13. Loss Contingencies Arising From Representations and Warranties of Our Discontinued Mortgage Operations

Overview. SCC ceased originating mortgage loans in December 2007 and, in April 2008, sold its servicing assets and discontinued its remaining operations. The sale of servicing assets did not include the sale of any mortgage loans.

Mortgage loans originated by SCC were sold either as whole loans to single third-party buyers or in the form of residential mortgage-backed securities (RMBSs). In connection with the sale of loans and/or RMBSs, SCC made certain representations and warranties. These representations and warranties varied based on the nature of the transaction and the buyer’s or insurer’s requirements, but generally pertained to the ownership of the loan, the validity of the lien securing the loan, borrower fraud, the loan’s compliance with the criteria for inclusion in the transaction, including compliance with SCC’s underwriting standards or loan criteria established by the buyer, ability to deliver required documentation, and compliance with applicable laws. Representations and warranties related to borrower fraud in whole loan sale transactions to institutional investors, which represented approximately 68% of the disposal of loans originated in calendar years 2005, 2006 and 2007, included a “knowledge qualifier” limiting SCC’s liability to those instances where SCC had knowledge of the fraud at the time the loans were sold. Representations and warranties made in other sale transactions effectively did not include a knowledge qualifier as to borrower fraud. In the event that there is a breach of a representation and warranty and such breach materially and adversely affects the value of a mortgage loan or a securitization insurer’s or bondholder’s interest in the mortgage loan and, as discussed below, the mortgage has not been liquidated, SCC may be obligated to repurchase the loan, may be obligated to indemnify certain parties, or may enter into settlement arrangements related to losses, collectively referred to as “representation and warranty claims.”

Claim History. Representation and warranty claims received by SCC have primarily related to alleged breaches of representations and warranties related to a loan’s compliance with the underwriting standards established by SCC at origination and borrower fraud. Claims received since May 1, 2008 are as follows:


											(in millions)
Received in Fiscal Year		2009		2010		2011		2012		2013		Total
Loan Origination Year:
2005	$	62	$	15	$	8	$	4	$	22	$	111
2006		217		108		194		325		133		977
2007		153		22		16		763		13		967
Total	$	432	$	145	$	218	$	1,092	$	168	$	2,055

Note: The table above excludes amounts related to indemnity agreements.

Approximately 95% of claims relate to loans originated in calendar years 2006 and 2007. During calendar years 2006 and 2007, SCC originated approximately $42 billion in loans, of which approximately 1% were sold directly to government sponsored entities. Government sponsored entities also purchased bonds backed by SCC-originated mortgage loans and, with respect to these bonds, have the same rights as other certificate holders in private label securitizations. Due to a variety of substantive defenses and other reasons, SCC may not be subject to representation and warranty losses on loans, including without limitation loans that have been paid in full, liquidated, repurchased, or were sold without recourse.

Based on its experiences to date, SCC believes the longer a loan performs prior to an event of default, the less likely the default will be related to a breach of a representation and warranty, and the less likely that SCC will have a contractual payment obligation with respect to such loan. The majority of claims asserted since May 1, 2008 determined by SCC to represent a valid breach of its representations and warranties relate to loans that became delinquent within the first two years following the origination of the mortgage loan. However, a loan that defaults within the first two years following the origination of the mortgage loan does not necessarily default due to a breach of a representation and warranty. Exclusive of loans that have been paid in full, repurchased or sold without recourse, loans originated in 2006 and 2007 that defaulted in the first two years totaled $6.1 billion and $2.7 billion, respectively.

SCC received $168 million in claims during the nine months ended January 31, 2013, most of which were asserted by a private-label securitization trustee or servicer on behalf of certificate holders ($144 million), with the remainder asserted by monoline insurers ($15 million) and Fannie Mae ($9 million). During the fiscal year ended April 30, 2012, SCC received claims totaling $1.1 billion. The amount of claims received varies from period to period, and these variances have been and could continue to fluctuate substantially.

During fiscal year 2013, SCC has either entered into, or is in discussions with several parties for tolling agreements to extend any applicable statute of limitations related to potential representation and warranty claims and other claims against SCC involving substantial amounts. SCC has experienced a recent decline in representation and warranty claims, which it believes may be partially attributable to the existence of these tolling agreements, and this may continue until the tolling agreements are terminated.

Liability for Estimated Contingent Losses. SCC estimates probable losses arising from representations and warranties on loans it originated by assessing, among other things, claim activity, both known and projected. Projections of future claims are based on an analysis that includes a review of the terms and provisions of related agreements, the historical claim and validity rate experience and inquiries from various third-parties. SCC’s methodology for calculating this liability also includes an assessment of the probability that individual counterparties (private label securitization trustees on behalf of certificate holders, monoline insurers and whole-loan purchasers) will assert future claims. SCC also considers the potential for bulk settlements when determining its estimated accrual for probable losses related to representations and warranties.

