Tag Archives: sampling

FHFA Wins on “Actual Knowledge”

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Judge Cote issued an Opinion and Order in Federal Housing Finance Agency v. HSBC North America Holdings Inc., et al. (11-cv-06189 July 25, 2014). The opinion and order granted the FHFA’s motion for partial summary judgment concerning whether Fannie and Freddie knew of the falsity of various representations contained in offering documents for residential mortgage-backed securities (RMBS) issued by the remaining defendants in the case.

I found there to be three notable aspects of this lengthy opinion. First, it provides a detailed exposition of the process by which Fannie and Freddie purchased mortgages from the defendants (who included most of the major Wall Street firms, although many of them have settled out of the case by now). it goes into great length about how loans were underwritten and how originators and aggregators reviewed them as they were evaluated  as potential collateral for RMBS issuances.

Second, it goes into great detail about the discovery battle in a high, high-stakes dispute with very well funded parties. While not of primary interest to readers of this blog, it is amazing to see just how much of a slog discovery can be in a complex matter like this.

Finally, it demonstrates the importance of litigating with common sense in mind. Judge Cote was clearly put off by the inconsistent arguments of the defendants. She writes, with clear frustration,

It bears emphasis that at this late stage — long after the close of fact discovery and as the parties prepare their Pretrial Orders for three of these four cases — Defendants continue to argue both that their representations were true and that underwriting defects, inflated appraisals and borrower fraud were so endemic as to render their representations obviously false to the GSEs. Using the example just given, Goldman Sachs argues both that Fannie Mae knew that the percentage of loans with an LTV ratio below 80% was not 67%, but also that the true figure was, in fact, 67%. (65)

Wary of FHA HAWKing Mortgage Access

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The Federal Housing Administration issued its Access Blueprint: What FHA is Doing to Expand Access to Mortgage Credit for Underserved Borrowers. The blueprint identifies a serious problem:

The economic crisis significantly constrained credit making it tough for anyone with less than perfect credit to obtain a mortgage.

According to the Urban Institute, the average credit score for loans sold to the GSEs is 752. Currently, there are 13 million people with credit scores ranging from 580 to 680. Shutting these consumers out of the market hurts American families and undermines our efforts to build more stable communities, create pathways to the middle class, and increase homeownership opportunities for minority and low-wealth borrowers.

A healthy mortgage market serves all qualified borrowers. FHA is committed to finding ways to responsibly increase access for underserved borrowers. (3)

Unfortunately, the FHA’s solutions to this problem seem half-baked. The blueprint states that “Responsible access can be enhanced by ensuring borrowers are well-educated about the home- buying and mortgage finance process.” (3) Under the heading, Homeowners Armed with Knowledge (HAWK), the blueprint states that “Housing Counseling works.  Research shows a strong correlation between housing counseling and mortgage performance.” (4)

As the FHA should know, correlation is not the same thing as causation. It could be that those who have the traits that make them likely to sign up for housing counseling also make them more likely to make their mortgage payments. In fact, the scholarly literature on making people financially capable is not so comforting when it comes to decreasing credit defaults.

The blueprint has other disturbing passages that make one wonder if the FHA is keeping safety and soundness concerns as high priorities. For instance, it states that

FHA primarily selects higher-risk loans for review, e.g. loans evidencing payment challenges. FHA recognizes that this risk-based approach does not accurately reflect a lenders overall underwriting quality as it is primarily focused on non-performing loans. Going forward, we plan to expand our evaluation of loans to include random sampling of performing loans closer to the time of endorsement. This approach provides a more balanced view of underwriting quality. (5)

This is kind of the inverse of the old saw about the drunk who is searching for something for a long time under a lamp post.  When asked why he is looking so long and so unsuccessfully in that one place, he responds that that is is where the light is. FHA appears to be saying that it is going to be spending less time looking in the problem areas because that is where they are likely to find problems. What is that about?#@!?

Obviously, the FHA should be focused on promoting sustainable homeownership for “all qualified borrowers.” (3)  Obviously, the FHA should find ways to “responsibly increase access for underserved borrowers.” (3) What is not obvious is whether the FHA’s blueprint will achieve those goals.

Battle of the Mortgage Experts

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Judge Saris of the United States District Court (D. Mass.) issued a Memorandum and Order in Massachusetts Mutual Life Insurance Company v. Residential Funding Company, et al., No. 11-30035-PBS (Dec. 9, 2013). The opinion addresses a battle of statistical experts over the proper way to sample some of the hundreds of thousands of mortgages at issue in this litigation.

Mass Mutual, the plaintiff, alleges that the defendants misrepresented material aspects of many of those mortgages. To prove this, Mass Mutual intends to “reunderwrite” about 3.5% of loans by reviewing the “original loan file to determine whether  it was originated in accordance with applicable standards.” (3) . More particularly, Mass Mutual alleged that

the defendants marketed the [RMBS] certificates with representations that the loans backing the securities were underwritten in accordance with prudent underwriting standards and the underlying properties were appraised in accordance with sound appraisal standards, in order to ensure that the borrower could repay the loan and to decrease the risk of default. Plaintiff asserts that the loans underlying each [loan pool] were, in reality, far riskier than represented. Plaintiff also alleges that the defendants knowingly reported false loan-to-value (“LTV”) ratios, and in the case of defendant HSBC, inaccurate owner-occupancy rates for underlying properties. The defendants deny that they made any material misrepresentations in the marketing and sale of the certificates. (4)

The Court stated that while the defendants had identified various methodological errors that would render the report of Mass Mutual’s expert unreliable, similar challenges had failed in four other RMBS litigations. The Court ultimately denied the defendants’ motion to exclude the opinions of the plaintiff’s expert.

A body of law about expert evaluation of misrepresentations in securitization is slowly developing as cases are moving from the motion to dismiss stage to the pretrial discovery phase. This will have broader significance than just securitization litigation, but I find it particularly interesting to watch experts attempt to reduce “questions of misrepresentation” regarding RMBS to yes/no answers. (15) Such attempts to quantify misrepresentation will be useful to resolve cases such as this but also to regulators and researchers down the line.