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These lawsuits against Bank of America are pretty lame, aren’t they? The SEC and Department of Justice each sued BofA yesterday for fraud in a 2008 prime jumbo mortgage securitization but it doesn’t really feel like fraud. The guns are smoke-free. The DoJ gets itself all excited because someone proposed including some bad mortgages in the deal, and a Bank of America trader said of those mortgages that, “like a fat kid in dodgeball, these need to stay on the sidelines,” but they did! The trader thought some of the mortgages were crap, and they were crap, and so they weren’t included in the deal. The system worked! It’s like if Fabulous Fab emailed his girlfriend saying “I am creating monstruosities,” and she told him to stop, and he did.
The complaints put their fraudy eggs in two main baskets. The first is that Bank of America omitted to tell investors some material facts, of which the most important is that 70% of the loans in this securitization were wholesale loans (originated through brokers), and that wholesale loans were worse – for both credit and prepayment risk – than loans originated by BofA directly. The idea here is that the channel composition was so material to investors that BofA should have disclosed it, and was fraudulent not to. Now one response here might be: if it was so material to investors, why didn’t they ask for it? And the answer is: some of them did! And BofA: gave them the information! And those investors: invested anyway! At the same price as everyone else.1 So: was the origination channel composition material to investors? If investors had known that these loans were 70% wholesale, would they have stayed away? That is an empirically answerable question, and the answer is no.
Now, there is clearly some badness here: the SEC is right to be mad that BofA disclosed loan origination data to some investors and not others, both because selective disclosure is a no-no and because really the way you’re supposed to write a prospectus is that if smart investors keep asking you specific questions about your securities you should put the answers in the prospectus, that’s sort of what it’s there for.2 But the SEC’s and DoJ’s claim that this undisclosed information was material to investors seems obviously false from their own claims.
The second, perhaps more serious claim is that Bank of America lied about the fact that the loans conformed to BofA’s own underwriting standards.3 The prospectus claims that all of the loans were underwritten “materially in accordance with” one or more of Bank of America’s many different sets of underwriting standards – at least one of which, the delightfully named “PaperSaver,” involved not a whole lot of underwriting – and that “A loan is considered to be underwritten in accordance with a given set of guidelines if, based on an overall qualitative evaluation, the loan is in substantial compliance with such underwriting guidelines.”
So that’s pretty mushy! The prospectus goes on about the standards but the point is that it very specifically does not claim that every loan followed every word of the standards: just that they were materially, based on an overall qualitative evaluation, in substantial compliance with those guidelines. The DoJ somewhat amazingly claims that “more than 40% of the 1,191 mortgages in the collateral pool did not substantially comply with BOA-Bank’s underwriting standards in place at the time they were originated,” which I guess means that the DoJ is much better than I am at reducing that mash of overall-qualitative-evaluations into quantifiable standards. Or that they made up the 40% thing. And in fact the noncompliance is pretty dull: a lot of somewhat suspect appraisals, unlikely primary residences, and failures to verify income in no-income-verification loans4 – not smoking guns of pretending to do fully documented and underwritten loans while in fact doing nothing.5
Why would you buy these mortgages? One answer might be that you trust BofA to underwrite them, fine – but that would be for commercial-reputational reasons, not because the mush in the prospectus gives you hard underwriting standards for which you could hold BofA accountable. Another answer might be that, as BofA puts it, investors had “ample access to the underlying data” and were comfortable with the underwriting overall. And in fact the prospectus has a 24-page appendix, Appendix A, full of data about the mortgages in this pool: the breakdown of primary residence vs. secondary vs. investment properties, of purchase vs. refi mortgages, of standard versus “PaperSaver” documentation, of geography, of debt-to-income and loan-to-value ratios, and of borrowers’ credit scores. You could look at that and, as of January 2008, decide whether you wanted to invest your money in a 70% California, 60% PaperSaver, but 85% 700+ FICO pool of mortgages. Obviously the answer was yes for some people anyway.
Really if Appendix A is correct then it’s hard to get all that mad at BofA: they gave you all the relevant data, in convenient tabular form, and you could make of it what you want. If on the other hand Appendix A is incorrect – if the LTVs were higher and incomes were lower than BofA represented – then they should really be liable: they gave out a prospectus, the meat of the prospectus was the loan-level data, the loan-level data was false. Fraud!6 In fact the SEC and DoJ think that Appendix A is incorrect, because the underwriting mistakes were not just failures of formality but actually produced incorrect appraisals, income data, etc.7 They just choose not to emphasize that, focusing on the squishy underwriting standards and the lack of channel data instead.
