To Be Fair, Bear Stearns Never Told Investors That Its RMBS Deals Weren’t “Shit Breathers”

So, subprime mortgage-backed securities. Here’s a schematic:

  • Banks packaged subprime mortgages into bonds and sold them to people.
  • Something.
  • The bonds were bad and the people lost money.

What’s the something? There are two main theories. Theory 1 says that everyone knew at some lizard-brain level that it was a bad idea to give lots of money to poor unemployed people with low credit scores to buy overpriced houses, but figured it would work out fine if house prices kept going up. This worked until it didn’t; when house prices went down, badness ensued.

Theory 2 says that, while mortgage originators and securitizers knew that they were giving mortgages to people who had no chance of paying them back, the buyers of those mortgages had no idea: they thought that the originators were holding them to rigorous underwriting standards, where “rigorous” is read to mean “other than requiring a job, or an income, or assets, or a credit score.” When that turned out to be false, badness ensued.

Theory 1 has the benefit of probably being right.1 Theory 2 is superior on every other metric. For one thing, it fits well with deep cultural desires to find villains for the subprime crisis, and punish them. For another, it better fits the explicit facts. No subprime offering document actually said “these guys are all just terrible reprobates and the only way you’ll get your money back is if they can find a greater fool to buy their overpriced house when their rate resets.” But there’s no shortage of internal emails that say – well:

In connection with the Bear Stearns Second Lien Trust 2007-1 (“BSSLT 2007-1”) securitization, for example, one Bear Stearns executive asked whether the securitization was a “going out of business sale” and expressed a desire to “close this dog.” In another internal email, the SACO 2006-8 securitization was referred to as a “SACK OF SHIT”2 and a “shit breather.”

Thanks Eric Schneiderman! That’s from his lawsuit against Bear Stearns, whose legacy mortgage liability JPMorgan now owns. Schneiderman is suing as New York Attorney General but also as some sort of quasi-rogue representative of the federal mortgage task force set up to, um, sue Bear Stearns for securitizing bad mortgages. Interestingly both JPMorgan and its enemies are disappointed with this lawsuit, and for the same reason, which is basically that they knew all about crappy RMBS securitization due diligence back before it was popular and are all snobby that Schneiderman is coming to this so late in the game.

The main claim here is securities fraud under New York’s Martin Act, claiming that Bear “employed deception, misrepresentations, concealment, suppression, fraud and false promises regarding the issuance, exchange, purchase, sale, promotion, negotiation, advertisement and distribution of securities.”3 And the main false promises, again according to the complaint, are:

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.

So let’s go to those representations. Here is the shit breather:

American Home’s underwriting philosophy is to weigh all risk factors inherent in the loan file, giving consideration to the individual transaction, borrower profile, the level of documentation provided and the property used to collateralize the debt. These standards are applied in accordance with applicable federal and state laws and regulations. Exceptions to the underwriting standards may be permitted where compensating factors are present. In the case of investment properties and two- to four-unit dwellings, income derived from the mortgage property may have been considered for underwriting purposes, in addition to the income of the mortgagor from other sources. With respect to second homes and vacation properties, no income derived from the property will have been considered for underwriting purposes. Because each loan is different, American Home expects and encourages underwriters to use professional judgment based on their experience in making a lending decision. …

American Home realizes that there may be some acceptable quality loans that fall outside published guidelines and encourages “common sense” underwriting. Because a multitude of factors are involved in a loan transaction, no set of guidelines can contemplate every potential situation. Therefore, each case is weighed individually on its own merits and exceptions to American Home’s underwriting guidelines are allowed if sufficient compensating factors exist to offset any additional risk due to the exception.

So: fraud, or not fraud? The thing is, this doesn’t say very much: basically “we have some guidelines, and we won’t tell you about them, and we can waive them when we think that’s a good idea.” As an epistemic matter it is hard to prove that someone lied when they said “trust us, we used our common sense.” Common sense is not so common and all that. But maybe it works here? According to the complaint, anyway, overworked outside consultants rubber-stamped files, incentives were exclusively to get loans approved rather than to do real credit review, and denials were changed to approvals for business-relationship rather than credit reasons. Particularly, but not exclusively, in hindsight, Bear’s and its originators’ underwriting does not seem to have been guided by what most of us would call common sense.

But to prove fraud you also need to prove materiality – that investors cared about the lie – and this seems harder. Because: why would you rely on someone selling something to you saying “trust us, we used our common sense”? Why wouldn’t you ask for detail about what they actually did? Turns out you had a little bit of that detail; from the shit-breather again:

Approximately 29.13% of the HELOCs were originated under full/alternative documentation programs. The remainder of the HELOCs were originated under limited or no documentation programs.

Bear Stearns’s “common sense” underwriting did not extend to getting any documentation of income or employment for the large majority of its borrowers, and it told investors that, and the investors bought it anyway.4 Perhaps this means that investors just trusted Bear Stearns’s subsidiaries’ and correspondents’ common sense so implicitly that they were willing to extend money based only on those subsidiaries and correspondents looking deeply and common-sensically into the souls of their borrowers. Or perhaps it means that they were betting on house price appreciation and were willing to sacrifice credit quality for yield.

