Post-Crisis Bank Settlements Leave Defrauded Mortgage Securities Investors High and Dry

8 Pages Posted: 21 Sep 2014

See all articles by William J. Dodwell

William J. Dodwell

Consultant to Financial Institutions

Date Written: September 13, 2014

Abstract

The Department of Justice and other public entities sued large banks specifically for misrepresenting the credit quality of mortgage-backed securities (MBS) sold to investors leading up to the 2008 financial crisis, resulting in huge losses for them. However, legal settlements utterly shut out non-agency, or private-label, MBS investors from any relief. Despite naming them as victims of underwriting fraud, prosecutors allocated most settlement proceeds to struggling borrowers who were not even alleged to have been affected by MBS activity, and who already were accommodated in separate litigation. Government entities Fannie Mae, Freddie Mac, and the Federal Housing Authority (FHA) also were indemnified, as well as public pensions. Indeed, private-label MBS investors, relying on credit rating agencies, were effectively dupes in the effort of banks to transfer subprime mortgage risk, largely forced upon them by government to accelerate its affordable housing policy. Yet no compensation for them.

What’s more, so-called “putback” private actions brought by non-agency MBS investors against issuing banks proved unreliable as well. Provisions in the MBS indenture permit those investors to petition issuers to repurchase mortgages underlying MBS securities that do not conform to the underwriting due diligence represented in the offering. But successfully executing a claim is fraught with obstacles, not the least of which is the reluctance of the bond Trustee to challenge the bank that contracts for its services.

Individual and institutional private-label MBS investors ignored in the bank settlements invested through brokerage accounts, 401(k) plans, mutual funds, asset-management accounts, and hedge funds. Loss victims include private pensions, corporate treasuries, non-profits, college endowments, as well as financial institutions which unwittingly purchased each other’s toxic securities. MBS investors holding bank shares before the crisis suffered substantial additional losses also attributable to MBS underwriting fraud, making their compensation more compelling. Notwithstanding the human toll for many homeowners, the magnitude of private-label MBS investor losses overall far exceeds the financial losses of foreclosed or underwater borrowers. In fact, some mortgagees engaged in fraudulent or imprudent borrowing, and most were previously compensated by a $25 billion multi-bank settlement in 2012.

Ironically, government, having sponsored irresponsible lending in the first place, now adjudicates the wrongdoing. Unrepentant, it continues to push its affordable housing agenda through Fannie Mae and Freddie Mac securitizations, and Federal Housing Authority (FHA) mortgage insurance, again putting taxpayers at risk. But now the banks are not as compliant in originating subprime mortgages the GSEs need for their operations, having lost billions from repurchase claims. And if the banks return to securitizing their own loans, private-label MBS investors will insist on provable quality collateral. In the absence of restored private securitization, including non-mortgage asset-backed securities, market liquidity and credit availability will suffer with implications for the entire economy.

Keywords: bank legal settlements, non-agency MBS investors, 2008 financial crisis, underwriting fraud, putbacks, securitization reform, government induced lending

Suggested Citation

Dodwell, William J., Post-Crisis Bank Settlements Leave Defrauded Mortgage Securities Investors High and Dry (September 13, 2014). Available at SSRN: https://ssrn.com/abstract=2498752

William J. Dodwell (Contact Author)

Consultant to Financial Institutions ( email )

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