Tag Archives: fraud

Kroll: Non-Banks A Non-Systemic Risk

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Kroll Bond Rating Agency released a Commentary on Capital Requirements for Non-Bank Mortgage Companies. I may be missing something, but this just seems to be a love letter to the securitization industry. The Commentary opens,

Federal and state regulators are currently considering the imposition of capital requirements and other prudential rules on various classes of non-bank financial institutions, including insurers and mortgage servicers. This report examines some of the issues involving non-bank financial companies with a focus on non-bank loan mortgage originators and/or servicers (“seller/servicers”) in the context of the evolving discussion among regulators and researchers toward developing “appropriate” regulation and supervision like that traditionally applied to insured depository institutions (IDIs).

We believe that regulatory efforts to impose capital requirements on non-bank financial institutions such as mortgage loan seller/servicers need to consider the following factors:

• First, most non-bank financial companies operating in the mortgage space have significantly higher levels of tangible capital and lower risk-weighted assets than do IDIs, especially when considering that much of the asset base of a seller/servicer is collateralized and that the mortgages which they service typically are owned by third parties, in most cases institutional investors. The chief sources of risk for seller/servicers are operational and legal, not credit or market risk.

• Second, the recent call by state and federal regulators for capital requirements for non-bank mortgage companies somewhat ignores the real point of the 2007-2009 financial crisis, namely the vulnerability of IDIs and non-banks which perform bank-like functions to a sudden decline in investor confidence and a related drop in market liquidity.

• Third, since non-banks in the US are already dependent upon the commercial banking system for short-term funding and are effectively prohibited from capitalizing their asset and maturity transformation activities in the short-term debt capital markets (e.g., commercial paper), it is unclear why capital requirements for non-banks are appropriate.

We believe that large non-bank companies and particularly seller/servicers in the mortgage sector do not require formal capital requirements and other types of prudential regulation. In our view, the real issue behind the 2007-2009 financial crisis involved securities fraud and the resulting withdrawal of investor liquidity behind various classes of securities issued by off balance sheet vehicles, not a lack of capital in either IDIs or non-bank firms. (1, footnotes omitted)

First of all, it is not clear to me why Kroll is conflating mortgage originators with seller/servicers in this analysis. I think that Kroll is right that seller/servicers predominantly face operational risk, and whatever credit risk they might face (unless they own mortgages that they service) is quite low. But mortgage originators are a different story completely. If they fund themselves from the short-term commercial paper market they are subject to runs much like an uninsured bank would be. See generally Gary Gorton, Slapped by the Invisible Hand (2009). One would expect that regulators would prescribe different capital levels for different types of non-banks — and could conceivably exempt some seller/servicers completely.

Second, Kroll writes that the financial crisis was caused by “the vulnerability of IDIs and non-banks which perform bank-like functions to a sudden decline in investor confidence and a related drop in market liquidity.” But capital requirements go directly to investor confidence in individual firms as well as in an entire sector.

Third, Kroll’s analysis is heavily dependent on describing the troubles of IDIs. Yes, big banks were at the heart of the problems of the financial crisis, but that does not mean that non-banks should get a free pass on regulation, one that will allow them to grow to be the 800 pound gorillas of the next crisis.

Finally, Kroll writes,

One of the most widely held views espoused by US regulators is that non-bank financial firms caused the subprime crisis. A better way to state the reality is that the non-bank firms were involved in subprime mortgage origination and sales because the largest commercial banks and their partners such as Fannie Mae and Freddie Mac had a monopoly position in the prime mortgage space. Large banks and the GSEs made the whole subprime market work by being willing to buy the senior tranches of subprime deals. (7)

I am not sure how to best characterize that argument, but it is of the ilk of “The Devil made me do it” or “Everyone else was doing it” or “I was just a small fry — much bigger companies than mine were doing it.” This is really not an argument against regulation — if anything it is a call for regulation. If appropriate incentives do not align without regulation, then that is just when the government should step in.

