by Michael McGraw, Associate Print Editor
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While the crippling collapse of the housing
market that resulted in devastating effects on the national and global economy
began in 2007, 2013 and the next several years have the potential for landmark
litigation results emanating from the Federal Housing Finance Agency’s (FHFA) suit
against eighteen of the world’s largest banks for $200B in damages.
To
any given member of the general public, there can be a level of unawareness as
to how the mortgage crisis impacted his
or her personal finances, but what he or she does know is that whatever happened resulted in a depleted retirement
account and/or investment portfolios. For
the average person wanting to secure a mortgage, he or she contacts a broker or
bank, applies for a mortgage, hopefully receives approval and make their monthly
payments. As such, it can seem abstract
as to how this process could have resulted in such sweeping and damaging economic
effects. However, the reality is that
the majority of mortgages such as these are sold, much like a stock, shortly
after they are executed between a borrower and lender.
Although
borrowers pay their individual payments each month to a given institution, there
are various stages through which a mortgage travels generally unbeknownst to
the borrower:
Stage 1
– Mortgage Origination
An individual decides that he
or she wants to apply for a mortgage. The
individual goes to a bank, mortgage broker or even a private entity to do
so. Once approved, the originator of the
mortgage (i.e., the bank, mortgage company, etc.) closes on the loan. Shortly thereafter, the originator typically sells
the mortgage into a “secondary mortgage market.” The theory behind this subsequent market is to
pass the risk associated with a given mortgage from the originator to a third
party, with the originator quickly receiving returned monies, which allows the
originating party to lend more monies out to new borrowers, ideally keeping the
housing market flowing strong.
Stage 2
–Selling Original Mortgages in Secondary Mortgage Market
To whom do the mortgage
originators sell their mortgages? The
purchasers of mortgages on the secondary market can be private third parties,
ranging from large mortgage originators to institutional investors,
governmental entities or quasi-public entities such as Freddie Mac (Federal
Home Loan Mortgage Corporation) or Fannie Mae (Federal National Mortgage
Association). These entities will then either
hold the mortgages, or pool the mortgages together and trade them as mortgage-backed
securities (MBS) in various formats, each with deviating risks and return
rates.
The most basic format is the
“pass-through MBS,” in which the principal and interest are collected by the
issuer and passed proportionally to bond or loan holders. There is also a derivative and more complex
MBS, the collateralized mortgage obligations (CMO). In CMOs, pass-through MBSs are repooled and
characterized into different risk categories, known as “tranches,” which
provide investors with specific purchasing and investment options depending on
priority of payment, level of risk and rate of return preferences (e.g.. a
hedge fun might prefer a riskier investment, while a pension fund might prefer
a less risky investment). An important
component to the attraction of these securities is a given security’s credit rating,
which affects investors’ decisions whether or not to purchase a particular loan
or bond.
Stage 3
– Selling Mortgage-Backed Securities to Investors
The investors who purchase
these mortgage-backed securities can be entities such as pension funds,
insurance companies, banks, hedge funds, or foreign governments. While the housing market excelled, these purchases
were viewed as solid investments, as the fallacious belief that fueled the
entire mortgage crisis was that housing values always increase.
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While this process represents
a typical flow, multiple foundational cracks at each stage ultimately contributed
to the problems of the housing and mortgage industry:
Stage 1 “Red
Flags” – Mortgage Orientation
One of the methods of
characterizing mortgages is “prime” or “sub-prime.” A prime mortgage refers to one given to a
borrower with good credit and solid, verifiable sources of income and generally
is associated with less borrower-default risk.
“Sub-prime” mortgages refer to those given to a borrower with lower
credit and unverifiable or unverified income sources. Prior to the emergence of the secondary
mortgage market, lenders would be extremely hesitant to give out any sub-prime
mortgages due to their direct risk of financial loss associated with a
potential default; however, with the ability to sell sub-prime mortgages in the
secondary mortgage market, lenders’ inhibitions disappeared, as their concerns
over borrowers’ ability to repay the loan was no longer their direct
concern.
Under the misguided theory
that housing prices would always increase, sub-prime borrowers were given
mortgages that placed those borrowers in serious jeopardy of being able to
repay the loans. A typical sub-prime loan
would be an adjustable rate mortgage (ARM) with a “teaser” that would propel
the interest rate from a lower rate in mortgage’s infant years to a higher rate
following that honeymoon period. The rationale,
retrospectively deluded, was that housing prices would do noting but increase,
so there would always be the ability for borrowers resell or refinance on the
property; however, as housing prices fell, these options became unobtainable
and sizable numbers of borrowers defaulted on their loans.
Stage 2 “Red
Flags” - Selling Original Mortgages in Secondary Mortgage Market
There is strong evidence that
many in the industry became aware that there were a large number of deficient
mortgages being dispensed, which were in turn being sold in the secondary
market, which were then sold to investors, such as the average person’s
pension, 401k, or retirement accounts. But
if those in a position to stop such poor habits were aware what was occurring,
how did this continue?
