Felix Salmon

The law that was broken in the mortgage scandal

By Felix Salmon
October 14, 2010

Update: Thanks to Economics of Contempt. This turns out not to be the cut-and-dried breaking of the law that it looks like. Because it turns out that Section 15E(s)(4)(A) of the Exchange Act is very new: it was only inserted into the Act by Dodd-Frank (page 1,376, if you’re following along at home). So it wasn’t in force when these bonds were issued. You couldn’t do this kind of thing any more — it would be illegal. But Section 15E(s)(4)(A) isn’t enforceable retroactively.

After my post yesterday on the mortgage bond scandal, a lot of commenters said that it looked like a violation of Rule 10b5-1 of the Exchange Act — the bit that prohibits trading on material nonpublic information. Well, it may or may not be a violation of 10b5-1. But that might be beside the point, because this looks like an absolutely textbook violation of Section 15E(s)(4)(A).

This rule is not dense legalese at all. In fact Section 15E(s)(4)(A) is written in very plain English. Here it is in full (see page 231 of the PDF):

The issuer or underwriter of any asset-backed security shall make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

I can’t for the life of me work out how every single mortgage bond that Clayton taste-tested didn’t violate this rule.

And in fact, the SEC has now proposed its own additional rule, which would mandate this kind of due diligence, and would also mandate that the issuer disclose the nature, findings and conclusions of any such taste test.

Up until now, underwriters have not been obliged to do this kind of due diligence. But the fact is that they did it, and that Clayton, in particular, made good money from performing such due diligence for just about every major investment bank in the world. As far as I know, not a single one of those banks disclosed Clayton’s results when they sold their bonds. And that looks to me like a blatant violation of Section 15E(s)(4)(A).

Or is there something I’m missing here? (Obviously, yes, there was.)

Update 2: If Section 15E(s)(4)(A) doesn’t do the job, what are we left with? Well, there’s still 10b5-1, of course. That prohibits the sale of any security on the basis of material nonpublic information. And there’s also Section 17 of the Securities Act:

It shall be unlawful for any person in the offer or sale of any securities… to obtain money… by means of any untrue statement of a material fact or any omission to state a material fact.

Which still does the job, I think.

12 comments so far | RSS Comments RSS


I’m no expert, Felix, but this seems like it would apply only to the reports of the rating agencies.

When I was a mortgage bond manager, it meant that we would get the rating agency presale reports, if there were any.

But I could be wrong. Anyone else have an opinion here?

Posted by DavidMerkel | Report as abusive

So ironic the name of the taste tester..

Check out http://en.wikipedia.org/wiki/Claytons

can be widely applied as in

“US government is a claytons government”

Posted by kmitchelson | Report as abusive

That subsection of Section 15E was added by the recent financial reform bill (specifically, section 932 of Dodd-Frank), and wasn’t in force during the time when these securities were issued. I don’t think it is retroactive in effect.

Posted by alkali | Report as abusive

It doesn’t say it is an “addendum”, alkali, it says it is amendment. I can’t read the original act because it froze twice on download.

It is on line anywhere so I can read it?

Posted by hsvkitty | Report as abusive

Sorry. I wennt running off to look around… and didn’t see the second update. Section 17 surely sounds promising.

Why would the Dodd Franks bill have the fact it is not retroactive only at the very end…. when the date it was signed and enacted and date of enforcement should be in the indexes.

Thanks for this Felix. it gives one hope that there will be enforcement of law and ethics, which is WHY these were enacted in the first place. (to fend off the greedy money grubbers and protect the public … and to charge them if they don’t comply!)

Posted by hsvkitty | Report as abusive

i have believed since the crisis broke that what we have is a conspiracy to commit fraudulent conveyance, and i still think that could work.

Posted by howard7 | Report as abusive

I doubt any law was broken. What was broken was the trust we had in rating agencies and in the management of investment banks and large and small banks. They knew better!!! Any of them that reinvented themselves after the fiasco can kiss a profitable company life goodby. In business, like in a life of crime, you don’t suddenly expect good things after changing your ways. There are consequences to any bad thing. This is one aspect of business that is not being taught in our institutions of higher learning.

Posted by fred5407 | Report as abusive

To be clear, Rule 10b5-1 hinges on the fact that any discounts the banks got from the originators as a result of the banks’ due diligence were not passed-through to the MBS buyers. Yes? If so, how do we know this fact to be true?

Posted by Sandrew | Report as abusive

100b5-1 applies to insider trading based on material nonpublic information, and is not applicable to this case. At least that’s what a top financial lawyer tells me – I am not a lawyer.

Posted by KidDynamite | Report as abusive

Sandrew, we know this fact to be true because they were selling securities, which can be, and were, traded in the secondary market. The price that the banks charge was therefore the going secondary-market price for such things.

Posted by FelixSalmon | Report as abusive

KD, the banks were certainly insiders, and they were certainly trading, and they certainly had nonpublic information, and it was certainly material. What am I missing here?

Posted by FelixSalmon | Report as abusive

10b statute of limitations has probably run at this point. I’m not sure what state law these are typically governed by, but they might have something if it’s NY state, where it’s six years.

Posted by Derrida | Report as abusive

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/