Mortgage lawsuit against JPMorgan offers refresher on basic compliance lessons

October 3, 2012

By Stuart Gittleman

NEW YORK, Oct. 3 (Thomson Reuters Accelus) – Securities issuers that claim to have conducted due diligence on their offerings should address and remediate problems found and not ignore red flags, as made clear by the New York state fraud lawsuit against JPMorgan over they way its Bear Stearns unit dealt in mortgage securities.The warnings may remind compliance and supervisory professionals of their early lessons, such as:

  • if you disclose that you will do something, do it;
  • if you don’t do it yourself, outsource it to a qualified well-vetted service provider;
  • conduct ongoing verification that the service provider is providing the service and maintaining the agreed-upon level of quality;
  • be sure the service provider is independent, and don’t interfere with that status;
  • follow up on exception reports and red flags from the service provider; and
  • you can outsource the work, but you still have a duty to supervise.

The reminders came in a state court lawsuit filed by New York Attorney General Eric Schneiderman against J.P. Morgan Securities LLC, formerly known as Bear Stearns & Co. Inc.; JP Morgan Chase Bank, N.A.; and EMC Mortgage LLC, formerly called EMC Mortgage Corporation.

The litigation, which was brought under the state’s Martin Act, involves residential mortgage-backed securities (RMBS) that were packaged and sold by Bear Stearns before it collapsed in March 2008 and was sold under fire-sale circumstances to JPMorgan Chase.

The complaint alleged that the defendants made fraudulent misrepresentations and omissions to promote the sale of the securities. Bear Stearns had represented that the quality of the underlying loans had been carefully evaluated and would be continuously monitored, but it failed to evaluate the loans, largely ignored any defects found, and hid the findings and the inadequacy of its review procedures.

Bear Stearns was motivated to keep the process going because of the revenue it generated, the complaint said. The company received fees on loans originated by its affiliates; proceeds from the sale of RMBS; fees from underwriting the securities and from servicing the loans; fees from collateralized debt obligations (CDOs) into which the securities were repackaged; gains and fees from trading the securities and interest in the CDOs; and management fees and carried interest from hedge funds and other investment vehicles that invested in the products Bear structured.

Bear Stearns was accused of failing to abide by its representations that the loans were made in accordance with the applicable underwriting guidelines to ensure, among other things, that loans were extended to borrowers who had shown they would repay. Bear claimed to have conducted due diligence to ensure that the loans it bought from originators, including ECM, complied with the standards but it routinely overlooked defects that were identified by the due diligence provider and ignored known deficiencies in the due diligence review process.

Clayton Holdings, one of Bear Stearns’ due diligence providers, brought to Bear’s attention potential discrepancies between the underwriting standards disclosed to investors and the quality of the actual loans, but the bank failed to follow up, the complaint said.

Bear Stearns knew Clayton’s employees were pushed to emphasize speed over quality in their loan reviews, the complaint alleged. “Due diligence reviewers were made to understand that because the loans could not be undone, a thorough reevaluation of loan quality was unnecessary, and even pointless,” it said.

Bear Stearns also knew Clayton’s managers had a conflict of interest between ensuring high quality due-diligence loan reviews and keeping Bear Stearns’ extensive business, the complaint added. It said Clayton’s revenue-driven approach was, as a former supervisor put it, to not “upset the apple cart.”

Bear Stearns had a quality control unit to detect red flags in loans after they were securitized, to determine whether they complied with underwriting guidelines, the complaint said. The unit was tasked with identifying and correcting problems in the loans and, if appropriate, having the originators buy the loans back, but it had too much work to function properly. Bear Stearns was aware of the crisis but took no action, and when the unit identified serious problems, the firm settled with the originators at the investors’ expense without disclosing the problems or practices to investors, the complaint said.

JPMorgan said it would contest the allegations and noted they concern actions by Bear Stearns before the investment bank was acquired by JPMorgan.

Clayton Holdings was not named as a defendant to the suit, and the company declined to comment on the allegations in the New York complaint. The firm had entered a cooperation agreement with New York in 2008, after receiving a subpoena for information. In 2007 Clayton Holding’s then-president, Keith Johnson, told Reuters that lenders had relaxed their underwriting standards during the housing boom and Wall Street firms followed suit by easing their guidelines that due diligence companies followed. “We were hired by the buyer … In hindsight, we got away from the roots which is saying ‘This is a good loan that is going to pay and this is a bad loan,'” Johnson said.

More to come?

Schneiderman announced the filing in his role as co-chair of the credit-crisis-related federal-state RMBS working group President Barack Obama created in January, but the underlying probe goes back to before the subprime lending bubble burst.

New York’s Martin Act gives Schneiderman’s office broader investigative authority than other working group members, such as the Justice Department and the Securities and Exchange Commission, possess, and the state’s inquiry has been underway since 2007.

Other authorities in the working group members may draw on the state’s investigation, Schneiderman noted. “We believe that this is a workable template for future actions against issuers of residential mortgage-backed securities that defrauded investors and cost millions of Americans their homes. We need real accountability for the illegal and deceptive conduct in the creation of the housing bubble in order to bring justice for New York’s homeowners and investors,” he said.

Schneiderman’s announcement of the lawsuit was hailed by two other working-group representatives, Colorado U.S. Attorney John Walsh and Federal Housing Finance Agency Inspector General Steve Linick.

“This announcement demonstrates that the RMBS working group model works,” said Walsh.

Linick alleged that Bear Stearns misled Fannie Mae and Freddie Mac, which are monitored by the FHFA, about the quality of the loans in the RMBS the agencies bought.

“Actions like this contributed to the financial crisis and those who engaged in such activities should be held accountable,” Linick said.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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