This New York Attorney General lawsuit against Credit Suisse is mostly the same as all the other lawsuits by all the other regulators against all the other banks. Here is a summary, based on the complaint:
- Some mortgage originators made crappy loans, because that was the style at the time.
- They sold them to Credit Suisse to bundle into MBS.
- Credit Suisse’s due diligence was of the form “hi, is this a loan? APPROVED,” in part because they sucked or whatever but mostly because there were competitive pressures where if they didn’t buy the loan someone else would1 and if you’re the guy whose job is to buy loans and you buy zero loans and say “well the thing is, they were all bad loans,” you are fired, so your incentives are not socially optimal.
- The offering documents for the MBS said things like “ooh our due diligence is so good, so good,” though no specific falsifiable claims are made about the quality of the mortgages or the diligence, and every claim of the form “we only approve good mortgages” is followed immediately by “unless we decide to approve bad ones.”2
- Dumb emails were sent because, you know how mortgage traders are with their email.3
- The MBS lost value for an assortment of reasons, some due to Credit Suisse’s bad diligence, some not.
- That all certainly seems fraudy, so New York is suing CS “for making fraudulent misrepresentations and omissions to promote the sale of residential mortgage-backed securities (RMBS) to investors.”
- Credit Suisse has a nontrivial argument that it didn’t break the letter of the law, fraudulent-misrepresentation-wise, since it never specifically said “these loans are good” but only things of the form “we have pondered the goodness of these loans in our heart, except when we haven’t.”
- But its loans, and its diligence process, and its emails, are all sufficiently dumb that there’ll probably be a settlement with a high-8/low-9-figure dollar amount and no admission of guilt.
Whatever, boring, the end. But then I came to this:
As the performance of Defendants’ RMBS declined, RMBS traders at Credit Suisse, who often held the “residual” portions of their RMBS – that is, the overcollateralization, as well as the first loss position – experienced significant losses and received calls from concerned investors. Recognizing that the bad “performance of the loans” meant that there was a “problem with underwriting,” the traders complained “that the conduit doesn’t always put [loan] performance as a high enough priority.” As one trader told the Head of Conduit:
[W]e the trading desk are on our heels a lot. I just took a $5mm hit … only 1.8mm of which is protected by EPD’s4 … [t]hat’s a tough P&L [real dollar] hit for me to make up.
… The traders’ view of the Head of Conduit as a senior executive who was biased in favor of appeasing originators was summed up in emails that described him as, among other things, “the king of quietly forgiving EPD[s],” for whom “volume [was its] own reward.”
Among what other things, New York Attorney General Eric T. Schneiderman? I feel like if I was trying to disparage a guy who was losing me money, “king of quietly forgiving EPD[s]” would be, like, that’s pretty tame, no?
Anyway though this goes on for pages: the traders were really pissed at the guys putting together Credit Suisse’s MBS deals, and they kept complaining about it. Lawsuits being what they are the narrative trails off and I don’t know how this was resolved, though I assume it involves (1) some trader gloating when events proved them right, (2) some trader non-gloating when they were all fired anyway, and (3) some highly motivated trader conversations with New York Attorney General Eric T. Schneiderman to help prepare this lawsuit.
Schneiderman’s complaint is kind of uninterested in nuance so it begins with a recitation of accepted recent history:
Between 1995 and 2005, the mortgage lending business shifted from an “originate-to-hold” model to what has been referred to as a “securitization machine,” in which originators no longer held mortgage loans to maturity, but rather sold them to banks for the purpose of securitization. Under this model, originators were paid when they sold mortgage loans, and bore none of the risk of non-payment. Instead, that long-term risk was transferred in large part to the investors in the securities.
Faced with the promise of immediate, short-term profits and no long-term risks, [everyone was an asshole, etc.]
But that’s not quite right here, is it? Credit Suisse really seems to have had a setup where:
- Some idiots securitized mortgages terribly to get immediate, short-term profits and no long-term risks, and so they went out and sourced terrible loans terribly.
- But some other people at Credit Suisse held some of the long-term risk, and took the losses.
Surely there is an absence of lessons in institutional design here. I feel like in most of these mortgage cases, the originators reported to the traders;5 at Credit Suisse, the originators seem to have done whatever they want, subject to a weekly ineffectual bitching session with the traders.
But everybody ended up in the same muck. Despite that weak record, I sort of like the Credit Suisse structure of keeping origination and trading P&Ls in separate places. If your origination P&L swamps your losses on holding back residual tranches, and you are an individual human and get both of them, then your incentives tend toward “originate as much as possible and don’t worry about the crappiness.” If one group gets the losses-on-crappiness and the other gets the gains-on-volume, then at least you get some pushback and some possibility of improvement. If the traders’ bitching is ineffectual, then off you go into the same abyss as everyone else, but at least you get a nice record for the future lawsuits.
1. Paragraph 27: “Defendants sought to achieve their volume-driven goals through competitive pricing, that is, a willingness to pay more than their competitors for loans …. Defendants’ main concern was ‘what can be done to try to increase volumes to the conduit,’ and this discussion ‘generally … revolved around how can we pay more for loans.’”
2. Paragraph 40: “According to the Offering Materials, loans underlying Defendants’ RMBS had been originated ‘generally in accordance with’ applicable underwriting standards. Any ‘exceptions’ were portrayed as the product of a considered decision, made only in ‘certain’ instances or on a ‘case-by-case’ basis, where ‘compensating factors’ existed.”
That says nothing. I mean, maybe it ought to say something, but it doesn’t. It says (1) we have standards (but we won’t tell you what they are), and (2) we sometimes approve loans according to those standards, and (3) sometimes we don’t, but (4) if we don’t, it’s because we decided not to. How can that be a misrepresentation?
3. Paragraph 4: “Defendants implemented an ‘incentives’ program … which, according to internal emails, effectively ‘encourage[d]‘ originators ‘to continue delivering … crap.’” That second ellipsis is in the complaint; I hope it’s in the actual email – like, the guy was trying to create suspense about what was being delivered. Crap. Turns out, it was crap.
5. Bear Stearns, for instance: “Bear’s RMBS securitization process was handled and/or overseen by employees of Bear Brokerage. The most senior officers at the sponsor entity EMC reported to the co-heads of Bear Brokerage’s Mortgage Finance Department, who reported to the former Global Head of Mortgage and Asset Backed Securities at Bear Brokerage.”