How weird! As complaints about fraud these suits are just terrible. There are no obvious lies, no evidence of intent to deceive, no hahaha-we’re-getting-away-with-it emails. Just dopes lazily and sloppily approving mortgages that don’t meet the high, vague standards they’ve set for themselves.
But that’s bad! You shouldn’t lazily and sloppily approve mortgages that don’t meet your standards and then sell them on to investors using not particularly correct numbers. As complaints about failures of BofA’s underwriting function you could get behind them.
Which makes sense. A key function of the securitization documents was to make it look like Bank of America was making helpful claims about the quality of its underwriting and the likelihood that its mortgages would be repaid, without actually making any claims that might incur liability. “We underwrite our loans, mostly. Materially. Substantially. Y’know.” Buried in a risk factor in the prospectus, BofA says that it’s making no representations or warranties about “the actual performance of any mortgage loan.”8 Of course it isn’t. The loans are your problem, not BofA’s.
You can understand why the SEC and DoJ would think that’s a pretty bad system – why they’d think, albeit almost six years later, that BofA really shouldn’t be able to get away with selling as prime mortgages that turned out to be crap. And you can see why BofA’s combination of careful lawyering and shoddy underwriting here, though it might actually make them not guilty of fraud, would not gain them much sympathy with the government.
SEC Charges Bank of America With Fraud in RMBS Offering [SEC & complaint]
Department Of Justice Sues Bank Of America For Defrauding Investors In Connection With Sale Of Over $850 Million Of Residential Mortgage-Backed Securities [DOJ & complaint via Reuters / DealBook]
BofA Sued by U.S. Over Mortgage Securities [WSJ]
BofA Put Toxic Debt in Bond as Staff Resisted, U.S. Says [Bloomberg]
181. As discussions progressed with potential investors, BAS sent two entities a preliminary loan tape that included data identifying loan origination channels.
182. A majority of the loans in the preliminary loan tapes became a part of the final structure of BOAMS 2008-A.
183. BAS also provided loan tapes containing origination channel information to Standard & Poor’s, who was responsible for rating BOAMS 2008-A.
184. Neither BOAMS nor BAS filed with the Commission all of the preliminary loan tape information that BAS shared with the potential investors.
185. The potential investors who received these loan tapes committed to purchasing BOAMS 2008-A shares prior to the time the structure was finalized.
2. Also one idiot salesman just told one investor the wrong thing, though I would bet a lot of money that this is not a conscious lie but just a salesman in Chicago with no idea what he’s talking about. From the DoJ complaint:
92. Even worse, on at least one occasion, a BOA-Securities salesman affirmatively misrepresented to an investor that none of the mortgages in the collateral pool for the BOAMS 2008-A securitization were originated from the Wholesale Channel. Specifically, in a January 29, 2008 communication sent over the Bloomberg messaging system, a BOA-Securities salesman located in Chicago, Illinois misrepresented to Shay that the BOAMS 2008-A securitization “is a 100% Retail pool. [W]e no longer do Wholesale and never did Correspondent.” This representation was materially false and misleading because over 70% of the collateral pool for the BOAMS 2008-A securitization consisted of Wholesale mortgages.
144. The prospectus and prospectus supplement were materially false, fictitious, and/or fraudulent because they contained, among others, the following materially false statements:
a. “Each Mortgage loan” in the trust “will have been underwritten … to the standards set forth in this prospectus….”
b. “Each mortgage … is underwritten in accordance with guidelines established in Bank of America’s Product and Policy Guides.”
c. “Under Bank of America’s “PaperSaver(R)” documentation program, verification of the applicant’s stated income and stated assets is not requested
(with the exception of self-employed applicants who are required to sign the IRS form 4506-T (Request for Transcript of Tax Returns)).”
