In the last few days, the Department of Justice (as well as the SEC) filed a case against Bank of America over a 2008 prime mortgage securitization that takes breaks some new ground in fraud allegations and is also saber-rattling in the form of launching a criminal investigation into JP Morgan’s sale of mortgage backed securities.
So what’s with the new-found religion? The Snowden effect? Perhaps, but given that cases take a while to gin up, this may be Holder trying to rebuild what little he has left in the way of a reputation after confirming remarks made by others in his office that some animals, um, banks, were more equal than others. From The Hill in March:
Testifying before the Senate Judiciary Committee, Holder told lawmakers that he is concerned that some institutions have become so massive and influential that bringing criminal charges against them could imperil the financial system and the broader economy. His remarks come as a growing number of lawmakers have suggested that big banks are, effectively, “too big to jail.”
“I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy,” he said. “And I think that is a function of the fact that some of these institutions have become too large.”
This statement was widely pilloried and a petition objecting to the “too big to jail” doctrine got over 300,000 signatures. And remember, the roughing up of Holder in the Senate was well-deserved, and at least in part the result of the outrage over the failure to prosecute HSBC or any individuals over large scale, institutionalized money laundering operations. As Matt Taibbi wrote last December:
Despite the fact that HSBC admitted to laundering billions of dollars for Colombian and Mexican drug cartels (among others) and violating a host of important banking laws (from the Bank Secrecy Act to the Trading With the Enemy Act), Breuer and his Justice Department elected not to pursue criminal prosecutions of the bank, opting instead for a “record” financial settlement of $1.9 billion, which as one analyst noted is about five weeks of income for the bank.
The banks’ laundering transactions were so brazen that the NSA probably could have spotted them from space. Breuer admitted that drug dealers would sometimes come to HSBC’s Mexican branches and “deposit hundreds of thousands of dollars in cash, in a single day, into a single account, using boxes designed to fit the precise dimensions of the teller windows.”
So how convincing is the DoJ’s effort to prove its manhood on the banking beat? Well, as we indicated, the suit against Bank of America makes some new types of fraud allegations, but that’s not necessarily a good thing. I hate to be on the same page as staunch bank defender Matt Levine, but it’s hard to like this case. If the legal arguments it makes really do have merit, then why did it wait until the statute of limitations had expired on the deals that helped blow up the global economy to go after…a 2008 jumbo deal? Let us turn the mike over to our house expert, MBS Guy:
This is a strange case in many ways….the DOJ seems to be going much farther in its allegations than it or the SEC have gone in any other MBS or CDO case. In fact, the complaint seems to raise issues that haven’t even been raised or been successful in private suits. As a result, I think the complaint is on fairly weak ground, precedent wise.
However, if the standards applied in the complaint were applied to earlier deals, especially Alt A and subprime deals, hundreds of cases could have been brought by the government against MBS which had similar or worse issues. So why did the DOJ and SEC decide to bring this case, and not others?
For example, the complaint says that BofA committed fraud by not disclosing that the bulk of loans were from its wholesale channel rather than its retail channel and, because performance on wholesale had deteriorated in recent months, BofA should have known that performance would have been weaker.
In addition, the complaint charges BofA with fraud for failing to perform any due diligence on the loans, which was against industry customs and internal BofA policies.
Also, the complaint alleges that BofA included performance statistics that were misleading because they represented the performance of mostly retail loans, rather than the mostly wholesale loans in the deal.
These are the key allegations, though the complaint also highlights loans that were improperly coded or which didn’t comply with underwriting guidelines – more akin to simple rep and warranty cases.
At the time this deal was issued, everyone in the market knew that wholesale loans were generally riskier than retail loans and that issuers had a responsibility to do some diligence. Most investors asked about these things prior to buying bonds in a deal, but they were rarely explicit disclosure items in an offering document. Nor were they disclosure items in this deal. Since the mix of wholesale/retail and amount of diligence weren’t mentioned in the offering document, and were almost never disclosed in MBS, how are the DoJ and SEC going to be able to prove it was fraud to include a lot of wholesale loans or not do any diligence?
Likewise, the comparative performance stats typically included extensive qualifications about past performance not being appropriate for projecting future performance and not being a perfect match for the loans in the deal. This was a much bigger issue for Alt A deals, which had almost no performance history and so relied on very rough proxies to overall portfolio performance. Had this standard been applied to other, earlier deals, almost every Alt A deal, and most subprime deals, would have been in violation of the standard.
Finally, the suit lists two unnamed senior BofA employees as being the parties primarily responsible for issuing a deal they knew was weaker than it was represented to be. Yet, these unnamed execs do not appear as defendants. The allegations make clear that many BofA employees, including a couple of traders, tried to keep bad loans out of the deal and tried to get diligence performed, but the two unnamed execs overruled them. How is it possible that these two get to remain unnamed and uncharged? In contrast, many private suits, as well as the FHFA suits, name everyone at the sued companies who signed the deal documents as defendants against fraud charges (rightly so, in my opinion).
Also, importantly, the suits don’t really allege that the disclosed data and information was incorrect (except in a few limited cases). The wholesale loans were bad, but they were generally originated in accordance with wholesale standards – it was just a weaker channel. The LTVs were low and the FICOs were high (over 720), as was typically for prime deals, and the suit doesn’t say that these numbers were wrong or misleading.
Despite his careful writing style, MBS Guy is on the hanging judge end of the spectrum relative to most mortgage industry participants. So if he can’t wrap his mind around this filing, one has to wonder why the DoJ and the SEC would both file cases that look likely to go splat, particularly when they’ve proven to be very sensitive to losing cases.
Now by contrast, the news of the DoJ investigating JP Morgan criminally for MBS sounds sexy. So curb your enthusiasm. I’d hazard that this case is likely to be about Bear Stearns, particularly since Bear managed to out-do the rest of the industry in the seediness of the practices in its MBS unit. Now the DoJ may well be onto something new, but my guess would be the investigation is related to double-dipping at EMC. The big problem with that idea is that how could the statute of limitations not have expired? But the article clearly refers to subprime mortgages and the subprime market breathed its last in 2007, so they must have found a way around that problem (or have a tolling agreement in place). From the Financial Times:
Investigators from the civil division of the United States Attorney’s Office for the Eastern District of California told JPMorgan in May that they had “preliminarily concluded that the firm violated certain federal securities laws” when it sold subprime loans packaged into securities, the bank said in the filing.
The New York Times has a smidge more detail:
It said that the civil division of the United States attorney’s office for the Eastern District of California, which covers a stretch of land that includes Sacramento and Yosemite, has “preliminarily concluded” that JPMorgan flouted federal laws with its sale of subprime mortgage securities from 2005 to 2007. The parallel criminal inquiry, according to one person briefed on the matter, is in a more preliminary stage.
Adding to scrutiny of the bank, federal prosecutors in Philadelphia are examining whether JPMorgan duped investors into buying troubled mortgage securities that later imploded, according to people briefed on the matter, who spoke on the condition of anonymity.
It’s inconceivable that the DoJ would indict JP Morgan at a corporate level. Not only would Holder not risk destabilizing the bank, there’s simply no way the Treasury would let him go there. If any actual criminal charges are contemplated (remember, this is just an investigation), expect a rerun of the UBS Libor strategy, where UBS paid a large fine for Libor rigging and admitted to criminal conduct…in its Japanese unit. I’d be delighted to be proven wrong, but there’s no reason to expect anything other than new and better optics from the Obama Administration at this late date.