Alison Frankel

For the last three years, since the housing bubble burst, the Securities and Exchange Commission has been investigating the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac). Fannie and Freddie, after all, were the biggest players in the mortgage lending and securitization business, and there’s a lot of sentiment that they deserve a hefty share of blame for encouraging the financial industry’s voracious appetite for mortgage loans, no matter how deficiently underwritten. The problem for regulators hoping to hold Fannie and Freddie accountable, though, is that the previously quasi-private agencies went into public receivership conservatorship in 2008. Any SEC suit against Fannie and Freddie would essentially be one wing of the U.S. government seeking damages against another.

But the people who ran Fannie and Freddie in the run-up to the mortgage meltdown were another story. About nine months ago the SEC issued Wells notices to top Fannie and Freddie executives. I’ve heard there was virtually no give-and-take between regulators and defense lawyers for the executives after initial defense responses. So it was a disappointment but not a big surprise to the defendants when, on Friday, the SEC sued three former top officials from both Fannie and Freddie. (Here’s the SEC’s complaint against Richard Syron, Patricia Cook, and Donald Bisenius of Freddie Mac; and here’s the complaint against former Fannie Mae execs Daniel Mudd, Enrico Dallavecchia, and Thomas Lund.) The SEC complaints charge two defendants in each case with full-on securities fraud (the third official in each complaint faces aiding and abetting claims) for allegedly misleading investors about their agencies’ exposure to subprime mortgages. In the Freddie complaint, the SEC asserts that the agency claimed only $2 to $6 billion of its single-family guaranteed mortgages were considered subprime loans, when, in fact, $140 billion to $244 billion in loans fit that classification. Fannie allegedly reported $4.8 billion in exposure when its subprime lending exceeded $40 billion.

There are a few points to keep in mind about the Fannie and Freddie suits. First, the allegations all center on disclosures. There’s no accusation of accounting manipulation or more obvious fraudulent acts. Yet four of the defendants are accused of intentionally defrauding investors — partly because Fannie and Freddie were not registered entities during the entire period of alleged wrongdoing, which means the execs couldn’t be accused of negligence. That’s a high bar, in which the agency has to show the defense acted with fraudulent intent. Second, the former Fannie and Freddie executives — unlike the Citigroup executives who agreed to an administrative settlement in the bank’s 2010 subprime exposure agreement with the SEC — had no leverage because the SEC wasn’t also negotiating with their employer. There was little reason for financial regulators to reign in aggressive allegations, especially because there’s a strong public-relations incentive for the SEC to charge senior executives of agencies that ended up in such severe straits that they had to be placed in receivership, with taxpayers bearing the burden of management’s overly risky strategy.

But if you parse the SEC’s complaints, you’ll see the weaknesses in the agency’s cases. Let’s start with which sector of Fannie and Freddie’s business the allegations involve. The government-sponsored entities, as they’re known, bought lots of subprime loans for the portfolios they securitized and resold as mortgage-backed notes. But that’s not where the SEC accusations lie. The SEC asserts that the Fannie and Freddie officials misrepresented subprime exposure in the mortgage-guarantee business, in which the agencies offered government backing for individual mortgage loans.

Both Fannie and Freddie had, at least in theory, strict guidelines on these guaranteed loans, in which they required mortgage lenders to assure, for instance, that borrowers met income requirements. Fannie and Freddie also bought guaranteed loans from prime lenders, not traditional subprime lenders.

It’s unquestionably true that as Wall Street’s hunger for mortgages to securitize encouraged prime lenders to abandon their own underwriting standards, Fannie and Freddie backed ever-shakier loans, as their internal controls noted. But were loans by prime lenders who purported to meet underwriting guidelines “subprime” loans for disclosure purposes?

The SEC says they were. The Freddie Mac complaint cites a glossary of terms the agency presented to its own board: “There is no longer a clear-cut distinction between prime and subprime mortgages as the mortgage market has evolved,” the glossary said, but Freddie officials relied on the old definitions — that subprime exposure came from loans originated by subprime lenders — in investor disclosures. Similarly, the complaint against Fannie cites a 2008 10Q in which Fannie Mae admitted that more of its traditional guaranteed mortgages resembled subprime loans, but it was not classifying them as such because they didn’t meet Fannie’s definition of subprime loans. (Nor, for that matter, the definition the Treasury Department promulgated in 2007.)