“Lies, Damned Lies, and Statistics”

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Judge Chesler issued an Opinion in The Prudential Insurance Company of America et al. v. Bank of America, National Association et al., No. 13-1586 (Apr. 17, 2014), deciding the motion to dismiss the Complaint. Claims relating to fraud, a theory of underwriting abandonment and the 1933 Securities Act survived the motion to dismiss. The Court summarized the case as follows:

In a nutshell, this case arises from a dispute over the sale of certain residential mortgage-backed securities (“RMBS”) by Defendants [various Bank of America parties , including Merrill Lynch parties] to Plaintiffs [various Prudential parties]. The Complaint alleges that Defendants obtained the underlying mortgages, created the securitizations based on them, issued “offering Materials” for their sale, and sold them to Plaintiffs.

*     *     *

The Complaint alleges a variety of statistics in support of its claims. It is often not clear, however, what the basis for a particular statistic is. (1-2)

The Court’s description of the Complaint is pretty damning. But the Court does not find that the poor use of statistics in the Complaint is fatal to all of its claims.

Here are some highlights of the Court’s assessment of the Complaint:

  • “this Court does not find that the Analysis, as described in the Complaint, is such obvious junk research that it fails to constitute relevant factual allegations which, considered along with the other factual allegations in the Complaint, make plausible certain of the assertions of misrepresentation.” (8)
  • “The Complaint alleges that Defendants knowingly misrepresented that they would properly transfer title to the underlying mortgage loans to the particular trusts. The sole factual allegation made in support is: ‘Prudential’s forensic loan-level analysis revealed that across the Offerings Prudential tested, 43% of the Mortgage Loans were not properly assigned to the Trusts.’ Yes, if true, that is an astonishing fact– but there is not even a suggestion in the Complaint of a theory of how this gives rise to the inference of a knowing misrepresentation.” (13)
  • “The Complaint has so little explanation of the AVM [automated valuation model] methodology that this Court has no idea of how the computer used what information to generate property appraisals.” (15)

Notwithstanding the Court’s critique, it ends up finding the Complaint persuasive in the main:

The claim that Defendants’ representations about the underwriting practices and standards used in the issuance of the underlying mortgage loans were fraudulent because of a systemic abandonment of such underwriting standards is perhaps the central claim in this case. in brief, this Court has carefully examined the Complaint and finds that it states an abundance of factual allegations supporting this claim. (21)

The drafters of the complaint might reckon, ‘no harm no foul’ from the Court’s conclusion. But the rest of us might better see this as their having dodged a bullet, a bullet that the Plaintiffs’ attorneys shot at themselves. Mark Twain had said that “There are three kinds of lies: lies, damned lies, and statistics.” Not sure what he would have said about those in this Complaint — damned statistics?

Reiss on Snuffing out FIRREA

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Law360 quoting me in BofA Fight Won’t Blunt DOJ’s Favorite Bank Fraud Weapon (behind a paywall). It reads in part,

A federal magistrate judge on Thursday put a Justice Department case against Bank of America Corp. using a fraud statute from the 1980s in peril, but the case’s limited scope means the government is not likely to abandon its favorite financial fraud fighting tool, attorneys say.

Federal prosecutors have increasingly leaned on the Financial Institutions Reform, Recovery and Enforcement Act, a relic of the 1980s savings and loan crisis, as a vehicle for taking on banks and other financial institutions over alleged violations perpetrated during the housing bubble years.

*     *     *

Some banking analysts hailed the ruling as potentially the beginning of the end of the government’s pursuit of housing bubble-era violations.

“If the judge’s recommendation is accepted by the federal district court judge, then this development will represent a significant setback for the government’s legal efforts and likely mark the beginning of the end for crisis-era litigation,” Isaac Boltansky, a policy analyst at Compass Point Research & Trading LLC, said in a client note.

