Epic Stakes in Mortgage War
Feds want billions from banks that sold Fannie, Freddie risky securities.
Jenna Greene ContactAll Articles
The National Law Journal
September 27, 2011
To hear Fannie Mae and Freddie Mac tell it, they were hoodwinked by Wall Street, the unwitting buyers of $200 billion worth of lousy mortgage-backed securities. From the investment banks’ point of view, the two were the most sophisticated investors around and knew exactly what they were getting into.
Ultimately, the Federal Housing Finance Agency’s (FHFA) recent lawsuits against 18 of the world’s largest financial institutions on behalf of Fannie and Freddie may come down to one basic question: disclosure. Did the banks omit or misstate material information about the securities they sold to Fannie and Freddie?
The stakes are high. With Fannie and Freddie’s future existence still tenuous, the suits, filed in New York federal and state courts and federal court in Connecticut, could provide a lifeline — a way to recoup some of the $160 billion the entities have cost taxpayers to date. But critics argue that Fannie and Freddie have no one to blame for their losses but themselves and that the suits themselves could destabilize the economy.
An intense legal fight is taking shape, with the government represented by a team from Quinn Emanuel Urquhart & Sullivan led by Philippe Selendy, a veteran litigator in the residential mortgage-backed securities arena. Counsel retained by the defendants include Brendan Sullivan and David Aufhauser of Williams & Connolly and Brian Pastuszenski of Goodwin Procter for Bank of America Corp.; Jay Kasner, the head of Skadden, Arps, Slate, Meagher & Flom’s securities class action defense group and Skadden partner Scott Musoff for UBS Americas Inc.; and Paul, Weiss, Rifkind, Wharton & Garrison Chairman Brad Karp for Citigroup Inc.
“Clearly this will be a battle of the heavyweights,” said Jacob Frenkel, who heads the securities enforcement practice at Potomac, Md.-based Shulman Rogers Gandal Pordy & Ecker and is not involved in the litigation. “This is one of those bouts where the federal deficit would be reduced by selling tickets to the arguments.”
The FHFA, which became conservator of Fannie and Freddie in 2008 after the $5.3 trillion government-sponsored enterprises faced insolvency, is suing the megabanks under the Securities Act of 1933 for passing off subprime mortgages as AAA-graded investments. The 88-page complaint against Bank of America contains typical allegations. According to the housing agency, BoA misrepresented key data about 23 residential mortgage-based securities it sold for $6 billion to Fannie and Freddie from 2005 to 2007.
For example, the FHFA contends that the percent of properties that were owner-occupied was “materially false and inflated.” Owner occupancy is one risk predictor, since people are more likely to make payments and maintain a home if they live there. One prospectus stated that 4.45% of the underlying properties were not owner-occupied, but the housing agency claims the actual number was more than 15%.
Another risk predictor is the loan-to-value ratio. BoA in another prospectus claimed that none of the underlying properties had loans that exceeded the value of the property. The housing agency asserts that in fact 11.13% of the mortgages were for more than the homes were worth. The complaint also alleges that BoA disregarded evidence from third-party due diligence providers showing “a high percentage of defective or at least questionable loans.”
The FHFA said Fannie and Freddie themselves “had no access to borrower loan files,” and therefore had no way to evaluate what they were getting up close. Instead, they “reasonably relied on [Bank of America Securities’] knowledge and their express representations made prior to the closing of the securitizations.”
If Fannie and Freddie had known the true quality of the underlying mortgages, the complaint states again and again, they never would have bought the securities. “Fannie Mae’s and Freddie Mac’s losses have been much greater than they would have been if the mortgage loans had the credit quality represented in the Registrations Statements.”
Bank of America doesn’t see it this way. In a statement, the company called Fannie and Freddie “among the most sophisticated, powerful and heavily regulated financial institutions in the U.S. mortgage finance system.” In the past, BoA said, the two have publicly acknowledged “that their losses in the mortgage-backed securities market were due to the unprecedented downturn in housing prices and other economic factors, including sustained high unemployment.
“Also, they claimed to understand the risks inherent in investing in subprime and alt-A securities and, in fact, continued to invest heavily in those securities even after their regulator told Freddie that it did not have the risk management capabilities to do so. Despite this, [Fannie and Freddie] are now seeking to hold other market participants responsible for their losses,” BoA said.
Onlookers also find it hard to believe that Fannie and Freddie had no idea what they were buying. “Fannie and Freddie knew perfectly well how weak the loans were,” said Peter Wallison, who is co-director of the American Enterprise Institute’s program on financial policy studies and served as general counsel of the U.S. Treasury Department from 1981 to 1985. Wallison noted that investment banks put together the pools of mortgages specifically for Fannie and Freddie — “the most sophisticated experts in mortgages and the quality of mortgages. They had to know what was in the pools,” he said.
In a statement released on Sept. 6, four days after the cases were filed, the FHFA acknowledged that the securities were customized for Fannie and Freddie, but said that was irrelevant. “It does not matter how ‘big’ or ‘sophisticated’ a security purchaser is, the seller has a legal responsibility to accurately represent the characteristics of the loans backing the securities being sold.”
