Back in October, investors began to demand that banks buy back mortgage securities that they sold. The investors argued that these institutions made mistakes when putting the mortgage deals together that breached their representations and warranties. As a result, investors sought to put these securities back to the banks that created them.
Of course, these investors wouldn't have been interested in pushing these securities back to their creators if their underlying mortgages were performing well. They weren't. The losses had begun to mount again, since home prices had begun to decline again after the home buyer credit expired. With their illness having returned, these securities turned toxic again and became hot potatoes that investors were trying to throw back to the banks that crafted them.
Why It's a Problem
In order to achieve some remedy, investors sued banks. So for some months, the problem slept. Then, in June a tidy resolution appeared to have been reached. The biggest mortgage originator of them all, thanks in large part to its acquisition of Countrywide, Bank of America agreed to pay $14 billion so that the problem would go away. A bunch of big investors agreed to this settlement. Other banks would likely come to similar settlements, but none as large as Bank of America's.
On Monday, however, we learned that this problem is a stubborn one. AIG is now suing Bank of America for $10 billion. It was not among the large investors content with the June settlement. Separately, last week Bank of America said that Fannie Mae wanted more money, removing the bank's previously estimated $3 billion cap for those losses.
Investors haven't shrugged off Bank of America's problems. In fact, they appear to be deeply concerned. Since July 22nd, in less than 3 weeks, the company's stock price is off 36%. Trading for just $6.51 per share at market close on Monday, the stock was at its lowest price since March 2009.
Financial Crisis 2.0?
AIG also plans to sue other big banks, and additional investors could follow. If the big banks begin to experience similar lawsuits due to mortgages deals that they issued, even on a smaller scale, then the market could begin to panic. Remember, the financial crisis was all about uncertainty over mortgage securities. The put-back fiasco renews precisely that problem.
Banks cannot hope for the best from litigation here, because courts need to decide the issue on a mortgage-by-mortgage basis. We're talking about millions of mortgages affected, so it's simply not feasible to endure those legal costs. That's why you'll see them settle. But how much will each investor demand from each bank?
You can see how much uncertainty the market might have to deal with here. Will some banks become insolvent? Will investors withdraw funding if they're worried about the magnitude of losses they could incur? If one giant bank fails will it bring down the rest of the sector with it?