Tag Archives: subprime crisis

Reiss on SCOTUS Junior Lien Decision

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Bloomberg BNA quoted me in Nagging Economic and Credit Questions Dampen Bankruptcy Victory for Bankers (behind paywall). It reads, in part:

The U.S. Supreme Court delivered an important bankruptcy ruling for bankers that doesn’t, however, do anything about still-struggling homeowners (Bank of Am. N.A. v. Caulkett, 2015 BL 171240, U.S., No. 13-cv-01421, 6/1/15); (Bank of Am. N.A. v. Toledo-Cardona, 2015 BL 171240, U.S., No. 14-cv-00163, 6/1/15).

In a June 1 decision, the court said Chapter 7 debtors cannot void junior liens on their homes when first-lien debt exceeds the value of the property, as long as the senior debt is secured and allowed under the Bankruptcy Code.

The decision is a victory for Bank of America, which held both junior liens in the two related cases, and for banking groups that said a different result could have destabilized more than $40 billion in commercial loans secured by similar liens.

But Brooklyn Law School Professor David Reiss June 2 said the case highlights the need for a broad remedy for homeowners who have continued to struggle to make payments since the financial crisis.

“The bank’s position as a legal matter is a very reasonable one, but from a policy perspective we needed and still need a bigger and more systemic solution to the problems that households face,” Reiss told Bloomberg BNA.

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[S]ome said the ruling highlights economic questions on several levels.

Reiss, who coedits a financial blog, June 2 said the case shows the federal government’s inability to deal head-on with the impact of financial turmoil in 2008 and 2009.

“Not enough is being done to move households beyond the crisis, and it’s bad for households and it’s bad for the financial sector,” Reiss said. “Here we are seven or eight years later and we’re sitting here with these valueless second mortgages. We’re just slogging through the muck and we’re not coming up with any good solutions to get past it.”

Seeking Justice Through Litigation

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Judge Caproni (SDNY) issued an Opinion and Order in Adkins v. Morgan Stanley, No. 12-CV-7667 (May 14, 2015). It opens,

This is one of many cases arising out of the collapse of the housing market. This one comes with a twist: homeowners in Detroit who received subprime loans seek to hold a single investment bank responsible under the Fair Housing Act (“FHA”) for discriminating against African-American borrowers, based on their claim that African-Americans were more likely than similarly-situated white borrowers to receive so-called “Combined-Risk loans.” Plaintiffs allege that Morgan Stanley so infected the market for residential mortgages — and for mortgages written by New Century Mortgage Company, a now defunct loan originator, in particular — that it bears responsibility for the disparate impact of New Century’s lending practices. Although Plaintiffs advance creative theories, their class action lawsuit founders on the requirements of Federal Rule of Civil Procedure 23. (1-2, footnote omitted)

Judge Caproni notes that she is “not unsympathetic to Plaintiff’s claims,” she concludes that this class action lawsuit is an inappropriate vehicle to rectify the wrong that Plaintiffs allege Morgan Stanley perpetrated.” (2) I am not an expert on the law of class actions, but the opinion does seem to identify a number of ways in which the proposed class is “unworkable.” (2)

We are now nearly ten years in from the start of the financial crisis and it seems like we can get a broad sense of whether justice has been served.  My instinct is that many people would say “No,” a resounding “No!”

At first glance that might seem odd, particularly to the shareholders and management of financial institutions who have paid tens of billions of dollars in fines and judgments. But there is a strong sense that those who have been harmed have not been able to get their day in court with those who did the harming. A case like this reveals the limitations of litigation as a means for seeking justice. Not every injustice is capable of being remedied in a court of law.

What does this tell us about preparing for the aftermath of the next crisis? How can laws be changed now to ensure that the right people and institutions are held accountable when it hits? While there are no easy answers to these questions, lawmakers should consider whether the scope of organizational liability is properly defined, whether agents of organizations are properly held accountable and whether organizations working in tandem with each other can be properly held accountable for the harms that they cause collectively. Easier said than done, I know, but still worth the effort.

