Author Archives: David Reiss

DoJ All FIRREA-ed Up With S&P Suit

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Law360 quoted me in a story, Prosecutors Unleashed As $5B S&P Action Rolls On (behind a paywall), about DoJ’s success in fending off S&P’s motion to dismiss its FIRREA case. It reads in part

While the latest ruling against S&P was lighter on substance, Brooklyn Law School professor David Reiss called it “a very big deal.”

“It adds to a body of law that gives the government another powerful tool to go after alleged misdeeds by financial institutions,” he said.

The suit, launched in February to much fanfare, targets S&P’s top-notch ratings for complex mortgage-backed securities that later failed. As part of a controversial, widespread practice known as the “issuer pays” model, banks created the securities, paid S&P to rate them and then sold them to investors. The DOJ claims S&P mismarked the securities on purpose to keep clients happy and boost profits.

In its motion to dismiss, the firm argued its public statements touting the ratings as objective, based on solid data and unaffected by potential conflicts of interest amounted to “puffery” and therefore could not form the basis of a fraud suit against S&P and parent company McGraw-Hill Cos. Inc.

But Judge Carter ruled Tuesday that the DOJ had sufficiently alleged S&P’s statements were not general, subjective claims, but were based on specific policies and procedures governing how the firm “shall” or “must not” rate securities. The judge called the firm’s puffery argument “deeply and unavoidably troubling when you take a moment to consider its implications.”

“Despite defendants’ protestations to the contrary, the court cannot find that all of these ‘shalls’ and ‘must nots’ are the mere aspirational musings of a corporation setting out vague goals for its future,” the judge wrote in an 18-page order. “Rather, they are specific assertions of current and ongoing policies that stand in stark contrast to the behavior alleged by the government’s complaint.”

Judge Carter also found the DOJ had sufficiently claimed S&P defrauded investors who had relied upon the ratings in determining the credit risk of certain investments. And the judge ruled the government did not have to plead “with a high degree of particularity” that S&P intentionally issued false ratings because the suit was filed under FIRREA. Tougher pleading requirements set out in the Private Securities Litigation Reform Act, which governs many securities suits, therefore do not apply, the judge ruled.

S&P spokesman Ed Sweeney noted Wednesday that the ruling did not address the merits of the case, as the judge was required to accept the government’s factual allegations as true during the early stages of litigation.

“We now welcome the opportunity to demonstrate the lack of merit to the Department of Justice’s complaint,” Sweeney said. “We firmly believe S&P’s ratings were and are independent, and expect to show just that in court.”

The decision followed a tentative July 8 ruling by Judge Carter. And indeed, given the sheer amount of resources the government has devoted to the case, the finding should have come as no surprise, according to Jacob Frenkel, an attorney at Shulman Rogers Gandal Pordy & Ecker PA who chairs the firm’s securities enforcement practice.

“When you have a deep-pocketed client that is willing to fight, a good lawyer will exhaust all options and remedies,” Frenkel said of S&P’s motion. “It would have been unreasonable to believe it stood any chance of success, but that does not mean you don’t try.”

Still, Judge Carter’s takedown should give the firm pause as it weighs whether to fight the claims or strike a settlement, according to Reiss, the Brooklyn professor.

“We now have a sense that the judge’s take on the guts of the case is pretty favorable to the government,” Reiss said. “And we’re now seeing the rating agencies start to crumble a little bit after their decades-long run of avoiding either settling or losing at trial.”

What Was S&P Puffing?

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I have been closely following DoJ’s suit against S&P since the complaint was filed in February (and see here, here and here).  DoJ alleges that S&P “issued or confirmed ratings that did not accurately reflect true credit risks” and seeks to obtain civil penalties pursuant to FIRREA. (4) Yesterday, Judge Carter issued a doozy of an order, denying S&P’s motion to dismiss the case.

Let’s remember that for the purposes of a motion to dismiss, the judge takes as true all of the facts alleged in the plaintiff’s complaint.  So, if a complaint survives a motion to dismiss, it means that the legal theory of the case is sound and that the plaintiff can win if the facts are as it alleges.