Misrepresentation of Income Resulting in Underreported DTI ratio: BOA-Bank originated Mortgage #*****70260 through the Wholesale Channel. BOA-Bank did not verify the claimed income or assets for this borrower who purported to be the director of a performance arts school in Los Angeles, California earning $234,000/year. When BOA-Bank attempted to verify the claimed employment status of the borrower, however, it was advised that the borrower was actually employed as a librarian for the school. According to the Bureau of Labor Statistics, the salary for librarians in the Los Angeles area at the 90th percentile is less than $85,000/year. Had BOA-Bank only considered a reasonable (i.e., at the 90th percentile) stated income, the borrower’s DTI ratio would have been nearly 75%, which exceeded the maximum ratios allowed by the underwriting standards. …
Misrepresentation of Intent to Occupy: BOA-Bank originated Mortgage #*****38239 through the Wholesale Channel. Although the mortgage application claimed the borrower was purchasing this house as a primary residence, at the time of origination the borrower owned three other properties. The borrower claimed to be moving from his current primary residence – a four bedroom, three bathroom, single family residence – to a two bedroom condo farther away from his place of employment. Moreover, the borrower’s housing payment under the new mortgage increased over 225%. Despite these obvious red flags, BOA-Bank
did not take any steps to investigate or resolve these issues and treated the application as if it were for a primary residence. Defendants misrepresented in
Preliminary Marketing Materials and a free writing prospectus that this mortgage was for a primary residence. This mortgage suffered losses.
Inflated Appraisal Resulting in Underreported LTV and CLTV Ratios: BOA-Bank originated Mortgage #*****12483 through the Wholesale Channel
based on an appraised price of $850,000, which resulted in an LTV ratio of 80% and a CLTV ratio of 95%. The appraisal report in the mortgage file dated October 16, 2007 indicated that the subject property had previously sold less than six months earlier for only $646,000. The appraisal report, which was unsigned, did not explain how the price could have increased $204,000 in less than six months. Had the appraised value been any less than $850,000, the LTV and CLTV ratios would have exceeded the maximums allowed under the underwriting guidelines in place at the time and the mortgage would have been declined. Despite these obvious red flags, BOA-Bank did not take any steps to investigate or resolve these issues and underwrote the mortgage using the appraised value of $850,000. Defendants misrepresented in Preliminary Marketing Materials and a free writing prospectus that this mortgage had an LTV ratio of 80% and a CLTV ratio of 95%. This mortgage suffered losses.
5. There is a certain amount of “employee X saw a study showing that a lot of BofA loans were defaulting and didn’t meet underwriting standards, but chose not to investigate whether the loans in this securitization met underwriting standards,” so, sure.
6. Of course there is a defense to this, which is that you’re generally not liable for misstatements in your prospectus if you performed “due diligence” to try to verify them. Here BofA did not: as the DoJ puts it, “at least in part to save the approximately $15,000 it would have cost to conduct Loan Level Due Diligence on a sample of the mortgages collateralizing the BOAMS 2008-A securitization, Defendants decided to expose investors to additional undisclosed risk by forgoing Loan Level Due Diligence.” (The “at least in part” because, the DoJ thinks, they also were afraid that diligence would require them to kick too many loans out of the deal, and the whole point was to sell those mortgages.)
Weirdly, the DOJ seems to believe that BofA had an affirmative duty to do due diligence, which is just … sort of not right about the law:
As the securities underwriter for the BOAMS 2008-A securitization, BOA-Securities had a duty to conduct due diligence prior to offering or selling the Certificates to investors. This duty arose out of general industry practice and custom, BOA-Securities’ own policies and procedures, and the federal securities laws, which provide securities underwriters an affirmative defense to investor claims concerning false statements in prospectuses and other offering documents if the underwriters can show they made a reasonable investigation into the accuracy and completeness of the offering documents and reasonably believed them to be true and accurate.
You don’t actually have a duty of diligence! It’s just a defense to false statements into the prospectus. If you do no diligence and by pure luck everything in the prospectus is right: no liability! You only create liability with actual falsehoods. If you say in the prospectus “we did due diligence,” and you didn’t: well, that’s a lie. But BofA didn’t say that. For the obvious reasons that (1) they didn’t do due diligence and (2) they weren’t total morons.
Credit Scores May Not Accurately Predict the Likelihood of Default
The sponsor generally uses credit scores as part of its underwriting process. The tables in Appendix A show credit scores for the mortgagors obtainedat the time of origination of their mortgage loans. A credit score purports only to be a measurement of the relative degree of risk a borrower represents to a lender, i.e., that a borrower with a higher score is statistically expected to be less likely to default in payment than a borrower with a lower score. In addition, it should be noted that credit scores were developed to indicate a level of default probability over a two-year period, which does not correspond to the life of most mortgage loans. Furthermore, credit scores were not developed specifically for use in connection with mortgage loans, but for consumer loans in general. Therefore, credit scores do not address particular mortgage loan characteristics that influence the probability of repayment by the borrower. Neither the depositor nor the sponsor makes any representations or warranties as to any borrower’s current credit score or the actual performance of any mortgage loan or that a particular credit score should be relied upon as a basis for an expectation that a borrower will repay its mortgage loan according to its terms.