Mortgage Investors Get Blindsided; Bonds Backed by Subprime Loans Had $1 Billion of Previously Undisclosed Losses

June 2, 2013, 8:26 p.m. ET

Mortgage Investors Get Blindsided

Bonds Backed by Subprime Loans Had $1 Billion of Previously Undisclosed Losses

By AL YOON

Some mortgage investors got an unexpected refresher course on the risks of subprime debt when they received notice of $1 billion of previously undisclosed losses.

The unhappy surprise came with May’s monthly statements on dozens of bonds backed by 75,743 home loans made before the financial crisis to borrowers with less-than-pristine credit. Many of the losses on the $15.2 billion of loans outstanding likely weren’t reported to bondholders for a year or longer.

Behind the sudden losses is a standoff between Wells Fargo WFC -1.70% & Co., the nation’s largest mortgage lender, and Ocwen Financial Corp., OCN -1.31% the largest servicer of subprime loans, over the treatment of loans subject to a type of modification in which the borrower’s repayment schedule has been extended to reduce the monthly payment.Both companies play roles in the complicated process of converting monthly mortgage checks into scheduled payments to investors. But so far in this case, neither is accepting responsibility for the errors.

The losses themselves likely aren’t backbreaking for investors in the $1 trillion market for nongovernment mortgage bonds. Like other riskier assets such as high-yield corporate debt, subprime mortgages have rallied since early 2012 as the economic recovery has gained steam and U.S. home prices have begun rising after a sustained decline.

Still, the development stunned analysts and investors, renewing concerns that were common during the subprime meltdown and subsequent financial crisis about the accuracy of financial reporting and the risks of certain assets associated with the housing and mortgage markets.

“It’s highly troubling,” said Michael Canter, head of securitized assets at AllianceBernstein about the surprise losses.

“Our concern is that it is not just in these particular deals,” he added.

Servicers such as Ocwen process mortgage payments and handle the paperwork behind loan modifications and foreclosures. In this case, Wells Fargo serves as the bond trustee, overseeing the administration of bonds, including how they are serviced.

Investors rely on accurate reporting of losses by bond trustees and loan-servicing companies when valuing their holdings. Losses are typically recorded immediately, and ripple through to the value of the mortgage bonds.

Wells Fargo said in its May monthly reports on the bonds that it found previously modified loans were “reclassified” by servicer Ocwen and reported to it as losses.

In the reports, Wells said it gained “actual knowledge” of the loans’ status only after the recent transfer of servicing responsibilities to Ocwen from Homeward Residential Holdings Inc., the new name for a business Ocwen acquired last year.

Homeward modified the loans before Ocwen’s purchase last year. Wells Fargo said Homeward had reported the loan modifications to Wells Fargo as “non-losses.”

But Ocwen said Homeward believes that it reported the modifications and losses to the trustee. Ocwen also said that Wells Fargo had “only recently determined” the status of the loans and thus signaled the losses to investors.

Ocwen has come under increased scrutiny by regulators over its methods for dealing with troubled borrowers, particularly as it has been acquiring several other servicers and has become one of the nation’s largest mortgage-processing companies.

Wells Fargo agreed last year to pay at least $175 million to settle allegations that the company discriminated against black and Hispanic borrowers.

Investors and analysts scrambled to discern if the payment-reporting problem was widespread or isolated. The bonds were originally issued by American Home Mortgage AHMIQ 0.00% and Option One Mortgage in 2005 to 2007.

Losses surged in May on affected securities. Those issued by American Home Mortgage indicated losses of about $430 million, according to the May monthly report on the bonds from Wells Fargo, said John Sim, head of nonagency mortgage bond strategy at J.P. Morgan Chase JPM -1.85% & Co. He said the bonds showed an average monthly loss of $35 million over the past three months.

The report showed losses on bonds issued by Option One Mortgage were $367 million in May, compared with an average of $28 million over the last three months, he said.

Another set of Option One bonds had losses of $240 million in the month, above their average monthly loss of $54 million, he added.