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Government Subpoenas Could Foreshadow Major Lawsuits Against Banks

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Earlier this week, the Federal Housing Finance Agency, which regulates and oversees the operations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks, issued 64 subpoenas to various security issuers and other entities to gather information on loan-level underwriting and performance data related to private-label mortgage-backed securities (PLS). According to the FHFA, the goal is to "determine whether PLS issuers and other are liable to Fannie and Freddie for losses on the two government-sponsored enterprises' (GSE's) investment portfolios.

Why the big to-do? Having closed down the bar, aren't they basically now spending the morning after fighting over who gets the last sip in the bottle? Yes! But so what.

“By obtaining these documents we can assess whether contractual violations or other breaches have taken place leading to losses for the Enterprises and thus taxpayers," said FHFA Acting Director Edward J. DeMarco. "If so, we will then make decisions regarding appropriate actions.” And that means one thing: lawsuits. Lots and lots of lawsuits.

The FHFA maintains that these subpoenas are merely "a financial inquiry" and not a lawsuit, but the stated purpose of the subpoenas is to figure out whether losses sustained by the GSE's are the legal responsibility of others. The issue is important because how this is ultimately decided could have far ranging impact on the relationship, rights and responsibilities between securities issuers and investors.It appears the agencies are now looking at every asset they bought.

If these subpoenas are, in fact, a prelude to lawsuits, the magnitude of the legal actions will be enough to provide a handsome living for the lawyers involved for decades to come. Between the two GSE's, we're talking portfolio assets just in private label securities of somewhere in the neighborhood of $275 billion. According to the Financial Times, as of May, private label securities held at Freddie accounted for $168 billion, 22 percent of its portfolio.

Even so, the bigger money will likely be in the chasing after the loan originations, and there the agencies have made it clear that they are going to look at every defaulted mortgage to see if the original representations and warranties were accurate.  And if they were not, they will put it back. Think of this as a giant Hoover vacuum being put into reverse.

While the FHFA won't publicly release the identities of subpoenaed parties in connection with its inquiries, a 2006 article from the trade journal Mortgage Banking (part of, a subsidiary of Dun &Bradstreet), on the rise of private label mortgage products provides a window of speculation.

"A change in the mortgage-backed securities (MBS) market that began more than two years ago appears to have completely reshuffled the industry's deck of cards. Now, issuers of private-label residential MBS are holding the aces that were once held by the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac," crows the article. Indeed. The FHFA subpoenas are being issued determined to see just how those aces came to be held.

Meanwhile, reading the 2006 Mortgage Banking article on the emergence of "dominant players" in the private label RMBS underwriting business is like walking through a graveyard of failed businesses: "A handful of issuers are emerging as the dominant players in the private-label RMBS, led by pace-setter Countrywide Financial Corporation. Countrywide issued $75.8 billion in private-label securities the first half of 2006--far ahead of No. 2, Seattle-based Washington Mutual, at $38.9 billion."

And then there's this: "And just who is buying all these private-label mortgage-backed securities? The answer is: just about every institutional investor group in America, and many overseas."

As of the first half of 2006, the top private label issuers of residential mortgage-backed securities, Total RMBS issuance ($ thousands):
1. Countrywide Financial Corp. $75,838.8
2. Washington Mutual $38,904.3
3. GMAC-RFC $32,856.1
4. Bear Stearns & Co. $32,850.2
5. Lehman Brothers $31,971.7
6. Wells Fargo $29,257.7
7. Goldman Sachs $26,406.2
8. Option One $23,052.8
9. New Century $22,368.3
10. Indymac $22,157.9

Looking at this list, Countrywide is now Bank of America Home Loans, a subsidiary of Bank of America (BAC). Washington Mutual was the largest savings and loan in the country until it became the largest bank failure in the country, shortly to be surpassed by Lehman Brothers (number five on the list above). There's GMAC_RFC (Residential Funcing Corp). checking  in at number three, followed by Bear Stearns and then Wells Fargo (WFC) at number six. Hey, Goldman Sachs (GS)! Option One at number eight. And bringing up the rear, New Century, which filed bankruptcy in 2007, and Indymac, seized by the FDIC in 2008.

Looking specifically at the top private-label subprime issuers in the first half of 2006, here's the list ($ thousands):
1. Option One $23,052.8
2. New Century $21,411.1
3. Washington Mutual $18,698.9
4. Countrywide Financial Corp. $16,245.7
5. GMAC-RFC $16,140.7
6. Ameriquest Mortgage $14,533.8
7. Morgan Stanley $13,886.3
8. WMC Mortgage $11,813.6
9. Fremont $11,766.4
10. First Franklin $9,710.9

So, when I write "Having closed down the bar, aren't they basically now spending the morning after fighting over who gets the last sip in the bottle?", the real question is whether there's anything left in the bottle, period.
POSITION:  No positions in stocks mentioned.