SCC has accrued a liability as of January 31, 2013 for estimated contingent losses arising from representations and warranties on loans it originated of $118.8 million, which represents SCC’s estimate of the probable loss that may occur. While SCC uses what it believes to be the best information available to it in estimating its liability, assessing the likelihood that claims will be asserted in the future and estimating probable losses are inherently subjective and require considerable management judgment. To the extent that the volume of claims, the level of claims (including whether the loan has been liquidated), the level of disputed claims, the level of threatened claims, the counterparties asserting claims, the nature and severity of claims, the outcome of various litigation related to claims, or the value of residential home prices, among other factors, differ in the future from current estimates, future losses may differ from the current estimates and those differences may be significant.

Because of these numerous uncertainties, SCC is not able to estimate reasonably possible loss outcomes in excess of its current accrual. However, such possible loss outcomes may be significant. A 1% increase in loss severities and a 1% decrease in assumed denial rates would result in losses beyond SCC’s accrual of approximately $27 million. This sensitivity is hypothetical and is intended to provide an indication of the impact of a change in key assumptions on this loss contingency. In reality, changes in one assumption may result in changes in other assumptions, which could affect the sensitivity and the amount of losses.

A rollforward of SCC’s accrued liability for these loss contingencies is as follows:


				(in 000s)
Nine months ended January 31,		2013		2012

Balance at beginning of period	$	130,018	$	126,260
Provisions		-		20,000
Payments		(11,253)		(3,337)
Balance at end of period	$	118,765	$	142,923

The recent federal court decision styled MASTR Asset Backed Securities Trust 2006-HE3 v. WMC Mortgages (Case No. 11-CV-2542 (JRT/TNL), 2012 WL 4511065 (D. Minn.), the “WMC Decision”), decided on October 1, 2012, recognizes the liquidation of a mortgage loan in a foreclosure sale as a defense to representation and warranty claims and related litigation. Specifically, the court noted that under the law of many states, including New York (which was applicable in the case at hand and governs most of SCC’s purchase agreements for mortgage loans), a foreclosure decree operates to merge the interest of the mortgagor and mortgagee and, consequently, foreclosure on the properties securing the mortgage loan extinguishes it and renders it unavailable for repurchase. Consistent with this approach, SCC is taking the legal position where appropriate, for both contractual representation and warranty claims and similar claims in litigation, that a valid representation and warranty claim cannot be made with respect to a mortgage loan that has been liquidated. However, the WMC Decision is subject to appeal and it is anticipated that the liquidated mortgage loan defense will be the subject of future judicial decisions. Until the liquidated mortgage loan defense is further validated in the courts or other developments occur, SCC’s estimated accrual for representation and warranty claims will continue to be determined using its prior methodology, which does not take this defense into account.

Settlement Actions. SCC has vigorously contested any request for repurchase when it has concluded that a valid basis for repurchase does not exist and will continue to do so in the future.

American International Group, Inc. (AIG) had threatened to assert claims of various types in the approximate amount of $650 million in connection with the sale and securitization of SCC-originated mortgage loans. On December 21, 2012, SCC and AIG entered into an agreement to resolve all of AIG’s claims, except that AIG retained the right to benefit from payments for representation and warranty claims by third parties, without AIG’s assistance or encouragement, that are made to securitization trusts in which AIG has a continuing interest.

SCC may enter into other bulk settlements it believes to be advantageous in lieu of a loan-by-loan review process. In addition, there are certain SCC contingencies described in note 12 that include representation and warranty claims that may be resolved through settlement or litigation. Any resulting payment from such settlements would be charged as a reduction to the accrual for representation and warranty claims.

Indemnification obligations. Losses may also be incurred with respect to various indemnification claims related to loans and securities SCC originated and sold. Losses from indemnification obligations can be significant and are frequently not subject to a stated term or limit. SCC believes it is not probable that it will be required to perform under its indemnification obligations; however, there can be no assurances as to the outcome or impact on our consolidated financial position, results of operations and cash flows related to claims which may arise from those indemnification obligations.

Reviewed Claims. Since May 2008, SCC has denied approximately 94% of all claims reviewed, excluding loans covered by other settlements. Of the denied claims, 1% related to loans that have been paid in full and 1% of claims were denied because they related to loans which have been liquidated. Paid claim loss severity rates have approximated 64% and SCC has not observed any material trends related to average losses. Repurchased loans are considered held for sale and are included in prepaid expenses and other current assets on the consolidated balance sheets.

SCC generally has 60 to 120 days to respond to a claimed breach of a representation and warranty and performs a loan-by-loan review of all claims during this time. Counterparties are able to reassert claims that SCC has denied. Claims totaling approximately $42 million remained subject to review as of January 31, 2013, of which, approximately $20 million represent a reassertion of previously denied claims.