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posted by Adam Levitin

A few very quick impressions about the NYAG's suit against JPMorgan.  

1. The suit brought under the Martin Act. That's a NY state statute and this is a NY AG suit, even though it has evolved as part of the federal-state mortgage crisis taskforce. The Martin Act is a very potent tool because it has only two elements that must be shown:  a misrepresentation/omission and materiality.  Unlike a 10(b)/10b-5 federal securities fraud suit, the Martin Act does not require scienter.  Unlike a section 11/12 federal securities fraud suit (and 10(b)/10b-5), the Martin Act does not require loss causation (or have a negative loss causation defense). The Martin Act only requires a material misstatement or omission in connection with the purchase, sale, etc. of securities. 

2. The suit is not about a specific deal. It's a platform-wide case. That's a new type of suit, and not one that has been brought under the Martin Act before.  The platform-wide basis for the case also majorly ups the ante for JPMorgan.  There's a 6-year statute of limitations for the causes of action in the complaint, so that takes us back to October 2006.  Tolling agreements might push this back further. That means this compliant covers an enormous volume of deals.  From Q4 2006-2008, Bear Stearns entities issued around $56 billion in private-label MBS.  Bear was involved with an even greater volume of private-label MBS underwriting: approximately $91.5 billion. (These numbers pro-rate annual 2006 figures for a single quarter.)  It's not clear to me from the complaint if Bear would only be on the hook when an issuer or also as an underwriter--the precise division of roles in the MBS manufacturing process doesn't always track statistical breakdowns.  In either case, that's an awful lot of MBS at issue.  And note that this is just about JPM's Bear Stearn's liability.  The allegations in the suit hardly seem specific to JPM/Bear.

3. It's not immediately clear to me what the remedy would be if the NYAG were to prevail.  The Martin Act provides for injunctive relief and possibly restitution.  The suit is seeking complete disgorgement and restitution as well as damages. In theory, at least, there is a huge amount of liability here. 

4. The allegations go to the heart of the mortgage bubble.  Why did investors underprice the risk in MBS?  The NYAG's complaint has an answer--because the banks did not disclose the real riskiness of the loans, which an adequate diligence process would have caught. 

5. JPM's main defense seems fairly predictable (if only because there aren't a lot of elements to prove in a Martin Act suit):  lack of materiality. I assume JPM's materiality defense will argue that investors didn't care about the due diligence process.  I expect this might turn into a question about whether investors cared about the marginal differences in the due diligence process as promised vs. as delivered or having a due diligence process at all. If the issue is framed as being about a few loans in each pool, it might still be material, but not as obviously as if the issue is about having a due diligence process overall:  if the diligence process isn't material, why waste time and money on it? As it stands, the NYAG's complaint is not that there were some diligence slip-ups at the margin, but that the whole process was fundamentally compromosed.

6. The paragraph that really struck me was this:

Defendants took in money from a variety of sources, including: (i) loan fees on loans originated by Bear Stearns affiliates, including EMC and BSRMC; (ii) proceeds from the sale of RMBS to investors; (iii) fees from underwriting mortgage-backed securities; (iv) fees from servicing of the securitized loans; (v) fees from CDOs into which these securities were repackaged; (vi) gains and fees from trading in these securities and interest in the CDOs into which they were placed; and (vii) management fees and carried interest from hedge funds and other investment vehicles that invested in the vast array of securities and financial products structured by Defendants.

If you are a bank that makes money from mortgage securitization in all these different ways, what is the surest way to maximize your revenue? Maximize the volume of loans being produced and securitized. More loans, more fees. This model only works, however, if you can find someone willing to take on the credit risk on the loans.  And to do that, you've got to convince MBS investors that these are well-underwritten loans.  Ergo the diligence process is critical.  If the diligence process is flawed, investors will underprice risk.  Since the risk-adjusted yield will be perceived as lower by investors, they will purchase (or finance) a greater quantity of mortgages, enabling the bank to increase the volume of mortgage loans going through its securitization pipeline and thus its fee income. 


Last part of number 80 is what I find interesting.

80. Defendants kept settlement amounts for themselves rather than depositing the settlements into the relevant RMBS trusts, and failed to disclose that they were recovering and pocketing money from originators for settled EPD claims on loans that remained in their RMBS Trusts. Defendants also failed to further investigate whether any of the settled claims based on EPD, which could be a sign of fraud at origination, also constituted a securitization breach.

And the aspects of THIS case weren't brought in 2008 in FTC v. EMC/Bear because......? http://www.ftc.gov/opa/2008/09/emc.shtm

Investors underpriced the risk in MBS because the rules that regulated them substituted rating agencies' ratings for investors' individual risk judgment. Risk weights were both minimized and standardized for mortgages and AAA rated securitiations thereof. As a result, the only differentiating factor guiding purchase of MBS was yield. As a result, market makers in MBS were constantly being asked to find higher and higher yielding mortgages to package into MBS and take to the rating agencies and to the voracious buyers. As is well known, rating agencies did not diligence the securitizations. And the investor didn't care, by and large, because it was conforming to regulations and within that context getting the highest possible annual income, and thus at the individual level, the highest possible bonus. Most of the buyers of MBS were not allowed or incented to short MBS or there might have been more reason to look at underlying credit quality.

I will never forget the conversation I had with someone who sat on a trading desk for a large European bank circa late 2005. I asked him why they were buying so much MBS when it seemed awfully clear to me that credit standards had been jettisoned and he said, "the United States will never let the housing market fail."

Why did the buyers keep buying? Because they perceived how tightly bound up with one another politicians' tenure in office, their control over the fiscs and fiat currencies, the highly regulated finance sector of the developed world and the financial needs of aging populations, in an economy where workforces pricing earning power has disappeared are with one another in relation to the multi trillion dollar mortgage market.

The finance sector in Europe dwarfs that of the US as a share of GDP. Their welfare burdens have been growing far faster than their economies which put ever increasing pressure on their financial sector to find yield wherever it could. And why their financial institutions have been so highly levered. It's how they serviced their welfare burdens with a stagnant economy. It's why they were so heavily invested in MBS. (And leveraged CDO's). Once that yield strategy cracked in 07, their whole system fell apart.

Same thing in the US. Why did F & F add subprime exposure in 07 and 08? It was their mandate. They had to make loans to risky credits. That was the only way to grow, given how many households already had mortgages, and they were mandated to grow by the politicians in office at the time.
It's inherent in Ponzi schemes - they have to go on or they collapse.

It is a Ponzi scheme but the governments of the developed nations are the orchestrators, because it's for a good cause, the welfare of their aging populations (and the politicians' own re-elections).


Spot on !

I am not clear whether this is a semi-civil suit in which a formal Defence and other pleadings will proceed, or otherwise, but if the former is the JPM Defence available yet ? (Google says "no".)

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