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With interesting developments occurring almost daily in the proposed Bofa/Countrywide settlement with Bank of New York, it has been hard to focus on anything else. Indeed, since the last time I posted on the settlement (discussing New York AG Eric Schneiderman’s momentous challenge), AIG and the Delaware Attorney General have filed petitions to intervene and BoNY and the 22 investor group have filed oppositions to the New York AG’s petition that matched the prosecutor in ferocity.
But that’s not what I want to talk about today. Instead, I’d like to take a few minutes to cover some of the most important developments in RMBS litigation aside from the BofA settlement and Death Watch (courtesy of Naked Capitalism). There are many from which to choose, but these five were, to me, the most interesting non-Countrywide RMBS developments.
Number 5 – JP Mogan Settles Charges over Magnetar CDO
On June 21, the SEC announced that it had entered into a $154 million settlement with JP Morgan over civil fraud charges associated with the Squared CDO, which the bank set up for a hedge fund named Magnetar. The SEC asserted that JPM misled investors regarding the synthetic securities and stuck these unsuspecting investors with some of the world’s ugliest mortgages just before the market tanked. Helpful infographic here.
Maybe it has something to do with the fact that I had just watched X-Men: First Class, but whenever I heard discussion about Magnetar, I couldn’t help but picture Magneto, the mutant arch-villain that could manipulate magnetic fields with his mind. In fact, there were a lot of parallels. Just like Magneto, hedge fund Magnetar weakened the architecture of Squared to profit from the structure’s collapse. It succeeded in shorting subprime mortgages by constructing Squared CDO with the worst mortgage securities it could find. We’ll call this “Magnetaring” a deal.
Just as Magneto was allowed to walk by authorities once he lost his powers, Magnetar has also escaped legal prosecution (as did hedge fund Paulson & Co., which played a similar role in selecting the mortgage derivatives to stuff into Goldman Sachs’ Abacus deals). It’s not technically illegal if there’s a sucker on the other side of the deal.
Instead, the SEC decided to go after JP Morgan for failing to disclose to its investors that the collateral for the CDO had been adversely selected by a party that would profit should the CDO fail. All I know is, if I were a CDO investor, I would certainly consider it material if a prospective deal had been Magnetared.
Though the SEC has not done much to address the glaring irregularities in the creation of MBS, it has at least taken a stab at addressing the underhanded behavior by investment banks surrounding the black boxes that were CDOs (often comprised of the leftover pieces of mortgage backed securitizations the bank couldn’t sell directly). Yet, I wonder whether this is really the best use of the SEC’s time and taxpayer dollars. Though the amount of these settlements sounds large to the average layperson, $154 million is a drop in the bucket to JP Morgan (JPM’s stock actually rose 18 cents to $41.09 on the news) and is less than one-third the size of the settlement Goldman Sachs paid as part of the Abacus deal. And while commentators speculate that the SEC will bring more such actions against other banks, my guess is that they won’t go after Goldman or JP Morgan for any other CDO transactions, including the Hudson-Mezzanine deal that garnered so much attention during the Levin Commission’s investigations.
So, while the SEC touts the fact in its press release that “harmed investors will receive all of their money back,” and provides a colorful infographic to illustrate how Squared CDO was “a bad deal for investors,” it is doing nothing to recover the monies lost by investors in the scores of other similar deals orchestrated by these banks. As with so many other problems arising out of the mortgage crisis, we’ll have to rely on private litigants to take remedial steps on this front. At least the SEC settlement might provide these plaintiffs with enough encouragement to come forward, sparking class action lawsuits like those that followed Goldman’s Abacus deal.
Number 4 – HUD Inspector General Accuses BofA of Obstructing Investigation
On June 13, the Huffington Post reported that Bank of America had “significantly hindered” a federal investigation into the firm’s foreclosure practices, according to William W. Nixon, the federal fraud examiner and assistant regional inspector general for HUD’s inspector general office. Nixon accused BofA of withholding key documents and data and preventing the agency from interviewing key employees with knowledge of BofA’s foreclosure practices. Nixon also stated that the bank prevented his team from conducting a walkthrough of the bank’s documents unit and failed to comply with subpoenas issued by Nixon’s team. Though Nixon’s investigation has been completed, news of these allegations just recently became public when documents created by Nixon and his team were filed in a lawsuit brought by the State of Arizona against the bank.
According to Nixon, BofA’s intransigence forced him to ask the DOJ to issue civil investigative demands to compel testimony, a much less effective means of carrying out his investigation. Ultimately, Nixon’s final report found that the nation’s five largest servicers defrauded taxpayers and violated the FCA by submitting false claims for FHA insurance coverage to the government. These investigation results have been turned over to the DOJ for possible prosecution.