However, others say the government’s case was brought under relatively narrow claims that Bank of America did not properly value the securities to induce regulated banks to purchase securities they otherwise might not have.

That is a tougher case to bring than the broad wire fraud and mail fraud claims that were available to the government under FIRREA. The government has employed those tools with great success against Bank of America and Standard & Poor’s Financial Services LLC in other cases in far-flung jurisdictions, said Peter Vinella, a director at Berkeley Research Group.

“There was no issue about whether BofA did anything wrong or not. It’s just that the case was filed incorrectly. It was very narrowly defined,” he said.

It is not entirely clear that Bank of America is in the clear in this case, either.

U.S. district judges tend to give great deference to reports from magistrate judges, according to David Reiss, a professor at Brooklyn Law School.

But even if U.S. District Judge Max O. Cogburn Jr. accepts the recommendation, the Justice Department has already lodged a notice of appeal related to the report. And in the worst-case scenario, the government could amend its complaint.

A victory for Bank of America in the North Carolina case is unlikely to have a widespread impact, given the claims that are at stake. The government will still be able to bring its broader, and more powerful claims, under a law with a 10-year statute of limitations.

“It is one opinion that is going against a number of FIRREA precedents that have been decided in others parts of the country,” Reiss said. “It also appears that this case was brought and decided on much narrower grounds than those other cases, so I don’t think that it will halt the government’s use of the law.”

Whitman on Servicer Lies

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Professor Dale Whitman posted a commentary on Quintana v. Bank of America, No. CV 11–2301–PHX, 2014 WL 690906 (D.Ariz. Feb. 24, 2014) (not reported in F.Supp.2d) on the Dirt listserv:

Synopsis: A borrowers who is “jerked around” by a mortgage servicer may have claims in fraud or on other theories.

Karoly Quintana’s home mortgage loan was serviced by Bank of America, When she began having difficulty making her payments in 2009, she was told by B of A that she would have to miss three payments to be considered for a loan modification, and that the servicer would forbear foreclosure while it did so. She missed the payments and applied for a modification, but (she alleged) B of A did not consider it, and instead accelerated her loan and commenced foreclosure.

Quintana filed a suit in federal court to stop the foreclosure. In March 2012 the suit was dismissed voluntarily on the assurance that B of A would again consider a loan modification, but again it did not do so. (Oddly, B of A’s counsel conceded these facts.)

The court held that the allegations of both the 2009 and 2012 conduct of B of A stated claims of fraud, sufficient to withstand a motion to dismiss. The statements that she would be considered for a modification were false, she relied upon them, and was damaged. Her damages were the expenditure of additional attorney’s fees, and the court found this sufficient, even though in general attorneys’ fees are not recoverable in a fraud action.

The court also held that the plaintiff’s count for breach of the implied covenant of good faith and fair dealing survived a motion to dismiss. While the loan documents did not require the servicer to consider the mortgage modification or to forbear foreclosure, when it promised to do so and then did not, it breached the implied covenant. The promise was only oral, and B of A asserted it was inadmissible under the Statute of Frauds, but the court found that Quintana’s detrimental reliance (in missing the payments) provided a basis for promissory estoppel, overcoming the Statute of Frauds defense.

However, the court dismissed Quintana’s claim under the Arizona Consumer Fraud Act (on the ground that it was barred by the 1-year statute of limitations). There’s a convoluted argument about whether B of A can be liable under the FDCPA, but the court ultimately refused to dismiss that claim.

Comment: Borrowers have often tried to claim that they should have received loan modifications, but have not in fact received them. In general, of course, there’s no legal right to a modification. But this court holds that a false promise to consider a modification is enough to make out a claim of fraud.

Plaintiffs Failed to Allege Facts Sufficient to Set Aside the Foreclosure Sale After the Expiration of the Statutory Redemption Period

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The court in deciding Glover v. JPMorgan Chase Bank, N.A., 2013 U.S. Dist. LEXIS 149354 (E.D. Mich. 2013) granted defendant’s motion to dismiss plaintiffs’ complaint pursuant to F.R.C.P. 12(b)(6).

