02/24/2012

MBS ‘Putback’ Investors Target Big Issuers

A growing number of hedge funds are scouring the files of securitized home loans, in hopes of reaping rich profits by forcing mortgage-bond issuers to buy back faulty credits.

Monarch Alternative Capital was among the first to begin carrying out the “putback” strategy last year. Now, Amherst Advisory & Management, Fir Tree Partners, Glenview Capital and Varde Partners are among other fund managers working either on their own or in teams to follow the same course.

The investment play is fueled by claims on the part of the firms, as holders of mortgage bonds, that the securities’ underlying loans failed to meet the standards advertised in the “representations and warranties” portion of the deal documents. If the collateral didn’t meet the criteria specified in the reps and warrants, bondholders can put back, or re-sell, the flawed mortgages to the issuers — typically deep-pocketed banks.

Last year, Monarch convinced an unnamed issuer to buy back loans from four of its mortgage-bond issues. In December alone, the issuer bought 30 loans for $8.5 million. Only part of those proceeds went to Monarch, with the rest going to other bondholders who benefitted from the firm’s work. In a letter to investors, the New York fund operator said it was pursuing other paths to enforce issuers’ reps and warrants.

Fir Tree also sees great potential in pursuing putbacks. In a letter to investors this month, it wrote, “The RMBS space is increasingly becoming a credit activist arena where certain bondholders can increase the value of their holdings through exhaustive work with other bondholders, trustees and mortgage originators.” The fund manager added: “We are confident that a positive return on these efforts will materialize over the next couple years.”

Last year, the New York firm returned 25%, largely by selling bonds whose values had risen. But it now sees higher returns flowing from efforts to build a team capable of picking apart securitized mortgage pools in search of fraud or other covenant violations before negotiating payouts.

However, the putback strategy is far from easy money. For starters, it requires considerable manpower to pore over detailed loan files in search of flaws. For instance, a due-diligence staffer would raise a flag when coming across multiple loans that name the same borrower with each underlying property listed as a primary residence. Fund managers use the threat of litigation to convince trustees to provide them with loan-by-loan data that often isn’t made available to investors.

Another complicating factor is the requirement that claims can only be made, and putback options exercised, by investors controlling at least 25% of a deal’s voting rights. Investors, therefore, must amass enough bonds to go it alone, or they must team up with other holders. Indeed, fund managers began banding together early last year for putback purposes.

There also are statutes of limitations in New York and other states that narrow the window during which the strategy can be pursued.

And when issuers agree to buy back loans, the money is paid directly to the trustee and flows through a securitization’s entire tranche-by-tranche waterfall, to the benefit of other investors. One mortgage-bond trader cited the “free rider” aspect as a disincentive to the strategy. But some hedge fund managers are instead able to negotiate private settlements with publicity-shy banks, walking away with profits and leaving the faulty loans in the bond issues’ collateral pools.

While subprime-mortgage securities typically trade for 30-35 cents on the dollar, issuers are sometimes willing to pay as much as 60 cents on the dollar for underlying loans that are subject to claims under reps and warrants.

While Amherst pursues the putback strategy as a fund manager, it also is offering its servicers as an advisor to institutional investors wishing to get in on the action. “[Amherst] generally expects to take an activist approach . . . in particular as [Amherst] deems necessary with respect to seeking to enforce the rights of security holders under the RMBS governing documents,” the firm said in an August 2011 SEC filing. “This may include filing legal actions in connection with RMBS governing documents, actively negotiating agreements where appropriate and otherwise bringing pressure to bear.”

Some of the funds searching for putback plays are longtime mortgage-bond traders seeking compensation from issuers whose securitized loans were of a poorer quality than advertised. Others are simply distressed-asset investors sensing opportunity.

Many larger fund operators, including Fortress Investment, considered the strategy but decided it was too cumbersome given relatively small balances among the home loans.

Pimco, BlackRock and the Federal Reserve Bank of New York initially pursued a putback strategy against Bank of America for bonds issued by its Countrywide unit. However, the group eventually opted for another legal strategy that led to a proposed $8.5 billion settlement with BofA and its trustee, BNY Mellon. The settlement is now pending in the Second Circuit U.S. Court of Appeals.

Fannie Mae and Freddie Mac also have been aggressively pushing billions of dollars of mortgages back to issuers.

If putback investors succeed on a widespread basis, the results could be catastrophic to the largest bank issuers, whose potential liability is enormous.

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