Not intentionally, perhaps, but Nomura’s equity analysts do a half-decent Perry Mason impersonation in a note sent out late Friday.
The note offers a fresh estimate for how much the banks sued by the FHFA stand to lose, and it’s a good deal more optimistic (for the banks) than other estimates we’ve seen — including FT Alphaville’s initial guess, and for that matter Nomura’s first effort too.
Nomura are not legal experts, which they happily admit, and neither are we. So we’ll take this note as more of an early guide to how the banks will come out swinging than a definitive guide to expected losses.
Boiled down, Nomura make the following points:
1) The banks might have a case that the statute of limitations for the FHFA to sue had run out. The statute of limitations for the claims made by the FHFA is “three years from the time of offering or one year from when the plaintiff should have reasonably discovered the problem… However, when the FHFA was formed, it received a special provision to allow more time (three years) to bring claims on behalf of Fannie and Freddie.”
This was the rationale behind the timing of the suits — that is, the FHFA had to bring within three years of taking them into conservatorship.
But Nomura believe the statute could be contested because the GSEs should have “reasonably discovered the problem” more than a year before the FHFA put them into conservatorship.
(We don’t buy this argument, and we’ll explain why in a minute.)
2) Whatever the ruling on the statute of limitations for the FHFA, it is unlikely there will be many copy-cat lawsuits. Other potentially litigious investors won’t have the same three-year arrangement as the FHFA and are unlikely to have signed tolling agreements, so those who haven’t filed a claim by now possibly can’t.
3) Estimated losses on the MBS have probably been overstated. Nomura produce a different analysis from the ones used by other analysts, who had simply applied the 21 per cent loss ratio the FHFA scored from its similar lawsuit against UBS earlier in the summer and concluded that the total losses would be about $40bn.
Nomura instead used its fixed-income team to go through each individual security to make a bottoms-up estimate of how much the GSEs were likely to have lost. Here’s the final tally, with the first graph showing the individual totals as a percentage of each bank’s tangible common equity and the second showing the expected losses as a percentage of the face amount (click to enlarge):
So the total estimated losses are $24bn, but Nomura expect that the FHFA would settle in the range of $10bn given the other arguments made here.
4) Fannie and Freddie knew what they were getting into, and in many cases the language in the securitisation filings was specific about the exceptions being made to underwriting guidelines. (Also known as, the sophisticated investor argument). A few quotes here will suffice:
We also find it noteworthy that, while there are likely someexceptions to the underwriting guidelines that were allowed into the mortgage pools, wefound instances of language clearly spelling this out (so maybe not all loans that didn’t fit the underwriting guidelines were actually breaches). For example, in relation to one ofthe Countrywide securitizations referenced in the FHFA suits, we found the followingverbiage: “Exceptions to Countrywide Home Loans’ underwriting guidelines may bemade if compensating factors are demonstrated by a prospective borrower.” Bottom line,we think Fannie and Freddie likely had a pretty good idea of what they were buying and were very involved in the underwriting selection process.
5) Banks will argue that only some of the losses on these securities was due to misrepresentations. The bulk of it, they’ll say, came from the economic downturn:
In our view, the banks are likely to take the position that losses related tomisrepresentation/underwriting are only a fraction of losses inherent in these securities.For example, Bank of America disclosed in its latest 10-Q filing relative to its whole loansand private-label securitizations that, “At least 25 payments have been made onapproximately 62 percent of the defaulted and severely delinquent loans.” This suggestsa majority of losses are due to the economic downturn and housing prices declinesrather than initial misrepresentation/underwriting. Somewhere in between the view thatall the losses were due to misrepresentations/negligence and that all were caused by theeconomic downturn lies a potential settlement range. Given the significant costs that willbe incurred to litigate these claims over time, we think each side will likely be motivatedto reach some middle-ground settlement.
So that’s Nomura’s case.
Our quick response would be to point out that Nomura’s estimates for total security-by-security losses could simply be wrong. This seems like the kind of calculation that could change quite a lot by tweaking just a few assumptions. And given the complicated and varying roles of the seventeen banks, it’s likely that quite a few assumptions were needed.
We also think that the statute of limitations defense seems like a long shot. For one thing, the GSEs did have tolling agreements with most of the financial institutions being sued, as a simple search through the filings reveals. So we’re not sure why this wouldn’t hold up.
We suppose the banks will use whatever argument they can, but we would further add that the three-year statute only applies to the most basic misrepresentation allegation; other claims, such as fraud, are not subject to the same statute of limitations as misrepresentations. Fraud may harder to prove, but the allegation won’t disappear on a technicality.
Nomura also “have not assumed any punitive damages”, and again we don’t know why. The FHFA is requesting punitive damages from eight of the seventeen banks.
It may well be that the FHFA will at some point seek to settle for less than everyone thinks if the case starts to go bad — but given the loss ratio in the UBS case, we’re guessing the regulator will be gunning for a much higher number than $10bn, at least as the start.
There are doubtless other issues involved here, and we’d encourage readers to help us round this out in the comments. We’ll pull up into the text any comments that mention something relevant that we missed.
By the way, here’s a helpful matrix showing which banks, other than Nomura, have been accused of what (click to enlarge):
Only two ran the table of allegations, giving JP Morgan some inauspicious company.
Full note in the usual place.
What price the FHFA lawsuit losses? – FT Alphaville