All of the plaintiffs’ claims stemmed from the defendant’s purported refusal to modify the plaintiffs’ mortgage obligations due to “title issues.” However, the plaintiffs’ allegations did not support their claims because the parties entered into a modification agreement in October of 2010. Consequently, since the defendant did in fact grant the plaintiffs a loan modification, the court found that their claim lacked any factual support suggesting that the defendant was liable to plaintiffs.

Additionally, the court noted that the plaintiffs had failed to allege facts sufficient to set aside the foreclosure sale after the expiration of the statutory redemption period. Once the redemption period following a foreclosure of a parcel of real property has expired, the former owner’s rights in and title to the property are extinguished.

The court dismissed the plaintiff’s claims.

Eastern District of California Court Dismisses Plaintiff’s Claims of Federal Statutory Violations, Unlawful Foreclosure, Fraud, Equitable Estoppel & Accounting

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The United States District Court for the Eastern District of California in deciding Herrejon v. Ocwen Loan Servicing, LLC, 2013 U.S. Dist. LEXIS 157126 (E.D. Cal. Nov. 1, 2013) dismissed the plaintiff’s complaint as it failed to allege cognizable claims. The plaintiff’s complaint purported to allege claims for federal statutory violations, unlawful foreclosure, fraud, equitable estoppel and accounting.

reporting authorized accounts

The plaintiffs (Ricardo G. Herrejon and Rosa E. Navarro-Herrejon) filed this action, which challenged the foreclosure of their property. The plaintiffs also sought to enjoin a November 4, 2013 property foreclosure sale. Plaintiffs’ complaint accused defendants of “unlawful foreclosure.” However, the court dismissed the plaintiff’s action in the absence of viable claims, the court also denied plaintiffs’ requested injunctive relief, and entered judgment on dismissal of plaintiffs’ claims.

Rating Agency 1st Amendment Defense Weakened, Again

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Federal District Judge O’Toole (D. Mass.) issued an Opinion and Order in Federal Home Loan Bank of Boston v. Ally Financial Inc. et al., No. 11-10952 (Sept. 30, 2013)  relating to the potential liability of S&P and Moody’s (the Rating Agency Defendants) for their ratings. The case “arises from the purchase of private label mortgage-backed securities” (PLMBS) by the plaintiff, FHLB Boston. (1)  FHLB Boston alleges that the rating agency defendants knew that their ratings “were inaccurate and based on flawed models, and that their conduct gives rise to” a claim for fraud as well as other causes of action. (1) The Rating Agency Defendants sought to have the claims dismissed for failure to state a claim. The Court rejected this as to the fraud claim:

The Rating Agency Defendants’ argument that their ratings are non-actionable opinions is unconvincing. As discussed in Abu Dhabi I, “[a]n opinion may still be actionable if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.” 651 F. Supp. 2d at 176 (internal citations omitted). Here the Bank has pled with sufficient particularity that the Rating Agency Defendants issued ratings that they did not genuinely or reasonably believe. For example, the Amended Complaint alleges that the Rating Agency Defendants diluted their own standards and carried out their ratings procedures in an intentionally lax manner as to PLMBS while maintaining higher standards in other contexts. The Bank has also sufficiently pled scienter, alleging that the Rating Agency Defendants competed for business by artificially inflating ratings, as they were only paid if they provided high ratings. (4)

Rating agencies were able to avoid liability for decades, claiming that their ratings were like min-editorials that were protected by the First Amendment. A number of recent cases reject that defense in a variety of contexts (See here, here and here for instance). It is unclear what will happen when these cases are appealed, but for now it appears that a number of courts have identified situations where an opinion can be more than an opinion — it can amount to actionable fraud.