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Fitch warns mortgage bond investors: Wells Fargo could keep more money for legal fees

$2.2 billion in RMBS classes now at risk of downgrade

Earlier this month, Wells Fargo unexpectedly kept $90 million away from residential mortgage-backed securities investors, stating that the bank needed the money to cover legal expenses.

Now, Fitch Ratings is warning RMBS investors that Wells Fargo’s move may not be an isolated incident. In fact, it may be a harbinger of similar moves to come in the future.

Of the $90 million that Wells Fargo held back, approximately $79 million came from 17 Fitch-rated RMBS transactions.

According to Fitch’s report, the redirection of trust funds by Wells Fargo resulted in insufficient remaining funds to pay off 55 Fitch-rated classes, including six classes with investment-grade ratings, which were included in the 17 RMBS deals.

Fitch reviewed similar RMBS deals and found a significant number that had similar characteristics to the 17 deals in question. Those deals, therefore, are at risk for Wells Fargo taking similar actions, Fitch writes.

As a result of that review, Fitch placed 299 RMBS classes from 98 RMBS transactions on "Rating Watch Negative," due to the potential for Wells Fargo to reserve against future expenses the bank may incur to defend itself against litigation.

According to Fitch’s report, the outstanding balance on those 299 RMBS classes is $2.2 billion.

In total, Fitch said the 299 classes are at an "increased risk for payment disruption" in the future, which basically means that Wells Fargo could do it again, so each of those classes are under review for rating downgrade.

"Wells Fargo has indicated that the withheld reserves are intended to cover future expenses related to lawsuits initiated in 2014 by institutional investors who claim they were damaged when Wells Fargo did not fulfill its obligation as trustee to protect them from defective mortgages," Fitch writes in its report. "Wells Fargo's action is notable due to its preemptive nature and due to the magnitude of the amounts withheld."

Fitch also notes that similar legal actions have been taken against all U.S. RMBS trustees – Bank of New York Mellon, Citibank, Deutsche Bank, U.S. Bank, HSBC Bank – which could mean that those banks could withhold money as well if the conditions deemed it necessary.

In its report, Fitch explains why all of this is significant:

U.S. RMBS transaction documents indemnify trustees against legal expenses incurred except those by reason of willful misfeasance, bad faith or gross negligence as determined by a court. To date, trustees have typically only withheld funds to cover expenses actually incurred or reserves in amounts not large enough to affect credit ratings.

That all changed when Wells Fargo elected to withhold that $90 million, with the potential for more that could be coming.

Fitch explains:

The amount withheld from the 17 called transactions reflects an assumption by Wells Fargo of future legal expenses of $3,000 per loan originally in the trust, plus $130,000 for each transaction.

Fitch assumes Wells Fargo will continue to pre-emptively redirect trust funds to reserve against future expenses in scenarios where they may not be able to reimburse themselves from the trust in the future, such as when a transaction is called or when the remaining pool balance is relatively small.

And if those conditions are present, Wells Fargo (and potentially other RMBS trustees) could withhold funds.

Fitch said that it contacted the other five trustees named in similar lawsuits and all five trustees were “unwilling or unable” to provide guidance on whether they intend to employ a strategy similar to Wells Fargo.

"J.P. Morgan's research team has identified four transactions where three trustees other than Wells Fargo (U.S. Bank, Bank of New York Mellon and HSBC) withheld funds on called transactions," Fitch notes. "The amounts were not large enough to affect Fitch-rated classes and the trustees would not disclose what portion, if any, was pre-emptively held for future expenses."

Fitch did note that the legality of Wells Fargo’s action is expected to be challenged in court, so this entire exercise could end up being a moot point.

But, for now, RMBS investors are on alert.

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