by Michael McGraw, Associate Print Editor
While the crippling collapse of the housing market that resulted in devastating effects on the national and global economy began in 2007, 2013 and the next several years have the potential for landmark litigation results emanating from the Federal Housing Finance Agency’s (FHFA) suit against eighteen of the world’s largest banks for $200B in damages.
To any given member of the general public, there can be a level of unawareness as to how the mortgage crisis impacted his or her personal finances, but what he or she does know is that whatever happened resulted in a depleted retirement account and/or investment portfolios. For the average person wanting to secure a mortgage, he or she contacts a broker or bank, applies for a mortgage, hopefully receives approval and make their monthly payments. As such, it can seem abstract as to how this process could have resulted in such sweeping and damaging economic effects. However, the reality is that the majority of mortgages such as these are sold, much like a stock, shortly after they are executed between a borrower and lender.
Although borrowers pay their individual payments each month to a given institution, there are various stages through which a mortgage travels generally unbeknownst to the borrower.
Stage 1 – Mortgage Origination
An individual decides that he or she wants to apply for a mortgage. The individual goes to a bank, mortgage broker or even a private entity to do so. Once approved, the originator of the mortgage (i.e., the bank, mortgage company, etc.) closes on the loan. Shortly thereafter, the originator typically sells the mortgage into a “secondary mortgage market.” The theory behind this subsequent market is to pass the risk associated with a given mortgage from the originator to a third party, with the originator quickly receiving returned monies, which allows the originating party to lend more monies out to new borrowers, ideally keeping the housing market flowing strong.
Stage 2 –Selling Original Mortgages in Secondary Mortgage Market
To whom do the mortgage originators sell their mortgages? The purchasers of mortgages on the secondary market can be private third parties, ranging from large mortgage originators to institutional investors, governmental entities or quasi-public entities such as Freddie Mac (Federal Home Loan Mortgage Corporation) or Fannie Mae (Federal National Mortgage Association). These entities will then either hold the mortgages, or pool the mortgages together and trade them as mortgage-backed securities (MBS) in various formats, each with deviating risks and return rates.
The most basic format is the “pass-through MBS,” in which the principal and interest are collected by the issuer and passed proportionally to bond or loan holders. There is also a derivative and more complex MBS, the collateralized mortgage obligations (CMO). In CMOs, pass-through MBSs are repooled and characterized into different risk categories, known as “tranches,” which provide investors with specific purchasing and investment options depending on priority of payment, level of risk and rate of return preferences (e.g.. a hedge fun might prefer a riskier investment, while a pension fund might prefer a less risky investment). An important component to the attraction of these securities is a given security’s credit rating, which affects investors’ decisions whether or not to purchase a particular loan or bond.
Stage 3 – Selling Mortgage-Backed Securities to Investors
The investors who purchase these mortgage-backed securities can be entities such as pension funds, insurance companies, banks, hedge funds, or foreign governments. While the housing market excelled, these purchases were viewed as solid investments, as the fallacious belief that fueled the entire mortgage crisis was that housing values always increase.
While this process represents a typical flow, multiple foundational cracks at each stage ultimately contributed to the problems of the housing and mortgage industry:
Stage 1 “Red Flags” – Mortgage Orientation
One of the methods of characterizing mortgages is “prime” or “sub-prime.” A prime mortgage refers to one given to a borrower with good credit and solid, verifiable sources of income and generally is associated with less borrower-default risk. “Sub-prime” mortgages refer to those given to a borrower with lower credit and unverifiable or unverified income sources. Prior to the emergence of the secondary mortgage market, lenders would be extremely hesitant to give out any sub-prime mortgages due to their direct risk of financial loss associated with a potential default; however, with the ability to sell sub-prime mortgages in the secondary mortgage market, lenders’ inhibitions disappeared, as their concerns over borrowers’ ability to repay the loan was no longer their direct concern.
Under the misguided theory that housing prices would always increase, sub-prime borrowers were given mortgages that placed those borrowers in serious jeopardy of being able to repay the loans. A typical sub-prime loan would be an adjustable rate mortgage (ARM) with a “teaser” that would propel the interest rate from a lower rate in mortgage’s infant years to a higher rate following that honeymoon period. The rationale, retrospectively deluded, was that housing prices would do noting but increase, so there would always be the ability for borrowers resell or refinance on the property; however, as housing prices fell, these options became unobtainable and sizable numbers of borrowers defaulted on their loans.
Stage 2 “Red Flags” – Selling Original Mortgages in Secondary Mortgage Market
There is strong evidence that many in the industry became aware that there were a large number of deficient mortgages being dispensed, which were in turn being sold in the secondary market, which were then sold to investors, such as the average person’s pension, 401k, or retirement accounts. But if those in a position to stop such poor habits were aware what was occurring, how did this continue?
