The Federal Home Loan Bank (FHLB) litigation against MBS underwriters, some of the first to arise out of the sale of toxic mortgage backed securities post-crisis, is progressing slowly but surely towards trial, without any major setbacks for the plaintiffs. As these suits have been followed closely since their inception by The Subprime Shakeout and its readers, and since it’s been a year since our last article on this front, we thought it was a good time for an update.
In the first of the six FHLB suits, brought by the Pittsburgh Bank, discovery is well underway and the court has ordered defendants to turn over extensive loan files. As previously reported on The Subprime Shakeout, the Bank’s complaint initially withstood dismissal without much hard evidence of wrongdoing, most of which could only be found in loan files that defendants and servicers had not been willing to turn over. Now that the bank is beginning to obtain loan files, one can only imagine what other evidence and/or claims of wrongdoing they will find.
The plaintiffs in the other FHLB suits are just now reaching the beginning stages of discovery, having overcome their defendants’ respective motions to dismiss. At the outset of most of these suits, the defendants employed the common tactic of removing the cases to federal court, in an effort to prolong the cases and drive up costs for the plaintiffs. Though the FHLBs of San Francisco, Seattle and Indianapolis have since been successful in having their cases remanded back to state court (to be heard by judges presumably more likely to broadly construe their own states’ Blue Sky laws), defendants have succeeded in delaying these cases for years. Motions to remand still are pending in the cases brought by the FHLBs of Chicago and Boston.
The good news for plaintiffs in these cases is that defendants’ motions to dismiss largely have failed. We’re going to dive into the Order on Defendants’ Motion to Dismiss in Seattle as an example. In that case, Washington state judge Laura Inveen shot down, on all but one issue, the consolidated motion of the eleven defendants that sought to dismiss the FHLB’s claims.
The Seattle Bank had asserted claims against the defendants pursuant to the Washington Blue Sky law allowing for rescission based on false or misleading statements. In particular, the FHLB focused on four types of misrepresentations in the MBS Prospectuses, which have since been repeated verbatim by the FHFA in its later-filed suits:
- Misreps regarding loan-to-value (LTV) ratio;
- Misreps regarding borrowers’ intent to occupy properties as primary residences;
- Misreps regarding originators’ and underwriters’ adherence to their own guidelines; and
- Misleading statements regarding the ratings of the certificates.
The defendants countered that the court must dismiss these claims for a number of reasons:
- The statements were just opinions;
- The statements were actually non-actionable statements of third parties;
- The trust documents contemplated the repurchase of non-performing loans, so the statements in the prospectuses could not have been considered absolute; and
- The Prospectuses contained sufficient disclaimers to warn investors not to trust the statements or the loan quality.
The court ended up denying the defendants’ motion to dismiss as to each of plaintiffs’ categories of alleged misrepresentations, with the exception of borrowers’ statements regarding their intent to occupy the premises as a primary residence (more on that below). The court pointed out that the standard for a motion to dismiss was high, especially since there were no allegations by the plaintiff of fraud. Also, the court refused to conduct a choice-of-law analysis, which would have resulted in the application of New York law with its more limited protections, since Washington’s Blue Sky laws provided investors greater protection than New York’s, and the court found that the state of Washington had a sufficient nexus to the litigation to apply its own law.
The court then addressed defendants’ arguments that the allegations of false and misleading statements were non-actionable opinions or statements of third parties. With respect to three out of the four categories of alleged misrepresentations (LTV, guidelines and ratings misreps), the court found there was enough verifiable information to make the material actionable and that the defendants sufficiently restated third-party statements and adopted them as their own, such that dismissal was not appropriate. As to the allegation regarding intent to occupy, however, the court held that,
Plaintiff was aware that occupancy assertions were based solely on the say-so of the borrower — an individual with a pecuniary motive to obtain a loan, with little, if any risk in being deceptive when misstating the occupancy status to obtain a favorable rate and terms. As a matter of law, it was not reasonable for Plaintiff, the sophisticated investor that it was, to rely upon statements about occupancy. (Order at 4)
This finding is notable, not so much because it rejected this category of misrepresentations – which seemed to be the weakest of the four categories – but because it pointed to the sophistication of the investors as one reason for dismissal. As discussed previously on The Subprime Shakeout, investor sophistication has been widely cited by defendant banks as a defense in MBS securities suits, and this argument is being pounded especially hard in cases where the investor was the presumably sophisticated Freddie or Fannie.
However, federal securities laws do not seem to allow for this consideration. Washington Blue Sky laws may be different, but the court does not cite to any case that so holds, so it’s not clear whether this opinion is an anomaly or whether other judges will follow this reasoning. Note also that Judge Inveen held that information regarding intent to occupy could still come in to prove other allegations, such as failure to adhere to underwriting guidelines.
Finally, as to defendants’ argument that there was sufficient qualifying language, such as disclaimers, in the underlying agreements, such that the investors should have been on notice that some of the loans would not turn out as described, the court ruled that this language was either not applicable to the loans at issue, was not specific enough, or amounted to issues for a trier of fact to decide.
We tend to think that unless there were disclaimers in the Prospectuses that “the underlying loans will be approved without regard for the borrower’s ability to repay, no matter how bad the credit risk appears,” the boilerplate language that “exceptions to the guidelines will be permitted where compensating factors are present” does not exempt issuer banks from liability. Exceptions were meant to be exactly that – occasional deviations from the guidelines – and the Prospectuses, as well as the originators’ underwriting guidelines themselves, generally provided that any exceptions had to be documented and supported by compensating factors. The practice of simply ignoring ones own underwriting guidelines for no good reason (except profit) was neither permitted by the guidelines nor disclosed to investors.
At the end of the day, Judge Inveen’s holding bodes well for the Federal Home Loan Bank cases and the securities law claims of other MBS investors. You can expect these cases to continue moving forward, and to begin settling or finding their way to their courts’ respective trial calendars sometime in the next year or two.