The SEC settled cases today with JPMorgan and Credit Suisse over “misleading investors in offerings of residential mortgage-backed securities” for a total of about $400 million, which the SEC plans to hand out to those misled investors. There’s been a lot of this sort of thing recently, so here’s a quick cheat sheet on who is suing whom over what mortgages:
- Everyone is suing every bank over all of their mortgages.
So fine but is that not weird? Two things to notice about big banks is that they are (1) big and (2) banks, both attributes that tend to accrue lawyers. And a thing that lawyers are supposed to do is stop stupid cowboy bankers from doing stupid illegal things. If you told me that one or two banks decided to go without lawyers for cost-cutting and/or risk-increasing reasons, I would be skeptical but perhaps willing to play along, but all of them? I am certain that JPMorgan has lawyers.1
The mystery is resolved and/or deepened if you look at most of what is being settled in these cases, which in highly schematic outline was:
- banks wanted to hose investors,
- they asked their lawyers if that was okay,
- the lawyers checked the documents and said “yes,”
- so they did.
In ever so slightly less schematic outline:
- Bear Stearns and Credit Suisse bought mortgages from originators.
- The originators made representations and warranties to BS/CS to the effect of “these mortgages are not garbage.” Call these reps and warranties “RW1.”
- The mortgage purchase and sale agreements between the originators and BS/CS – call them “PSA1” – provided that, if RW1 were false, the originators would buy back the loans from BS/CS.
- BS/CS then sold those mortgages on to RMBS pools.
- BS/CS made reps and warranties – “RW2” – to the effect of “these mortgages are not garbage.”
- The purchase and sale agreements between BS/CS and the RMBS pools – call them “PSA2” – provided that, if RW2 were false, BS/CS would buy back the loans from the pools.
- RW1 and RW2 were not identical.
- Various mortgages had “early payment defaults” (EPDs), which triggered reviews by BS/CS, which led them to notice that the mortgages were in breach of RW1, viz., garbage.
- Under PSA1, the originators had to repurchase them from BS/CS, but the originators were feckless and broke and/or good clients of BS/CS.
- So BS/CS just negotiated “bulk settlements” where, instead of buying back $10 million or whatever of EPD mortgages, the originators would just pay BS/CS $1 or $2 or $9 million and not buy back the mortgages.2
- Then a curious thing would happen: BS/CS would notice that, while the mortgages breached RW1 – i.e. they were “bad” or “fraudulent” or “garbage” as between BS/CS and the originators – they did not breach RW2. That is, as between BS/CS and the pool of mortgage investors, the mortgages were not garbage at all. Actually they were fine.
- So BS/CS would keep the money.
Before you ask, this is not some mortgage officer at Bear Stearns or Credit Suisse just trousering the money without asking anyone. They asked people! They asked piles of lawyers and ended up with an eight-page document detailing what they were allowed to do with the money they got from the bulk settlements.3 And they asked their quality control department to review loans that had breached RW1 – and been subject to bulk settlements – and check if they breached RW2. And here is what they came up with:4
To implement the allocation specified in the Settlement Waterfall, EMC [i.e., Bear] began performing a PSA breach review on bulk settlement loans to determine whether there was a breach of a representation or warranty made by EMC to the trust [i.e., a breach of RW2]. Prior to this time, when EMC conducted the PSA breach review on loans that a loan originator had agreed to repurchase, EMC found a breach nearly 100% of the time [i.e., before bulk settlements, Bear seemed to think that RW1 = RW2].
However, with regard to bulk settlement loans, EMC did not find a breach on every loan.
In a July 2007 e-mail, the head of EMC’s Quality Control Department confirmed an understanding of the differing approaches, pointing out that, if an EPD loan was not to be repurchased by an originator, then “we don’t want to find a PSA breach . . .” Thus, certain EMC employees believed that EMC did not “want to find” PSA breaches on bulk settlement loans.
When reviewing bulk settlement loans, EMC found that only about 12.7% of the bulk settlement loans breached its representations and warranties in the Sponsor MLPA [i.e. breached RW2 in PSA2].
You can see why this case settled! On the one hand, I’d bet that the lawyers and quality control people who ran this process had an argument every time they refused to repurchase a bulk-settled loan from a mortgage pool. “Oh, see, RW1 says that every borrower has a job, but RW2 just says every borrower is working, and you can work without having a job,” or whatever. Or the commas, or the “materially”s, are in different places, I dunno.
And the SEC’s complaint doesn’t really refute that: there’s no smoking gun of bad faith, no example of BS/CS knowing that a loan breached RW2 and yet refused to repurchase it, no open-and-shut fraud. The whole SEC complaint5 is just eyebrow-raising circumstantial evidence like “well how come RW1 = RW2 100% of the time when you were just passing money through, but only 13% of the time when you decided to keep the money?”
On the other hand: good question, no? That eyebrow-raising circumstantial evidence is extremely compelling and obviously right and if you were JPMorgan you’d hate to have those quality control officers get up in court and go through the list mortgage by mortgage and be all “well these reps and warranties say ‘material breach’ but those say ‘materially adverse breach.’” Come on, man.