This should be the scariest passage in the order, as far as S&P is concerned:

Defendants lead off with a proposition that is deeply and unavoidably troubling when you take a moment to consider its implications.  They claim that, out of all the public statements that S&P made to investors, issuers, regulators, and legislators regarding the company’s procedures for providing objective, data-based credit ratings that were unaffected by potential conflicts of interest, not one statement should have been relied upon by investors, issuers, regulators, or legislators who needed to be able to count on objective, data-based credit ratings. (7-8)

This is repudiation of S&P’s “puffery” defense: their statements about their objectivity and rigorous methodology were merely “non-actionable puffery” along the lines of Charmin’s claim that it is the softest of all toilet papers. (8)

The Court follows this line of thought through to its logical conclusion:

if no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting that, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness? (12)

One wonders how S&P executives responded to their lawyers when they proposed this argument — were they thinking about anything else other than winning this motion?  Did they consider how regulators might react to this argument?

And, while this goes beyond the matter at hand, the Court’s reaction to S&P’s argument is an implicit indictment of the business model of the major rating agencies: they are really in the business of selling licenses to access the capital markets more than they are in the business of issuing mini-editorials about the creditworthiness of securities, as they have successfully argued in previous cases challenging their ratings.

Mortgage Bankers Ask Permission to Hijack GSE Reform

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The Mortgage Bankers Association issued a concept paper that calls for a board of mortgage industry representatives to “have the authority to direct the scope and immediate priorities of the [Central Securitization] Platform’s development, and the capability to redirect resources from the GSEs’ back offices to aid the project.” (3) So, to be clear, the mortgage industry wants not only to (a) define the scope and activities of the Platform but also (B) tell Fannie and Freddie how to spend their money to do so.  As Christmas is still a ways away, let’s spend some time working through this industry wishlist in the concept paper, The Central Securitization Platform: Direction, Scope, and Governance.

To start, what is the purpose of this mysterious “Platform?” According to the FHFA, it is supposed to “streamline and simplify those functions that are commoditized and routinely repeated across the secondary mortgage market.”(Building a New Infrastructure for the Secondary Mortgage Market, 5-6)

The MBA is calling for the establishment of “a strong panel of industry representatives to guide the development of the Platform.” (1)

But here is where I become nervous: “this Platform is just one piece of a much larger puzzle that impacts borrowers, lenders and the market as a whole. For these reasons, it is critical to appoint an industry advisory panel with real authority over the Platform’s early development. FHFA should establish and convene this panel before any further development is undertaken.” (2, emphasis added) Moreover, the MBA “believes the Platform should ultimately be owned by the industry as a cooperative.” (2)

So we have an acknowledgement that the Platform impacts “borrowers” and “the market as a whole.” But we have a call for a board with real powers that is only made up of “industry representatives.” Where have I heard a similar story like this before?  Oh, the Mortgage Electronic Recording System (MERS), a system designed by the mortgage industry that has been consistently attacked by local government officials and borrowers.

For now, I am agnostic as to whether the Platform is a good idea or not. But I certainly do not believe that only the industry should have the power to define its “scope and activities” and I certainly don’t believe that the industry should have the power to spend Fannie and Freddie’s money to pursue its vision. There are a lot more interests at stake than just the special interests represented by the MBA.

 

 

Where’s Perry? Are Phannie and Freddie Busted?!?

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With all apologies to Perry the Platypus who stars in my sons’ favorite TV show, Phineas and Ferb, today I look at the complaint in Perry Capital, LLC v. Lew et al. Perry Capital has sued the federal government for destroying the value of Fannie and Freddie securities held by Perry and the investment funds it manages. In particular, the complaint (drafted by Theodore Olson and others at Gibson Dunn) states that

Perry Capital seeks to prevent Defendants from giving effect to or enforcing the so-called Third Amendment to preferred stock purchase agreements (“PSPAs”) executed by Treasury and the FHFA, acting as conservator for the Companies. The Third Amendment fundamentally and unfairly alters the structure and nature of the securities Treasury purchased under the PSPAs, impermissibly destroys value in all of the Companies’ privately held securities, and illegally begins to liquidate the Companies. (2)

The plaintiff alleges that the government’s actions violate the Administrative Procedures Act (APA) and the Housing and Economic Recovery Act of 2008 (HERA). The APA governs the decision-making procedures of federal agencies like Treasury and independent agencies like the Federal Housing Finance Agency (FHFA). HERA was passed at the outset of the financial crisis and governs the process by which Fannie and Freddie may be put into conservatorship. (I discuss the enactment of HERA in Fannie Mae and Freddie Mac and the Future of Federal Housing Finance Policy: A Study of Regulatory Privilege, which is also available on BePress.)