USING THE ’33 ACT
The key here is that the suits were filed under the Securities Act of 1933, a little-used statute that’s limited to buyers — like Fannie and Freddie — that purchased an initial securities offering, as opposed to in a secondary market such as a stock exchange.
Unlike more commonly invoked securities fraud laws, the 1933 act does not require a showing of intent to defraud or recklessness, said Peter Henning, a professor at Wayne State University Law School. Nor does the government have to prove that Fannie and Freddie relied on the misleading or omitted information.
What matters is simply whether the securities’ registration statement or prospectus was inaccurate — or, as Section 11 of the act puts it, “contained an untrue statement of a material fact or omitted to state a material fact…necessary to make the statements therein not misleading.”
“It all depends on materiality,” Henning said. If [the government] can show there was a material misstatement, liability is easy to establish after that.”
The banks will “find it tough to win a motion to dismiss,” he said, because courts at the outset tend to take a broad view of whether omitted or misstated facts could be material to a reasonable investor. “That can be difficult to determine without a case going to trial,” Henning said. “There are very few cases in which the court found something is not material,” at least initially.
The remedy is the difference between the securities’ purchase price and its remaining value. As the housing agency noted in its Sept. 6 statement, press reports that it is “seeking nearly $200 billion in damages or recoveries are excessive; such numbers reflect the original amount of such securities purchased, not the losses incurred or the potential recoveries.”
In the BoA complaint, for example, the FHFA said Fannie and Freddie suffered “hundreds of millions of dollars in damages.” The statute allows cases to be brought in state or federal court, and the government is trying its luck in both venues.
The majority of the cases — 13 of them — are in U.S. District Court for the Southern District of New York, where Bank of America, Barclays Bank PLC, Citigroup, Credit Suisse Holdings (USA) Inc., Deutsche Bank A.G., First Horizon National Corp., Goldman Sachs & Co., HSBC North America Holdings Inc., JPMorgan Chase & Co., Merrill Lynch & Co., Nomura Holding America Inc. and Société Génerale S.A. were all sued on Sept. 2. The complaint against UBS was filed there on July 27. (It’s not clear why it came first, but may be due to the statute of limitations.)
Judge Lewis Kaplan last week in an order wrote that the cases “appear to bear substantial similarities.” He asked all counsel to submit a joint report by Oct. 19 “describing the respects in which these cases are similar and the respects in which they differ” and proposing “means by which the cases can be most efficiently and conveniently handled.”
In New York state court, cases were filed against Ally Financial Inc., Countrywide Financial Corp., General Electric Co. and Morgan Stanley. The Royal Bank of Scotland Group PLC is being sued in Connecticut federal court. In addition, a total of 135 individuals who signed the registration statements are named in the suits, though they face no allegations of specific wrongdoing other than signing the forms.
Onlookers believe that one potential weakness in the government’s case is the pending investigation of Fannie and Freddie by the U.S. Securities and Exchange Commission. “On the one hand we have the FHFA looking to recoup losses from the likes of JPMorgan and Goldman Sachs, but then we also have the SEC investigating whether Fannie and Freddie mislead investors about the status of their own books,” said Hugh Totten, a partner at Chicago-based business litigation firm Valorem Law Group, who is not involved in the cases. Totten predicted the SEC matter would soon settle with minimal penalties, but said nonetheless it “weakens Fannie and Freddie’s position that the banks are to blame.”
But David Reiss, a professor at Brooklyn Law School, said that, although the argument that “it’s hypocritical to claim you were deceived if you deceived people, too” may be good politics for the banks, it may be legally irrelevant. “They’re two different things,” he said.
The housing agency “would be derelict in its duty if it didn’t pursue the claims” against the banks, Reiss said, but he wondered if the argument that the suits could destabilize the banking industry might prove politically potent.
For example, one analyst, Paul Miller of FBR Capital Markets & Co., wrote in a client note that the suits “drain capital from the banking system, and they cause banks to overly tighten credit standards, which pushes potential home buyers onto the sidelines,” according to Bloomberg. Miller wrote the plaintiffs were “acting in their own self-interest as opposed to that of the broader U.S. economy.”
The FHFA was quick to answer its critics: “Some have claimed that these suits will disrupt economic recovery, or endanger the targeted banks, or increase their cost of capital. While everyone is concerned with these important issues, the long-term stability and resilience of the nation’s financial system depends on investors being able to trust that the securities sold in this country adhere to applicable laws.”
Still, David Min, associate director for financial markets policy at the Center for American Progress, noted that there is at least an element of self-interest to the suits. “This is all happening against the backdrop of Fannie and Freddie reform,” he said. “If FHFA is able to recover a lot of money, that may reduce the amount Fannie and Freddie will cost taxpayers, and it strengthens the argument that they should stick around. If they don’t win, it strengthens the camp that wants to get rid of them.”
This article originally appeared in The National Law Journal.