Notebook on MBS Litigation: The Securities and Exchange Commission Could Be Going to School on Private Litigation Being Brought against MBS Issuers

By Rao, Pravin; Lee, Suleen | Mortgage Banking, April 2011 | Go to article overview
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Notebook on MBS Litigation: The Securities and Exchange Commission Could Be Going to School on Private Litigation Being Brought against MBS Issuers


Rao, Pravin, Lee, Suleen, Mortgage Banking


Despite recent statistics showing an overall decline in securities lawsuits stemming from the subprime mortgage crisis, civil claims against the banking industry for losses related to mortgage-backed securities (MBS) do not appear to be slowing anytime soon. * Plaintiffs in these cases--mostly institutional investors--have alleged that banks misrepresented the underwriting standards used to evaluate the borrowers' ability to repay the loans underlying the securities. For instance, in February, Massachusetts Mutual Life Insurance Co., Springfield, Massachusetts, filed a lawsuit against Deutsche Bank Securities Inc., an indirect subsidiary of Frankfurt, Germany-based Deutsche Bank AG, alleging that the bank had misrepresented certain characteristics of loans backing its MBS and disregarded or abandoned underwriting guidelines. * The Allstate Corporation, Northbrook, Illinois, has filed similar suits against JPMorgan Chase & Co., New York, and Countrywide Financial (now Bank of America, Charlotte, North Carolina), seeking damages related to its purchases of nearly $1.5 billion in MBS from these banks. Even before the Allstate suit was filed, Bank of America disclosed in its Securities and Exchange Commission (SEC) quarterly 10-Q report for the third quarter of 2010 that it was facing multiple lawsuits alleging misstatements or omissions in the issuance of $375 billion in MBS. * Citigroup Inc., New York, similarly disclosed in its fourth-quarter 10-Q that it was facing at least five investor lawsuits involving billions of dollars more of these same securities. * In terms of actual recovery, however, the investors filing these suits have faced a number of challenges--including stringent pleading standards and statutes of limitation. Yet, the uncertain track record resulting from civil litigation over MBS will not necessarily translate to similar outcomes in potential enforcement actions pursued by the SEC.

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For one thing, procedural technicalities such as pleading standards and statutes of limitation that have hampered civil suits will not impede an SEC action. In fact, it appears that the SEC has already begun focusing its investigative resources on MBS-related improprieties; sources have confirmed that an SEC investigation was well under way as of December 2010,

This article discusses how MBS have become a significant priority for the SEC's investigative resources, describes what might constitute a potential SEC action against banks, and suggests proactive measures banks should take to ensure they do not become ensnared by regulatory or private litigants.

Background

MBS emerged from a small niche in the bond market to a multi-trillion-dollar segment in the years leading up to the subprime mortgage meltdown. Large banks (mostly Wall Street firms) quickly learned that individual mortgage loans could be transformed into financial commodities. Thus, the banks (called depositors in this process) began purchasing loans from smaller lenders (also called originators), pooling residential real estate mortgages together, and then transferring these assets into the possession of trusts created by the depositors.

The assets then were securitized and partitioned off as MBS, being sold to institutional investors who would receive cash flows generated from the underlying mortgages in exchange for their purchase of these securities.

In the years leading to the housing collapse in 2007, smaller lenders became increasingly willing to lend money to borrowers with little documented ability to repay the loans, then reselling these loans to larger banks. Some of the larger banks buying up the loans appeared to become lax in their own securities underwriting, having underwriters (charged with the task of evaluating the pool of mortgages) accept the entire pool--even if the pool included borrowers who were likely to default.

Once the mortgage crisis hit, investors realized that their purchases of MBS were not as safe as they initially appeared.

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