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.