Wells Fargo and the New York Fed: Three Fronts and A Big Issue

Yesterday was big for the New York Fed on the MBS problem. Bill Dudley implicitly questioned the adequacy of the current back office operations in a speech and in a demand letter the New York Fed joined a group of other potential plaintiffs in starting the clock ticking on BofA in a situation involving bad loan putbacks.

Meanwhile, out on the left coast Wells Fargo today vigorously defended its own mortgage servicing operation. Admittedly, the defense could be interpreted, depending on one's perspective, as either 'our operations meet and exceed industry standards' or 'we're not as lame as the rest of the business.' But it was vigorous.

All of this has been freighted with much meaning. But I'm not so sure that the people either dismissing or heralding these developments have enough to go on to be very persuasive. The old joke about litigators--frequently wrong but never in doubt--comes to mind.

So I'm not going to say anything about the viability of the litigation implicitly threatened by a demand letter. I'm not going to speculate on the course of regulatory response to the possibility that material operations of some too big to fail financial institutions suffer from inadequate systems, procedures and controls, or management failures that have resulted in a pattern of routine violations of law. And I don't know how to sort out what Wells Fargo senior management says on the quarterly earnings call versus what Wells Fargo operating managers say under oath in deposition (beyond observing that maybe neither bank officers nor sworn testimony enjoy the confidence they'd once earned).

Instead, I'll offer something organizational--three fronts and a big issue. There are three fronts on which the mortgage backed securities business is being challenged.

Front No. 1. The originate to distribute part of the model. This where the put back issue comes from. There appear to be some problems with the disclosures made in offering documents. This will all be the grist of expensive and lengthy litigation. Both the plaintiffs and the defendants will be drawn from the financial services sector. There may be tax issues, though I'd be stunned if the IRS challenged the conduit status of the REMICs. The separation of record and beneficial ownership of the notes and security interests occurred at this point, but the problems it is now presenting lead directly to Front No. 2.

Front No. 2. The ongoing mortgage servicing operations of trustees and servicing organizations. In a kinder and gentler time (the boom of five years ago), these operations were seen as essentially custodial (the trustee holding the property for the benefit of the trust that issued the MBS) and ministerial--the accounting, recording keeping, reporting, disbursing of cash flows, etc.--of the mortgage servicer. These systems are now being stressed past the breaking point. In the first instance, that stress showed up in the foreclosure scandal, but it's rapidly spreading to other issues (viz., the demand letter). That first stress takes us to Front No. 3.

Front. No. 3. The legal issues coming out of the foreclosure disclosures. This is rough stuff. Without prejudging the question of whether the actual conduct was an endemic and indefensible as it appears to have been, the policy question of what to do about it is just beginning to surface. Do you settle for a patch and a local fix? Or do you conclude that the too big to fail financial institutions require rethinking? One relevant observation--those institutions seems to have many, many problems in a wide variety of different arenas. Foreclosure gate is part of a pattern, not a one-off. Consider the pay to play scandals in state and municipal finance. Consider the pay practices. And, don't forget the meltdown in the financial markets two years ago (a situation salvaged by bureaucrats and the taxpayer, though the leadership of those institutions and their publicists have conveniently forgotten that).

And, finally, the big issue. It's less global than pondering what to do about too big to fail financial institutions, but it's an aspect of their size. Conflicts of interest are a huge problem in the mortgage servicing business. The extent to which the different roles are intertwined in different operations of the same ultimate parent organization are going to be an enormous obstacle to resolving this mess. (It also may be a fatal weakness in legal attempts to contain it). One of the institutions joining in the demand on Bank of America is 34% owned by BofA. Wells Fargo is famous for making both first and second mortgages on the same property. One reason HAMP is believed to have had such dismal results is that the servicers were in a blatant conflict of interest situation.

All in all, interesting times. A lovely mess of policy issues, legal complications, operational challenges, all in a stew of tangled jurisdictional questions, potential criminal liabilities, and so on. A recipe for . . .