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FHFA Readies Lawsuits Against Top Banks in Mortgage Bond Scandal

Ed DeMarco

FHFA's Ed DeMarco

People probably picked up their morning New York Times with their coffee and spat it out (the coffee, not the paper) when they read the headline U.S. Is Set to Sue a Dozen Big Banks Over Mortgages by Nelson Schwartz. Is Obama finally “getting tough” with the too big to fail banks? Is this a new day in America?

No, it’s not. Because Schwartz provides too little context, you have to know a few things about the federal agency involved. Here’s an excerpt of the story:

The federal agency that oversees the mortgage giants Fannie Mae and Freddie Mac is set to file suits against more than a dozen big banks, accusing them of misrepresenting the quality of mortgage securities they assembled and sold at the height of the housing bubble, and seeking billions of dollars in compensation.

The Federal Housing Finance Agency suits, which are expected to be filed in the coming days in federal court, are aimed at Bank of America, JPMorgan Chase, Goldman Sachs and Deutsche Bank, among others, according to three individuals briefed on the matter.

The suits stem from subpoenas the finance agency issued to banks a year ago. If the case is not filed Friday, they said, it will come Tuesday, shortly before a deadline expires for the housing agency to file claims.

The suits will argue the banks, which assembled the mortgages and marketed them as securities to investors, failed to perform the due diligence required under securities law and missed evidence that borrowers’ incomes were inflated or falsified. When many borrowers were unable to pay their mortgages, the securities backed by the mortgages quickly lost value.

So these lawsuits are a year in the making and forced by a deadline. And they come from the Federal Housing Finance Agency. If you’ve been following the story here, you’d know that FHFA is the federal overseer of the GSEs, currently run by Ed DeMarco, a Bush Administration holdover. The FHFA is an independent agency created in 2008 as a conservator for Fannie and Freddie, whose director has a 5-year term. The Bush-appointed director, David Stevens, left to run the Mortgage Banking Association (!), and DeMarco, his deputy, was put in his place. That was two years ago, and the White House has yet to get a replacement confirmed by the Senate. Joseph Smith, a prior nominee, withdrew back in January, and nobody has been nominated since.

CommunityThe Bullpen

FHFA Readies Lawsuits Against Top Banks in Mortgage Bond Scandal

Ed DeMarco

FHFA's Ed DeMarco

People probably picked up their morning New York Times with their coffee and spat it out (the coffee, not the paper) when they read the headline U.S. Is Set to Sue a Dozen Big Banks Over Mortgages by Nelson Schwartz. Is Obama finally “getting tough” with the too big to fail banks? Is this a new day in America?

No, it’s not. Because Schwartz provides too little context, you have to know a few things about the federal agency involved. Here’s an excerpt of the story:

The federal agency that oversees the mortgage giants Fannie Mae and Freddie Mac is set to file suits against more than a dozen big banks, accusing them of misrepresenting the quality of mortgage securities they assembled and sold at the height of the housing bubble, and seeking billions of dollars in compensation.

The Federal Housing Finance Agency suits, which are expected to be filed in the coming days in federal court, are aimed at Bank of America, JPMorgan Chase, Goldman Sachs and Deutsche Bank, among others, according to three individuals briefed on the matter.

The suits stem from subpoenas the finance agency issued to banks a year ago. If the case is not filed Friday, they said, it will come Tuesday, shortly before a deadline expires for the housing agency to file claims.

The suits will argue the banks, which assembled the mortgages and marketed them as securities to investors, failed to perform the due diligence required under securities law and missed evidence that borrowers’ incomes were inflated or falsified. When many borrowers were unable to pay their mortgages, the securities backed by the mortgages quickly lost value.

So these lawsuits are a year in the making and forced by a deadline. And they come from the Federal Housing Finance Agency. If you’ve been following the story here, you’d know that FHFA is the federal overseer of the GSEs, currently run by Ed DeMarco, a Bush Administration holdover. The FHFA is an independent agency created in 2008 as a conservator for Fannie and Freddie, whose director has a 5-year term. The Bush-appointed director, David Stevens, left to run the Mortgage Banking Association (!), and DeMarco, his deputy, was put in his place. That was two years ago, and the White House has yet to get a replacement confirmed by the Senate. Joseph Smith, a prior nominee, withdrew back in January, and nobody has been nominated since.

