Ratings Arbitrage a/k/a Fraud

Investment banks bundled mortgage loans into securities and then often rebundled those securities one or two more times. Those securities were given high ratings and sold to investors, who have since lost billions of dollars on them.

Editor’s Note: The significance of this report cannot be overstated. Not only did the investment bankers LOOK for and CREATE loans guaranteed to fail, which they did, they sold them in increasingly complex packages more than once. So for example if the yield spread profit or premium was $100,000 on a given loan, that wasn’t enough for the investment bankers. Without loaning or investing any additional money they sold the same loans, or at least parts of those loans, to additional investors one, two three times or more. In the additional sales, there was no cost so whatever they received was entirely profit. I would call that a yield spread profit or premium, and certainly undisclosed. If the principal of the loan was $300,000 and they resold it three times, then the investment bank received $900,000 from those additional sales, in addition to the initial $100,000 yield spread profit on sale of the loan to the “trust” or special purpose vehicle.

So the investment bank kept $1 million dollars in fees, profits or compensation on a $300,000 loan. Anyone who has seen “The Producers” knows that if this “show” succeeds, i.e., if most of the loans perform as scheduled and borrowers are making their payments, then the investment bank has a problem — receiving a total of $1.3 million on a $300,000 loan. But if the loans fails, then nobody asks for an accounting. As long as it is in foreclosure, no accounting is required except for when the property is sold (see other blog posts on bid rigging at the courthouse steps documented by Charles Koppa).

If they modify the loan or approve the short sale then an accounting is required. That is a bad thing for the investment bank. But if they don’t modify any loans and don’t approve any short-sales, then questions are going to be asked which will be difficult to answer.

You make plans and then life happens, my wife says. All these brilliant schemes were fraudulent and probably criminal. All such schemes eventually get the spotlight on them. Now, with criminal investigations ongoing in a dozen states and the federal government, the accounting and the questions are coming anyway—despite the efforts of the titans of the universe to avoid that result.

All those Judges that sarcastically threw homeowners out of court questioning the veracity of accusations against pretender lenders, can get out the salt and pepper as they eat their words.

“Why are they not in jail if they did these things” asked practically everyone on both sides of the issue. The answer is simply that criminal investigations do not take place overnight, they move slowly and if the prosecutor has any intention of winning a conviction he must have sufficient evidence to prove criminal acts beyond a reasonable doubt.

But remember the threshold for most civil litigation is merely a preponderance of the evidence, which means if you think there is more than a 50-50  probability the party did something, the prima facie case is satisfied and damages or injunction are stated in a final judgment. Some causes of action, like fraud, frequently require clear and convincing evidence, which is more than 50-50 and less than beyond a reaonsable doubt.

From the NY Times: ————————

The New York attorney general has started an investigation of eight banks to determine whether they provided misleading information to rating agencies in order to inflate the grades of certain mortgage securities, according to two people with knowledge of the investigation.

by LOUISE STORY

Andrew Cuomo, the attorney general of New York, sent subpoenas to eight Wall Street banks late Wednesday.

The investigation parallels federal inquiries into the business practices of a broad range of financial companies in the years before the collapse of the housing market.

Where those investigations have focused on interactions between the banks and their clients who bought mortgage securities, this one expands the scope of scrutiny to the interplay between banks and the agencies that rate their securities.

The agencies themselves have been widely criticized for overstating the quality of many mortgage securities that ended up losing money once the housing market collapsed. The inquiry by the attorney general of New York, Andrew M. Cuomo, suggests that he thinks the agencies may have been duped by one or more of the targets of his investigation.

Those targets are Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch, which is now owned by Bank of America.

The companies that rated the mortgage deals are Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. Investors used their ratings to decide whether to buy mortgage securities.

Mr. Cuomo’s investigation follows an article in The New York Times that described some of the techniques bankers used to get more positive evaluations from the rating agencies.

Mr. Cuomo is also interested in the revolving door of employees of the rating agencies who were hired by bank mortgage desks to help create mortgage deals that got better ratings than they deserved, said the people with knowledge of the investigation, who were not authorized to discuss it publicly.

