Author Archives: David Reiss

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?”

Building a Model for Housing Finance

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Following up on Friday’s post, I want to discuss Chambers, Garriga and Schlagenhauf’s draft that they recently posted to SSRN (free here).  It presents some interesting historical analogies to the issues we face as we attempt to chart a new direction for federal housing policy.

They too review the housing subsidies that exist in the financing system and in the tax code.  They attempt to “study the effects of changes in government regulation on individual incentives and relative prices” (4)  They include an interesting Table (2) on page 8 that shows the growing percentage of home mortgages that were insured or guaranteed by the FHA and VA.

What I find most interesting about this article is that it attempts to model the impact of better financing terms on the housing market.  For instance, they argue that their “model suggest that the extension of the FRM contract from 20 to 30 years can explain around 12 percent of the increase in ownership” for a certain period of time. (25)  More generally, they find that the “total impact of mortgage innovation is approximately 21 percent” when combined with “a narrowing mortgage interest rate wedge . . ..” (31) I would love to see more economics articles that model the impact of credit terms on housing prices and homeownership rates.  While this seems fundamental to housing economics, there is less out there about this than there should be.

While their conclusion that “mortgage innovation did make a significant contribution to the increase in homeownership between 1940 and 1960”  is not surprising, their model helps us understand why that is the case. (26)

Goldilocks Homeownership

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It has only been since the housing bust have we had a serious conversation about how much homeownership is just the right amount.  Mostly, the federal government (under both Democrats and Republicans) has pushed for more, more, more without regard to whether more was better.  Principled commentators on the Left (Paul Krugman, for instance) and the Right have rightly criticized this unthinking commitment to more, but it is very politically attractive to push policies that appear to benefit homeowners (read, voters).

Morris Davis has recently posted his Cato Institute policy analysis critique of federal homeownership policy to SSRN, Questioning Homeownership as a Public Policy Goal. Like others, he criticizes the extraordinary subsidization of homeownership through the significant tax benefits (such as the deductibility of mortgage interest on a personal residence) and financing subsidizes (through the FHA, Fannie and Freddie).  But he also attempts to quantify the subsidy.  He comes up with an estimate of $2.5 trillion.

While I agree with Davis that we oversubsidize homeownership, I am not sure that I am so convinced by the price tag he puts on it. This is because the class of homeowners overlaps so much with the class of taxpayers.  It would be very interesting if he could refine his analysis more to see if federal homeownership subsidies effect a transfer from one group to another — that refinement could lead to an interesting fight in Congress.

I was also surprised that Davis did not rely at all on the work by Glaeser and Gyourko regarding the inefficiencies of federal housing subsidies given restrictive local land use policies.  This work would support his overall argument — not only do we oversubsidize, but the subsidies don’t even help homeowners as much as we think they do.

Well, let’s see if Congress takes Krugman and Cato’s views under advisement as we chart a new direction for housing policy . . ..

Borden and Reiss on Dearth of Prosecutions for Mortgage Misrepresentations

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We published Cleaning Up the Financial Crisis of 2008:  Prosecutorial Discretion or Prosecutorial Abdication? (paywall) today in the BNA Criminal Law Reporter.  (You can also get a copy on SSRN or BEPress).  It builds on things we have said here and here.  In short, we argue

When finance professionals play fast and loose, big problems result. Indeed, the 2008 Financial Crisis resulted from people in the real estate finance industry ignoring underwriting criteria for mortgages and structural finance products. That malfeasance filled the financial markets with mortgage-backed securities (MBS) that were worth a small fraction of the amount issuers represented to investors. It also loaded borrowers with liabilities that they never had a chance to satisfy.

Despite all the wrongdoing that caused the financial crisis, prosecutors have been slow to bring charges against individuals who originated bad loans, pooled bad mortgages, and sold bad MBS. Unfortunately, the lack of individual prosecutions signals to participants of the financial industry that wrongdoing not only will go unpunished but will likely even be rewarded financially. Without criminal liability, we risk a repeat of the type of conduct that brought us to the edge of financial ruin.

