Author Archives: David Reiss

S&P’s Coy-ful Analysis of Basel Securitization Framework

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S&P has long taken the public position that ratings from an NRSRO (like S&P or Moodys) should not be required.  This position would seem to be against its own interest and thus be quite public spirited.

Its recent Response to Consultation on Basel Securitization Framework may make one question whether it really stands by that public position after all.

The response raises a “number of significant concerns” about proposed revisions to the Basel securitization framework:

  • In seeking to reduce the framework’s reliance on external ratings, the proposals increase its reliance on various formula-based approaches. These generally do not take into account the full range of factors that can affect the creditworthiness of a securitization exposure, potentially undermining the framework’s risk sensitivity.
  • Because the proposed framework includes at least five different approaches to calculating securitization capital charges, there is significant scope for inconsistencies in treatment between different banks and/or jurisdictions.  . . .
  • Notwithstanding the Committee’s aim of ensuring more prudent capital charges for some securitization exposures, we question whether the losses experienced by securitizations globally since the 2007-2008 financial crisis warrant the scale of increase in capital charges that the proposals would result in, especially for investment-grade tranches.
  • Our analysis suggests that in many situations the Revised Ratings-Based Approach (RRBA) leads to significantly higher capital charges than the other proposed approaches, which suggests the RRBA may be incorrectly calibrated.
  • Although the proposals envisage various capping mechanisms to mitigate the risk of excessively high capital charges, our analysis suggests that these caps could determine capital charges in many situations, rather than being an exception. . . . (2)
The first two concerns appear to argue that NRSROs are necessary to the rating process.  The second two appear self-interested (consistent with their behavior for years) in that they argue against higher capital charges.  Higher capital charges would slow the growth of the securitization market and thus their own rating business income. Given that S&P had gotten its models for RMBS so wrong, it is disconcerting to see it oppose capital requirements that might err the other way for once.  And the last concern — that the exception may swallow the rule — is deliciously ironic, given that that was a major problem with S&P’s ratings of RMBS during the boom. As always, S&P’s input on this topic must be viewed through the lens of its self-interest to ensure that its positions are in the public interest.

Reiss on CFPB Complaint Database

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E-Commerce.com has a story on this tempest in a teapot, Finance Companies Bristle at Public Airing of Consumer Complaints.  It reads in part as follows:

The angst of the finance industry isn’t universal, however.

This database is evolutionary — not revolutionary — in that it expands what has been done with credit card companies, noted David Reiss, a professor of law at Brooklyn Law School.

“As a general rule, regulators should favor disclosure, which is integral to most consumer protection regimes,” he told CRM Buyer. “Banks and financial institutions have focused on the way that the database can be used inappropriately — allowing, for instance, adversaries to build an unverified record of wrongdoing by financial institutions.”

There is no evidence that this has occurred so far, Reiss said — and if it does occur, it can be addressed.

Motion to Dismay

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A recent Opinion and Order by Judge Forrest (SDNY) in IBEW Local 90 Pension Fund v. Deutsche Bank AG gives hints of some of the challenges facing plaintiffs in cases alleging misrepresentations and a scheme to defraud investors.

Like many other cases alleging misrepresentation (here, here and here for instance), this case has some juicy examples/.  They include the following:

  • Greg Lippmann, Deutsche Bank’s top gobal RMBS trader, described Deutsche Bank’s RMBS products as “crap” and shorted it to the tune of billions of dollars. (6)
  • Lippmann described the process of selling CDOs based on RMBS as a “ponzi scheme.” (7)
  • Lippmann described some Deutsche Bank CDOs as “generally horrible.” (8)

Because this Opinion and Order is considering a motion to dismiss, it treats the allegations as true for the purposes of the motion. But the opinion does not consider the back story here (not that it should). And the back story undercuts the plaintiff’s case quite a bit, such that it illustrates the markedly different standards that would apply if this case were to be decided on a motion for summary judgment or if it went to trial.

So what is the back story?  Well, Greg Lippmann is no faceless Wall Street operator. Rather, he is one the handful of Wall Street rebels who bet big against the conventional wisdom about subprime mortgages and was profiled by Michael Lewis in the Big Short.

So imagine how the defense will contextualize these alleged statements.  Lippmann has been well-documented to have been a lone wolf within Deutsche Bank.  In fact, Deutsche Bank was overall long on these products.  Deutsche Bank was acting responsibly by hedging its exposure across the whole bank, even if some desks and units were at odds with each other.

Bottom line:  this plaintiff will have a tough row to hoe as this case proceeds past the motion to dismiss phase.

 

Rating Agency Reform

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Emily McClintlock Ekins and Mark A. Calabria have recently posted a policy analysis to SSRN, Regulation, Market Structure, and Role of the Credit Rating Agencies.  They argue, as others have before them, that the major rating agencies are an oligopoly.  And like others, they argue that references to ratings should be weeded out from financial regulations.  The main value of their analysis, at least as far as I am concerned, lies with their analysis of other options.  They review three alternative regimes:

  • Open Access
  • Licensing
  • Licensing with captive demand

They define an open access regime as “an industry specific regulatory framework not stipulated by the state.” (24) With a licensing regime, “the state would stipulate that credit risk analysis be used to either require or incentivize investors to purchase high quality financial instruments.” (25) And with a licensing regime with captive demand, the state would, in addition to licensing,  also “stipulate, or ‘designate,’ whose credit risk analyses would be eligible to be used to meet requirements or incentives when purchasing financial instruments.” (26) They reject other reforms, such as (i) having the government take on the role of the rating agencies, (ii) holding the rating agencies liable for their ratings and (iii) banning ratings of overly complex financial instruments.

