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Analysis: Regulators Want to “Build Second Table” for Financial Fraud Claims

I think you can divine what I think of the foreclosure fraud settlement which releases liability on a host of fraudulent conduct for only a $5 billion guarantee from the banks, as well as $20 billion made up mostly of “credits” that HUD believes will translate into around $34.5 billion overall. The credits play out over three years, so you can adjust for inflation, and in fact if you adjust in that way, as Matt Yglesias does, you find that this is around 10 times less than the tobacco settlement of the late 1990s. And needless to say, it’s a drop in the bucket compared to the negative equity in the country which stands at around $700 billion. The $2,000 for foreclosed borrowers represents the bare minimum homeowners would expect to receive. As Yves Smith writes (and I should just outsource my commentary to her), “We’ve now set a price for forgeries and fabricating documents. It’s $2000 per loan. This is a rounding error compared to the chain of title problem these systematic practices were designed to circumvent.”

I don’t get the sense that any law enforcement official wanted to touch chain of title. It’s the great unmentionable in this entire escapade. The title system in this country is horribly broken. The banks would say it was broken before the mid-1990s when they used MERS to “fix” it. Most of us know better. I don’t have any direct quotes here, but I take it that opening up chain of title would have been seen by the powers that be as an impossible problem to fix. I think it’s the problem that fixes the entire housing market for the better. But not even the title insurance companies really want to fix the title problem. Individual homeowners and foreclosure defense lawyers will have to keep banging on this, and they can potentially recover substantial amounts for their clients. But law enforcement will go off the playing field.

Not totally, of course. There are still open MERS suits in New York, Delaware and potentially Massachusetts. Yves believes that the banks will only clean up this mess if they have to, and they got a favorable deal previously where they don’t have to clean it up. The banks will look to settle on the MERS issues and, at worst, create something not called MERS that acts just like MERS.

Let me focus on what the people who settled this deal will probably tell you. They would say that the interlocking state and federal claims, and the relative intensity of the law enforcement officials in the various states, many of whom would decline to go after any claims, means that the maximum you could get out of all of these lawsuits on servicing and foreclosure issues would be commensurate with the $40 billion they believe will be the ultimate outcome of the settlement. I’ve had that told to me. You can look at the fact that Catherine Cortez Masto in Nevada secured around $57,000 per homeowner in a settlement with Morgan Stanley on these issues and dismiss that claim. But that’s the thinking, at least from some parts of this.

The other part is that a “second table” had to be built. Under this theory, the first table was the settlement over foreclosure and servicing issues, the “post-bubble” conduct. Then you have the “pre-bubble” conduct, the securitization fail, which brings in tax fraud and securities fraud and insurance fraud and some related issues. That’s the second table, exemplified by this RMBS working group. As we know, the co-chairs of that group, outside of Eric Schneiderman, have a history of either ignoring this fraudulent conduct or actually facilitating it, in the case of former Deutsche Bank general counsel (and current head of SEC enforcement) Robert Khuzami. But it is an election year and the Administration wants to look tough on these issues. In fact, federal regulators are sending Wells notices to leading banks today, informing them that they will soon sue them on securities fraud matters. The statute of limitations may be running out on quite a bit of these securities deals, and every day they wait is another day the deals get a kind of immunity.

But why build a second table? As Yves says, “It’s a bad idea to settle obvious, widespread wrongdoing on the cheap. You use the stuff that is easy to prove to gather information and secure cooperation on the stuff that is harder to prove.” We seem to be running in the other direction. Forgeries and falsified physical documents are being given up as evidence, to chase a securitization claim. Senior officials will tell you that the team you can assemble to go after these claims matters. In the “post-bubble” conduct you have to go through the sand states, including Florida and Arizona, with their Republican AGs disinclined to fight. I should mention that Democrat Terry Goddard was the AG of Arizona when all of this broke before the 2010 elections. With the “pre-bubble” conduct you have mostly the two states where securitization trusts were amassed, New York and Delaware, as the principals, along with states with big pension funds like California and Illinois. On paper, the thinking goes, this is a better group of AGs to wage the fight.

Furthermore, the goal here is the same: to get substantial relief for homeowners abused by the system. That’s unquestionably important. But it’s not the only job of a law enforcement official. They have to keep in mind not only adequacy (and so far this deal is not adequate) but also justice and accountability. So far, we have criminal indictments on this conduct in Nevada and Missouri, though presumably they will be blocked from going up the chain and hitting those who directed the activities. Bankers have little to fear from the consequences of breaking the largest market in the world, the residential housing market. And so there’s no real deterrent to stop them from doing this all over again. “Criminal affirmance” leads to repeat offenses.

One major consequence of this could end up being the indignation of mortgage-backed securities investors who will never again return to this market, as Yves writes:

We’ll now have to listen to banks and their sycophant defenders declaring victory despite being wrong on the law and the facts. They will proceed to marginalize and write off criticisms of the servicing practices that hurt homeowners and investors and are devastating communities. But the problems will fester and the housing market will continue to suffer. Investors in mortgage-backed securities, who know that services have been screwing them for years, will be hung out to dry and will likely never return to a private MBS market, since the problems won’t ever be fixed. This settlement has not only revealed the residential mortgage market to be too big to fail, but puts it on long term, perhaps permanent, government life support.

I don’t know why we should be pleased with that outcome.

The only way a second table gets built, the only way we get some measure of accountability on these issues, is by massing an extreme amount of pressure on those with the authority to take action and refusing to let go. But there was a lot of pressure this time and we see the result.

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David Dayen

David Dayen