FHFA’s $500MM Win

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Bloomberg quoted me in Nomura, RBS Defective-Bond Suit Loss Seen Spurring Deals. It reads, in part,

Nomura Holdings Inc. and Royal Bank of Scotland Group Plc may face $500 million in damages for what a judge called an “enormous” deception in the sale of defective mortgage-backed securities, a ruling that may spur other banks to settle similar claims tied to the 2008 financial crisis.

Nomura and RBS were excoriated in a 361-page opinion by U.S. District Judge Denise Cote in Manhattan, whose ruling followed the first trial of claims that banks sold flawed securities to government-owned mortgage companies. After a three-week trial, Cote said they misled Fannie Mae and Freddie Mac and set a damages formula that may result in the government winning about half its original claim of $1 billion.

“The offering documents did not correctly describe the mortgage loans,” Cote, who heard the case without a jury, wrote Monday. “The magnitude of falsity, conservatively measured, is enormous.”

Before the trial, FHFA had reached $17.9 billion in settlements with other banks, including Bank of America Corp., JPMorgan Chase & Co. and Goldman Sachs Group Inc. The ruling against Nomura and RBS may encourage other banks to settle mortgage-related suits brought by regulators and private investors rather than face the bad publicity and cost of an adverse judgment, said Robert C. Hockett, a professor at Cornell Law School.

“They look pretty bad,” Hockett said in an interview. “They look like the strategy has blown up in their faces.”

Cote ordered the Federal Housing Finance Agency, which filed the case, to propose how much the banks should pay as a result of her ruling.

*     *     *

Cote rejected the banks’ claim that the housing crash, and not defects in the loans, was responsible for the collapse of the mortgage-backed securities.

David Reiss, a professor at Brooklyn Law School, called Cote’s ruling “incredibly thorough.” The judge included detailed factual rulings that may make it difficult for Nomura and RBS to win on appeal, he said.

SEC Update on Rating Agency Industry

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The staff of the U.S. Securities and Exchange Commission has issued its Annual Report on Nationally Recognized Statistical Rating Organizations. The report documents some significant problems with the rating agency industry as it is currently structured. The report highlights competition, transparency and conflicts of interest as three important areas of concern.

Competition. There are some of the interesting insights to be culled from the report. It notes that “some of the smaller NRSROs [Nationally Recognized Statistical Rating Organizations] had built significant market share in the asset-backed securities rating category.” (16) That being said, the report also finds that despite “the notable progress made by smaller NRSROs in gaining market share in some of the ratings classes . . . , economic and regulatory barriers to entry continue to exist in the credit ratings industry, making it difficult for the smaller NRSROs to compete with the larger NRSROs.” (21)

Transparency. The report also notes that “there is a trend of NRSROs issuing unsolicited commentaries on solicited ratings issued by other NRSROs, which has increased the level of transparency within the credit ratings industry. The commentaries highlight differences in opinions and ratings criteria among rating agencies regarding certain structured finance transactions, concerning matters such as the sufficiency of the credit enhancement for the transactions. Such commentaries can serve to enhance investors’ understanding of the ratings criteria and differences in ratings approaches used by the different NRSROs.” (23) The report acknowledges that this is no cure-all for what ails the rating industry, it is a positive development.

Conflicts of Interest.Conflicts of interest have been central to the problems in the ratings industry, and were one of the factors that led to the subprime bubble and then bust of the 2000s.  The report notes that the “potential for conflicts of interest involving an NRSRO may continue to be particularly acute in structured finance products, where issuers are created and operated by a relatively concentrated group of sponsors, underwriters and managers, and rating fees are particularly lucrative.” (25) There is no easy solution to this problem and it is important to carefully study it on an ongoing basis.

The staff report is valuable because it offers an annual overview of structural changes in the ratings industry. This year’s report continues to highlight that the structure of the industry is far from ideal. As the business cycle heats up, it is important to keep an eye on this critical component of the financial system to ensure that rating agencies are not being driven by short term profits for themselves at the expense of long-term systemic stability for the rest of us.

