If you haven't already, read Jesse Eisinger's piece for
ProPublica and The New York Times on the Securities and Exchange
Commission's case against the upstart credit rating agency
Egan-Jones. The SEC sued Egan-Jones -- which challenged the
traditional business model for rating agencies by charging
users, not issuers, to opine on the riskiness of securities --
for exaggerating its bona fides in a 2008 filing. Eisinger
questioned the wisdom of sending Egan-Jones "to the guillotine"
while letting bigger players, with business models that are
susceptible to corruption, off the hook for their patently
ridiculous ratings of toxic mortgage-backed securities. "This is
your S.E.C., folks," Eisinger wrote. "It courageously assails
tiny firms, and at the pace of a three-toed sloth. And when it
goes after its prey, it's because it has found a box unchecked,
rather than any kind of deep, systemic rot."
Inspired by the piece, I went back to take another look at
the SEC's April 12 complaint against Option One, a r elative
s mall-timer in the mortgage-backed securities market. Could
Eisinger's criticism of the SEC's credit-rating enforcement --
that the agency is netting minnows while the sharks swim away --
apply just as well to MBS issuers?
Well, yes. But I'm getting tired of asking why the SEC has
been so slow to enforce accountability for banks that packaged
and sold securities backed by subprime mortgages that didn't
meet even the lax underwriting standards they warranted. So
instead, I'm choosing to regard the Option One case as a model
for the kinds of actions the already much-maligned mortgage
fraud task force keeps promising to bring. From my reading,
there's no reason other MBS defendants can't be held liable for
the same disclosure problems that Option One agreed to settle for $28.2 million.
Granted, the case against the H&R Block subsidiary was
clear-cut by the standards of financial fraud litigation. Option
One was a major originator of subprime mortgages. In 2006 and
2007 it got into the securitization business. In addition to
selling packages of loans to other MBS issuers, it acted as the
sponsor of seven MBS trusts with a face value of $4.3 billion,
all backed by Option One-issued mortgages. The MBS trust
contracts included a provision promising that Option One, as the
mortgage issuer, would buy back mortgages that materially failed
to meet its representations and warranties. But according to the
SEC, Option One knew it didn't have enough money to make good on
those repurchase promises. At the time Option One issued those
mortgage-backed notes, H&R Block was quietly propping up its
subsidiary, a fact Option One omitted from its MBS disclosures.
(For more on Option One and put-backs, here's a piece I did on
its successor Sand Canyon's attempts to block the company that
bought the loan servicing business from turning over loan files
to noteholders. Stay classy, Sand Canyon!)
How could the SEC extend the theory of the Option One case
to other mortgage-backed securitizers? It's a matter of what MBS
issuers knew about the originators of the loans underlying the
notes they sold. Option One wasn't the only subprime mortgage
originator that was in trouble in 2007 and 2008. IndyMac, New
Century, Ameriquest, American Home Mortgages: the list goes on
and on. They all sold loans that were packaged and resold via
MBS tr u sts, which typically offered the same sort of put-back
promises as the Option One MBS trusts, assuring investors that
the loan originator was responsible for buying back materially
deficient underlying mortgages.
In the Option One case, there was a clear link between the
originator's precarious financial condition and the MBS
sponsor's knowledge of the originator's problems, since the
sponsor and originator were one and the same. But couldn't the
same be said about Countrywide and Washington Mutual? History
certainly shows those two mortgage giants didn't have the funds
to back repurchase promises. Could their successors at Bank of
America and Wells Fargo be liable under the Option One theory?
It would be tougher for regulators to use the Option One model
against issuers that didn't originate their own underlying
mortgages, but the agency could use its subpoena power to find
out what exactly the banks snapping up mortgage portfolios from
the likes of New Century knew about originators' true ability to
make good on repurchase claims. My guess is that many of the
banks were well aware of their mortgage suppliers' problems.
My Reuters colleague Aruna Viswanatha has been doing a
bang-up job covering the mortgage-fraud task force. Last month,
for instance, she reported that the Justice Department used the obscure 1989 Financial Institutions Reform, Recovery, and Enforcement Act to issue MBS-related subpoenas to top financial
institutions. FIRREA violations, which require a lower burden of
proof than criminal charges, carry stiff civil penalties for
misconduct like mail and wire fraud. But there's nothing wrong
with an old-fashioned disclosure case either. The SEC got almost
$30 million from Option One without even explaining a damages
theory. If it can do the same against some of the bigger names
in mortgage-backed securitization, that would shut its critics
up.
(Reporting by Alison Frankel)
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