naked capitalism

K Ackermann says:

One step back, one forward…

Identifying anonymous email might be getting easier, but data forensics is about to get a whole lot more difficult, if not impossible.

http://www.jdfsl.org/subscriptions/JDFSL-V5N3-Bell.pdf

Peripheral Visionary says:

@ “Minimal Work To Indict For Securities Fraud In Real Estate Mortgage-Backed Securities”

I read through it, and to put it bluntly, I do not believe that the recommended course of action would succeed in most cases. (Comments on the post are closed or I would have put this comment there.)

Long analysis below, but the TL;DR is: issuers can’t be sued over bad performance or poor due diligence because they never made any representations with regard to either performance or the thoroughness of their own due diligence. Given that the law is based on disclosure rather than good faith–e.g., they are held to what they said they would do, not what they should have done–there is no course of action.

This actually isn’t that difficult to see firsthand, if you have a stomach for mind-numbing legalese. Take, for instance, one particularly toxic strain of MBS, WaMu 2007-OA1. Documents are here; note that the supplement to the prospectus is immediately after the main body of the document.

http://www.sec.gov/Archives/edgar/data/1317069/000093041307002278/c45467.htm

http://content.edgar-online.com/edgar_conv_pdf/2007/01/25/0001277277-07-000049_FWPTERMSHEETWMALT07_OA1.PDF

First off, if you’re looking for any representations as to future performance, they aren’t there. There’s no guarantee that even a cent will be paid out on the security. All the risk disclosures are to the contrary, e.g.:

“The Mortgaged Properties May Fail to Provide Adequate Security for the Mortgage Loans”

Well, yeah.

“There May Be a Greater Likelihood of Losses on Mortgage Loans Originated Under Some Underwriting Standards”

OK.

“Violations of Consumer Protection Laws May Result in Losses on the Mortgage Loans and the Securities Backed By Those Mortgage Loans”

Translation: our underwriters could break consumer protection laws, but don’t even think about taking action against us on that basis, because we told you that could happen.

“Assignments of Mortgages to the Trustee or the Trust Will Not Be Prepared or Recorded”

Turns out some active minds (likely at the white shoe law firms where these documents are assembled) were preparing for the lost/unassigned note issue long before it hit the headlines.

But enough about the risks. What about the underwriting? Let us take a look at the relevant section (on S-29, roughly 2/3 of the way through the document):

“All of the mortgage loans owned by the Trust have been originated in accordance with the underwriting guidelines of the sponsor as described in this section. Mortgage loans may have been underwritten directly by the sponsor or by correspondent lenders with delegated underwriting approval.”

OK, this sounds promising. And what exactly are those guidelines?

Well, quite simply, they are guidelines, not standards, and very loose guidelines at that. They are peppered with words and phrases like “generally”, “some”, “in the case of . . . not required”, “exceptions . . . may be made”, etc. Note particularly the following section:

“The sponsor has several ‘streamline’ documentation programs under which the prospective borrower’s income and assets either are not required to be obtained or are obtained but not verified. Eligibility criteria vary but may include minimum credit scores, maximum loan amounts, maximum debt-to-income ratios and specified payment histories on an existing mortgage loan (generally, a history of timely mortgage payments for the past twelve months, or for the duration of the mortgage loan if less than twelve months old) or on other debt.”

That’s a “guideline” in only the loosest sense of the word. They could qualify someone for a mortgage with a statement of income written in crayon on toilet paper and it would qualify under this “guideline”.

But what about due diligence? Let us take a look at the promising-sounding “Quality Control Review” section:

“The sponsor’s credit risk oversight department conducts quality control reviews of statistical samplings of previously originated mortgage loans on a regular basis.”

That’s it, not a section of it, that is literally all of it. The issuer promises that it will do unspecified “quality control reviews”, but there are no promises regarding the frequency or extent of such reviews, and certainly no promise of what, if anything, will be done with the results of those reviews.

But what of the issuer’s representations regarding the pool itself? Could those representations be incorrect? Certainly, but I do not think that it is likely.

Take a close look at the term sheet, the second document listed above. One thing becomes very clear: the representations of the loan pool are entirely statistical. There are no representations as to real creditworthiness, and absolutely no representations as to future performance. There is nothing in the term sheet to indicate that any of the borrowers are in any way creditworthy (FICO is not a reliable indicator, as the prospectus clearly recognizes), and obviously there are no projections of the likelihood of future payments.

That highlights one serious problem that is pervasive in the financial crisis: in so many cases, financial products were sold as-is, with disclosure regarding the securities being almost exclusively at a statistical level, and based on backward-looking statistics at that. Is it possible that the issuers lied on the statistics? Yes, but highly unlikely, given the lengths to which they went to wash their hands of anything that could go wrong with the securities.

I don’t see a course of action here, at least not in the legal documents. It certainly is possible that there were problems with the marketing; who knows what winks and nods were given by the salesmen as regards the real quality of these securities. But for that you will need direct testimony from participants; and it would be in contradiction of the disclosures that were made in the legal documents.

But overall, violations of the law in the sale of MBS is not the straightforward case that so many people think it is, not at all. The problem is not that toxic securities were not sold–they certainly were, the problem is that when the toxic securities were sold, the legal documentation attached to them made it perfectly clear that there were absolutely no representations being made regarding their relative level of toxicity.