Opinion

Alison Frankel

Where’s accountability to MBS investors in $13 bln JPMorgan deal?

By Alison Frankel
October 21, 2013

By all accounts, JPMorgan Chase is on the verge of a record-setting $13 billion settlement with the Justice Department and other state and federal regulators that will resolve the bank’s civil liability to the government for the sale of mortgage-backed securities, by JPMorgan itself and by Bear Stearns and Washington Mutual. We still don’t know precisely what admission JPMorgan will make as part of the deal, and based on the bank’s shrewd blame-taking in its London Whale trade losses settlement with the Securities and Exchange Commission, we can assume any admissions will be tailored to limit collateral damage in private litigation. Nonetheless, regardless of how JPMorgan phrases its acceptance of responsibility, the bank’s $13 billion settlement is an acknowledgment of the obvious: The mortgage-backed securities market was infested at its foundation, like a house gnawed away by termites.

So why are investors in private-label MBS still standing in the rubble of collapsed mortgage-backed trusts? We haven’t seen a final allocation plan for the $13 billion settlement, but I haven’t seen any indication that money has been set aside for private investors in JPMorgan, Bear or WaMu MBS offerings. To the contrary: Certificate holders are already asking whether the bank intends to shift the cost of the settlement’s reported relief to underwater homeowners on to MBS trusts.

Investors in private-label MBS have experienced hundreds of billions of dollars in losses. Let’s look, for instance, at JPMorgan’s description of the fate of mortgage-backed securities sold by the bank and its predecessors Bear and WaMu. According to JPMorgan’s 2012 annual report, the three entities sold a combined $450 billion in MBS to private investors (as opposed to Fannie Mae and Freddie Mac) between 2005 and 2008. More than a quarter of the original face value of the securities, or $118 billion of that $450 billion, has been liquidated, with investors suffering average losses of more than 60 percent on liquidated underlying loans. By my math, that’s about $71 billion in losses for private-label JPM, Bear and WaMu MBS trusts as of the filing of the bank’s annual report last December – with more likely, since the report also disclosed that $39 billion in underlying mortgage loans were at least 60 days overdue.

So private investors in JPMorgan MBS trusts are out at least $71 billion and possibly as much as $90 billion. Of course, JPMorgan and its predecessors aren’t to blame for all of those losses. Some of them, as MBS issuers have been proclaiming since the first MBS fraud suit was filed five or so years ago, were unquestionably due to the collapse of the economy. Homeowners who otherwise would have faithfully paid their mortgages, directing revenue to MBS investors, lost their jobs and defaulted on loans. It’s also true that MBS purchasers were supposed to be sophisticated investors with a high tolerance for risk and their own due diligence capabilities. To return to the termite analogy, MBS purchasers – in the view of MBS defendants – shouldn’t be able to claim that they relied on assurances from a seller when they didn’t take care to bring in their own home inspector.

But what we’ve learned in the last five years – partly through private MBS litigation: first, fraud suits by bond insurers and investors suing through class actions; later, fraud claims by individual investors and breach of contract suits by MBS trustees acting at the direction of certificate holders – is that the MBS process was rigged by sellers. Mortgage originators knew they were writing loans that didn’t meet their stated underwriting standards. MBS sponsors disregarded reports by their own re-underwriters about deficiencies in the loans. Credit rating agencies were more concerned with capturing their share of the lucrative market in rating complex securities than in evaluating the offerings with investors in mind. The sell side knew it was peddling heaps of junk. Many (albeit not all) on the buy side didn’t share that knowledge.

The JPMorgan settlement proves that government entities will recoup at least a chunk of what they lost as a result of the banks’ deception, even though state and federal regulators took far more time than private investors to recognize systemic rot in the MBS market. By the summer of 2011, when the Federal Housing Finance Agency filed a slew of securities fraud cases based on MBS purchases by Fannie Mae and Freddie Mac, untold private investors had already been excluded from class actions by federal judges who generally restricted such cases to trusts in which lead plaintiffs held a stake. To settle its claims against JPMorgan and its predecessors, Fannie and Freddie’s conservator will reportedly receive $4 billion as part of the JPMorgan settlement. The National Credit Union Administration, which has brought MBS fraud suits on behalf of failed credit unions, is also said to be slated for a piece of the settlement, as is the New York attorney general.

Private investors haven’t fared nearly as well in fraud cases. MBS class actions have been a big disappointment for certificate holders, even after the 2nd Circuit Court of Appeals redefined standing to permit more claims. Some certificate holders will recover pennies on the dollar of their losses through MBS class actions. But with total MBS class action settlements totaling less than $2 billion and addressing losses in a very restricted number of trusts, I’m willing to bet that most MBS holders haven’t and won’t see any recovery on their losses through mass litigation. Some individual investors with big MBS losses, including several European regional banks and U.S. investors like AIG, Allstate and Mass Mutual, decided it was worth their while to file individual fraud suits, often relying on state and common law claims after time ran out on their causes of action under federal securities laws. A few of those cases, as I reported last week, have quietly settled on confidential terms. I doubt, however, that if you added up every dollar of recovery for fraud claims asserted by private MBS certificate holders (excluding bond insurers), you’d come up with the $4 billion FHFA is said to be getting to settle its fraud suit.

Investors’ breach-of-contract claims may still bring recoveries that MBS fraud litigation has not. In these suits, as you know, certificate holders in a particular trust direct the MBS trustee to demand that banks repurchase, or put back, underlying mortgages that materially breach contractual representations about loan terms. In the last two years – after Bank of America agreed to settle put-back claims by private Countrywide MBS investors for $8.5 billion – certificate holders have swamped New York state and federal dockets with put-back suits. (Many of the cases have been filed by investor groups that bought MBS specifically to assert put-back claims.) JPMorgan, for one, is cagey about its disclosures on these suits. Its third-quarter earnings report suggests that it has received $1.3 billion in put-back demands from trustees of private MBS trusts, but the bank said that the disclosure excludes claims that are the subject of pending or threatened litigation – and we already know that the big institutional investors that negotiated BofA’s put-back deal have targeted JPMorgan (as well as other banks). It could be that investors in private JPMorgan, Bear and WaMu MBS are demanding breach-of-contract damages for a big percentage of the $71 billion in losses they’ve experienced.

Perhaps put-back settlements will bring private investors recoveries akin to those the government stands to see in the JPMorgan deal. Something’s out of whack if private-label MBS holders can’t mitigate their losses. Our securities regime is premised on a fair balance of information between buyers and sellers. That balance was off in the MBS market, no less for private investors than for the government.

(Reporting by Alison Frankel)

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