Insurance could reduce your REPO lossJeffrey A. Kiburtz Esq.Fannie Mae, Freddie Mac, credit crunch, Alt-A
Over a year into the credit crunch, the hits just keep on
coming. The first to take the hit were the frontline Main Street
lenders, mortgage companies and financial-oriented real estate
investment trusts (lenders, for ease of reference). Then came Wall
Street underwriters and the government-sponsored enterprises Fannie Mae and Freddie Mac, and now the
contagion appears likely to spread into other areas of the United
States economy, and possibly the world.
The severity of this storm and the speed with which it hit
largely defies description, but words such as surreal, frightening
and unprecedented come to mind. However, the storm waters
eventually will recede and the dust will clear—and not a
minute too soon. When it does, the more fortunate will be tasked
with sorting out the cards. For better or worse, this means
litigation in many cases. With the recent acquisitions,
bankruptcies and government interventions, it is not clear who will
be suing who. However, whether it is borrowers, distressed asset
funds, bankruptcy trustees, creditors' committees or the modern day
Resolution Trust Corporation, it appears likely that much of that
litigation will be centered around the Main Street lenders and
their directors and officers.
One area of particular concern for Main Street lenders engaged
in an originate-to-sell model is repurchase agreements. Loans sold
to Fannie Mae or other investors are typically subject to
repurchase agreements that purport to obligate the originator or
seller of the loan to buy back the loan in the event of early
payment default, fraud or other underwriting irregularities.
Whether the loan which the lender is being asked to repurchase
meets the applicable criteria is, of course, subject to dispute.
However, repurchase demands are high and increasing, and present a
significant problem for a large numbers of lenders.
In the beginning of August, Fannie Mae made a significant
announcement concerning its Alt-A portfolio. Fannie Mae announced
that its Alt-A book (estimated at approximately $330 billion, or 11
percent of its $3 trillion mortgage portfolio) accounted for 50
percent (approximately $2.675 billion) of the total second quarter
losses. As a result of these losses, Fannie Mae announced its plans
to exit the Alt-A business by the end of 2009. Further, Fannie Mae
made the following announcement concerning Alt-A loss
recoveries:
"[We are] ramping up defaulted loan reviews to pursue
recoveries from lenders, focusing especially on our Alt-A book. The
objective is to expand loan reviews where the company incurred a
loss or could incur a loss due to fraud or improper lending
practices. To achieve this, we are increasing post-foreclosure loan
reviews from 900 a month in January, to 4,000 a month by the end of
the year, expanding our quality-control reviews for targeted
products and practices, and are on track to double our anti-fraud
investigations this year. We expect this effort to increase our
credit loss recoveries in 2008 and 2009."
Given the size of Fannie Mae's Alt-A book, the default rate on
those products, the projected increase in defaults associated with
Alt-A loans set to recast in the coming years, and the
concentration of Alt-A loans issued in high default states like
California, Nevada, Arizona and Florida, lenders active in Alt-A
products over the recent years (especially the more problematic
2005 through 2007 vintage loans) should expect to feel the impact
of Fannie Mae's increased scrutiny.
In 2006, I wrote about preemptive measures lenders could have
taken to ensure that their insurance portfolios were optimized for
protecting against future mortgage-related losses. While it is a
little too late for that, it is not too late to develop a
coordinated plan to mitigate losses arising from repurchase
obligations (REPO loss). This article provides an overview of how
insurance might help reduce the net risk of REPO loss.
Direct insurance
Many lenders carry, as relevant here, directors and officers
liability insurance (D&O), professional liability insurance
(E&O) and/or first-party fidelity coverage (e.g., a financial
institution bond), depending on the specific business model
employed. These policies may, depending on the circumstances,
provide lenders with a source of recovery for REPO loss.
To the extent that it does not involve securities suits for
alleged accounting irregularities related to REPO loss, coverage
for REPO loss under D&O policies (or D&O portions of
blanket E&O policies) might be problematic. Primarily, D&O
coverage for public companies typically provides Side C coverage
(for the entity itself, not individual directors or officers) only
for securities claims. Of course, if the policy provides broad
entity coverage or the claim for REPO loss implicates individual
insureds, coverage under D&O policies may very well be
available. That coverage, however, likely will be subject to
disputes concerning prior knowledge of allegedly wrongful conduct,
prior related claims, whether the relief sought is restitutionary
in nature, applicability of exclusions specific to mortgage
securities and conduct subject to characterization as intentionally
wrongful.
