Opinion

Alison Frankel

Banks should fear ominous new rulings in Fannie/Freddie MBS cases

By Alison Frankel
November 9, 2012

JPMorgan Chase filed quite a remarkable¬†quarterly report¬†with the Securities and Exchange Commission on Thursday, crammed with far more details about its exposure to litigation and mortgage repurchase demands than the¬†earnings report the bank issued¬†in mid-October. Among the revelations: JPMorgan has reached an agreement in principle to settle two SEC investigations, one involving a single unidentified JPMorgan securitization, the other involving Bear Stearns’s crafty (alleged) trick of keeping put-back recoveries from mortgage originators for itself instead of passing them on to investors in mortgage-backed securities trusts. The SEC deal has been long rumored, and though we still don’t know any of its terms, the bank’s filing confirms it.

JPMorgan also disclosed that it is now¬†facing put-back claims, in one form or another, on $140 billion in mortgage-backed notes. Yes, you read that right: $140 billion. That doesn’t mean there are $140 billion in claims, but it means that holders of $140 billion in MBS notes have asserted, in litigation or through contractual demands, that the bank must buy back deficient mortgages in their trusts. Given that MBS investors generally claim breach rates in excess of 50 percent, JPMorgan’s exposure to mortgage put-backs is tens of billions of dollars.

The bank, of course, thinks the put-back demands are meritless and its entire litigation exposure is a trifling matter. The SEC filing’s 10-page discussion of the various litigation headaches facing JPMorgan — which include really serious matters, such as the securities class action over its CIO losses, various Libor suits and the Federal Energy Commission’s¬†market manipulation case¬†– begins with the brash assertion that the bank’s “reasonable possible losses” in all of this litigation (aside from its litigation reserves) range from zero dollars to $6 billion.

Zero dollars? I think not. In fact, I’m prepared to say that based on two rulings this week by U.S. District JudgeDenise Cote¬†of Manhattan in the Federal Housing Finance Agency’s securities fraud litigation against MBS issuers and underwriters, JPMorgan has exceedingly low odds of getting out of the Fannie Mae and Freddie Mac conservator’s case — which involves claims on $33 billion in JPMorgan, Bear and Washington Mutual MBS — wit h out a settlement.

More importantly, Cote’s rulings this week make it clear that the judge, who is overseeing the FHFA’s cases against 16 banks that issued or underwrote mortgage-backed securities, does not intend to let any of them out of this litigation.¬†I’ve already told you¬†that the banks still have a slim chance of wiping out most of the FHFA’s claims on timeliness grounds, if the 2nd Circuit Court of Appeals overturns¬†Cote’s holding¬†that Congress intended to extend the obscure statute of repose, along with the statute of limitations, when it passed the law that created the FHFA. But unless the banks win a reprieve from the appeals court, it looks like Cote intends to send Fannie and Freddie’s claims to a jury.

Her rulings this week addressed motions to dismiss by JPMorgan and Merrill Lynch, which are represented by, respectively,¬†Sullivan & Cromwell¬†and¬†Williams & Connolly. (The FHFA is represented in both cases by¬†Quinn Emanuel Urquhart & Sullivan.) In both decisions, Cote dismissed FHFA fraud claims based on the banks’ representations of loan-to-value ratios and owner-occupancy rates in the pools of loans underlying the mortgage-backed notes they offered. But otherwise, she said that Fannie and Freddie’s conservator could proceed with state and federal securities and fraud claims. Cote’s one-two punch against JPMorgan and Merrill rejects just about every substantive argument any of the banks in the FHFA litigation can raise in a dismissal motion — and leaves open the terrifying prospect of rescission and punitive damages against the banks.

In the¬†JPMorgan decision, issued Monday, Cote specifically addressed the adequacy of Fannie and Freddie’s evidence that the bank knowingly misrepresented underwriting standards on the loans underlying various mortgage-backed notes issued by JPMorgan, Bear and Washington Mutual. Cote pointed to the FHFA complaint’s 60-page discussion of deficient underwriting and said they were sufficient to permit the case to proceed. But she also said that the FHFA doesn’t have to show underwriting flaws marred each of the mortgage-backed offerings, just that “there was a systematic failure by the defendants in their packaging and sale of RMBS.” (MBS geeks should note that in explaining this point, Cote refers to the¬†2nd Circuit’s recent ruling¬†on standing in MBS class actions, which has¬†already hurt JPMorgan in another case.)

As she did in her previous ruling denying UBS’s motion to dismiss FHFA claims, Cote once again shrugged off arguments that Fannie and Freddie cannot reasonably claim to have relied on JPMorgan’s representations because they were the most sophisticated MBS investors in the market. That sophistication, Cote said, didn’t give Fannie and Freddie access to the specific information that established deficiencies in the securities they bought. “It is difficult to see how they could help but rely on the representations of defendants, who did have access to those materials,” Cote wrote. “And while (Fannie and Freddie) were certainly aware that they were purchasing securitizations backed by subprime loans, neither the amended complaint nor documents integral to it establish that they knew that the loans supporting these particular securitizations were so haphazardly originated as to put in jeopardy even the AAA-rated certificates they purchased.”

The banks, in other words, are not going to be able to persuade Cote that Fannie and Freddie knew what they were getting when they invested in subprime-backed MBS, so they shouldn’t be able to make claims against issuers. Cote said that the banks can try to persuade a jury otherwise. She also said JPMorgan can tell a jury that it didn’t knowingly deceive Fannie and Freddie. But you have to regard Cote’s references to a jury trial as code for encouraging settlement talks. She’s signaling that she’s not going to be receptive to bank arguments on summary judgment, and warning that if the case continues, the banks will have to defend their underwriting to a group of ordinary people who aren’t likely to be kindly disposed to them.

And if that’s not enough to scare the banks into settlement talks, consider Cote’s findings in Thursday’sdecision¬†upholding just about all of the FHFA’s claims against Merrill Lynch. In particular, Cote refused to rule out the possibility of rescission — which would require Merrill to buy back the FHFA’s holdings in Merrill MBS offerings — and punitive damages. Merrill argued that the FHFA waited too long to file claims to demand rescission under the Securities Act and the common law; Cote said there were plenty of legitimate reasons for the FHFA’s delay in filing. As for punitive damages, which are based on New York law, Merrill asserted that the FHFA hadn’t shown the requisite exceptional misconduct. Cote disagreed, in what has to be considered ominous language for the bank defendants.

“FHFA alleges that the defendants acted recklessly by seeking to profit from ever more risky mortgage lending while, at the same time, passing on the risk (and ultimately the losses) associated with these practices to the public via their sale of securities to Fannie Mae and Freddie Mac,” Cote said. The judge went on to turn the banks’ arguments that Fannie and Freddie’s MBS losses were due to a downturn in the housing market completely against the banks. They’re not the victims of the housing crisis, she wrote, but (at least according to FHFA) the cause of “the most severe economic downturn this country has experienced since the Great Depression.” And yes, she said, “These allegations are sufficient to support the plaintiff’s demand for punitive damages.”

Seems to me that’s a pretty clear warning to the banks, which are now facing a trial date in June 2014. JPMorgan’s zero-dollar prediction aside, I bet we’ll see some FHFA settlements before then.

JPMorgan didn’t respond to¬†Reuters’ request for comment, and a representative of Merrill Lynch parent Bank of America¬†declined comment.

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