Current Loan-Level Information Would Have Prevented Potential Fraud on RMBS Investors

Bloomberg reported on potential double standards in RMBS deals for bad mortgages that would be easily prevented with current loan-level data on an observable event basis managed by an independent firm with no conflicts of interest.

The action that gives rise to potential double standards:

JPMorgan Chase & Co. demanded that a lender repurchase bad mortgages even while resisting calls that it buy back the loans from bonds created by Bear Stearns Cos., an insurer said in court papers. 

Potential Double Standard 1:  Denying a mortgage for repurchase from an RMBS deal while seeking to put back mortgage to lender who sold mortgage.

Naturally, investors and insurers believe that the terms of the deal of the RMBS transaction entitle them to symmetrical treatment:  mortgages that are put back to the lender for repurchase should be repurchased from the collateral pool.   Ambac filed a suit arguing just this against JPMorgan.

... Mortgage-bond investors and other insurers, including Allstate Corp., Pacific Investment Management Co. and MBIA Inc., have accused loan sellers or bond underwriters of sometimes misrepresenting the quality of the underlying debt enough to trigger contractual or legal provisions requiring repurchases.  

... Bear Stearns sought on March 11, 2008 -- just weeks before the collapsing company agreed to be bought by JPMorgan -- to have a lender buy back mortgages in bonds insured by Syncora Guarantee Inc., according to the filing. Bear Stearns said the mortgages failed to meet promised standards of quality.

At the same time, Bear Stearns was denying demands from Syncora that it repurchase the loans, even though the insurer cited the same flaws, according to the filing. Bear Stearns had bought the loans and packaged them into bonds to sell to investors.

... JPMorgan later maintained “that it is EMC’s position that these breaches materially and adversely affect the value” of the loans, according to the complaint, which cited a June 26, 2008, letter from Alison Malkin, an executive director in JPMorgan’s securities unit, to the lender, a now-closed unit of Capital One Financial Corp.

“Remarkably, Malkin took diametrically opposing positions in repeatedly refusing to comply with all but 4 percent of Syncora’s repurchase demands,” Ambac said in the proposed amended complaint.

... The bank also ignored the findings of mortgage-review firm Clayton Holdings LLC in abandoning mortgage repurchases that Bear Stearns had been considering in early 2008 stemming from a pool of 596 of loans in bonds guaranteed by Ambac, according to the insurer’s amended complaint.

Clayton found that 56 percent of the loans involved “material” breaches of Bear Stearns’s contractual promises, according to the filing, which cited a copy of a November 2007 document from the review firm to the company.

As Malkin overruled Bear Stearns decisions on which mortgages to repurchase to limit JPMorgan reserve expenses, the portion of those loans that were approved for repurchase fell to 2.2 percent by September 2008, according to the complaint.

Proof that the bank ignored a third-party review is “major, that’s hugely newsworthy,” said Isaac Gradman, a San Francisco- based consultant and formerly a lawyer at Howard Rice Nemerovski Canady Falk & Rabkin.

With the Syncora loans, “if they’re making an argument out of one side of their mouth and a different argument out of the other, that is arguably a breach of an implied covenant of good faith and would be very strong evidence to prove repurchase demands,” he said in a telephone interview. Gradman represented mortgage insurer PMI Group Inc. in a now-settled lawsuit over similar issues against General Electric Co. and its defunct mortgage unit.

Potential Double Standard II:  Accepting money or other consideration from the lender that sold the mortgage on the basis of defects or early non-performance and not forwarding this immediately to the trust holding the mortgage.  The working assumption here was that the investors would be made whole by the firm insuring the deal.

Ambac also alleges in its proposed complaint that, as early as 2005, Bear Stearns was making a strategy out of earning “double” money on shoddy mortgages. First Bear Stearns sold securities backed by the debt, then forced the mortgage lender that sold it the loans to pay up when they turned delinquent in the first few months or were otherwise proved to have breached originators’ representations, Ambac said.

Bear Stearns generally wouldn’t refund investors with that second pool of money, Ambac said in the filing.

While such so-called early payment defaults may not require repurchases of mortgages out of securities by the issuers of the bonds, because of differences between securitization contracts and those entered into by lenders, Bear Stearns’s policy raised questions at the time, according to the complaint.

External auditor PricewaterhouseCoopers LLP advised Bear Stearns in August 2006 that it needed to review loans that were defaulting or defective to see if their quality breached its obligations and begin the “immediate processing of the buy-out if there is a clear breach in order to match common industry practices, the expectation of investors and to comply” with its mortgage bonds’ contracts, according to the amended complaint.

Its own lawyers by early 2007 were making similar suggestions, according to the complaint.

By the end of 2005, Bear Stearns had moved to making sure to securitize home loans before their early payment default periods ended, without informing investors and insurers of the switch, according to the complaint.

Then, if the loans went delinquent or were otherwise found defective, the company would seek settlements from lenders, rather than repurchases, which would have required the cash paid by originators to flow through to the securitization trusts so the debt could be passed back, according to the complaint.

“That is how we pay for the lights,” one employee told another in an Aug. 11, 2005, e-mail cited in Ambac’s filing.

In 2007 and the first quarter of 2008, Bear Stearns resolved repurchase claims to lenders on more than $1.3 billion of mortgages through settlements or for other consideration, according to the complaint, which cited the deposition of an employee. The securities firm received more than $367 million of “economic value,” according to the complaint.

The case is Ambac v. EMC Mortgage, 08-cv-9464, U.S. District Court, Southern District ofNew York (Manhattan).

Current loan-level performance information on an observable event basis would greatly reduce, if not eliminate the ability of a Bear, Stearns/JPMorgan to act in the manner alleged in the complaint.

• If the investors know how the mortgages are currently performing, they can reject bad mortgages before they ever become a part of the deal.  
• If the investors know how the mortgages are currently performing, they would also know if the lender that sold the mortgage was repurchasing or otherwise making a settlement payment on the mortgage.  This would allow the investor to make sure the proceeds were forwarded to the trust.  At a minimum, investors and insurers would know that there was far less collateral in the trust. 

At a minimum, the allegations in this case raise the standard of due diligence that must be done by European credit institutions under Article 122a before they can invest in a private label RMBS deal.  It is hard to claim to know what you own if the mortgages in the collateral pool have already been put back to the lender under a settlement.