Tag Archives: misrepresentation

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.

 

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.

 

 

 

Asset Quality Misrepresentation in RMBS Market

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Piskorski, Seru & Witkin have posted Asset Quality Misrepresentation by Financial Intermediaries:  Evidence from RMBS Market, in which they “identify misrepresentations by comparing the characteristics of mortgages in the pool that were disclosed to the investors at the time of sale with actual characteristics of these loans at the same time and show that such misrepresentations constitute a significant proportion of the loans.” (2) In particular, they

identify two, relatively easy-to-quantify, dimensions of asset quality misrepresentation by intermediaries during the sale of mortgages. The first misrepresentation concerns loans that are reported as being collateralized by owner-occupied properties when in fact these properties were owned by borrowers with a different primary residence (e.g., a property acquired as an investment or as a second home). The second form of misrepresentation concerns loans that are reported as having no other lien when in fact the properties backing the first (senior) mortgage were also financed with a simultaneously originated closed-end second (junior) mortgage. (3)

The paper has some extraordinary findings:

  • there “are instances where, in the process of contractual disclosure by the sellers, buyers received false information on the characteristics of assets.” (2)
  • “loans with misrepresented borrower occupancy status have about a 9.4% higher likelihood of default (90 days past due on payments during the first two years since origination), compared with loans with similar characteristics and where the property was truthfully reported as being the primary residence of the borrower.” (3-4)
  • “loans with a misrepresented higher lien . . . have about a 10.1% higher likelihood of default . . ..” (4)
  • lenders were “aware of the presence of second liens, and hence their misreporting likely occurs later in the supply chain.” (5)

The conclude that these “results suggest that RMBS investors had to bear a higher risk than they might have perceived based on the contractual disclosure.” (4)

SEC Complaint on Improper Trading of MBS — Much Ado?

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Floyd Norris, the only journalist to whom I have written fan mail (sorry Gretchen, you’re next), has another interesting column about a case that the SEC has brought against an MBS trader, Jesse Litvak.  The complaint alleges that

On numerous occasions from 2009 to 2011, Litvak lied to, or otherwise misled, customers about the price at which his firm had bought the MBS and the amount of his firm’s compensation for arranging the trades. On some occasions, Litvak also misled the customer into believing that he was arranging a MBS trade between customers, when Litvak really was selling the MBS out of Jefferies’ inventory. Litvak’s misconduct misled customers about the market price for the MBS, and, thus, about the transaction they were agreeing to. Litvak also misled customers about whether they were getting the best price for their MBS trades and how much money they were paying in compensation. MBS are generally illiquid and discovering a market price for them is difficult. Participants trading in the MBS market must rely on informal sources, including their broker, for this information.(1-2)

Norris is right to highlight what this case can reveal about the lack of transparency in the trading of MBS, a lack of transparency that does not exist in many other major secondary markets for securities.

But I was struck by how little is at stake in this SEC case.  The complaint alleges that the misconduct occurred in 25 (count ’em, 25!) trades from 2009 through 2011 (7) and that Litvak’s behavior “generated over $2.7 million in additional revenue for his firm.”  (2)  Not for him personally, mind you, but for his firm!  He, of course, should be punished if the allegations prove to be true.  And yet . . ..

Time after time, the government brings cases against mid-level players somehow involved in the financial crisis.  Time after time, people wonder why these are the best cases that can be brought.  My earlier thoughts about this can be found here and here.  Is it possible that even the SEC lacks the resources to investigate the massively document intensive cases that would get to the heart of the matter?

 

NCUA Sues JP Morgan over MBS Representations

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The National Credit Union Administration has sued J.P. Morgan Securities and Bear, Stearns & Co. for alleged securities laws violations relating to the sale of mortgage-backed securities to 4 credit unions that are now in NCUA conservatorship.  According to the complaint, Bear Stearns (now owned by JPMorgan) made misrepresentations to the purchasing credit unions as part of its underwriting and sales of the MBS.  The press release notes that NCUA has initiated eight similar suits against a variety of financial institutions.

One of the representations at issue states that “a mortgage loan will be considered to be originated in accordance with a given set of underwriting standards if, based on an overall qualitative evaluation, the loan is in substantial compliance with those underwriting standards.” (Complaint paragraph 408, page 170)

Given what we know about a lot of the securities that were issued, it is hard to imagine that reps like this were not violated for many of them.