Both Fannie Mae and Freddie Mac — even as they declined to reclassify loans as “subprime” and failed to disclose that increased exposure to investors — did disclose reams of information about the loans they guaranteed. Expect their lawyers to argue that investors were fully apprised of the increasingly risky nature of the mortgages the GSEs were backing.

In other words, the case will turn on how Fannie Mae and Freddie Mac defined subprime loans, and whether executives committed fraud when they did not revise internal definitions to reflect the changing mortgage market. (The complaints are filled with phrases like “subprime-like” and “otherwise subprime.”) From what I hear, the defendants are vowing to fight the SEC all the way to trial (where, OTC has reported, the agency has a decidedly mixed track record). The agency will also have to face formidable defense teams. Here’s the lineup: Thomas Green of Sidley Austin for former Freddie CEO Richard Syron; Steven Salky of Zuckerman Spaeder for former Freddie Chief Business Officer Patricia Cook; Walter Ricciardi of Paul, Weiss, Rifkind, Wharton & Garrison for former Freddie Executive Vice-President Donald Bisenius; James Wareham of DLA Piper for Fannie Mae CEO Daniel Mudd; Laurie Miller of Nixon Peabody for Chief Risk Officer Enrico Dallavecchia; and Michael Levy of Bingham McCutchen for Executive Vice-President Thomas Lund.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

Last Friday evening, after the Federal Housing Finance Agency filed 17 blockbuster suits against just about every major issuer of mortgage-backed securities, the buzz was about the staggering size of Fannie Mae and Freddie Mac’s investments in mortgage-backed notes and certificates. The suits, 13 filed by Quinn Emanuel Urquhart & Sullivan and four by Kasowitz Benson Torres & Friedman, cite about $196 billion in MBS holdings by Fannie and Freddie. Under both state and federal damages theories, the suits demand rescission, or a buyback of the notes by their issuers. Does that mean we should we assume that FHFA has $196 billion in claims?

Nope. Not even close. FHFA doesn’t specify any damages numbers in the complaints filed Friday, but in the agency’s previously-filed $4.5 billion MBS suit against UBS, FHFA asserted that Fannie and Freddie had “lost in excess of 20 percent” of their investment in UBS notes, including unrealized losses. Apply that rough logic to the FHFA’s new suits, and the agency’s claims are knocked down to $40 billion — a huge number, to be sure, but not a heart-stopping one. The banks, meanwhile, are cranking up defenses to shrink even that reduced estimate of FHFA losses. One bank defense lawyer told me Tuesday that by his firm’s calculation, which I’ll explain later, Fannie and Freddie have actually realized losses of no more than about $50 million on their $4.5 billion investment in UBS mortgage-backed certificates. Do the math: if FHFA’s losses are similar across the board, that would put Fannie and Freddie’s recoverable damages on MBS securities claims in the universe of a few billion dollars.

That is, of course, a lot of supposition. But any estimate of banks’ MBS liability, by necessity, involves supposition. MBS investor litigation is so new that there’s not much precedent to guide predictions of how FHFA’s suits, or those of any other MBS investor, will fare in court or in settlement talks. So far, there’s only been one public settlement of an MBS securities case — Wells Fargo’s $125 million deal in a class action involving investors in 28 MBS offerings. Lots of other MBS investors have filed federal court cases, including several class actions, but the litigation hasn’t progressed very far. (Late Tuesday FHFA put out a press release that clarified its damages theories and claims, spelling out some of the same points I make below.)

So, let’s take a look at what Fannie and Freddie are claiming and how the banks are likely to respond. As an initial matter, it’s important to distinguish between the two kinds of suits investors can bring against MBS issuers and originators of the underlying mortgage loans. One class of cases involves contract claims based on the representations and warranties issuers and originators made about the underlying mortgage loans. Under standard MBS securitization agreements, if investors can show that underlying mortgages don’t measure up to the stated standards, they can demand that issuers buy back those deficient loans. Those are straightforward breach of contract claims, but there’s a big catch: In order to bring a so-called put-back suit under standard securitization contracts, investors have to control 25 percent of the voting rights within an individual MBS trust. Gibbs & Bruns was able to negotiate the proposed $8.5 billion Bank of America MBS settlement, which would resolve investors’ representations and warranties claims, because its group of 22 large institutional investors had the requisite voting rights in more than 200 Countrywide trusts. Fannie and Freddie previously settled their own reps and warranties claims against BofA (for mortgages they bought directly from Countrywide) in a $3 billion deal last January. But generally, plaintiffs lawyers have struggled to piece together coalitions of investors to cross that 25 percent threshold and bring contract claims.

