Author Archives: David Reiss

Reiss on Fannie and Freddie Multifamily Contraction

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GlobeSt.com interviewed me (and others) about Federal Housing Finance Agency Acting Director Edward J. DeMarco plans to reduce Fannie and Freddie’s multifamily finance volume by 10% from last year’s levels:

Also consider this, says David Reiss, a professor of Law at Brooklyn Law School who has published papers on the GSEs: “We are living through a very abnormal time when the federal government dominates the market for single family and multifamily mortgages.”

This is neither necessary nor optimal, he tells GlobeSt.com. “It is not necessary because there have been long stretches in the past when the government had a much smaller role in those markets. And other credit markets operate well with no or a much smaller government footprint.”

This is not to say that there is no role for the federal government in the multifamily mortgage market, Reiss continues — just that it is far too large at this point in time. “If the reduction in the GSE footprint is telegraphed over a reasonable time horizon to the other market participants, this change should be taken in stride by the multifamily market,” he predicts.

 

Second Circuit Finds Plausible Claims of Widespread Misconduct in RMBS Offering

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The Second Circuit ruled in New Jersey Carpenters Fund v. The Royal Bank of Scotland Group et al. on a number of issues, but of interest to me are the sections dealing with allegations of misrepresentations.

The Court writes that “numerous courts, including the First Circuit in Nomura, have concluded that misstatements of an underwriter’s guidelines are not ‘so obviously unimportant’ that they are immaterial as a matter of law. Id. at 162; see Nomura, 632 F.3d at 773; J.P. Morgan, 804 F. Supp. 2d at 154; IndyMac, 718 F. Supp. 2d at 510; Tsereteli v. Residential Asset Securitization Trust 2006-A8, 692 F. Supp. 2d 387, 392-93 (S.D.N.Y. 2010). We agree. The Series 2007-2 Trust consisted primarily of a pool of mortgage loans and interests in the properties that secured those loans. Investors would profit from their interests in the Series 2007-2 Trust only if the trust could recoup a sufficient portion of the balance of those loans. Thus, a ‘substantial likelihood’ exists that a reasonable investor would want to know whether those underwriting the loans had adhered to the procedures in place for evaluating ‘the capacity and willingness of the borrower[s] to repay the loan[s] and the adequacy of the collateral securing the loan[s].’ J. App’x at 370. Given the apparent importance of this information, we conclude that, at this stage of the proceedings, the alleged misstatements and omissions are not immaterial as a
matter of law.” (25-26)

The Court further writes that “knowledge that the borrowers had low credit scores and that many of the mortgages had high loan-to-value ratios would make a reasonable investor more, rather than less, interested in whether NMI [one of the Novastar defendants] had adhered to its processes for evaluating ‘the capacity and willingness of the borrower[s] to repay.’ J. App’x at 370. Accordingly, for the reasons described above, we conclude that the alleged misstatements and omissions are not immaterial as a matter of law.” (28)

The cumulative effect of the cases (see here for another example) arising from the Subprime Crisis is that broad carve-outs from representations will not protect parties from claims of misrepresentation.  This seems to be an example of schoolyard law — in the good sense.  Just because you crossed your fingers, it doesn’t mean that you weren’t lying.

 

 

 

Rakoff Rules Again for an Investor Against a Securitizer

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Judge Rakoff explains his denial of the defendants’ (various Bear Stearns, JPMorgan and WAMU entities) motion to dismiss the suit. The suit alleges that the defendants “made fraudulent representations regarding the riskiness of he securitizations and the underlying loans” upon which the plaintiffs (Dexia and FSA entities) relied to their detriment. (5)

A judge does not typically do much fact-finding in a denial of a motion to dismiss, but there are still some interesting bits:

  • “a reasonable fact-finder could conclude that” disclosures about exceptions to underwriting guidelines “suggested to a reasonable investor not the systematic deviation from established underwriting standards alleged by plaintiffs, but rather a low level of occasionally non-compliant loans in the loan pools that could be subject o repurchase.”  (11-12) This is important.  It means that disclosures must be relatively specific as to the level of risk that the investor will face by deviations from stated underwriting objectives.
  • Judge Rakoff also reiterates that underwriters and others involved in securitizations must at least believe themselves the representations that they make. (15)  The fact that the investors are sophisticated does not matter:  “even a sophisticated party may reply on the representations of another where the facts misrepresented  were ‘peculiarly within the Defendants’ knowledge.'” (19, quoting Allied Irish Banks, PL.C. v. Bank of Am., N.A., No. 03-Civ. 3748, 2006 WL 278138 (S.D.N.Y. Feb. 2, 2006))
  • “Judge Rakoff did make one tentative finding of fact:  “the confidential witness statements incorporated into the Amended Complaint, combined with the documentary sources, support a strong inference that the defendants knew that the mortgages included within the loan pools were not of the quality represented in the offering documents.” (17)

The cases arising from the financial crisis stand for the important (but hopefully uncontroversial) principle that material lies and omissions can be fraudulent even among sophisticated parties.  This might make the most sense in Latin:  caveat emptor for sure, but there has to be some bona fides.

 

(Hat tip to Peter Liem)

 

More on Housing America’s Future

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I blogged about some of the big themes in the Bipartisan Policy Center’s Housing America’s Future report.  Today, I take a closer look at their position on housing finance in particular:

The report states that “it is highly unlikely that private financial institutions would be willing to assume both interest rate and credit risk, making long-term, fixed-rate financing considerably less available than it is today or only available at higher mortgage rates.” (42) This statement is far from uncontroversial.  First, the jumbo private label-market had originated 30 year fixed rate mortgages.  There is at least some tolerance for a product in which the private sector bears both credit and interest rate risk.  Second, the fixation on the 30 year fixed mortgage product is counter-productive.  The typical American household moves every seven years.  In an invisible way, pushing people into 30 year fixed mortgages can harm them.  Think, for instance, of a young couple moving into a one bedroom condominium unit.  The odds that they will be there for 30 years without ever even refinancing to get a lower interest rate or to access the equity they built up is miniscule.  But that couple will be paying an interest rate premium to have their interest rate fixed for that whole thirty years.  That couple would likely be better served by a 5/1 or 7/1 ARM which would balance a low interest rate in the near term with the risk that they stay longer than expected and pay a higher interest rate in the long term.

