Many
on Wall Street have long argued that the banks did not generally break
the law when they packaged shoddy mortgages and sold them to investors
in the lead-up to the financial crisis of 2008.
Many
on Wall Street have long argued that the banks did not generally break
the law when they packaged shoddy mortgages and sold them to investors
in the lead-up to the financial crisis of 2008.
But
on Monday, in the starkest of terms, a federal judge dealt a strong
blow to that version of history. She ruled that two banks misled Fannie Mae and Freddie Mac in selling them mortgage bonds that contained numerous errors and misrepresentations.
“The
magnitude of falsity, conservatively measured, is enormous,” Judge
Denise L. Cote of Federal District Court in Manhattan wrote in a
scathing 361-page decision.
The
ruling came in a closely watched case brought by the government against
the Japanese bank Nomura Holdings and Royal Bank of Scotland. They were
the only two of 18 financial firms that took their case to trial,
arguing that it was the housing crash, and not deceptive loan documents,
that caused the bonds to collapse.
The
government, under pressure to hold Wall Street accountable after the
crisis, has pursued a wide range of actions against domestic and foreign
banks. Agencies including the Justice Department and the Securities and
Exchange Commission have reached multibillion settlements.
But
some of the government’s biggest wins — including its victory on Monday
— have come from an unlikely source: the Federal Housing Finance
Agency, a relatively obscure Washington entity set up to oversee Fannie
Mae and Freddie Mac, the beleaguered government-sponsored enterprises
rescued by taxpayers in September 2008.
The
agency’s lawyers have aggressively pursued the banks, helping the
government secure big-dollar settlements. But unlike the relatively
opaque settlements, the trial against Nomura and R.B.S. opened a window
into the behavior of banks heavily involved in subprime mortgages at the
peak of the housing boom.
Judge
Cote, and not a jury, decided the case, after the government dropped a
claim that would have entitled the banks to a jury. After that, legal
experts became more pessimistic about the banks’ chances: Judge Cote has
a reputation for taking a hard line against the banks. They also
expressed surprise that the Nomura and R.B.S. did not settle, though
some suspected that as foreign banks, they were less concerned with
risking their reputations in the United States.
Judge
Cote has asked the F.H.F.A. to submit a proposal for damages, which are
expected to be about $500 million. “It is clear the court found that
the facts presented by F.H.F.A. were convincing,” Alfred M. Pollard, the
agency’s general counsel, said in a statement.
A
Nomura spokesman, Jonathan Hodgkinson, said the bank plans to appeal
the decision. “Nomura is confident that it was consistently candid,
transparent and professional in all of its dealing with Fannie Mae and
Freddie Mac,” he said. A spokesman for R.B.S. could not immediately be
reached for comment.
Judge
Cote’s ruling described a dangerous and toxic period in the American
economy. As house prices were soaring, Wall Street banks were purchasing
high-risk mortgages and then bundling them into bonds that were sold
around the world. As this huge mortgage machine churned on, the quality
of the loans plunged.
Some
financiers and housing industry analysts have since asserted that,
while Wall Street was acting out of greed and with a cavalier disregard
for risk, it did not act deceptively. But Judge Cote, in her order, took
a dim view of the banks’ conduct. She said that loan guidelines were
“systematically disregarded” and found “disturbing examples” showing
that Nomura was willing to package and sell defective loans.
“This
case is complex from almost any angle, but at its core there is a
single, simple question. Did defendants accurately describe the home
mortgages in the offering documents for the securities they sold that
were backed by those mortgages?” she wrote in her decision. “Following
trial, the answer to that question is clear. The offering documents did
not correctly describe the mortgage loans.”
Judge
Cote described Nomura as a late-to-the-party participant in the
mortgage boom that cut corners to win business, which, she asserted, led
the bank to stuff the pools of mortgages that it sold to Fannie Mae and
Freddie Mac with defective loans. The Federal Housing Finance Agency,
which was represented by Quinn Emanuel Urquhart & Sullivan, said
two-thirds of the mortgage loans underlying the securities had
underwriting defects.
“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,” the judge wrote. “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.”
During
the trial, expert witnesses performed analyses of some of the loans
backing the disputed bonds. The experts brought in by the housing
finance agency said far more of the loans than the documents stated had
characteristics that made them much more likely to default.
Lawyers
for Nomura and R.B.S. argued that those experts’ analyses were
seriously flawed. In his closing argument last month, David B. Tulchin, a
lawyer for Sullivan & Cromwell, representing Nomura, called the
experts’ methodologies “entirely artificial in the extreme.”
The
banks’ lawyers could argue on appeal that even though Fannie Mae and
Freddie Mac took steep paper losses on the bonds, their actual losses
have been small. All payments on the roughly $2 billion in bonds have
been made, except for about $25 million, according a member of Nomura’s
legal team, who spoke on the condition of anonymity.
More
broadly, Nomura, in its appeal, will most likely continue to argue that
the government’s losses on mortgage bonds were caused by the wider
housing crash, making it a legal stretch to tie the losses on those
bonds to flaws in the underlying loans.
Judge Cote, however, said that the banks’ misconduct exacerbated the collapse in the mortgage market.
“The
origination and securitization of these defective loans not only
contributed to the collapse of the housing market, the very
macroeconomic factor that defendants say caused the losses,” she wrote,
“but once that collapse started, improperly underwritten loans were hit
hardest and drove the collapse even further.”
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