Contacted after subpoenas were issued by Mr. Cuomo’s office late Wednesday night notifying the banks of his investigation, spokespeople for Morgan Stanley, Credit Suisse and Deutsche Bank declined to comment. Other banks did not immediately respond to requests for comment.

In response to questions for the Times article in April, a Goldman Sachs spokesman, Samuel Robinson, said: “Any suggestion that Goldman Sachs improperly influenced rating agencies is without foundation. We relied on the independence of the ratings agencies’ processes and the ratings they assigned.”

Goldman, which is already under investigation by federal prosecutors, has been defending itself against civil fraud accusations made in a complaint last month by the Securities and Exchange Commission. The deal at the heart of that complaint — called Abacus 2007-AC1 — was devised in part by a former Fitch Ratings employee named Shin Yukawa, whom Goldman recruited in 2005.

At the height of the mortgage boom, companies like Goldman offered million-dollar pay packages to workers like Mr. Yukawa who had been working at much lower pay at the rating agencies, according to several former workers at the agencies.

Around the same time that Mr. Yukawa left Fitch, three other analysts in his unit also joined financial companies like Deutsche Bank.

In some cases, once these workers were at the banks, they had dealings with their former colleagues at the agencies. In the fall of 2007, when banks were hard-pressed to get mortgage deals done, the Fitch analyst on a Goldman deal was a friend of Mr. Yukawa, according to two people with knowledge of the situation.

Mr. Yukawa did not respond to requests for comment.

Wall Street played a crucial role in the mortgage market’s path to collapse. Investment banks bundled mortgage loans into securities and then often rebundled those securities one or two more times. Those securities were given high ratings and sold to investors, who have since lost billions of dollars on them.

Banks were put on notice last summer that investigators of all sorts were looking into their mortgage operations, when requests for information were sent out to all of the big Wall Street firms. The topics of interest included the way mortgage securities were created, marketed and rated and some banks’ own trading against the mortgage market.

The S.E.C.’s civil case against Goldman is the most prominent action so far. But other actions could be taken by the Justice Department, the F.B.I. or the Financial Crisis Inquiry Commission — all of which are looking into the financial crisis. Criminal cases carry a higher burden of proof than civil cases. Under a New York state law, Mr. Cuomo can bring a criminal or civil case.

His office scrutinized the rating agencies back in 2008, just as the financial crisis was beginning. In a settlement, the agencies agreed to demand more information on mortgage bonds from banks.

Mr. Cuomo was also concerned about the agencies’ fee arrangements, which allowed banks to shop their deals among the agencies for the best rating. To end that inquiry, the agencies agreed to change their models so they would be paid for any work they did for banks, even if those banks did not select them to rate a given deal.

Mr. Cuomo’s current focus is on information the investment banks provided to the rating agencies and whether the bankers knew the ratings were overly positive, the people who know of the investigation said.

A Senate subcommittee found last month that Wall Street workers had been intimately involved in the rating process. In one series of e-mail messages the committee released, for instance, a Goldman worker tried to persuade Standard & Poor’s to allow Goldman to handle a deal in a way that the analyst found questionable.

The S.& P. employee, Chris Meyer, expressed his frustration in an e-mail message to a colleague in which he wrote, “I can’t tell you how upset I have been in reviewing these trades.”

“They’ve done something like 15 of these trades, all without a hitch. You can understand why they’d be upset,” Mr. Meyer added, “to have me come along and say they will need to make fundamental adjustments to the program.”

At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as “ratings arbitrage,” according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.

The rating agencies may have facilitated the banks’ actions by publishing their rating models on their corporate Web sites. The agencies argued that being open about their models offered transparency to investors.

But several former agency workers said the practice put too much power in the bankers’ hands. “The models were posted for bankers who develop C.D.O.’s to be able to reverse engineer C.D.O.’s to a certain rating,” one former rating agency employee said in an interview, referring to collateralized debt obligations.

A central concern of investors in these securities was the diversification of the deals’ loans. If a C.D.O. was based on mostly similar bonds — like those holding mortgages from one region — investors would view it as riskier than an instrument made up of more diversified assets. Mr. Cuomo’s office plans to investigate whether the bankers accurately portrayed the diversification of the mortgage loans to the rating agencies.

