Until recently, much of the attention surrounding so-called "put-back risk" has focused on the legal aspect, notably whether judges will require lenders to repurchase loans they sold to securitizers.
But bankers are now starting to wonder about the potential regulatory costs of such risk, as observers predict it could cause the banking agencies to raise a firm's capital, reserve and liquidity requirements.
The agencies are "going to have to look bank by bank and try and make some assessment of how that legal risk is going to manifest itself and to what degree in financial risk," said Kevin Jacques, the Boynton D. Murch chair in finance at Baldwin-Wallace College in Ohio. "Because this is going to be determined by the legal system, that creates an unknown or a wild card as to what amount of that risk is going to be put back to the bank."
The Federal Reserve Board is now leading an examination of put-back risk at the largest banks, asking institutions to include their exposure to repurchases in reports to the central bank about their capital strength. Many see this as a first step toward higher regulatory requirements.
"I would suspect that examiners are trying to assess at the bank what are the associated litigation and reputational risks, as well as the amount of underperforming securitized loans that could ultimately be subject to put-backs," said Sabeth Siddique, a director at Deloitte & Touche LLP and the former assistant director of the Fed's credit risk section. "As the bank conducts their analysis and they kick the tires … some banks may come up with a higher-than-expected number and some banks may come up with a lower-than-expected number. … They have to incorporate that perspective in their overall capital planning process."
How far regulators will go turns on how much risk is present in the system, and so far everyone involved appears uncertain.
In testimony to the Senate Banking Committee last week, Fed Gov. Dan Tarullo evaded questions on quantifying the level of put-back risk, but suggested it was substantial.
Excluding potential put-back claims from private-label investors, he said that outstanding repurchase requests from mortgage giants Fannie Mae and Freddie Mac exceed $13 billion, well above the nearly $10 billion of reserves for potential put-backs at the four largest banks.
"This liability could be quite significant for some firms, although particularly with respect to private-label securitizations, the losses may well be spread over a considerable period of time as litigation ensues," he said. When pressed by Jeff Merkley, D-Ore., to measure the risk "on a scale of 1 to 10," Tarullo said it was still hard to gauge.
"I don't want to give you a number on that, because we really are in the middle of the process right now," Tarullo said. "If I had to guess I would guess that for a few institutions that number would be reasonably high, and for many it will be reasonably low — even if the dollar amount is significant — because of the significant size of the institutions."
Investors can attempt to force a repurchase on claims that the quality of a security does not meet the so-called "representations and warranties" outlined in the original contract.
For example, investors can claim a bank attested to sound underwriting for the underlying loans, which did not actually turn out to be true. But the claimant would have to prove the misrepresented statement was directly related to a significant loss by the investor.
Put-back requests are common from Fannie and Freddie, which typically make claims independent of any litigation. But observers say claims recently have escalated, thanks to the persistence of foreclosures, as well as the attention to the robo-signing scandal emboldening investors to act. Recent notable lawsuits have been filed by individual Federal Home Loan banks as well as the Pacific Investment Management Company, known as Pimco.
Laurence Platt, an attorney at K&L Gates, said private-label investors usually make claims through their securitization's trustee. But now, in some cases the investors are considering claims themselves, because of the magnitude of their losses.
"The big difference is the investors are in effect trying to unionize around repurchasing," Platt said. "Investors are less happy today than probably they have ever been. They're looking for reasons to reallocate the risk of loss."
But whereas other types of risk can be correlated to figures on an income statement, helping to guide regulators on an appropriate course of action, observers said the impact of put-back risk can depend on a judge's discretion or a fine legal interpretation of a contract.
"We can all sit here as finance professionals and say, 'It's not that big of a deal' or 'I think it's a huge deal,' or 'the media is blowing it out of proportion,'" said Jacques, a former economist at the Treasury Department. "No, the legal system is ultimately going to be the one that determines whether this is hype, or we have underestimated it, or we have figured it out right."
Still, an investor has a difficult case to prove grounds for a put-back.
Platt said investors first must win a procedural argument that they can bring a case independent of the trustee. Then, they would have to find where a lender misrepresented itself in the contract, and then prove that that misrepresentation was tied to a huge loss by the investor. For example, an investor claiming the lender had overstated a borrower's income in the contract would have a weak case if the loan had defaulted because the borrower lost a job.
"A lot of it is hype. A lot of it is strained readings of contracts. And a lot of it is: maybe there are some claims under those contracts," Platt said. "Whenever there is hype about an issue the regulators want to make sure that there's not material financial risk to the banks. So they've announced they're looking at these issues as well."
David Gibbons, a former official at the Office of the Comptroller of the Currency, said an outcome of a claim can rest on "who has the best argument."
"I'm always concerned about litigation bringing down precedent from 30 or 40 years of industry practice. It can be a game-changer," said Gibbons, now a managing director at Promontory Financial Group.
Gibbons added that put-back risk could strain not only reserves and capital. "It's about liquidity because they literally have to take the loans back," he said. "They'd have to buy them back and come up with the funding to do so. It is a legitimate supervisory concern."
The most likely regulatory outcome, Gibbons said, is that the agencies will require an institution to hold higher reserves.
"They'd be interested in getting to the bottom of what is the representation-and-warranty, repurchase risk to the institution, and do they have adequate reserves and capital to cover it?" he said.