One position with support is that
Freddie Mac and Fannie Mae are to blame for what occurred, as they are knowledgeable
investors who should not have continued to purchase, hold and sell these bad
mortgages. There is also the position
that the large private institutions who packaged and sold these MBSs were aware
that the they were pooling and selling bad securities, but did their best to shield
any inadequacies and continue to represent the securities as solid buys to
eager investors.
Moreover, why were investors
so eager to purchase these potentially worthless securities? There is another position that credit rating agencies
were manipulating credit ratings, giving high-grade ratings (e.g., AAA) to
investments that should never have received such a level. Some believe that, due to the overwhelming quantity
of work provided to certain credit rating agencies from the large pooling
institutions, the rating agencies were at the mercy of these large institutions
and acquiesced in representing lower-grade loans or bonds as high-grade
commodities.
Regardless of the reasoning, what
transpired left the American and global economy in ruins: borrowers defaulted
on mortgage loans they arguably should never have been given in the first
place, the secondary mortgage market continued to sell substandard pools of MBS
to investors and, when it came time for investors to collect, there was no
money for them to receive.
Controversially, American tax
dollars provided significant financial relief to private financial companies
and quasi-governmental enterprises like Freddie Mac and Fannie Mae. Private investors who lost substantial sums
of money believed material misrepresentations were made regarding the quality
of the securities they purchased. As a
result of this mortgage crisis, prosecutors, investors and regulators have all
litigiously attacked those whom they feel are responsible for the lost billions
of dollars, resulting in some of the world’s largest financial institutions
dealing with abundant, complex lawsuits and/or making settlements for their
involvement in the mortgage crisis.
For example, Bank of America, which in 2008
purchased the country’s largest mortgage originator at the time, Countrywide
Financial, as well as Merrill Lynch, has already paid an estimated $40B in settlements
to private plaintiffs and the government.
JPMorgan Chase, who acquired Bear Sterns and Washington Mutual, settled
a nearly $300M suit with the Securities and Exchange Commission (SEC) for its
role in packing mortgage-backed securities, has been sued by private companies
including Dexia, Group, Syncora Guarantee and
Stichting Pensioenfonds ABP, among others, and estimates that its total
end-cost associated with its role in the mortgage crisis could reach $120B. In
addition, the Department of Justice filed a $5B suit
against Standards & Poor (S & P), one of the country’s largest credit
rating agencies, claiming that it fraudulently misrepresented credit ratings of
MBSs, which investors relied upon in purchasing these securities.
The
strongest stance taken by the government so far is the FHFA’s $200B lawsuit against eighteen major financial
institutions for their supposed role in the financial fallout. In addition to the first party sued by the
FHFA, UBS AG, the other defendants include the following: Ally Financial Inc. f/k/a GMAC, LLC, Bank of America Corporation,
Barclays Bank PLC, Citigroup, Inc., Countrywide Financial Corporation, Credit
Suisse Holdings (USA), Inc., Deutsche Bank AG, First Horizon National
Corporation, General Electric Company, Goldman Sachs & Co., HSBC North
America Holdings, Inc., JPMorgan Chase & Co., Merrill Lynch & Co./First
Franklin Financial Corp. Morgan Stanley, Nomura Holding America Inc., The Royal
Bank of Scotland Group PLC, and Société Générale.
FHFA was appointed conservator of Fannie
Mae and Freddie Mac under the 2008 Housing and Economic Recovery Act. Under this act, the period for filing suit on
behalf of Freddie Mac and Fannie Mae was extended, allowing a suit to be
initiated three years from which a claim accrued (defined as the date of
appointment of the FHFA as conservator).
This statutory timeframe language has been challenged, however, as seen
in what has served as a trial suit against the
aforementioned first major defendant, UBS AG.
UBS
has claimed that the suit was brought too late, according to the Securities Act
of 1933’s statue of repose, which functions to set a fixed time at which a
plaintiff cannot bring an action, regardless of if the time expires prior to
the plaintiff actually experiencing the injury.
The suit’s timing, brought in the Southern District of New York, was
upheld by United States District Judge Denise Cote upon UBS AG challenging on
the aforementioned grounds. However, if
the FHFA v. UBS AG suit is to be later
overturned due to this timing question, as it is currently on appeal to the
Court of Appeals for the Second Circuit, the ramifications could bestow doubt
on the United States’ ability to further collect against these major
institutions.
Perhaps recognizing some warning signs,
General Electric Company became the first of the defendants to settle with the
FHFA, doing so in January 2013, to avoid what has the makings of a lengthy
litigation schedule (UBS, the first defendant, has a trial commencement schedule
of January 2014).
As
thousands of suits have been filed as a result of the mortgage crisis and its pandemic
implications, it is clear that 2013 and the subsequent years have the potential
for billion-dollar settlements and contentious litigation between public and
private parties and some of the world’s largest financial institutions. While there might be positive indications
that the economy and housing industry are in the rehabilitation process, the
legal ramifications for the targeted culprits of the collapse are far from
over.
