RMBS Put-Back Litigations and the Efficient Allocation of Endogenous Risk Over Time
62 Pages Posted: 5 Oct 2014 Last revised: 29 Mar 2015
Date Written: September 1, 2014
In many cases pending around the country, purchasers of residential mortgage-backed securities (RMBSs) are suing the financial institutions that created and sold the RMBSs, alleging that representations and warranties made by these institutions concerning the quality of the underlying mortgage loans were false in various respects. Because the agreements memorializing the securitization transactions that created the RMBSs generally provide that, if a loan fails to conform to the seller’s representations, the seller will repurchase the loan at full value, these cases are generally referred to as the RMBS Put-Back Litigations. A key issue in many of these cases, including cases currently before the United States Court of Appeals for the Second Circuit and the New York Court of Appeals, concerns whether the plaintiffs’ claims are barred by the statute of limitations. The issue turns on whether the statute began to run on the date that the seller made an allegedly false representation about the loans, in which case the statute would in many cases have already expired, or only on the much later date when the plaintiff demanded that the seller repurchase the allegedly non-conforming loans and the seller refused.
This seemingly highly-technical issue raises important questions about the efficient allocation of risk in sophisticated commercial agreements. The seller’s representations about the loans, backed up by the repurchase provision, shifts the endogenous risks associated with the loans to the seller, which is exactly what economic theory would predict because the seller is undoubtedly the superior bearer of these risks. The running of the statute of limitations, however, retransfers these risks back to the holders of the RMBSs. Since all the factors that make the seller the superior risk bearer still obtain on the date the statutory period expires, it would seem that the statute of limitations is creating an inefficient allocation of risk.
This article shows why retransferring endogenous risks to the RMBS holders is in fact efficient, that is, why the seller is the efficient risk bearer for a given period of time after the closing of the transaction but that, at a certain later point in the time, the RMBS holders become the efficient risk bearers. The argument turns on the fact that error rates in determining whether loans are conforming and the transaction costs of implementing the repurchase provision both rise over time, with the result that at some point the net benefit captured by shifting endogenous risks to the seller is reduced below the costs involved in implementing the repurchase provision. At this point, which the article denominates the moment of efficient repose, it becomes efficient to allow the costs of materializing endogenous risks to remain where they fall.
Keywords: RMBS, Put Back, Statute of Limitations, Risk
JEL Classification: G10, K12, K22, K41
Suggested Citation: Suggested Citation