An E&O policy issued by financial institutions (e.g., Chubb
Bankers Professional Liability Insurance is a common policy) is the
type of liability policy most likely to respond to claims for REPO
loss. Coverage available under these types of policies will likely
be subject to disputes concerning general exclusions for
contractual liability and other exclusions specifically keyed to
mortgage-related businesses. Additionally, insureds should expect
insurers to raise many of the coverage issues mentioned above in
the D&O section (prior knowledge of allegedly wrongful conduct,
prior related claims, whether the relief sought is restitutionary
in nature, applicability of exclusions specific to mortgage
securities and conduct subject to characterization as intentionally
wrongful).
Fidelity policies are first-party indemnity policies that provide
coverage for loss sustained by the insured. For this reason, these
policies are unlikely to directly respond to loss caused by a
third-party bringing suit against a lender. That said, the
distinction between what is a covered first-party loss and a
non-covered loss caused by a third-party suit is not clear in many
situations, and insureds should pay careful consideration of the
facts underlying loan losses to ascertain whether facts supporting
a claim exist. Insureds should keep in mind, however, that these
policies often contain reporting requirements that purport to
require prompt notice to the carrier upon discovery of a loss and
specified time periods within which to provide full information
concerning the loss. For this reason, prompt notice and a thorough
investigation of loan losses should be performed promptly upon
discovery of facts which might support a claim under a fidelity
policy.
Lenders should expect significant push-back from the carriers in
response to claims submitted for REPO loss. The fact that disputes
may arise concerning coverage issues does not necessarily mean that
the carrier advancing the position is correct. It merely reflects
the hot-button issues that insurers frequently raise with respect
to most complex claims. Preparing for the issues likely to be
disputed and proper presentation of claims is critical in
maximizing the potential for recovery under these policies.
Counterparty insurance
Lenders facing significant REPO loss often have other third parties
to whom risk can be shifted. For example, lenders might have claims
against brokers or mortgage companies from which the lender
purchased loans. Claims might exist against former directors and
officers of entities acquired by a lender in recent years. Other
sources, which are pursued more frequently in the insolvency
context, are former directors, officers, lawyers, accountants and
auditors.
Many of these third parties have insurance potentially applicable
to a claim made by the lender. As with direct insurance, D&O
and E&O policies are the most likely to respond to claims for
REPO loss. For example, the tail purchased by a merged-out entity
for its former directors and officers might provide coverage for
claims based on those directors' and officers' failure to disclose
during due diligence material facts concerning their
pre-acquisition lending practices.
Whatever the context, a lender must, in its capacity as a
plaintiff, identify those parties with insurance, and properly
structure and execute the claim against those parties to maximize
the REPO loss shifted to these third parties, especially when the
recovery source may not be sufficiently solvent to fund an adverse
judgment or settlement. Understanding the coverage available to
potential recovery sources is critical to employing a successful
third-party insurance recovery strategy. Equally important is
understanding the types of claims and allegations that create
coverage and the types of claims and allegations that may provide
the carrier with a coverage defense. Those, however, are only two
of the factors that must be considered when pursuing coverage
available to a third-party. Other factors and strategies must be
considered, both before making a claim and during the course of
litigation, to maximize the insurance recovery.
Conclusion
Over a year into the current crisis, squeezed between increased
loan losses and very hard capital markets, many lenders are facing
unprecedented challenges. For those that have already succumbed to
the cycle, insolvency players are working to maximize the value of
the remaining assets. The woes currently faced by many lenders will
be compounded when, as appears imminent, Fannie Mae ramps up its
efforts to mitigate its own losses by increased pursuit of REPO
claims. Finding ways to offload that risk will be critical to the
future viability of many lenders and the preservation of value in
lender bankruptcies. Insurance should not be overlooked as a
potential source of funding for REPO loss.
Jeffrey A. Kiburtz Esq. is an attorney with Ventura,
Calif.-based Wood & Bender
LLC. He may be reached at (805) 288-1300 or e-mail
[email protected].