The reports fixation on put-back risk (46) is a canard.  There is no need to regulate in this area.  Now that private parties are aware that it is a serious issue, they will negotiate accordingly.

The report’s concern with “uncertainty related to pending regulations and implementation of new rules” also seems misguided. (47)  The housing finance system just went through a near death experience.  Of course there is some uncertainty as we plan to take it off of life support.

The report’s position that any “government support for the housing finance system should be explicit and appropriately priced to reflect actual risk” is right on, but the devil will be in the details. (48) How can we set up a system in which political interference won’t distort the pricing of risk?  The government does not have a good track record in this regard.

More anon . . .

Rakoff Rules for Monoline Insurer Against Securitizer

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Judge Rakoff ruled for Assured Guaranty against Flagstar and awarded Assured more than $90 million.  The 103 page order is a pretty compelling read as it is a careful review of a battle of the experts and has lots of details about the loans in two Flagstar securitizations.  Some interesting bits:

  • the third-party due diligence providers, the Clayton Group and the Bohan Group, “were only expected to flag issues if something in the loan files appeared ‘ridiculous.’” (18)
  • the court found that many of the loans had “blatant” defects. (75)

Ultimately, the court found “that the loans underlying the Trusts here at issue pervasively breached Flagstar’s contractual representations and warranties.” (91)  The court’s findings may have unexpected relevance to other burning issues coming out of the financial crisis, such as whether these securitizations complied with the REMIC rules.

New Direction for Federal Housing Policy? Finally!

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The Bipartisan Policy Center has released Housing America’s Future: New Directions for National Policy.  The Wall Street Journal reported (behind a paywall) that the report represents a “behind-the-scenes effort to jumpt-start the debate over Fannie’s and Freddie’s future . . ..”  My preliminary thoughts on it:

  • The report’s first key policy objective is exactly right:  “The private sector must play a far greater role in bearing
    credit risk.” (8) I have taken this position for years.  There is no reason that a large share of the credit risk should not be underwritten and borne by the private sector.  That is, after all, what they are supposed to do in free market.  This is not to say that the federal government has no role.  But the current state of affairs — with the government supporting more than 90 percent of home loans — is a recipe for the next housing disaster.
  • The government’s role should be limited to supporting the mortgage market for low- and moderate-income households and to playing the role of lender/insurer of last resort when the mortgage market dries up.
  • The report is again exactly right when it says that Fannie and Freddie should be wound down and replaced with a wholly-owned government entity that will not suffer from the dual mandate of fulfilling a public mission and maximizing profits for its shareholders.
  • The report favors a policy of assisting all very low-income households with their housing expenses.  This is a great and radical step.  But any such policy should take into account the Glaeser and Gyourko’s research that indicates that local land use policy can be at odds with federal housing policy in order to make sure that federal monies are used effectively.

I do not agree with the report in all respects.  Some examples:

  • The report characterizes the FHA as having only one “traditional mission of primarily serving first-time homebuyers.” (8) This characterization repeats the conventional wisdom but the conventional wisdom reads the history of the FHA incorrectly.  I will be posting an article on the history of the FHA later this year that will hopefully set the record straight.  The FHA certainly needs reform, but we should start with all of the relevant facts before jumping in.
  • The report asserts that housing counseling is effective (9) but the empirical evidence is not so clear.  Any policy that devotes significant resources to counseling should be built on a solid basis of empirical support.

Notwithstanding these criticisms, the report is a great first step toward developing a federal housing policy for the 21st Century.  More on the report anon.

Regulating the Distribution of Home Equity

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Ian Ayres and Joshua Mitts have posted Three Proposals for Regulating the Distribution of Home Equity which brings welcomed attention to the systemic risk implications of consumer protection regimes.  In particular, they argue that the proposed Qualfied Residential Mortgage “rules do not effectively address the systemic consequences of mortgage terms which in aggregate can exacerbate market volatility.” (4) They also argue that the new and proposed regulations governing residential mortgages are too static and that they have too many bright line rules that could needlessly reduce variation and innovation for mortgage products.

The authors apply cap and trade to the residential mortgage market in a novel way — one that is is worthy of exploration.  They propose that the government sell mortgage lenders licenses to originate a range of low downpayment mortgages, with the total number capped so as not to pose a systemic risk to the mortgage market.

This is not to say that the paper is flawless.  I find the modeling of the mortgage market overly simplistic.  For instance, its discussion of circuit breaker gaps (an empty range “of equity levels  that can absorb small decreases in prices by keeping homeowners above the range in positive equity”) assumes that LTV ratios at origination will somehow be carried over even when a mortgage is seasoned. (14) That would not be the case.

Its proposal to require that debt-to-income ratios be increased from the 5 years in the proposed regulation to the life of the loan does not seem to take into account the fact that it would kill just about the entire market for ARMs. (32) Given that many ARM products (5/1s ,7/1s, 10/1s) are legitimate and important products, this proposal seems off. (32)

Finally, there is something a bit “turtles all the way down” about the cap and trade proposal. (see 34) The proposal does not let us know how regulators would come up with the optimal (from a systemic risk perspective) distribution of licenses.  Until we know how to answer that question, it will be hard to determine the value of this proposal.