Last week, when several major investors, including the New York Federal Reserve, demanded that Bank of America repurchase $47 billion in mortgage securities, some people began to worry. These investors believe that the bank's sloppy procedures resulted in flawed bonds. The big fear is that if other investors follow, and other banks are accused of the same behavior, then the U.S. could have a refreshed financial crisis on its hands. Could it happen?
This question was addressed this morning by the Congressional Oversight Panel for the TARP bank bailout. It is holding a hearing on the Treasury's foreclosure prevention program, but broader mortgage market issues were also discussed. Deputy Chair of the panel Damon Silvers, who is also Director of Policy and Special Counsel to the AFL-CIO, appears to believe that the buyback mess could pose a systemic risk.
Silvers explained that these investors are demanding that Bank of America (BoA) buyback $47 billion securities at par. He also said that the Federal Reserve estimates these bonds to be worth 50 cents on the dollar. In other words, BoA would be pay $47 billion for these bonds and have to immediately declare a $23.5 billion loss.
That's pretty bad, but Silvers imagines that it could get much worse. He says that these investors say that there's nothing unique about these mortgage securities. In other words they aren't worse than any others that BoA (or Countrywide, which is now owned by the bank) originated. He next explained that BoA has $2 trillion of such bonds outstanding. With a market cap of $115 billion, five such requests would completely wipe the bank out. And obviously, BoA is systemically critical.
Phyllis Caldwell, the Treasury's Chief of the Homeownership Preservation Office, had earlier said that the Treasury did not believe that the put-back threat posed a systemic risk. After explaining the above scenario, Silvers asked Caldwell if she wanted to revise her statement, as he thinks it's completely obvious that forced buybacks could pose a systemic risk. She did not revise her assertion, however. She said that there didn't appear to be evidence of a major systemic risk created by the buyback demands at this time.
So who's right? In a way, they both are. Silvers is definitely correct that, if the sorts of losses he imagines result, then the financial system will be in a great deal of trouble again. But Caldwell is also right so say that right now, we just can't be sure. While it's possible that this threat could be very serious, it's also possible that it could turn out to be nothing. It's too early to tell.
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