If you’ve ever wondered about the magnitude of deception that caused the financial crisis of 2008, read no further than a recent ruling by a federal court in New York that orders Nomura Holdings and Royal Bank of Scotland to pay a combined $806 million in damages to the government-owned mortgage agencies for misleading them about the quality of securities backed by residential mortgages.
The ruling, by the U.S. District Court in Manhattan, resolves one of 17 lawsuits filed by the Federal Housing Finance Agency (FHFA) in September 2011 against some of the nation’s biggest banks to recover losses on behalf of Fannie Mae and Freddie Mac, the government-sponsored entities that purchased residential mortgage-backed securities (RMBS) in the run-up to the financial crisis.
The lawsuit, which FHFA filed in its role as conservator of Fannie Mae and Freddie Mac, charged Nomura and RBS with misrepresenting, among other things, the underwriting and origination of the loans that backed the RMBS, the variation between the value of houses that secured the loans and the amounts of indebtedness, compliance with standards of appraising the properties, occupancy of the homes themselves and the assessments of the securities by ratings agencies.
The trial presented the court with a straightforward question. “Did defendants accurately describe the home mortgages in the offering documents for the securities they sold that were backed by those mortgages?” U.S. District Judge Denise Cote wrote in a 361-page opinion that instructs readers on practices that prevailed at Nomura and RBS. “Following trial, the answer to that question is clear. The offering documents did not correctly describe the mortgage loans. The magnitude of falsity, conservatively measured, is enormous.”
The ruling leaves little question about the extent of the deception that occurred among lenders that originated mortgages, the firms that appraised loans and the financial institutions that bundled the loans for sale to investors. Though by now the financial crisis has been well chronicled, few accounts rival Cote’s for its description of the failures, abuses and outright fakery that occurred.
It’s not as if no one warned of the crisis, which led to the longest recession since the Great Depression. As Cote recounts, 90% of real estate appraisers in a national survey fielded in late 2006 said they felt pressure from lenders to inflate values.
A year later, 11,0000 licensed and certified appraisers petitioned Congress and the Federal Financial Institutions Examinations Council to ask for assistance in ending pressure on appraisers to match or top a predetermined value on properties. “We believe that this practice has adverse effects on our local and national economies and that the potential for great financial loss exists,” the court quotes the group as warning. “We also believe that many individuals have been adversely affected by the purchase of homes which have been over-valued.”
FHFA charged that over a two-year period starting in 2005 the GSEs had purchased seven sets of RMBS underwritten by one or both of the defendants that had an unpaid principal balance of roughly $2.05 billion.
The court found that the group within Nomura that the company charged with reviewing the quality of the loans that the firm bought “was too small to do an effective job” and “lacked independence” from traders at the firm who held sway.
“The Diligence Group was too leanly staffed to do any careful review of the data,” according to Cote. “Over and over again, it simply ‘waived in’ and purchased loans its vendors had flagged as defective.
The group also was beholden to Nomura’s trading desk, which “was seemingly oblivious to the very serious risks associated with some of its decisions,” wrote Cote. “For example, it proposed that Nomura purchase loans whose files were missing critical documents… and enter a side-letter agreement allowing the seller to produce the missing forms later.”
The problem was greed or, more specifically, the pressure to compete in a market that had become a free-for-all. That led to Nomura buying mortgages from such firms as The Mortgage Store, which originated loans that failed consistently to comply with Nomura’s guidelines. As Cote explained:
The reason for Nomura’s lackluster due diligence program is not hard to find. Nomura was competing against other banks to buy these subprime and Alt-A loans and to securitize them. As its witnesses repeatedly described and as its documents illustrated, Nomura’s goal was to work with the sellers of loans and to do what it could to foster a good relationship with them. Given this attitude, it is unsurprising that even when there were specific warnings about the risk of working with an originator, those warnings fell on deaf ears.
Similar problems plagued RBS. “Its due diligence team had no role in reviewing the accuracy of representations in prospective supplements and did not understand that its work was in any way connected to the representations that would be made in prospectus supplements,” according to Cote. “As was true for Nomura, there was no one at RBS who acted to ensure that the representations in the prospectus supplements that are at issue in this case were truthful.
At trial, Nomura and RBS charged that the loans they underwrote constituted a relatively small share of RMBS sold in the years that preceded the meltdown. The firms also contended that factors in the larger economy—from government policies to fluctuations in housing market—also fueled losses that Fannie and Freddie incurred.
The court rejected those assertions. Instead, it tied the practices that prevailed at the underwriters directly to the crisis that ensued. As Cote explained:
The evidence at trial, including expert testimony, as well as common sense drive a single conclusion. Shoddy origination practices that are at the heart of this lawsuit were part and parcel of the story of the housing bubble and the economic collapse that followed when that bubble burst.
While that history is complex, and there are several contributing factors to the decline in housing prices and the recession, it is impossible to disentangle the origination practices that are at the heart of the misrepresentations at issue here from these events. Shoddily underwritten loans were more likely to default, which contributed to the collapse of the housing market, which in turn led to the default of even more shoddily underwritten loans.
Thus, the origination and securitization of these defective loans not only contributed to the collapse of the housing market, the very macroeconomic factors that defendants say caused the losses, but once the collapse started, improperly underwritten loans were hit hardest and drove the collapse even further. The evidence at trial confirms the obvious: Badly written loans perform badly. In short, defendants could not propound a cause unrelated to the alleged misrepresentation.
That’s the financial crisis in a nutshell. “While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages—that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008,” the Financial Crisis Inquiry Commission concluded in a report published in January 2011.
Yet while others have chronicled the causes of the crisis. Cote’s decision shows, in the case of two financial firms, the extent of the wrongdoing that occurred.
As the court noted, during the two years beginning in 2003, the number of subprime loans nearly doubled, to 1.9 million. By 2005, subprime loans made up one fifth of all new mortgages. According to Cote:
The ability of originators to quickly sell and shift the risk of subprime loans off their books reduced their incentive to carefully screen borrowers. They approved loans that did not comply with stated underwriting guidelines and they misrepresented the quality of those loans to purchasers. Appraised values were overstated, owner occupancy was misreported, credit risk was hidden, and second liens were undisclosed. In short, these shoddy practices contributed to the housing price boom.
Though prospectuses told investors that the loans that backed the securities at issue were underwritten in conformity with the originators’ standards, the prospectuses failed to inform investors that the originators has disregarded their own standards. “In sum,” wrote Cote, “notice that loans were not being extended to borrowers who had a less-than-perfect credit history through the adoption of relaxed underwriting guidelines was not notice that originators would ignore even those guidelines.”
That, as the court concluded, shows the problem that led to liability for at least two financial firms that sold securities that turned out to be toxic.
Cote noted that in the middle of the Great Depression, Congress passed the Securities Act, which obligates issuers of securities to disclose fully information that a reasonable investor might rely on in deciding whether to invest. “Now, in the aftermath of our great recession, FHFA seeks to vindicate those principles,” writes Cote. “For the reasons stated here, it is entitled to judgment.”
For its part, Nomura said in a statement that it “will review the judgment and consider all options, including appeal,” and that the judgment would have an “insignificant” impact on the company’s performance. RBS said in a securities filing that “it intends to pursue a contractual claim for indemnification against Nomura with respect to these damages.”