Posted on Wednesday, January 12, 2011
BANK investors cheered the announcement last week that Bank of America would pay $2.6 billion to buy back mortgages it had improperly sold during the housing bubble to Fannie Mae and Freddie Mac, the beleaguered mortgage finance giants. It seemed a sweet deal for the bank, whose Countrywide Home Loans unit had peddled tens of billions of dollars in risky loans to the taxpayer-owned companies.
While it is unfortunate that the Bank of America deal won’t recoup much for taxpayers, the resolution could have one important benefit. It might just open the door to a much-needed reckoning of the liabilities created by questionable mortgage practices at the nation’s largest banks. These institutions have not yet made a full and realistic accounting of their liabilities.
It seems clear, after all, that Bank of America will not be the only institution forced to buy back billions of dollars’ worth of loans because it did not meet the lending standards promised to buyers. Costs associated with foreclosure improprieties that have come to light in courts across the country — robosigners, forged legal documents — are also likely to be substantial.
But you’ll find precious little clarity on these liabilities in the financial statements of Bank of America, Citigroup, JPMorgan Chase and Wells Fargo. The amounts that these banks, the nation’s four largest, have reserved for possible mortgage repurchases — about $10 billion as of the third quarter of 2010 — is microscopic when compared with the more than $5 trillion in mortgage securities issued from 2005 through 2007.
For some investors, this is the accounting equivalent of whistling past the graveyard. And they are demanding that the audit committees of the banks’ boards step up their scrutiny of these institutions’ practices.
Last Thursday, officials overseeing 11 large public pension funds that own shares in the big four banks sent a letter to the directors who head each board’s audit committee. The investors are asking that the audit committees conduct in-depth and independent reviews of all the internal controls related to the banks’ mortgage operations.
Once the review has been completed — by a different accounting firm from the one currently signing off on the bank’s books — the investors want the audit committees to report their findings to shareholders.
John C. Liu, the New York City comptroller and overseer of five city pension funds, instigated the campaign to focus the banks’ audit committees on mortgage problems. “There is a fundamental problem in the banks’ procedures that endangers not just homeowners, but shareholders, and local economies,” he said in a statement on Thursday. “Given the risks involved, only a swift and unbiased audit can reassure shareholders that the pension funds of 700,000 working and retired New Yorkers are in safe hands.”
Joining him in signing the letters were the heads of the Connecticut Retirement Plans, the Illinois State Board of Investment and its State Universities Retirement System, the North Carolina Retirement System, the Oregon State Treasury and the New York State Common Retirement Fund. Together, the funds own $5.6 billion of stock in the top four banks and oversee $430 billion in assets.
THE New York City pension funds have also put forward a shareholder proposal asking for an independent audit of the top four banks’ mortgage operations. Mr. Liu hopes that the proposal will be put to a stockholder vote at the banks’ annual meetings this year.
It is unclear whether the proposal will be subject to such a vote. Citigroup doesn’t want it considered and has already asked the Securities and Exchange Commission to allow it to exclude the proposal from matters to be voted on at its coming meeting. The other banks will probably follow suit.
An official at JPMorgan Chase declined to comment on the shareholders’ request for an independent audit of its mortgage operations. Officials at Bank of America, Citigroup and Wells Fargo said that they were reviewing the letter but that they had confidence in their internal controls and audit committees’ vigilance. The Bank of America spokesman added that it had hired external auditors to review its foreclosure processes, which led it to enhance its practices.
But Robert L. Christensen, an authority on financial services accounting, says it is high time that investors — and regulators, for that matter — scrutinize the banks’ auditing processes. “I believe there is an avalanche of liabilities that has not been recorded in their reserves,” Mr. Christensen said. “They say it’s not estimable, but the question is, are they really accounting for it properly and are regulators pushing them hard enough to do it?”
He thinks they haven’t. Mr. Christensen, a certified public accountant who spent 24 years as an auditor at Arthur Andersen, is a senior adviser to Natoma Partners, a forensic accounting and litigation consulting firm. He says the banks have understated the liabilities for possible loan repurchases that they were supposed to have recorded in recent years.
Under accounting rules, when a bank sells a loan or a pool of them to investors, the gain on that sale is supposed to be reduced by an amount reflecting the possibility that some loans will have to be bought back later. These amounts are estimates.
It wasn’t until 2009 that banks began to discuss in their filings the reserves they had set aside for these potential liabilities. Mr. Christensen said reserves should have been set aside much earlier, given that the banks selling these loans were in position to know that underwriting standards were slipping and that forced buybacks could rise.
“Where were these banks’ internal controls?” Mr. Christensen asked. “Somebody inside knew that they were lowering their underwriting standards. They should have had processes that told them if these loans ever go bad, they will be put back because we are not meeting our representations and warranties.”
Banks are beginning to disclose more about their reserves in this area, but investors deserve far more, Mr. Christensen said. Regulators seem to agree. Last October, the S.E.C. sent letters to chief financial officers of public companies reminding them of their obligation to disclose the potential pitfalls in their mortgage operations. For example, the letter tells them to detail the risks associated with potentially higher loan repurchase requests and defects in the loan securitization process.
Mr. Christensen welcomes the regulatory interest, especially because the banks have set aside so little to repurchase loans sold to investors other than Fannie and Freddie. “They still haven’t taken any significant reserves for private-label deals, which were very large and probably contained lower-quality loans,” he said.
For example, JPMorgan Chase said in its third-quarter 2010 filings that it had set aside $3.3 billion in reserves for potential loan repurchases. But most of this applies to the roughly $380 billion of loans sold to Fannie and Freddie from 2005 through 2008, the bank said. Reserves to cover any potential putbacks from purchasers of the $450 billion in private-label securitizations the bank sold during that period are unspecified. They are included in a bucket designated for litigation costs, which consisted of $5.2 billion in the third quarter.
The bank said that because repurchase demands from private-label buyers had been limited thus far, it is tough to estimate future requests. Analysts in JPMorgan Chase’s own research unit published a report last fall stating that possible mortgage repurchase liabilities for the overall banking industry ranged from a best case of $20 billion to a worst case of $90 billion.
IT is unclear whether regulators or auditors will require the banks to increase reserves for the questionable loans they sold to private investors. The banks say investors will have a tough time proving the buybacks are warrented. Still, it is becoming more obvious by the day that these reserves are probably too low.
“There may be a reluctance to challenge the banks because of the overall fragility of the financial system,” Mr. Christensen speculated. “But I don’t think it’s a good thing to mix politics and accounting. That’s not a legitimate reason not to enforce the rules.”
By GRETCHEN MORGENSON, THE NEW YORK TIMES