Strip-Downs Are Good

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The Philadelphia Fed has posted a Working Paper, Using Bankruptcy to Reduce Foreclosures: Does Strip-Down Of Mortgages Affect The Supply of Mortgage Credit? The paper’s abstract reads,

We assess the credit market impact of mortgage “strip-down” — reducing the principal of underwater residential mortgages to the current market value of the property for homeowners in Chapter 7 or Chapter 13 bankruptcy. Strip-down of mortgages in bankruptcy was proposed as a means of reducing foreclosures during the recent mortgage crisis but was blocked by lenders. Our goal is to determine whether allowing bankruptcy judges to modify mortgages would have a large adverse impact on new mortgage applicants. Our identification is provided by a series of U.S. Court of Appeals decisions during the late 1980s and early 1990s that introduced mortgage strip-down under both bankruptcy chapters in parts of the U.S., followed by two Supreme Court rulings that abolished it throughout the U.S. We find that the Supreme Court decision to abolish mortgage strip-down under Chapter 13 led to a reduction of 3% in mortgage interest rates and an increase of 1% in mortgage approval rates, while the Supreme Court decision to abolish strip-down under Chapter 7 led to a reduction of 2% in approval rates and no change in interest rates. We also find that markets react less to circuit court decisions than to Supreme Court decisions. Overall, our results suggest that lenders respond to forced renegotiation of contracts in bankruptcy, but their responses are small and not always in the predicted direction. The lack of systematic patterns evident in our results suggests that introducing mortgage strip-down under either bankruptcy chapter would not have strong adverse effects on mortgage loan terms and could be a useful new policy tool to reduce foreclosures when future housing bubbles burst.
This paper seems to cut through some of the hyperbole that surrounds this topic. Its concluding paragraphs indicate how a modest introduction of strip-downs would have only a modest impact on the availability of mortgage credit. It contrasts such a modest step with more far-reaching proposals, such as using eminent domain to take underwater mortgages throughout an entire jurisdiction. The paper seems to argue that the more modest proposal could be acceptable to the lending industry. I am not so sure that that is true, particularly in the current political environment. But it is certainly true that strip-downs could be a useful tool to have when “future housing bubbles burst,” as they most certainly will.

Frannie Reps and Warranties Crisis Brewing

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The Inspector General of the Federal Housing Finance Agency released an audit, FHFA’s Representation and Warranty Framework. Reps and warranties are a risk-shifting device that sophisticated commercial parties use in transactions. If a party makes a representation or warranty that turns out to be false, they other party may have some remedy — maybe the ability to return something or to get some kind of payment to make up for the failure to live up to the promise.

For instance, a lender may sell a bunch of mortgages to a securitizer and represent that all of the borrowers have FICO (credit) scores of 620 or higher. If it turns out that some of the borrowers had scores of less than 620, the securitizer may be able to make the lender buy back those mortgages pursuant to a rep and warranty clause. The IG undertook this audit because of recent changes to the reps and warranties framework for Fannie and Freddie. Before these changes were implemented,

the Enterprises’ risk management model primarily relied on reviewing loans for underwriting deficiencies after they defaulted as the representations and warranties were effective for the life of the loans. In contrast, the new framework transfers responsibility to the Enterprises to review loans upfront for eligible representation and warranty deficiencies that may trigger repurchase requests. If the Enterprises fail to do so within the applicable period, their ability to pursue a repurchase request expires if it is based upon a representation and warranty that qualifies for repurchase relief. (2)

The IG’s findings are disturbing. It “found that FHFA mandated a new framework despite significant unresolved operational risks to the Enterprises.” (3) It also found that

FHFA mandated a 36-month sunset period for representation and warranty relief without validating the Enterprises’ analysis or performing sufficient additional analysis to determine whether financial risks were appropriately balanced between the Enterprises and sellers. Freddie Mac, in contrast to Fannie Mae which provided analysis limited to a 36-month period, provided FHFA with the results of an internal analysis of loans that indicated loans with a 48-month clean payment history were significantly less likely to exhibit repurchaseable defects than loans with a 36-month clean payment history. Thus, losses to the Enterprise could be less with a longer sunset period. Therefore, FHFA cannot support that the sunset period selected does not unduly benefit sellers at the Enterprises’ expense. (3)

This is all very technical stuff, obviously. But it is of great significance. Basically, the IG is warning that the FHFA has not properly evaluated the credit risk posed by changes to the agreements that Fannie and Freddie enter into with the lenders who convey mortgages to them. It also implies that this new framework “unduly” benefits the lenders.