[Warning:  necessary but complex details follow.  Those who are not GSE geeks may skip to the end.]

After the two companies were put into conservatorship in 2008,

Treasury and the FHFA executed the PSPAs, according to which Treasury purchased 1 million shares of the Government Preferred Stock from each company, in exchange for a funding commitment that allowed each company to draw up to $100 billion from Treasury as needed to ensure that they maintained a net worth of at least zero. As relevant here, the Government Preferred Stock for each company has a liquidation preference equal to $1 billion plus the sum of all draws by each company against Treasury’s funding commitment and is entitled to a cumulative dividend equal to ten percent of the outstanding liquidation preference. The PSPAs also grant Treasury warrants to purchase up to 79.9% of each company’s common stock at a nominal price. (2-3)

 According to the complaint, the Third Amendment to the PSPA changed the way that profits would be distributed by the two companies:

Under the original stock certificates, Treasury’s dividend was paid quarterly in the amount equal to an annual ten percent of the Government Preferred Stock’s outstanding liquidation preference. In the Third Amendment, the FHFA and Treasury amended the dividend provision to require that every dollar of each company’s net worth above a certain capital reserve amount be given to Treasury as a dividend. . . . Treasury’s additional profits from the Third Amendment are enormous. (5)

This is a very complex case, and I will return to it in future posts.  For now, I would just flag some issues that may pose problems for Perry.

First, is this case ripe for adjudication?  Perry states that they will be harmed when the two companies liquidate, but they are nowhere near liquidation.  Will the harm Perry predicts necessarily come about? The claim that they are harmed as to their expected dividends is stronger. Yet Perry acknowledges that the PSPAs “explicitly prohibit the payment of any dividend to any shareholder other than Treasury without Treasury’s consent.” (16)

Second, to what extent is this matter governed by the APA? I am not an APA expert, and I am wary of second-guessing Olson’s complaint in a blog post. But I would note that the court may not find that the APA even applies in this case and may find that HERA governs this dispute on its own. And even if the APA applies, the court may give great deference to the decisions of Treasury and the FHFA.

Finally, does the language from HERA that Perry relies on really give it much to hang its hat on? I think the crux of Perry’s argument is that the Third Amendment “created new securities”  instead of changing the terms of existing securities. (24) If a court disagrees with Perry on this (and it seems like a bit of a stretch to me), the theory of the case will be severely weakened.

All of this being said, I would agree with Perry that the holders of the Private Sector Preferred Stock — particularly the holders that predate conservatorship — look like they are receiving a raw deal from the federal government.  Various regulations encouraged lending institutions to hold Fannie and Freddie preferred stock over other investments. Those incentives sure looked like an implied guarantee before the subprime crisis knocked Fannie and Freddie off their feet.

Bottom line: this dispute cannot be settled in a late night blog post.  We’ll have to wait and see if Agent P can pull off what may be his most difficult mission yet.

Ain’t Misrepresentin’

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According to Wikipedia, the performers in the musical Ain’t Misbehavin’ “present an evening of rowdy, raunchy, and humorous songs that encapsulate the various moods of the era and reflect” a “view of life as a journey meant for pleasure and play.” In U.S. RMBS Roundtable: Arrangers And Investors Discuss The Role Of Representations And Warranties In U.S. RMBS Transactions, S&P does something similar with securitization. It presents the views of industry players as they try to predict and shape the future of the recently emerging private-label RMBS market, in the hopes of “achieving a healthy and sustainable RMBS market.” (2)

ACT I:  Lookin’ Good but Feelin’ Bad

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The piece contains a lot of important insights, including the following point made by investors: “standardizing R&Ws would be a step towards improving the transparency and their ease of understanding. Smaller investors noted that they can be particularly limited in distinguishing R&Ws given the complexities involved.” (3)

This point encapsulates in so many words the classic market for lemons problem, famously formalized by George Akerlof.  The lemon problem leads us to ask how a buyer is to price a purchase where the buyer has less information about the product than the seller.  Because of this information assymetry, the purchaser will assume the worst about the product and offer to buy it with that in mind.

