A vital word in business and accounting. If you don’t exactly understand its meaning in this context, don’t feel bad. Leading up to the Great Recession, neither did a lot of people who were supposed to understand exactly what it meant: CPAs, bankers and federal regulators, to name a few.
And the word is at the heart of why it got shockingly difficult to qualify for a vanilla mortgage loan after about 2010, even though published underwriting guidelines really weren’t all that onerous.
The vast majority of residential mortgage loans are, and have been for years, sold to conduits that package these deals into mortgage-backed securities for sale to investors, big and small, worldwide.
This movement of assets is essential if mortgage lending, and the U.S. housing industry, are to continue. This is because the originators of the loans can’t hold them indefinitely on their balance sheets. Banks, for example, are required by law to have a certain percentage of net worth to total assets. If the assets grow exponentially, and the net worth doesn’t, then the bank has to stop making loans, and even could be required to shrink. Even the Wells Fargos and Chases couldn’t swallow trillions in mortgages.
So, they sold the loans. They got rid of them, so they were no longer on the balance sheet. And accounting regulations are very clear on this: The loans must be sold “without recourse,” which means that the seller can’t be compelled to buy them back.
This is the way it was supposed to work, but it didn’t. The whole process was a sham, and happened because everybody turned a blind eye to it: the accounting profession, bank examiners and, certainly, the originators themselves, banks and mortgage companies.
In every loan purchase and sale agreement there is an extensive section called “Representations and Warranties.” This requires the seller of the loan to give a plethora of guarantees as to the quality and soundness of the loan, from the buyer’s qualifications, to the property’s value, to the correctness of the title work, and a lot of other things as well.
If one of these representations is violated in any fashion, the seller must buy the loan back if requested to do so by the purchaser. Quite simply, these loans were not sold “without recourse.” The originator might as well have said, “I’ll buy it back in a year if you don’t like the interest rate.”
When borrowers began to default on loans that many of them knew they couldn’t repay when they took them out, the sewage began running downhill. Holders of securities screamed at the packager of the paper because the security wasn’t performing. The packager found a warranty violation and told, say, Countrywide to buy the loan back. Countrywide notified Last State Bank of East Podunk that they’d been sold a bad loan and Last State had 15 days to repurchase the paper.
After the meltdown, it wasn’t the return to common sense loan underwriting that made it so hard to qualify for a home loan. It was fear.
Lenders took the new Fannie and Freddie mortgage criteria and made them even tougher. They wanted, and needed, every defense possible should they be notified of a buyback order. They were scared to death.
Imagine the CEO of a small bank with maybe $100 million in annual mortgage production being told to buy back $25 million in sick loans. It probably meant the demise of his business, and it actually happened to a lot of people during the Great Meltdown.
So why didn’t somebody blow the whistle? Hard to say, but maybe because nobody wanted to be responsible for pushing the first domino.
Pat Dalrymple is a western Colorado native and has spent almost 50 years in mortgage lending and banking in the Roaring Fork Valley. He’ll be happy to answer your questions or hear your comments. His e-mail is firstname.lastname@example.org.