Aside from putting the banks at risk of criminal prosecution, the government’s recent scrutiny of FHA claims submitted by the big banks could create significant legal exposure. A report issued on June 13, 2011 by Bernstein Research estimates that, since inception of BofA’s relationship with the FHA, BofA originated $800 billion worth of FHA loans. The report notes that, “[e]arlier in the year, our discussions with the company left us with the impression that FHA loans were not a material risk for BofA. However, during our recent Strategic Decisions Conference, CEO Brian Moynihan said that the FHA loans and BofA’s servicing activities are ‘a risk that [the company] continues to monitor.’” Though the report does not provide a specific estimate of losses related to false claims for FHA insurance – including stemming from lawsuits such as the one the DOJ has already filed against Deutsche Bank for this type of conduct – it does estimate that BofA will face another $27 billion of housing-related losses between 2Q11-2013. That’s on top of the $46 billion BofA has already lost.
With the Treasury having cut off HAMP payments to several servicers, including BofA, and the AGs still hot on extracting a $20+ billion settlement from servicers, it’s not surprising that many banks want out of the servicing business entirely. This will open the doors for independent servicers to fill the void – ideally those without prior origination activities or section lien holdings.
Number 3 – Class Actions Alive and Well
Much has been made about the fact that class actions on behalf of RMBS investors have not fared well in courts around the nation. This article discusses how this trend resulted in 85% of the RMBS originally included in the suits being dismissed. This guest post by Josh Silverman in The Subprime Shakeout discusses some of the consequences of that trend and the specter of additional RMBS litigation.
Earlier this week, Judge Jed Rakoff in the Southern District of New York issued the explanation for his June 16 opinion granting class certification in the case of Public Employees’ Retirement System of Mississippi, et al. v. Merrill Lynch & Co., et al. (08-CV-10841), and sent a strong signal to banks and investors that the class action vehicle was alive and well. Whereas many earlier opinions on RMBS class cert had limited the scope of the class to those investors who bought the same securities as the named plaintiffs (that is, they had to own securities in the same tranche as the named plaintiffs, not just securities from the same offering), Judge Rakoff certified a class that included all investors that purchased any Merrill Lynch-issued mortgage backed securities from 18 separate offerings between 2006 and 2007.
Rakoff’s opinion may be found here. Therein, Rakoff found that Plaintiffs had “satisfied all of the requirements for class certification under Rules 23(a) and 23(b)(3). As courts have
repeatedly found, suits alleging violations of the securities laws, particularly those brought pursuant to Sections 11 and 12(a)(2), are especially amenable to class action resolution.” (Rakoff Opinion at 3) This is a far cry from the earlier decision of Judge Harold Baer, Jr. in the Southern District of New York (yes, the same court on which Rakoff sits), who found that investors varied in sophistication to such an extent that individual questions predominated. I think “risk?” is a question that most investors know how to ask.
Likewise, Rakoff held that the action before him depended primarily on “establishing that certain statements and omissions common to all the offerings were material misrepresentations: a classic basis for a class action.” (Id. at 3-4) Because the class action approach would result in an “enormous savings in judicial resources,” Rakoff affirmed his June 15, 2011 Order granting class cert in all respects. (Id. at 4)
Rakoff’s opinion comes on the heels of another momentous decision, handed down last week by Judge Paul Crotty, also from the Southern District of New York. In the 15-pager, Crotty approved class certification for a group of 103 RMBS investors who had purchased Credit Suisse securities. In doing so, he made clear that he wasn’t buying the argument that the disparity of sophistication among RMBS investors destroyed the commonality of the class. Colorfully, Crotty noted that, “Defendants’ view is apparently that, in order for a class to be certified, it must be like Baby Bear’s porridge in the story of Goldilocks: just right. This suggestion is untenable.” (Crotty Opinion at 11 n.1)
These two judicial opinions confirm what many of us following RMBS legal developments have known for some time: underwriting deficiencies and misleading prospectuses were not isolated occurrences – they were par for the course. By 2005, the abandonment of sound underwriting practices and the packaging of defective loans without proper disclosure had become part of the industry standard on Wall St., and this conduct harmed investors at every level of seniority and sophistication. Permitting class actions allows investors to overcome many of the procedural hurdles that banks have been hiding behind in recent years while discounting their potential put-back liabilities on their earnings statements. Namely, if a few investors can bring class actions on behalf of all other affected investors, they can overcome the difficulties that bondholders have had in finding one another and banding together. They all ate the same porridge, and it had been Magnetared in the microwave too long. Larger global settlements now become more likely. Already, a reputable law firm has re-filed a massive class action against several underwriters that purports to cover $350 billion worth of RMBS. And that’s far too hot for even the biggest banks.