R&Ws are an attempt to overcome that problem because the RMBS arranger or the mortgage originator promises to compensate the investor for lemons that are contained with a mortgage pool securing an RMBS. Consistent with that view, investors noted that “they expected to be compensated for losses caused by origination defects, rather than legitimate life events.” (2) In other words, origination defects are the lemons that should be borne by the arranger/originator with its superior information about the mortgages. And “legitimate life events” represent the credit risk that the investors have signed up for.

ACT II:  That Ain’t Right

Arrangers and originators made the following points:

  1. [o]ne arranger indicated that the R&W process should be governed only by the contractual obligations negotiated for each deal. (2)
  2. [o]riginators have strict underwriting guidelines and said they take great care to follow those procedures before issuing a loan. Arrangers are also currently subjecting all or almost all loans to a third-party due-diligence review. (2)
  3. arrangers said that standardizing R&Ws will not be an easy task as differences between arrangers and product types will limit the degree to which R&Ws can be homogenized. (3)

These points clearly align with the interests of the seller in a market for lemons.  To restate them a bit, 1. caveat emptor; 2. arrangers and originators don’t sell lemons (!); and (3) it is too hard to come up with provisions that consistently protect investors so don’t bother trying.

ENCORE:  Find Out What They Like

S&P notes that there “was broad agreement that one of the keys to achieving a healthy and sustainable RMBS market is aligning the interests of arrangers and investors.” (2) From that broader perspective, S&P is right that the industry should work toward a state of affairs that “minimizes the cost of unknown risks and ultimately reduces losses and related litigation.” (2) Given the spate of lawsuits over reps and warranties, we had fallen shy of that mark in the past (here, for example).  It remains to be seen if the industry can get it better next time and if the incentives are aligned enough to do so.

 

FHA Whitewash, Redux

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Richard Brooks and Carol Rose have recently published their book Saving the Neighborhood:  Racially Restrictive Covenants, Law, and Social Norms.  This well-written book brings to mind my recent post on the FHA Whitewash which reviewed a recent paper by HUD-affiliated researchers.  The paper minimized the role that the FHA played in furthering housing discrimination.  I mentioned that Kenneth Jackson’s classic book, Crabgrass Frontier, documented this sorry chapter of the FHA’s history.  Saving The Neighborhood covers some of the same ground, but from a legal and legal history perspective.  By doing so, it adds depth and texture to the historic record.

The book makes clear just how much of a role the FHA played.  The FHA’s

Underwriting Manual reflected private developers’ and brokers’ views of the kinds of features that made housing values stable and secure. Those features clearly included racial segregation.  In a section on “Protection from Adverse influences,” the Manual stated bluntly that “[a] change in social or racial occupancy generally leads to instability and a reduction in values” (par. 233). Thus property evaluators were to investigate the surrounding areas for the presence of “incompatible racial and social groups” and to assess whether the location might be “invaded” (par. 233). The Manual specifically noted that deed restrictions on “racial occupancy” could create a “favorable condition” (par. 228). in the section on subdivisions that were still in the development stage, the Manual recommended deed restrictions that included, among other matters, “. . . (g) Prohibition of the occupancy of properties except by the race for which they are intended” (par. 284(3)). (109)

The authors argue that these preferences gave developers, even those who did not favor segregation, an incentive to employ racially restrictive covenants in their projects. (110)

The FHA’s record of racial discrimination during the first few decades of its existence is clear, for all to see.

Assignment Ball and Chain

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An undated Nationwide Title Clearing, Inc. “White Paper” (actually, more of an advertorial), Understanding Current Assignment Verification Practices, is making the rounds of the blogosphere. It opens,

The scrutiny of the completeness of collateral review and valid assignment chains has hit the mortgage industry hard, primarily because the industry went from  a securitization process that didn’t  require assignments to be recorded to a heavily scrutinized process requiring complete chains to be recorded at the county. This has made compliance extremely difficult for many lenders and others, especially because the industry went for so many years without this  level of scrutiny. (1)

I’ll say!

This widespread lack of assignments could have negative consequences under the REMIC Rules. This is particularly a concern if it undercuts claims by purported REMICs that they acquired mortgages within the time required by statute.

I also found this passage intriguing:

just because a loan is supposed to be in MERS doesn’t always mean it is. We’ve found many examples of loans never having been assigned to MERS on land record, as well as loans that have been assigned multiple times out of MERS by prior investors/servicers, I would assume due to a poor review and preparation process . . ..(4-5)

I am not sure how courts would unwind such transactions. But I am sure we will find out . . ..