Gretchen Morgenson contributed reporting

Foreclosure Defense and Offense: Class Actions in Play

Mortgage ruling could shock U.S. banking industry
Mon Jun 30, 2008 8:14pm BST
By Gina Keating – Analysis

LOS ANGELES (Reuters) – A lawsuit filed by a Wisconsin couple against their mortgage lender could have major implications for banks should a U.S. appeals court agree that borrowers can cancel their loans en masse when their lenders violate a federal lending disclosure law.

The case began like hundreds of others filed since the U.S. housing boom spawned a rise in sales of adjustable rate loans. Susan and Bryan Andrews of Cedarburg, Wisconsin, claimed that lender Chevy Chase Bank FSB had hidden the true terms of what they believed was a good deal on a low-interest loan.

In their 2005 lawsuit, the couple said the loan’s interest rate had more than doubled by their second monthly payment from the 1.95 percent rate they thought was locked in for five years. The interest rate rose well above the 5.75 percent fixed-rate loan they had refinanced to pay their children’s college tuition.

The Andrews filed the case seeking class action status; and in early 2007, U.S. District Judge Lynn Adelman ruled that the bank had violated the Truth in Lending Act, or TILA, and that thousands of other Chevy Chase borrowers could join them as plaintiffs.

The judge transformed the case from a run-of-the-mill class action to a potential nightmare for the U.S. banking industry by also finding that the borrowers could force the bank to cancel, or rescind, their loans. That decision was stayed pending an appeal to the 7th U.S. Circuit Court of Appeals, which is expected to rule any day.

The idea of canceling tainted loans to stem a tide of foreclosures has caught hold in other quarters; a lawsuit filed last week by the Illinois attorney general asks a court to rescind or reform Countrywide Financial Corp (CFC.N: Quote, Profile, Research) mortgages originated under “unfair or deceptive practices.”

‘MASSIVE CLASS SUITS’

The mortgage banking industry already faces pressure from state and federal regulators, who have accused banks of lowering underwriting standards and forcing some borrowers, through fraud, into costly adjustable loans that the banks later bundled and sold as high-interest investment vehicles.

The loans have caused serious instability in the financial sector, as mortgage interest rates adjusted upward and borrowers began defaulting at a significant rate starting in 2007, drawing lawsuits from investors and homeowners.

Federal appeals courts disagree over whether class-wide rescission under the Truth in Lending Act is available, said attorney Christine Scheuneman, whose firm represented Chevy Chase at the district court.

“If class treatment is found to be available for rescission …, given the current crisis not predicted in 2005, the result all over the country could be massive class suits,” said Scheuneman, a partner at Pillsbury Winthrop Shaw Pittman LLP.

The Truth in Lending Act, a 1968 federal law designed to protect consumers against lending fraud by requiring clear disclosure of loan terms and costs, lets consumers seek rescission, or termination, of a loan and the return of all interest and fees when a lender is found in violation.

Should the 7th U.S. Circuit Court of Appeals agree with Judge Adelman, banking industry associations predict “confusion and market disruption” as banks curtail lending further.

“Class certification of rescission claims would saddle the mortgage lending industry and secondary market with billions of dollars of class action exposure for supposed violations of TILA that do not give rise to any actual damages,” the financial services associations wrote in an amicus brief.

But the Andrews’ attorney, Kevin Demet, said lenders want to scare the judiciary into banning class action rescissions because they were unable to convince Congress to do so in the 1990s.

“If (banks) get relief (from the appeals court), it’s activist judges trying to give them what they could not get legislatively,” said Demet, of Demet & Demet of Milwaukee, Wisconsin.

Consumer advocates said the banks would have “no more or no less” liability for the tainted mortgages if the court found in favor of the Andrews plaintiffs.

But an adverse ruling for borrowers would cut off an important remedy. Borrowers would “lose the opportunity to use rescission to save their homes from foreclosure or to rescind their mortgages and refinance into affordable ones,” the Center for Responsible Lending, the National Consumer Law Center, Public Citizen and AARP Foundation Litigation wrote in an amicus brief filed in the case.

Both sides said the case will likely be decided by the U.S. Supreme Court.

(Reporting by Gina Keating; Editing by Mary Milliken and Gerald E. McCormick)

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