HRB stock has taken a stumble recently after it was revealed that a group of bond investors are attempting to force HRB to repurchase subprime mortgages issued by its erstwhile subsidiary SCC during the housing boom. Estimates of $12B in losses to HRB, which is 2 to 3 times HRB’s market cap, have caused a sudden panic in the market, causing a nearly 10% decline in stock price.
First, it should be noted that this is not a new risk, and that HRB has disclosed for several years now the possibility of losses from mortgage repurchases. To date, HRB has reported about $740M in claims registered with SCC (with a principal balance of $33B), and has put aside $188M in reserve for repurchases. These numbers are vastly smaller than the $12B estimate that has been bandied about. As far as I can tell, the $12B appears to be an estimate of the TOTAL probable losses on SCC mortgages due to delinquency and foreclosure. The percentage of losses that are due to fraudulent underwriting is a fraction of the total, and the proportion would obviously vary from company to company. Estimates of the losses due to fraudulent underwriting (and therefore eligible for repurchases) range from 2-20% of the total losses on the portfolio. Furthermore, the group of bond investors is likely to own only a small proportion of the mortgages issued by SCC, and is unlikely to claim the entire $12B of losses.
Secondly, to date, most mortgage repurchases have been forced by Fannie Mae and Freddie Mac. These entities have taken a lot of losses from subprime mortgages, to the extent that a government bailout has been necessary, and they are seeking to minimize their losses however possible. They are also basically the only entities still insuring mortgages, and hence have enormous leverage against banks, which are under enormous pressure to repurchase the mortgages if they want to have an ongoing relationship with Fannie and Freddie and continue to stay in the mortgage business in the future. (And it should be noted that HRB no longer has a mortgage business and have to need to stay in the good graces of either mortgage investors or insurers.) In this situation, the repurchase litigation is often settled out of court. In the handful of other repurchase situations involving other private mortgage insurers and not Fannie or Freddie, most are now still in litigation, and not enough cases have been resolved to illustrate what the critical legal points are. The burden of proof for any wrongdoing will be on the prosecution, and there are ambiguity regarding key points, including whether litigation must be carried out on at the level of the individual loan or at the level of the entire portfolio, whether bond investors or bond insurers have the legal standing to sue, and what constitutes adequate wrongdoing to breach the warranty clauses. I am not a lawyer and am not sure how these points are likely to be resolved, but it is clear to me that any litigation will be protracted and span years, and is hardly a slam-dunk. Even today, several years past the height of the subprime crisis and with most shaky subprime mortgages already in default, surprisingly few repurchase cases involving non-Fannie/Freddie insurers have made it through the court system.
In summary, I think that the latest development is more a ploy by bond investors to apply pressure to HRB management through the court of public opinion, to do what they know will be difficult to accomplish in the legal system. The story will play out at glacial pace in the legal system, leaving more than adequate time for HRB to recapitalize and negotiate a settlement if necessary. My read on the recent stock movements is that investors with a short time horizon are taking their profits from the recent rapid rise in HRB stock, with long-term investors taking advantage of the recent dip to increase their positions. As for myself, I will be hanging on to my stock, as I believe that HRB is still substantially undervalued at these levels, and is an excellent defensive stock for these times.
Disclosure : I have a long position in HRB.
