Editor: David Reiss
Brooklyn Law School

March 7, 2018

Ghost of A Crisis Past

By David Reiss

photo by Chandres

The Royal Bank of Scotland settled an investigation brought by New York Attorney General Schneiderman arising from mortgage-backed securities it issued in the run up to the financial crisis. RBS will pay a half a billion dollars. That’s a lot of money even in the context of the settlements that the federal government had wrangled from financial institutions in the aftermath to the financial crisis. The Settlement Agreement includes a Statement of Facts which RBS has acknowledged. Many settlement agreements do not include such a statement, leaving the dollar amount of the settlement to do all of the talking. We are lucky to see what facts exactly RBS is “acknowledging.”

The Statement of Facts found that assertions in the offering documents for the MBS were inaccurate and the securities have lost billions of dollars in collateral. These losses led to “shortfalls in principal and interest payments, as well as declines in the market value of their certificates.” (Appendix A at 2)

The Statement of Facts outlines just how RBS deviated from the statements it made in the offering documents:

RBS’s Representations to Investors

11. The Offering Documents for the Securitizations included, in varying forms, statements that the mortgage loans were “originated generally in accordance with” the originator’s underwriting guidelines, and that exceptions would be made on a “case-by-case basis…where compensating factors exist.” The Offering Documents further stated that such exceptions would be made “from time to time and in the ordinary course of business,” and disclosed that “[l]oans originated with exceptions may result in a higher number of delinquencies and loss severities than loans originated in strict compliance with the designated underwriting guidelines.”

12. The Offering Documents often contained statements, in varying forms, with respect to stated-income loans, that “the stated income is reasonable for the borrower’s employment and that the stated assets are consistent with the borrower’s income.”

13. The Offering Documents further contained statements, in varying forms, that each mortgage loan was originated “in compliance with applicable federal, state and local laws and regulations.”

14. The Offering Documents also included statements regarding the valuation of the mortgaged properties and the resulting loan-to-value (“LTV”) ratios, such as the weighted-average LTV and maximum LTV at origination of the securitized loans.

15. In addition, the Offering Documents typically stated that loans acquired by RBS for securitization were “subject to due diligence,” often described as including a “thorough credit and compliance review with loan level testing,” and stated that “the depositor will not include any loan in a trust fund if anything has come to the depositor’s attention that would cause it to believe that the representations and warranties of the related seller regarding that loan will not be accurate and complete in all material respects….”

The Actual Quality of the Mortgage Loans in the Securitizations

16. At times, RBS’s credit and compliance diligence vendors identified a number of loans as diligence exceptions because, in their view, they did not comply with underwriting guidelines and lacked adequate compensating factors or did not comply with applicable laws and regulations. Loans were also identified as diligence exceptions because of missing documents or other curable issues, or because of additional criteria specified by RBS for the review. In some instances, RBS disagreed with the vendor’s view. Certain of these loans were included in the Securitizations.

17. Additionally, some valuation diligence reports reflected variances between the appraised value of the mortgaged properties and the values obtained through other measures, such as automated valuation models (“AVMs”), broker-price opinions (“BPOs”), and drive-by reviews. In some instances, the LTVs calculated using AVM or BPO valuations exceeded the maximum LTV stated in the Offering Documents, which was calculated using the lower of the appraised value or the purchase price. Certain of these loans were included in the Securitizations.

18. RBS often purchased and securitized loans that were not part of the diligence sample without additional loan-file review. The Offering Documents did not include a description of the diligence reports prepared by RBS’s vendors, and did not state the size of the diligence sample or the number of loans with diligence exceptions or valuation variances identified during their reviews.

19. At times, RBS agreed with originators to limit the number of loan files it could review during its due diligence. Although RBS typically reserved the right to request additional loan-level diligence or not complete the loan purchase, in practice it rarely did so. These agreements with originators were not disclosed in the Offering Documents.

20. Finally, RBS performed post-securitization reviews of certain loans that defaulted shortly after securitization. These reviews identified a number of loans that appeared to breach the representations and warranties contained in the Offering Documents. Based on these reviews, RBS in some instances requested that the loan seller or loan originator repurchase certain loans. (Appendix A at 4-5)

Some of these inaccuracies are just straight-out misrepresentations, so they would not have been caught at the time by regulators, even if regulators had been looking. And that’s why, ten years later, we are still seeing financial crisis lawsuits being resolved.

It is not clear that these types of problems can be kept from infiltrating the capital market once greed overcomes fear over the course of the business cycle. That’s why it is important for individual actors to suffer consequences when they allow greed to take the driver’s seat. We still have not figured out how to effectively address tho individual actions that result in systemic harm.

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