So you have the only Bush Administration holdover in the entire Obama economic/housing team pursuing prosecution against the banks over their mortgage bonds.

And this is something DeMarco has pursued for some time. He has sought to force repurchases of bad loans by the banks since the very beginning of his tenure. And he’s been fairly successful. This isn’t even the first lawsuit of this type from FHFA; they filed one in July against UBS, seeking $900 million. This January, DeMarco netted $3.3 billion in repurchase settlements with two banks.

This is a representations and warrants case. It alleges that the banks in question misrepresented the content of mortgage pools when they packaged them and sold them to the GSEs. We know that this was a widespread practice; the Financial Crisis Inquiry Commission referred to the Justice Department information about improper disclosure on mortgage bonds, violating federal securities laws. They discovered this through the testimony of Clayton Holdings, a third-party due diligence shop which found large percentages of mortgages they sampled for MBS deals to be inadequate, which the too big to fail banks ignored and still placed in their deals. This is an enormous scandal that investors have been looking at for some time. And so has the FHFA.

This is the Dr. Jekyll side of Ed DeMarco’s leadership of FHFA. He sees his conservatorship duties extremely narrowly, merely to mitigate GSE losses for taxpayers. Getting banks to put back mortgages when they lied about their quality certainly fulfills that role. The Mr. Hyde side of this is when DeMarco refuses to allow principal reductions on GSE-backed loans, because that would represent a loss for the taxpayer. It wouldn’t in the long run because a foreclosure would be costlier. But that’s been his shortsighted position.

Some other things about this. The foreclosure fraud settlement just isn’t going to happen, and this is just another reason. The timing is coincidental and based on statutes of limitations, but it cuts against what the settlement is trying to do, as Felix Salmon says. “It would be a major securitization-related lawsuit being filed by one arm of the federal government, just as another arm is trying to put a big settlement together which might (or might not) give the big banks immunity against precisely such suits.” This probably also spells the end of the Obama Administration’s GSE refinance program, because if the GSEs refinance, they lose out on the opportunity to put back those mortgages on the banks, and DeMarco is disinclined to do that.

Second, this is the nightmare scenario for the banks. FHFA is joining a slew of other private investors seeking to force repurchases on these mortgage backed securities which they clearly screwed up during the bubble years. Bank of America tried to settle a bunch of these cases, but thanks to Eric Schneiderman, some investors not in on the settlement and even a group of homeowners, that MBS settlement looks in tatters. A federal judge yesterday questioned the rush to settlement. Bank of America, by the way, would face the biggest dollar value in an FHFA suit because they sold the most MBS to Fannie and Freddie. The Fed has been asking BofA for contingency plans; that doesn’t happen with healthy firms.

Years after the financial crisis crested, the banks are suffering with the exact same liabilities that threaten their very existence. So the next time someone talks your ear off about how TARP worked and we had to make the banks healthy for the good of the economy, tell them this story and ask them if you think banks with enormous mortgage liabilities and vulnerabilities on fraud are healthy. A major problem with the economy is that we have these zombie banks which, despite extraordinary government support, cannot escape the tremendous losses from their housing bubble schemes.

All you have left are tools like the one quoted in the NYT piece whining that we cannot impose the rule of law on the banks because then they’d be in trouble again and we can’t have that.

“While I believe that F.H.F.A. is acting responsibly in its role as conservator, I am afraid that we risk pushing these guys off of a cliff and we’re going to have to bail out the banks again,” said Tim Rood, who worked at Fannie Mae until 2006 and is now a partner at the Collingwood Group, which advises banks and servicers on housing-related issues.

Yeah, I bet you are worried about that. But the thing is: the banks pushed themselves off the cliff by committing all kinds of fraud for years upon years. We shouldn’t suspend the rule of law because it would inconvenience a handful of corporations. Other industry wags whined to the Financial Times about the “activist law firm” FHFA is using on the cases. Um, how about activist banksters that actively tossed homeowners out of their homes with fabricated documents, defrauded investors and destroyed the lives of millions?

Finally, we learned from Ezra Klein and Brad Plumer this week that Tim Geithner “began looking for ways to fire DeMarco” a few months ago. This lawsuit certainly puts a whole new spin on that, although I should note that a Treasury spokesperson denied this alleged action by Geithner.

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David Dayen

David Dayen