Kneecapping the banks in remaining FHFA MBS suits
I suspect that the American public doesn’t have much sympathy to spare for the big-time lawyers whose firms have reaped untold millions of dollars defending Too Big to Fail institutions against accusations that they caused the Great Recession. But those lawyers sure cast themselves and their clients in a pitiable light at a securities conference at the New York Bar Association on Tuesday. Brad Karp of Paul, Weiss, Rifkind, Wharton & Garrison, best known for representing Citigroup, said he was “relentlessly pessimistic” about the near-term litigation prospects for banks, given the de facto impossibility of standing up to threats from government enforcers. Scott Musoff of Skadden, Arps, Slate, Meagher & Flom, who defended UBS (and is still defending Societe Generale) against securities fraud claims by the Federal Housing Finance Agency, noted that FHFA’s wards, Fannie Mae and Freddie Mac, were quasi-private concerns when they took on risk from securitized subprime mortgages, yet claims by FHFA are treated as though they’re asserted by a government regulator. And Julie North of Cravath, Swaine & Moore questioned whether it’s fair to preclude banks from attributing investor losses in mortgage-backed securities to the broad economic downturn and not to bank misrepresentations.
If you’re not a bank lawyer, you’re probably more inclined to agree with the underlying sentiment of the keynote address, delivered by U.S. District Judge Jed Rakoff, who dismantled the Justice Department’s “excuses” (his word) for failing to prosecute top corporate officials for causing the economic crisis. Though Rakoff swaddled the speech in caveats, it seemed clear that in his view bank officials merited scrutiny they apparently didn’t receive from prosecutors. So at least when it comes to accountability for criminal fraud, individual bank executives (if not their institutions) should perhaps consider themselves lucky rather than beset.
Nonetheless, North’s discussion of loss causation – shorthand for the banks’ argument that the economic downturn is as least partly to blame for investors’ MBS losses – as well as Musoff’s point about FHFA’s potentially undeserved recovery sent me to the docket for the FHFA cases proceeding before U.S. District Judge Denise Cote of Manhattan. As you know, FHFA has recently settled with JPMorgan Chase for $5.1 billion, with Ally Financial for an undisclosed amount and with Wells Fargo for a reported $335 million. That’s on top of the conservator’s previous settlements with UBS for $885 million and with Citigroup and General Electric for undisclosed amounts. Eleven banks are still facing claims that their misrepresentations about mortgage-backed securities led to billions of dollars of losses for Fannie Mae and Freddie Mac. (I’m counting FHFA’s claims against BofA, Merrill Lynch and Countrywide as one case even though they’re sued separately.)
FHFA has asserted state-law securities claims against 10 of the banks, under so-called “blue sky” laws of Virginia, where Freddie Mac is based, and the District of Columbia, the headquarters of Fannie Mae. If there could possibly be any reason to question whether banks face undue punishment for their securitization practices, FHFA’s motion for partial summary judgment on bank defenses under those blue sky laws might be it.
The conservator’s motion, which was filed at the end of September by FHFA’s lawyers at Quinn Emanuel Urquhart & Sullivan and Kasowitz, Benson, Torres & Friedman, argues that Virginia and D.C. blue sky laws require issuers to compensate investors in full for securities sold via materially deceptive offering materials. There’s no language in the statutes that would permit the banks to limit FHFA’s recovery to losses tied to specific misrepresentations, FHFA asserts, nor any public policy justification for such limits. The only defense to the Virginia and D.C. statutes, according to FHFA, is that the banks didn’t know and couldn’t have known of misrepresentations in the offering materials. FHFA argues that unless the banks can show that reasonable due diligence would not have revealed flaws in the offering materials, then they’re on the hook for the full purchase price Fannie and Freddie paid (less income they received) for deficient MBS, plus 6 percent statutory interest and attorneys fees.
FHFA asked Cote to rule that as a matter of law the banks may not argue for lower damages because some losses for Fannie and Freddie were due to the broad housing market collapse. As you know, this is not the first time that the loss causation defense has popped up in MBS litigation. It was thoroughly vetted in monoline suits against issuers, though all of the monoline loss causation decisions I’m aware of interpreted New York law. Those rulings were also complicated by state insurance law and contract considerations, so they’re not directly applicable, in most instances, to securities claims by MBS investors. A grant of summary judgment to FHFA, on the other hand, would have enormous financial implications in FHFA’s own suits but would also send a powerful message to judges overseeing other MBS securities cases about limits on bank defenses to state-law claims.
The banks filed a joint motion earlier this month to certify to the Virginia Supreme Court the question of whether state blue sky law permits a loss causation defense, citing uncertainty in state law precedent and the billions of dollars at stake in their litigation. The banks’ brief in opposition to summary judgment was filed on the same day but is, unfortunately, not yet available on the public docket of the FHFA cases.
Based on comments at Tuesday’s conference by North and Musoff, whose firms are both defending banks in the FHFA litigation, the banks are undoubtedly arguing that precluding them from attempting to restrict FHFA’s damages and awarding statutory interest that may be more than FHFA would have received from the MBS it purchased amounts to an undeserved windfall for Fannie Mae and Freddie Mac, which may even be in line to recover more than they lost. That outcome would be especially galling to the banks, which have argued since the FHFA litigation began (to little effect with Cote) that Fannie Mae and Freddie Mac knew more about subprime risk exposure than any other player in the mortgage-backed securities market.
Okay, so FHFA’s potential windfall may not change your view of bank liability for the financial crisis. After all, even if Fannie and Freddie had private shareholders when it made bad bets on MBS, its recovery for those losses will go to the government, otherwise known as us taxpayers. On the other hand, we should no more want to recover more than we deserve than we should want prosecutors to mete out less than bank officials deserve. I’ll be interested to see what Judge Cote concludes.
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