Mortgage insurance company Ambac Assurance Corp. has become the latest plaintiff to bring a lawsuit against a mortgage originator for improper underwriting, suing Bear Stearns subsidiary EMC Mortgage Corp. in the United States District Court for the Southern District of New York. The lawsuit (available here) alleges that mortgage originator and “aggregator” EMC, under the control and behest of Bear Stearns, made loans that it knew borrowers could not afford to repay and sponsored securitizations that created a market for such defective loans. It further alleges that EMC made specific representations to Ambac to induce it to provide insurance for four separate securitizations, maintaining that the loans were underwritten without fraud, errors or omissions and that EMC would repurchase any loans that were found to be defective. Interestingly, while Ambac brings several claims based on EMC’s eventual breach of these representations and warranties, it does not bring a claim for fraud or negligent misrepresentation.
This lawsuit is structured very similarly to others that have been brought against mortgage originators, including the one we brought on behalf of PMI Mortgage Insurance Co. against WMC Mortgage Corp. and GE Money Bank in Los Angeles County Court. It details the many representations made by the originator in selling or acquiring insurance on the loans, notes the now-staggering delinquency rate of the loans, and then through due diligence reviews on random samples of loans, shows that the originator’s representations of quality underwriting could not have been true.
But, what’s most interesting about this action is the lengths to which Ambac goes to create a distinction between the poor performance of the loans stemming from the downturn in the housing market and the overall financial crisis, and the poor performance engendered by EMC’s irresponsible lending. For example, in paragraph 25, Ambac alleges that “EMC assumed the risk that the loans did not conform to its representations and warranties, while the insurers agreed to assume the risk that loan pools conforming to EMC’s representations did not perform as anticipated.” (emphasis in original) Ambac explains this concept further in paragraph 58:
The ability to evaluate the risk of the Transactions and adequacy of structural protections therefore depended on the ability to assess and control for the risk of default on the securitized loans. Certain default risk – e.g., due to changes in interest rates, changes in borrowers’ creditworthiness over time, adverse macroeconomic developments, and geographic concentration – is not subject to the control of the originator or sponsor, is measurable and quantifiable to an acceptable degree, and is the type of risk that Ambac knowingly assumes when it insures these types of transactions in exchange for a premium. Other default risk – e.g., due to misrepresented loan attributes, fraud or abject failures in origination and underwriting practices – depends directly on the controls, protocols, and practices of the originators and sponsor, and is not reasonably measurable or quantifiable by their counterparties.
While I admire these attempts to explain the complex subject of mortgage insurance in a straightforward manner, it seems this argument anticipates the defense that the downturn in the market is entirely responsible for these failing loans. And in this sense, methinks Ambac doth protest too much. Trying to explain what risks are anticipated and accepted by an insurance company to a judge or jury that likely has little experience with the subject matter might take the focus off of the main point – that the insurer and originator explicitly agreed that the insurer would not provide coverage for loans that were improperly underwritten. By sticking to detailing the representations and warranties made by EMC and the due diligence reports showing considerable breaches of these reps, the action would appear much more like an ordinary (and understandable) breach of contract case to an uninitiated audience.