Most investors — including Fannie and Freddie in the suits filed Friday — have instead asserted securities law claims against MBS issuers under federal, state, and common law theories. The housing finance agency’s federal claims are based on the Securities Act of 1933. There are two key reasons why. The ’33 Act sections FHFA is asserting involve standards for offering documentation. Under those provisions, investors don’t have to show that issuers intended to deceive them or that they relied on the allegedly misleading documents. As I’ve previously explained, the ’33 Act holds issuers to a strict liability standard, meaning investors just have to show that an offering statement contained false representations about the securities. As alternative routes to the same damages they’re seeking under the ’33 Act, Fannie and Freddie are also making claims under Virginia and District of Columbia securities laws, and under common law fraud or negligent misrepresentation theories.

Under both the state and federal claims, FHFA can demand that the banks repurchase securities issued under false offering documents. Here’s where MBS contract cases and securities cases intersect: Both types of suits rely on investors’ claims that issuers misrepresented the underlying mortgage loans. Fannie and Freddie’s complaints against the banks offer pages and pages of evidence that issuers fed investors false information about the quality of the underlying loans. On their face, the complaints make quite a compelling case for issuer liability.

Don’t underestimate the banks’ potential defenses, though. There’s reliance, for instance: Fannie Mae and Freddie Mac practically invented the business of securitizing mortgage loans, so they were among the most sophisticated MBS investors in the market. Did they really rely on issuers’ representations about the underlying mortgages? That’s not a defense the banks can assert against FHFA’s federal-law ’33 Act claims, which don’t depend on reliance. But it will come into play in the state and common-law causes of action. The banks will also point to disclaimers in their MBS offering documents , and they’ll argue that some of the allegedly-false statements, such as home appraisal values, are non-actionable opinions. Despite tolling agreements with FHFA, they may have statute-of-limitations defense as well; Los Angeles federal judge Mariana Pfaelzer, in the Countrywide MBS litigation now consolidated before her, has set a cut-off date for claims that will help Countrywide enormously.

The banks’ best defense, however, will be to question how much Fannie and Freddie actually lost as a result of the allegedly misleading offering documents. This is a two-pronged argument. First, the banks will assert that any value their mortgage-backed securities lost is due to the overall decline in the housing market and the general economy, not to problems with their MBS offerings. (We saw defendants use that argument, to varying degrees of success, in securities class actions alleging shareholders were deceived about subprime mortgage exposure.) Finally — and this is the banks’ last, best defense — they will argue that Fannie and Freddie haven’t lost much on their MBS investments.

Believe it or not, MBS notes haven’t been the total debacle you might think if you spent all your time reading investors’ complaints. Many trusts have been paying principal and interest more or less on schedule. Remember that $50 million in UBS mortgage-backed losses one bank defense firm calculated? The firm (which doesn’t represent UBS), analyzed the value of FHFA’s UBS investments using MBS trustee reports and Bloomberg data on already-paid principal, interest, and trading value of the securities the housing finance agency specified in the UBS complaint. By the defense firm’s calculation, Fannie and Freddie had lost about $48 million as of July, when the FHFA complaint was filed, and $50 million as of September 1.

So even if the notes are worth less today than they were at time they were issued, the banks will argue, Fannie and Freddie have already received billions in repaid principal and interest from their MBS investments, with billions more still to come from securities that continue to perform.

These are heady days for litigators, given the widespread theory that the economy can’t recover until banks resolve their liability for mortgage-backed securities. For the rest of us, here’s hoping for some clarity, the sooner the better, on the parameters of that liability.

For more of Alison’s posts, please go to Thomson Reuters News & Insight

Follow Alison on Twitter