Four years after abuse of mortgage-backed securities led to the financial crisis, few financial companies have faced prosecution for their role in the meltdown. That could be set to change.
The Residential Mortgage-Backed Securities Working Group, now nine months old, took its first enforcement steps this month when it filed a lawsuit against Bear Stearns, later acquired by JPMorgan Chase, accusing the bank of misconduct in the promotion and sale of mortgage-backed securities. It promises more to follow.
President Obama created the joint state-federal working group in January to investigate and prosecute those responsible for misconduct contributing to the financial crisis. The task force consists of officials from the Justice Department, the Securities and Exchange Commission, and other federal and state agencies.
Since its establishment, however, the task force has remained largely silent … until now. On Oct. 1, New York State Attorney General Eric Schneiderman, in his role as co-chair of the working group, file a civil suit in New York Supreme Court on the allegations against Bear Stearns.
According to the complaint, Bear Stearns made flagrant misrepresentations and omissions to promote the sale of residential mortgage-backed securities to investors prior to its collapse in 2008. Defendants in the lawsuit include JP Morgan and two of its subsidiaries, J.P. Morgan Securities and EMC Mortgage.
Bear Stearns led investors to believe that the loans in its securities backed by mortgages were being continuously evaluated and monitored to ensure that lenders were following guidelines and assessing the quality of the loans, the suit contends. “In fact, Bear Stearns did neither,” the complaint states. “Instead, it systematically failed to evaluate the loans, largely ignored defects that its limited review did uncover, and kept its investors in the dark about the inadequacy of the review procedures and defects in the loans.”
Even when these flawed processes happened to identify defective loans, Bear Stearns executives routinely overlooked the findings and continued to package many of those loans into securities for sale to investors, who incurred losses totaling more than $22 billion to date. The lawsuit seeks a variety of remedies, including restitution of all funds obtained from investors.
“We're disappointed that the New York attorney general decided to pursue its civil action without ever offering us an opportunity to rebut the claims and without developing a full record.”
—Joseph Evangelisti,
Spokesman,
JPMorgan
JPMorgan spokesman Joseph Evangelisti says the company intends to contest the allegations. “We're disappointed that the New York attorney general decided to pursue its civil action without ever offering us an opportunity to rebut the claims and without developing a full record, instead of relying on recycled claims already made by private plaintiffs,” he says. “We will, nonetheless, continue to work with members of the president's RMBS Working Group and are fully cooperating with their inquiries.”
Wider Implications
John Walsh, U.S. attorney for the District of Colorado, expects to see similar announcements of lawsuits against other banks in the coming months. “Much work on many investigations remains to be done,” he said, during a press conference on the Bear Stearns filing.
In fact, some banks are warning shareholders that they face similar probes in their latest quarterly filings. Citigroup, for example, stated that it “continues to cooperate fully in response to subpoenas and requests for information” from various state and federal authorities “in connection with formal and informal—and, in many instances, industry-wide—inquiries concerning Citigroup's mortgage-related conduct and business activities, and other matters related to the credit crisis.”
PRELIMINARY STATEMENT
Below is an excerpt from the complaint in the case against JPMorgan.
1. This action arises out of defendants' role in connection with the creation and sale
of residential mortgage-backed securities to investors. RMBS were pools of
mortgages deposited into trusts. Shares of RMBS Trusts were sold as
securities to investors, who were to receive a stream of income from the mortgages packaged in
the RMBS.
2. Defendants committed multiple fraudulent and deceptive acts in promoting and
selling its RMBS. For example, in publicly filed documents and in marketing materials,
Defendants led investors to believe that Defendants had carefully evaluated—and would
continue to monitor—the quality of the loans in their RMBS. In fact, defendants systematically
failed to fully evaluate the loans, largely ignored the defects that their limited review did
uncover, and kept investors in the dark about both the inadequacy of their review procedures
and the defects in the underlying loans. Furthermore, even when defendants were made aware
of these problems, they failed to reform their practices or to disclose material information to
investors. As a result, the loans in defendants' RMBS included many that had been made to
borrowers who were unable to repay, were highly likely to default, and did in fact default in
large numbers.
3. At the heart of defendants' fraud was their failure to abide by their
representations that they took a variety of steps to ensure the quality of the loans underlying their
RMBS, including checking to confirm that those loans were originated in accordance with the
applicable underwriting guidelines, i.e., the standards in place to ensure, among other things, that
loans were extended to borrowers who demonstrated the willingness and ability to repay.