The FHFA’s response is unsettling — it effectively rejects the IG’s concern without providing a reasoned basis for doing so. Its express rationale for doing so is to avoid “adverse market effects” and because addressing the IG’s concern “may not align with the FHFA objective of increased lending to consumes . . ..” (32)

Whenever federal regulators place increased lending as a priority over safety and soundness, warning bells should start ringing. Crises at Fannie and Freddie (and the FHA, for that matter) begin with this kind of thinking. Increased lending may be important today, but it should not be done at the expense of safety and soundness tomorrow. We are too close to our last housing finance crisis to forget that lesson.

Reiss on FIRREA Penalties

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Bloomberg quoted me in S&P Faces Squeeze After $1.3 Billion Countrywide Fine. It opens,

Standard & Poor’s (MHFI)’ chances of settling the government’s lawsuit over mortgage-bond ratings for less than $1 billion may have slipped away after Bank of America Corp.’s Countrywide unit was socked with a $1.3 billion fine.

The Countrywide ruling was the first to lay out what penalties financial institutions could face under a 1989 bank-fraud law the Obama administration is using against alleged culprits of the subprime mortgage crisis. It has boosted the government’s hand against McGraw Hill Financial Inc.’s S&P, said Peter Henning, a law professor at Wayne State University.

“If the starting negotiation point for the Justice Department to settle was $1 billion before, that number has just gone up,” Henning said in a phone interview.

The U.S. sued S&P and Countrywide under the Financial Institutions Reform, Recovery and Enforcement Act, a law passed by Congress in the wake of the savings and loan crisis of the 1980s. The administration, which seeks as much as $5 billion from S&P, is using the law to punish alleged misconduct in the creation and sale of residential mortgage-backed securities blamed for the financial crisis two decades later.

For the Justice Department, the case against S&P goes to the heart of the financial crisis, attacking the company’s claims that its ratings — relied on by investors worldwide — were honest and neutral. S&P has countered that the case is really retribution for it downgrading the U.S. government’s own debt and it has subpoenaed officials including former Treasury Secretary Timothy Geithner in an effort to prove that.

Hearing Today

A hearing on the company’s request to force Geithner and the government to turn over records is scheduled for today in federal court in Santa Ana, California.

Countrywide was found liable by a federal jury in Manhattan for lying about the quality of the almost $3 billion in mortgages it sold to Fannie Mae (FNMA) and Freddie Mac (FMCC) in 2007 and 2008. U.S. District Judge Jed Rakoff in Manhattan agreed with the Justice Department that the penalty should be based on how much money the mortgage lender fraudulently induced the companies to pay for the loans.

“The civil penalty provisions of FIRREA are designed to serve punitive and deterrent purposes and should be construed in accordance with those purposes,” the judge said in his July 30 ruling.

S&P is accused of defrauding institutions that relied on its credit ratings for residential mortgage-based securities and collateralized debt obligations that included those securities. The government claims S&P lied to investors about its ratings on trillions of dollars in securities being objective and free of conflicts of interest.

*     *     *

Appeal Probable

The judge’s analysis, using the nominal value of the transactions as a starting point to determine the penalty, was “out of whack” and will probably be appealed by Bank of America to the U.S. Court of Appeals for the Second Circuit in New York, said David Reiss, a professor at the Brooklyn Law School.

“The Second Circuit has no problem reversing Rakoff,” Reiss said in in a phone interview. “The ruling pushes the balance of power in favor of the government by expanding the definition of a civil penalty.”

While other judges aren’t obliged to follow Rakoff’s reasoning, they will pay close attention to the decision because the federal court in Manhattan is the leading business law jurisdiction in the country and the ruling was clearly explained, Reiss said.