Number 2 – NCUA Opens Fire On Behalf of Failed Credit Unions
This agency is racking up the lawyer points. I thought it was pretty bold when the National Credit Union Administration (NCUA) threatened to sue some of Wall Street’s biggest banks over MBS losses. But then, the NCUA actually backs it up with four separate lawsuits, seeking a total of $2 billion in damages? It’s safe to say somebody over there is fired up.
In the first batch of suits, filed on June 20 in Kansas City federal court, the NCUA sued J.P. Morgan Chase & Co. and Royal Bank of Scotland (RBS) for $278 million and $565 million, respectively, in damages from purchases of RMBS by the five failed corporate credit unions. The suits allege that the banks “systematically disregarded the underwriting guidelines stated in the offering documents,” resulting in securities that “were destined from inception to perform poorly.” According to the suits, at the time of filing, nearly half of the mortgage loans underlying the securities were delinquent, in bankruptcy or tied up in foreclosure. This was exactly what I used to see all day when reviewing subprime due diligence reports, and trust me, you get pissed.
On July 18, the NCUA struck again, firing off another lawsuit against RBS, this time in Los Angeles federal court with a demand for $629 million in damages based on violations of federal and state securities laws. This lawsuit was filed on behalf of WesCorp, which failed and was taken over by the NCUA on March 20, 2009. In a press release issued by the NCUA contemporaneously with this filing, the regulator stated that RBS’s misrepresentations “caused WesCorp to believe the risk of loss associated with the investment was minimal, when in fact the risk was substantial.” A subtle, but important difference.
Most recently, on August 9, the NCUA sued Wall St. paragon Goldman Sachs in federal court in Los Angeles, seeking over $491 million in damages. This lawsuit likewise alleges misrepresentations relating to 22 separate securities offerings, stating that, “a material percentage of the borrowers whose mortgages comprised the RMBS were all but certain to become delinquent or default shortly after origination. As a result the RMBS were destined from inception to perform poorly.” Aka, Magnetared.
So, who is behind this aggressive federal action? Maybe it’s NCUA Chairman Debbie Matz, who issued a statement saying that, “NCUA continues to carry out our responsibility to do everything reasonable in our power to seek maximum recoveries. Those who caused the problems in the wholesale credit unions should pay for the losses now being paid by retail credit unions.” Matz is just saying what every institutional investor should be saying right now – “these deals are totally Magnetared, and I want my money back.”
By the way, the NCUA has stated that it anticipates filing a total of 5 to 10 lawsuits in this space before all is said and done. Since, of the banks mentioned in its initial threats, only Merrill Lynch and Citigroup have not yet been sued, I’d bet dollars to donuts that these guys are also racking up the lawyer points.
Number 1 – FHFA Subpoenas Bear Fruit
Over a year ago, I wrote an article about how the Federal Housing Finance Agency (FHFA), as conservator for Freddie and Fannie, had issued 64 subpoenas to various participants in mortgage securitization, seeking underwriting documents for the RMBS the GSEs had purchased. Since then, I have received many inquiries regarding the status of those subpoenas. Until recently, I had little to offer, as it was all quiet over at FHFA.
Then, on July 27, FHFA finally pounced, filing a lawsuit against various UBS entities and executives in the Southern District of New York to recover losses on $4.5 billion worth of private label mortgage backed securities. The 102-page Complaint alleges violations of the federal securities laws based on misrepresentations regarding borrower creditworthiness and underwriting standards, yadda-yadda.
In a press release, the federal agency stated that it expects additional lawsuits to follow. “FHFA is taking this action consistent with our responsibilities as conservator of each Enterprise,” said FHFA Acting Director Edward J. DeMarco. “From the issuance of 64 subpoenas last year to the filing of this lawsuit and further actions to come, we continue to seek redress for the losses suffered by the Enterprises.”
The big question that remains for me is whether the FHFA will show the same aggression toward U.S. banks that it has toward the Swiss banking giant. For political reasons (e.g. “too big to fail” protectionism), they may not, which would mean leaving a lot of money on the table for the GSEs (and thus taxpayers). Remember that FHFA inherited over $250 billion in private label MBS garbage when it took over the failed institutions as conservator.
While the claims asserted in the cases filed by the FHFA and NCUA may not be novel, they are significant because of their size and the fact that they are being driven by federal regulators. This hints at a subtle shift in the “too big to fail” political climate since the outset of the crisis, and banks are no longer being viewed or treated as off-limits. Instead, investors of all sorts (even Treasury-owned AIG, which recently sued BofA for over $10 billion in damages) are looking to recover their losses however they can, and in particular from the banks that make for ready villains.
As the last dominoes fall for many hulking financial institutions, they will be forced to admit that their “past experience” with private label put-backs no longer applies, and they will continue to blow through each successive round of loss reserves. Indeed, the size of this country’s subprime shakeout seems only to expand as investors – and courts – come to fully understand the true villainy that was involved in putting mortgage securities together.