While I do not take a position on their reform agenda (other than finding the analysis of the open access option to be overly optimistic), it is important that people are thinking about what life would be like without the NRSRO designation for rating agencies that grants them the power to act as gatekeepers to the capital markets.  While many have criticized, few have come up with real alternatives to the system we now have.  Much more thought needs to go into creating a real alternative, and this analysis is part of effort to come up with one.

(As a side note, they have some interesting charts and tables, including Figure 5 which shows the increase in rated RMBS by Moody’s and S&P from 2002 to 2006.  Bottom line:  they more than doubled.).

Bransten Trio: Part Tres

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The last of the Bransten Trio of cases (previously, I wrote of Part Un and Part Deux) dealing with Allstate’s complaint against Morgan Stanley has some of the allegedly misrepresentative language at issues in such cases.  A sampling includes

  • “These mortgage loans may be considered to be of a riskier nature than mortgage loans made by traditional sources of financing . . ..  The underwriting standards used in the origination of [these loans] are generally less stringent than those of Fannie Mae or Freddie Mac with respect to a borrower’s credit history and in certain other respects . . . . As a result of this less stringent approach to underwriting, the mortgage loans purchased by the trust may experience higher rates of delinquencies, defaults and foreclosures . . ..” (24)
  • “It is expected that a substantial portion of the mortgage loans will represent”  a DTI ratio exception, a pricing exception, a LTV ratio exception or “an exception from certain requirements of a particular risk category.” (25)
  • The court noted that the Morgan Stanley defendants indicated that in connection with various MBS certificates they issued, “‘a significant number,’ ‘a substantial portion,’ or a ‘substantial number’ of the loans represented underwriting exceptions.” (25)

Justice Bransten found, as she did in the other two cases referenced above, that such warnings are “ineffective.” (26) She further notes that the defendants’ “statements are misleading to the extent that they imply that defendants would act in accordance with, rather that [sic] completely disregard, the results of their findings” from their reviews of the loans securing the MBS certificates at issue in the case. (29)

 

Martin-et Act?

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I am on the record in favor of greater prosecutorial attention to the events that led to the financial crisis, but I also believe that any prosecutions that result from such investigations should arise from laws that clearly outline potential liability.  Jeff Izant, a 3L at Columbia, has written a Note on an important, related topic:  Mens Rea and The Martin Act: A Weapon of Choice for Securities Fraud Prosecutions?

In particular, Izant argues

that the mental state requirements for Martin Act Section 352-c misdemeanor and felony liability need to be clarified and more thoroughly supported, because the statutory text and legislative history are somewhat ambiguous, and the subsequent jurisprudence has failed to provide a coherent explanation for the current state of the doctrine. Nonetheless, the Martin Act’s text, history and underlying policy rationale can be interpreted to support strict liability prosecutions for misdemeanor securities fraud, and to impose felony liability only for reckless violations of the statute. (919)

I have already noted that the Martin Act is in need of a thorough review, but Izant makes a strong case that strict liability under the act is on shaky grounds both as a legal and policy matter.

Izent notes that the Martin Act is a powerful club for the NY Attorney General to wield. Because those under investigation fear it so and typically choose to settle, there is little case law to guide our understanding of its reach.  Indeed, the New York Court of Appeals has never directly addressed the mens rea element of a Martin Act violation and Izant argues that lower courts have also not addressed it satisfactorily.  Because of this, Izant concludes that the Martin Act  poses dangers to the rule of law, particularly when the citizenry is calling for blood after a financial crisis.

Jean Martinet came to be a symbol of one “who demands absolute adherence to forms and rules.”  The Martin Act poses a greater danger:  in the wrong hands, it can demand absolute adherence to ambiguous rules that are only clearly articulated after the fact.  The Martin Act is in need of legislative attention.  Let us hope that some in the NY State Assembly or Senate agree.

Bransten Trio: Part Deux

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As I work through the Bransten Trio of cases on misrepresentation in the securitization process, I am struck by the arguments of the defendants, arguments that do not seem to carry much weight with judges who hear them.  In the Merrill Lynch case, the defendants (all Merrill-affiliated entities) “argue that it was not reasonable for plaintiffs, as sophisticated investors in the mortgage-backed security market, to rely on ‘unverified information.'” from the mortgage originators that was repeated by the defendants with the defendants making “no representations or warranties as to the accuracy or completeness of that information.”. (22)

This court, like others, does not treat “boilerplate disclaimers and disclosures” as Get Out of Jail Free Cards” for underwriters. (22) The court reviews a number of cases in which courts similarly refuse to treat such disclaimers as such, including

  • Plumbers’ Union Local No. 12 Pension Fund v. Nomura Asset Acceptance Corp., 632 F.3d 762, 773 (1st Cir. 2011)
  • In re Morgan Stanley Mortgage Pass-Through Certificates Litig., 810 F. Supp. 2d 650, 672 (S.D.N.Y. 2011)
  • New Jersey Carpenters Vacation Fund v. Royal Bank of Scotland Group, PLC, 720 F. Supp. 254, 270 (S.D.N.Y. 2010)
  • Pub. Employees’ Ret. Sys. of Mississippi v. Merrill Lynch & Co., Inc., 714 F. Supp. 2d 475, 483 (S.D.N.Y 2010)
  • In re IndyMac Mortgage-Backed Sec. Litig., 718 F. Supp. 2d 495, 509 (S.D.N.Y. 2010)

It will be interesting to see how disclaimers will be modified to offer increased protection to underwriters in the future.  Could an underwriter protect itself by saying that “there is a high likelihood that the representations and warranties contained in offering materials are false and intended solely to convince potential purchasers of the securities to purchase them?”