampling of 6,533 loans in 12 securitizations by Countrywide found 97 percent failed to conform to underwriting guidelines, according to a lawsuit filed Sept. 29 by Ambac Assurance Corp. in New York state Supreme Court.

Richard M. Bowen, former chief underwriter for Citigroup's consumer-lending group, said he warned his superiors of concerns that some types of loans in securities didn't conform with representations and warranties in 2006 and 2007.

"In mid-2006, I discovered that over 60 percent of these mortgages purchased and sold were defective," Bowen testified on April 7 before the Financial Crisis Inquiry Commission created by Congress. "Defective mortgages increased during 2007 to over 80 percent of production."

Some analysts say that the losses will be manageable by the banks. Last week, Mike Mayo, an analyst at Credit Agricole Securities USA in New York, estimated a cost of $20 billion for repurchases. Goldman Sachs Group Inc.'s Richard Ramsden said a worst-case scenario would be $84 billion.

The other front in the battle is the potential cost to banks of improper documentation used in foreclosures. 

Attorneys general in all 50 states are jointly investigating foreclosure procedures, including the use of so-called "robo-signers" who didn't check the material they were signing. Litigation costs for such cases may reach $4 billion, while a three-month delay in foreclosures would add an additional $6 billion to industry expenses, FBR Capital Markets estimated in an Oct. 19 report.

To settle disputes with homeowners about attempts to foreclose, banks may offer borrowers more generous loan modifications, potentially including principal reductions, said Frank Pallotta, managing partner of Loan Value Group, a mortgage-consulting firm in Rumson, New Jersey.

"The potential for owners to challenge lenders on foreclosure improprieties certainly is there," Pallotta said. "Even if it turns out that the banks were right in 99 percent of these foreclosures, the additional diligence on their part, going forward, is going to cost them more money."

The litigation over buybacks, also known as putbacks, can also pit big banks against each other. Last month, Deutsche Bank AG, acting as a trustee, refiled a lawsuit over misrepresented mortgages in $34 billion of Washington Mutual Inc. mortgage securities, with $165 billion in original balances.

Like WaMu, many lenders that originated the mortgages have gone out of business, making litigation more complex, said Kurt Eggert, professor of law at Chapman University in Orange, California. And top executives at the surviving companies, such as the CEOs of Bank of America and Citigroup, have been replaced.

"It's troubling that the people who caused the problem have walked away and left everybody else to fight over who gets stuck with the tab," Eggert said in a telephone interview. "It's like a massive game of dine and dash."

Gallery

Business and Economic News

On one front, U.S. homeowners are challenging the banks' right to foreclose because of sloppy paperwork. On the other, investors who bought mortgage bonds are demanding refunds that could approach $200 billion because the underlying loans are flawed.

Banks face two-front war on bad mortgages, flawed foreclosures

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