Seems straightforward to us, but many other lawyers seem to disagree, including the outgoing Assistant Attorney General in charge of the Criminal Division, Lanny Breuer.  He told the NY Times, “I understand and share the public’s outrage about the financial crisis. Of course we want to make these cases. … If there had been a case to make, we would have brought it. I would have wanted nothing more, but it doesn’t work that way.”  More interesting stuff in the article.

A Bransten Trio Join Judicial Chorus on Misrepresentation

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Justice Bransten, a judge in the Commercial Division of the N.Y. S. Supreme (trial) Court, issued three similar decisions last week denying motions to dismiss lawsuits by Allstate over its purchase of hundreds of millions of dollars of MBS. The net result is that various Deutsche Bank, BoA’s Merrill Lynch and Morgan Stanley entities must continue to face allegations of fraud relating to those purchases.

In the Deutsche Bank case, the court rejected “the notion that defendants are immunized from liability because the Offering Materials generally disclosed that the representations were based on information provided by the originators.”  (22)

The court also found that “defendants can be held liable for promoting the securities based upon the high ratings from the credit rating agencies, if, as alleged, thy knew the ratings were based on false information provided to the agencies.” (22)  Finally, the court found that “Defendants’ occasional disclaimers cannot be invoked to excuse the wholesale abandonment of underwriting standards and practices.”  (24-25)

Justice Bransten joins a growing chorus of judges who reject the notion that vague disclosures can protect parties who engage in rampant misrepresentation.  One wonders how this body of law will impact the behavior of Wall Street firms during the next boom.

 

Reiss on CFPB’s New Escrow Rules

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The CFPB Journal interviewed me here about the new five year escrow requirement for Higher-Priced Mortgage Loans (HPMLs):

According to David Reiss, professor of law at Brooklyn Law School, the text of the Dodd-Frank Act itself requires the five-year escrow period be implemented.

Specifically, the CFPB’s rule implements sections 1461 and 1462 of the Dodd Frank Act, which amends the requirements for maintaining escrow accounts in connection with higher-priced mortgage loans.

“CFPB has indicated that it is trying to have a coordinated roll out of new mortgage regulations and this is part of that roll out,” Reiss says. “Creditors will benefit from the float on the aggregate escrow accounts—a small amount for each individual homeowner but potentially a meaningful amount for creditors, particularly if interest rates rise to their historic average or higher in coming years.”

Per the rule, a creditor may not cancel escrow accounts required under the rule except with the termination of the loan or the receipt of a consumer’s request to cancel the escrow account no sooner than five years after it was established, whichever happens first.  The CFPB’s rule also states that the creditor may not cancel the escrow account unless the unpaid principal balance is less than 80 percent of the property’s original value and the consumer is not delinquent or in default on the loan at the time of the request.

One key aspect of the rule involves the exempting small creditors who operate primarily in rural or underserved areas. According to the CFPB, to qualify for the exemption, a creditor must:

  • Make more than half of its first-lien mortgages on properties located in counties that are designated either “rural” or “underserved” by the CFPB
  •  Have had assets of less than $2 billion at the end of the preceding calendar year
  •  Have originated, together with its affiliates, 500 or fewer covered, first-lien transactions during the preceding calendar year
  • Together with its affiliates, not maintain escrows for property taxes or insurance for any mortgage it or its affiliate currently services, except when the escrow account was established for a first-lien, higher-priced mortgage loan between April 1, 2010 and before June 1, 2013
  • Escrow accounts established after consummation as an accommodation to assist distressed consumers in avoiding default or foreclosure

One outcome of the escrow requirement as it pertains to creditors is the marginal cost of maintaining escrows for five years instead of one. “To some extent, creditors may be able to pass along the increased cost of the longer escrow term to homeowners,” Reiss says. “This is a rule that is probably good for homeowners and creditors in the aggregate.”