People get mad at the SEC for not bringing financial-crisis cases against individuals, but these settlements are a perfect illustration of why they don’t. Nobody did anything wrong. There’s no rogue banker altering all the documents to deceive investors, no straight-up “they lied to you in paragraph 8.”6 The bankers acted on the advice of counsel, and counsel’s advice was based on reasonable readings of the documents and reasonable reliance on business people reasonably telling them what they reasonably believed to be true and material.
And yet! Somehow the RMBS system constructed by those bankers and those counsel worked out such that, while everyone acted defensibly and plausibly under the law and the documents at every step, the final result was absurd. And somehow, by some coincidence, it was absurd in the banks’ favor.
JPMorgan, Credit Suisse settle SEC cases for $417 million [Reuters]
SEC Charges J.P. Morgan and Credit Suisse With Misleading Investors in RMBS Offerings [SEC]
In the Matter of Credit Suisse Securities (USA) LLC et al. [SEC]
SEC v. J.P. Morgan Securities LLC, et al. [SEC]
1. TBF most – not all – of the bad stuff JPMorgan is settling today is actually legacy Bear Stearns stuff. If you told me Bear Stearns had no lawyers I would believe you.
2. E.g. from the JPMorgan settlement, paragraph 34:
The settlements varied somewhat, but generally included a release by EMC [i.e. Bear] of its repurchase claims on a specific population of loans. In exchange for EMC’s release, the originator generally agreed to pay some cash amount representing a fraction of the total claim amounts listed in the agreement. The fractional amounts recovered spanned a wide range from just pennies on the dollar to as high as 90%. The settlements did not release Bear from any of its obligations to the trusts.
3. Here is who got asked at Bear Stearns, from paragraphs 37-39 of the JPM settlement::
Deliberations about how to deal with the bulk settlements involving counsel and Bear executives continued for many months through the end of 2006 and into early 2007, during which time certain of the funds were held in a separate account. By the end of February 2007, Bear decided that the practice would continue, that certain funds collected to date would be taken into income for first quarter 2007, and that future settlement funds would be allocated pursuant to a procedure that was yet to be devised, and which eventually became known as the “Settlement Waterfall.”
The Settlement Waterfall, created with the involvement of counsel, is an eight-page document setting forth in detail how incoming bulk settlement funds were to be allocated.
Under this allocation, Bear first reimbursed itself for legal fees, costs and other expenses; second, it covered the full amount of certain “monetary” claims (such as, e.g., tax and escrow adjustments); and third, it divided any remaining funds pro-rata between inventory and trust-owned loans. Bear then used the pro-rata amount allocated to trust-owned loans to reimburse itself for its repurchases of all bulk settlement loans that EMC deemed “mandatory” because the representations and warranties to the trusts had been breached on these loans. Finally, if any funds remained after all of the above allocations, EMC would use the money for repurchases that EMC deemed “optional,” both of bulk settlement loans and of other loans from securitizations.
4. At Bear Stearns. At Credit Suisse they came up with the following amazing procedure (paragraph 18 of the Credit Suisse settlement):
Credit Suisse sampled 3% to 5% of all loans every month to identify deficiencies associated with origination of the loans. Through this loan quality review process, Credit Suisse learned facts that could constitute breaches of representations and warranties Credit Suisse made to RMBS trusts. However, beginning in at least late 2007, when Credit Suisse issued a repurchase demand to an originator, it excluded the relevant loan from its quality review process. Because Credit Suisse sent repurchase demands to originators on EPD loans, during this time Credit Suisse did not perform a quality review process on these loans. As a result, Credit Suisse’s quality review process did not identify evidence of breaches of its own representations and warranties on loans that were the subjects of bulk settlements.
I.e. they just assumed that any loan that was fraudulent as to them could not be fraudulent as to the RMBS pool. That is … dumb. They might want to look into better lawyers.
5. Kidding! In the text I’m focusing on the common element in the two complaints that represents the bulk of the settlements, but each bank also did other things that were more straightforward whoopsies. In CS’s case there were two transactions in which CS explicitly promised that any loan with a first payment delinquency would be repurchased, with no haggling over reps and warranties. “Notwithstanding this provision, Credit Suisse, without disclosure, did not ensure the removal of all such loans.”
In JPMorgan’s case – and this was JPMorgan, not Bear – this happened:
With respect to current and historical delinquencies, JP Morgan and JPMAC represented that .04%, or 4, of the loans were the only loans that had had an instance of delinquency. While JP Morgan and JPMAC personnel were preparing the prospectus supplement for the WMC4 transaction, they had information that more than 7% of the loans, with a balance of more than $135 million, were at least 30 days delinquent.
7% is, sadly, more than 0.04%.
6. So for instance paragraph 20 of the Credit Suisse settlement bugged me:
Offering documents for all of the RMBS transactions represented that the sponsor and depositor transferred all “right, title and interest” to the loans, as well as all “proceeds” from the loans, into the trusts. These documents also stated that the trusts qualified for REMIC tax status. Credit Suisse did not disclose that, despite this transfer and the relinquishment of control over the loans, Credit Suisse enforced rights against originators for loans owned by the trusts, without repurchasing them.
Those are just words, man! You can transfer all “right, title and interest’ to the loans while still having additional rights, outside the loans, to go yell at the originator and try to get money from them. If the SEC is going to fight RMBS structurers over their ability to proliferate contracts and rights and remedies and lines on flowcharts, it will lose.