To silence critics, SEC should use Option One MBS case as template

May 3, 2012

If you haven’t already, read Jesse Eisinger’s piece for ProPublica and the New York Times on the Securities and Exchange Commission’s case against the upstart credit-rating agency Egan-Jones. The SEC sued Egan-Jones – which challenged the traditional business model for rating agencies by charging users, not issuers, to opine on the riskiness of securities – for exaggerating its bona fides in a 2008 filing. Eisinger questioned the wisdom of sending Egan-Jones “to the guillotine” while letting bigger players, with business models that are susceptible to corruption, off the hook for their patently ridiculous ratings of toxic mortgage-backed securities. “This is your S.E.C., folks,” Eisinger wrote. “It courageously assails tiny firms, and at the pace of a three-toed sloth. And when it goes after its prey, it’s because it has found a box unchecked, rather than any kind of deep, systemic rot.”

Inspired by the piece, I went back to take another look at the SEC’s Apr. 12 complaint against Option One, a relative small-timer in the mortgage-backed securities market. Could Eisinger’s criticism of the SEC’s credit-rating enforcement – that the agency is netting minnows while the sharks swim away – apply just as well to MBS issuers?

Well, yes. But I’m getting tired of asking why the SEC has been so slow to enforce accountability for banks that packaged and sold securities backed by subprime mortgages that didn’t meet even the lax underwriting standards they warranted. So instead, I’m choosing to regard the Option One case as a model for the kinds of actions the already much-maligned mortgage fraud task force keeps promising to bring. From my reading, there’s no reason other MBS defendants can’t be held liable for the same disclosure problems that Option One agreed to settle for $28.2 million.

Granted, the case against the H&R Block subsidiary was clear-cut by the standards of financial fraud litigation. Option One was a major originator of subprime mortgages. In 2006 and 2007 it got into the securitization business. In addition to selling packages of loans to other MBS issuers, it acted as the sponsor of seven MBS trusts with a face value of $4.3 billion, all backed by Option One-issued mortgages. The MBS trust contracts included a provision promising that Option One, as the mortgage issuer, would buy back mortgages that materially failed to meet its representations and warranties. But according to the SEC, Option One knew it didn’t have enough money to make good on those repurchase promises. At the time Option One issued those mortgage-backed notes, H&R Block was quietly propping up its subsidiary, a fact Option One omitted from its MBS disclosures. (For more on Option One and put-backs, here’s a piece I did on the attempts of Sand Canyon, its successor, to block the company that bought the loan servicing business from turning over loan files to noteholders. Stay classy, Sand Canyon!)

How could the SEC extend the theory of the Option One case to other mortgage-backed securitizers? It’s a matter of what MBS issuers knew about the originators of the loans underlying the notes they sold. Option One wasn’t the only subprime mortgage originator that was in trouble in 2007 and 2008: IndyMac, New Century, Ameriquest, American Home Mortgages – the list goes on and on. They all sold loans that were packaged and resold via MBS trusts, which typically offered the same sort of put-back promises as the Option One MBS trusts, assuring investors that the loan originator was responsible for buying back materially deficient underlying mortgages.

In the Option One case, there was a clear link between the originator’s precarious financial condition and the MBS sponsor’s knowledge of the originator’s problems, since the sponsor and originator were one and the same. But couldn’t the same be said about Countrywide and Washington Mutual? History certainly shows those two mortgage giants didn’t have the funds to back repurchase promises. Could their successors at Bank of America and Wells Fargo be liable under the Option One theory? It would be tougher for regulators to use the Option One model against issuers that didn’t originate their own underlying mortgages, but the agency could use its subpoena power to find out what exactly the banks snapping up mortgage portfolios from the likes of New Century knew about originators’ true ability to make good on repurchase claims. My guess is that many of the banks were well aware of their mortgage suppliers’ problems.

My Reuters colleague Aruna Viswanatha has been doing a bang-up job covering the mortgage-fraud task force. Last month, for instance, she reported that the Justice Department used the obscure 1989 Financial Institutions Reform, Recovery, and Enforcement Act to issue MBS-related subpoenas to top financial institutions. FIRREA violations, which require a lower burden of proof than criminal charges, carry stiff civil penalties for misconduct like mail and wire fraud. But there’s nothing wrong with an old-fashioned disclosure case, either. The SEC got almost $30 million from Option One without even explaining a damages theory. If it can do the same against some of the bigger names in mortgage-backed securitization, that would shut its critics up.

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