One position with support is that Freddie Mac and Fannie Mae are to blame for what occurred, as they are knowledgeable investors who should not have continued to purchase, hold and sell these bad mortgages. There is also the position that the large private institutions who packaged and sold these MBSs were aware that the they were pooling and selling bad securities, but did their best to shield any inadequacies and continue to represent the securities as solid buys to eager investors.
Moreover, why were investors so eager to purchase these potentially worthless securities? There is another position that credit rating agencies were manipulating credit ratings, giving high-grade ratings (e.g., AAA) to investments that should never have received such a level. Some believe that, due to the overwhelming quantity of work provided to certain credit rating agencies from the large pooling institutions, the rating agencies were at the mercy of these large institutions and acquiesced in representing lower-grade loans or bonds as high-grade commodities.
Regardless of the reasoning, what transpired left the American and global economy in ruins: borrowers defaulted on mortgage loans they arguably should never have been given in the first place, the secondary mortgage market continued to sell substandard pools of MBS to investors and, when it came time for investors to collect, there was no money for them to receive.
Controversially, American tax dollars provided significant financial relief to private financial companies and quasi-governmental enterprises like Freddie Mac and Fannie Mae. Private investors who lost substantial sums of money believed material misrepresentations were made regarding the quality of the securities they purchased. As a result of this mortgage crisis, prosecutors, investors and regulators have all litigiously attacked those whom they feel are responsible for the lost billions of dollars, resulting in some of the world’s largest financial institutions dealing with abundant, complex lawsuits and/or making settlements for their involvement in the mortgage crisis.
For example, Bank of America, which in 2008 purchased the country’s largest mortgage originator at the time, Countrywide Financial, as well as Merrill Lynch, has already paid an estimated $40B in settlements to private plaintiffs and the government. JPMorgan Chase, who acquired Bear Sterns and Washington Mutual, settled a nearly $300M suit with the Securities and Exchange Commission (SEC) for its role in packing mortgage-backed securities, has been sued by private companies including Dexia, Group, Syncora Guarantee and Stichting Pensioenfonds ABP, among others, and estimates that its total end-cost associated with its role in the mortgage crisis could reach $120B. In addition, the Department of Justice filed a $5B suit against Standards & Poor (S & P), one of the country’s largest credit rating agencies, claiming that it fraudulently misrepresented credit ratings of MBSs, which investors relied upon in purchasing these securities.
The strongest stance taken by the government so far is the FHFA’s $200B lawsuit against eighteen major financial institutions for their supposed role in the financial fallout. In addition to the first party sued by the FHFA, UBS AG, the other defendants include the following: Ally Financial Inc. f/k/a GMAC, LLC, Bank of America Corporation, Barclays Bank PLC, Citigroup, Inc., Countrywide Financial Corporation, Credit Suisse Holdings (USA), Inc., Deutsche Bank AG, First Horizon National Corporation, General Electric Company, Goldman Sachs & Co., HSBC North America Holdings, Inc., JPMorgan Chase & Co., Merrill Lynch & Co./First Franklin Financial Corp. Morgan Stanley, Nomura Holding America Inc., The Royal Bank of Scotland Group PLC, and Société Générale.
FHFA was appointed conservator of Fannie Mae and Freddie Mac under the 2008 Housing and Economic Recovery Act. Under this act, the period for filing suit on behalf of Freddie Mac and Fannie Mae was extended, allowing a suit to be initiated three years from which a claim accrued (defined as the date of appointment of the FHFA as conservator). This statutory timeframe language has been challenged, however, as seen in what has served as a trial suit against the aforementioned first major defendant, UBS AG.
UBS has claimed that the suit was brought too late, according to the Securities Act of 1933’s statue of repose, which functions to set a fixed time at which a plaintiff cannot bring an action, regardless of if the time expires prior to the plaintiff actually experiencing the injury. The suit’s timing, brought in the Southern District of New York, was upheld by United States District Judge Denise Cote upon UBS AG challenging on the aforementioned grounds. However, if the FHFA v. UBS AG suit is to be later overturned due to this timing question, as it is currently on appeal to the Court of Appeals for the Second Circuit, the ramifications could bestow doubt on the United States’ ability to further collect against these major institutions.
Perhaps recognizing some warning signs, General Electric Company became the first of the defendants to settle with the FHFA, doing so in January 2013, to avoid what has the makings of a lengthy litigation schedule (UBS, the first defendant, has a trial commencement schedule of January 2014).
As thousands of suits have been filed as a result of the mortgage crisis and its pandemic implications, it is clear that 2013 and the subsequent years have the potential for billion-dollar settlements and contentious litigation between public and private parties and some of the world’s largest financial institutions. While there might be positive indications that the economy and housing industry are in the rehabilitation process, the legal ramifications for the targeted culprits of the collapse are far from over.