Just when you thought the hubbub surrounding mortgage backed securities (MBS) was starting to subside, federal regulators have taken their most aggressive stance yet against the banks that sold toxic loans as investment grade securities, according to an article in the Wall Street Journal (subscription required). The National Credit Union Administration (NCUA), the agency that oversees federal credit unions and guarantees the deposits of both federal and state-chartered credit unions, has threatened to sue Goldman Sachs, BofA’s Merrill Lynch, Citigroup, and JP Morgan if the banks refuse to refund over $50 billion in MBS purchased by five wholesale credit unions that have since collapsed.
With some minor differences, the NCUA is to credit unions as the FDIC is to banks, overseeing the safety and soundness of the member-owned credit unions that act like banks for groups of workers in the same field (e.g. firefighters, teachers, or military servicepeople). In its role as conservator, the NCUA seized wholesale credit unions WesCorp, U.S. Central, Southwest, Members United and Constitution between 2009 and 2010, which had collapsed under the weight of their investments in MBS. Now, in an effort to recover the losses on the bonds it inherited–currently priced at half their face value–the NCUA is accusing the banks that created them of misrepresenting the risks.
Though many other federal regulators, including the Fed, the FDIC and the Treasury, hold large amounts of distressed mortgage derivatives, none prior to the NCUA has seemed interested in confronting these issuer banks. Sure, the New York Fed, which holds $70 billion worth of these assets from its rescues of Bear Stearns and AIG, has said that it would be engaging in a broad effort to enforce its rights. However, the only public action we’ve seen the Fed take in this regard is to sign its name to the letter sent by Kathy Patrick to Countrywide and Bank of New York back in October 2010. According to several sources, this amounts to little more than an effort at striking a sweetheart deal for BofA that would preserve the bank’s financial strength while setting a low bar for future settlements. Notably, this effort has made very little noise since its opening salvo (with both sides saying that they are currently engaging in negotiations).
The most interesting thing about the NCUA’s efforts is their focus on misrepresentation. As I’ve noted, we’re seeing a trend away from putback lawsuits and towards claims based on misrepresentations by issuing banks, such as Securities Act, Blue Sky and tort claims. Though plaintiffs originally shied away from alleging fraud or misrepresentation because they had little hard evidence to support such claims, significant revelations from discovery in ongoing litigation and testimony in federal investigations have exposed shenanigans in the loan buying and packaging business during the boom years of 2005-2008. In addition, as the recent holding in the FHLB of Pittsburgh case against JPM (analysis here and full order here) makes clear, less evidence is needed than previously thought to ensure the survival of misrepresentation claims.
In the NCUA’s case, sources indicate that the reason the agency is banging the drum of misrepresentation rather than breach of rep and warranty is that it may not be able to overcome the significant procedural hurdles required to obtain standing. The NCUA, on its own, does not appear to hold at least 25% of the voting rights in many MBS trusts, meaning it would have to band together with other investors to pursue these claims. This is still a possibility, but until then, the NCUA is wise to pursue the more accessible Securities Act and Blue Sky claims.
Turning to the big picture, the WSJ article quotes Quinn Emanuel lawyer Jonathan Pickhardt as saying, “[t]here’s plenty more litigation yet to come,” and I tend to agree. The statute of limitations (“SOL”) for federal securities claims is five years, while the SOL for rep and warranty contract claims under New York law is six years, meaning that claims on securities backed by 2005- and 2006-vintage loans will expire en masse by the end of this year. Should institutional investors fail to take action on these assets, despite the emergence of substantial evidence that these assets were misrepresented or defective, they could be exposed to breach of fiduciary duty claims by the pensioners, retirees and ordinary Americans whose funds they oversee.
Thus, I expect to see a significant number of MBS-related lawsuits hit the courts this year, including action by the Investor Syndicate, which has been ominously silent over the last few months. When that 800-lb gorilla finally begins beating its chest, Wall Street and institutional investors alike will be forced to sit up and take notice.