Tuesday, September 6, 2011

FHFA lawsuit against banks over mortgage-backed securities documents Wall Street's informational advantage

The FHFA lawsuit on behalf of Fannie Mae and Freddie Mac memorializes the informational advantage that Wall Street had regarding mortgage-backed securities and how Wall Street used this advantage to the detriment of other market participants.

Regular readers know that Wall Street invested in and purchased sub-prime mortgage originators and servicers to gain an informational advantage over other market participants.  Their investments and acquisitions put Wall Street's traders in the position of having tomorrow's news today while all other market participants had tomorrow's news several days or weeks later.

Your humble blogger has talked about this informational advantage since before the credit crisis.  My focus has always been on the need to eliminate this informational advantage to restore confidence in and attract investors back to the private RMBS market.

It is the FHFA lawsuit that has shown how the informational advantage could be used for fraud.  Courtney Comstock wrote a long post discussing the FHFA lawsuit, Goldman Sachs and Dan Sparks.
And there are two big reasons why the FHFA says Goldman's actions were fraudulent. In short, they are the money it paid to get a window into the mortgage origination process and Dan Sparks. 
Here's the first. From a key sentence in the FHFA lawsuit: 
Because the information that Goldman provided or caused to be provided [to ratings agencies] was false, the ratings were inflated... [and] also that Goldman Sachs knew, or was reckless in not knowing, that it was falsely representing the underlying process and riskiness of the mortgage loans... because Goldman’s longstanding relationships with the problematic originators, and its numerous roles in the securitization chain, made it uniquely positioned to know the originators had abandoned their underwriting guidelines... [and because] as a result, the GSEs paid Defendants inflated prices for purported AAA (or its equivalent) Certificates, unaware that those Certificates actually carried a severe risk of loss and inadequate credit enhancement.
The big thing here is that Goldman funded mortgage originators, who encouraged property appraisers to inflate home values by firing them if they didn't and gave half million dollar loans to people like hairdressers and gardeners.... 
Goldman is also on the hook because it saw the poor quality of the loans it bought from the mortgage originators it funded (the lawsuit says Goldman received daily updates on how many loans were delinquent), retained third-party due diligence providers to analyze those loans that it considered securitizing regardless of the delinquencies (a smart move considering that it might have absolved Goldman of responsibility for any poor-quality loans in the Securitizations) but Goldman didn't listen to the companies' recommendations to exclude a significant number of loans. Goldman included the loans in its Securitizations anyway. Then it got the ratings agencies to rate them attractively. But it stated in offering documents that the loans had generally met the guidelines of the due diligence review.
Please re-read the highlighted section of the lawsuit again.

Your humble blogger has been saying since before the start of the financial crisis that all structured finance market participants should have access to daily updates on all the observable events that occurred involving the underlying loans.  Observable events include payments and non-payments/delinquencies!

Compare and contrast the use by Wall Street of observable event based information to the once-per-month disclosure that the Wall Street dominated industry trade groups (American Securitization Forum and the European Securitisation Forum/Association for Financial Markets in Europe) have argued is adequate to the SEC, ECB, BoE and CEBS - regulators who tried to bring asset-level performance transparency to structured finance.

Clearly, the trade groups are trying to protect Wall Street's informational advantage.  However, with the FHFA lawsuit, Wall Street's informational advantage is over as all market participants will have to have access on an observable event basis.

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