4. While the “due diligence” review that defendants represented they undertook
should have assessed the quality of the loans deposited into the RMBS, defendants' actual due
diligence process was very different from their public representations about it. Defendants failed
to use due diligence as a tool to identify and eliminate the many defective loans that they
purchased from originators. Rather, and in order to preserve their relationships with loan
originators, defendants routinely overlooked defective loans that were identified through the due
diligence review and ignored deficiencies that they knew existed in the due diligence review
process itself. Furthermore, defendants failed to disclose to investors the defects in the loans
that they purchased and the deficiencies in their due diligence process. And despite being made
aware of the need to reform their review of the loans in their RMBS, defendants made no efforts
to improve the process. As an internal Bear Stearns document (dated July 2007) acknowledged,
in addition to having “wide guidelines,” defendants “abused the controls of them.” This, as the
document put it, created a “perfect storm.”
5. Defendants also failed to respond properly to defects identified after securitization
by their post-purchase quality control process. Defendants represented that this quality control
process would result in the identification of problematic loans and their removal from
defendants' RMBS. In reality, defendants' quality control department was so overwhelmed by
the sheer number of defects in the underlying loans that it could not properly function.
Defendants were aware that quality control was essentially unable to respond to the enormous
numbers of problems in the underlying loans, but they did nothing to reform the process—and
they failed to inform investors about the problems. Instead, defendants used the quality control
process to secure monetary recoveries for themselves, which they failed to pass on to investors.
6. Defendants' misconduct in connection with their due diligence and quality control
processes constituted a systemic fraud on thousands of investors. As a result of this fraudulent
misconduct, investors were deceived about the fundamentally defective character of the
mortgages underlying the RMBS they purchased. Mortgagors defaulted on their loans in
exceedingly large numbers, causing the value of these securities to plummet, which in turn
caused investors in RMBS to incur monumental losses.
Source: JP Morgan.
In another example, Goldman Sachs Group noted in its latest quarterly filing that it continues to receive requests for information and subpoenas from federal, state, and local law enforcement authorities relating to the mortgage-related securitization process and sub-prime mortgages and is “cooperating with these regulators and other authorities.”
The Bear Stearns lawsuit sheds light on how the government plans to approach similar investigations moving forward. “We believe that this is a workable template for future actions against issuers of residential mortgage-backed securities that defrauded investors,” said Schneiderman.
Such a workable template refers to, in part, the extensive collaborative effort between the many state and federal authorities that culminated in the filing of the lawsuit against Bear Stearns' acquirer, JP Morgan. The Department of Justice provided 11 assistant U.S. attorneys general and 12 investigative analysts who helped conduct interviews of critical witnesses and review millions of pages of documents, Schneiderman said, while the SEC assisted in developing legal theories and providing substantial evidence in its investigations.
Broad Powers
The lawsuit provides crucial insight into just how wide a spectrum the working group's powers span. The lawsuit against JP Morgan, for example, falls under the purview of the Martin Act, a state law that gives the New York attorney general's office broad powers to investigate and file claims related to commodities and securities fraud. To impose liability under the law, prosecutors only need to show proof of negligence, rather than proof of intent, on the part of the defendant.
Even though the Martin Act has a six-year statute of limitations to bring criminal liability, some financial services firms—such as JP Morgan and Goldman Sachs—have entered into tolling agreement with prosecutors, waiving the statute of limitations.
Ernie Patrikis, a partner at law firm White & Case and a former general counsel of the Federal Reserve Bank of New York, says such lawsuits could make financial firms more cautious about rescuing a troubled financial company in the future. “In the past, the scales have always tipped on the side of benefits, but I think that's changed somewhat in people's minds,” he says.
Buyers in those types of situations need to practice adequate due diligence “to be able to get a grasp of what liabilities there are that don't show up on the balance sheet,” Patrikis says. Such due diligence may entail maintaining that particular business unit as a separate entity so that any liability doesn't adversely affect the rest of the organization. The challenge in a crisis situation is that companies don't get much time to conduct due diligence, he says.
In JP Morgan's case, for example, the bank acquired Bear Stearns “over the course of a weekend at the behest of the U.S. government,” says Evangelisti. The Federal Reserve and the Treasury Department organized the deal as a last resort to prevent the investment bank's losses from weakening other banks.
Acquiring a company in financial distress may still have its benefits, Patrikis says, but it requires conducting a careful cost-benefit analysis to determine whether that entity's line of business aligns with the areas where the company wants to grow versus the risk that that acquisition poses.
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