This defense only takes you so far; here is a sensible take:

I assume JPM’s materiality defense will argue that investors didn’t care about the due diligence process. I expect this might turn into a question about whether investors cared about the marginal differences in the due diligence process as promised vs. as delivered or having a due diligence process at all. If the issue is framed as being about a few loans in each pool, it might still be material, but not as obviously as if the issue is about having a due diligence process overall: if the diligence process isn’t material, why waste time and money on it? As it stands, the NYAG’s complaint is not that there were some diligence slip-ups at the margin, but that the whole process was fundamentally compromised.

This is true, and the case will be interesting, by which I mean “settled quickly.” Though in Bear’s counterintuitive defense, they didn’t waste much time or money on diligence.

JPMorgan Unit Is Sued Over Mortgage Securities Pools [NYT]
Complaint: New York v. J.P. Morgan Securities LLC [via NYT]
Schneiderman Suit Against JP Morgan: A Rehash of Other Lawsuits, Likely to Produce Meager Settlement [NC]
NYAG MBS Suit [Credit Slips]

1. This paper is a thoughtful evaluation of the competing hypotheses; it finds that basically the industry correctly and publicly predicted expected losses conditional on housing price depreciation; it was just overly optimistic about housing prices. Also I like Gary Gorton’s book a lot, and I’d say it does a great job of laying out the case for Theory 1, though it doesn’t necessarily refute Theory 2 – they’re not exactly mutually exclusive.

2. Get it? SACO SHIT? I feel like that Bear dude high-fived himself for that acronym pun.

3. Another, perhaps more compelling, claim is that when Bear found loans with early payment defaults, rather than putting them back to the originators as the securitization documents required, Bear basically hit up the originators for settlements that it pocketed itself. That sounds … bad.

4. None of this is a surprise but, like, here’s an excerpt from a list of “documentation programs” in another Bear securitization named in Schneiderman’s suit:

No Income/No Employment/Verified Assets (NIVA): The NIVA program requires that the borrower state his/her assets on the Form 1003, but the borrower’s employment or income need not be stated. The applicant must submit a written verification of deposit with 2 months’ average balance or his/her most recent bank statements covering a 2-month period. Any large increases between the average balance and the current balance of the account must be satisfactorily explained.

Stated Income/Stated Assets (SISA): Under the SISA program, the borrower’s employment, income and assets are stated on the Form 1003, but income and assets are not verified. The borrower’s income must be reasonable given the employment stated. A verbal verification of employment is required within 10 calendar days of funding the loan, and the borrower’s employment must be located within 100 miles of his or her residence. For self-employed borrowers, a CPA’s certification or a copy of a business license is also required.

No Income/No Assets/Verified Employment (NINA w/Employment): Under the NINA w/employment program, the borrower states his/her employment on the Form 1003 but not his/her income or assets. A verbal verification of employment is required within 10 calendar days of funding the loan, and the borrower’s employment must be located within 100 miles of his or her residence. For self-employed borrowers, a CPA’s certification or a copy of a business license is also required.

No Income/No Assets/No Employment (NINA (No Doc)): Under the NINA (No Doc) program, the borrower does not provide his/her employment, income, or assets on the Form 1003.

Precisely what common-sense underwriting would you expect to be done on a borrower who won’t tell about you his/her employment, income or assets?

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33 Responses to “To Be Fair, Bear Stearns Never Told Investors That Its RMBS Deals Weren’t “Shit Breathers””

  1. AQR Astrology Quant says:

    Two Matt posts in a row, five Tuesdays in this month, this means something.

  2. Guest says:

    – DB had technical difficulties before the opening bell.

    – Two Matt posts before any sign of Bess.

    Was there an overnight coup d'état at DB ? A Levine – Levin putsch, perhaps.

    Should we be searching for Bess in Suffolk county, at the Levine family hog farm?

  3. Steve in Stamford says:

    "Interestingly both JPMorgan and its enemies are disappointed with this lawsuit"

    Come on, your not even a bit angry too, not even a little bit?

  4. Matt's Mom says:

    Mathew, did you kill the interwebs again, sugar pie?

  5. VonSloneker says:


    "Something" = "Profit"

    – Ace

  6. Evil David Letterman says:

    Since were on the topic of "Shit Breathers:, who would you rather have sit on your face? Paul Shaffer, Jessica Alba, or Selena Gomez?

  7. j.herrold says:

    I suck – I mean I breath shit and I waste everyone's time

  8. Guest says:

    I stopped reading after "schematic"

  9. ILoveLamp says:

    So let me get this straight. JPM shareholders are going to write a multi-billion dollar check to NY State Treasury, in order to make things right for MBS investors who were wronged by former Bear Stearns employees. Makes perfect sense to me.

  10. Guest says:

    Where are these clowns who ran that business. Funny how they probably have jobs and they were front and center crooks. Wtf.

  11. ConcofConservative says:

    Bear Stearns did not under-write the securities in accordance with the prospectus, PSA and other guide-lines. The fact that the borrowers were of poor quality is not the issue, it's that Bear did not follow it's own gudelines as lax as they were. If a car maker sold a product that was not built as advertised it would be sued and have to recall. Mortgages are no different.

  12. Robin Meyer says:

    this is pretty interesting

  13. dan says:

    serious fraud here…

  14. Theory 2 is superior on every other metric. For one thing, it fits well with deep cultural desires to find villains for the subprime crisis, and punish them. For another, it better fits the explicit facts