The housing and mortgage loan crisis that culminated with the financial collapse of 2008 have left a trail of litigation in the last few months. Chris Gamaitoni of Compass Point Trading & Research LLC says action taken by investors and the government could ultimately result in securities issuers paying compensation in the neighborhood of $200 billion dollars. The litigious MBS environment includes lawsuits from individual investors, such as Massachusetts Mutual Insurance Company and Allstate Insurance. Class action lawsuits, SEC investigations, and other actions also move toward settlement or litigation.
Class Action Lawsuits
Investors have filed about 20 class action lawsuits against MBS issuers. The lawsuits claim that issuers violated the Securities Act of 1933 by creating and selling trillions of dollars worth of mortgage-backed securities as “investment grade” bonds. Generally, lawsuits assert that issuers distributed offering documents, which outline the objectives, risks, and terms of the investments, but contained false and misleading information, or omitted material information. Offering documents given to investors represent “legal documents.”
Since many of the MBS activities occurred several years ago, many potential cases are running up against the Statutes of Limitation (SOL). SOL rules come under section 3(a)(47) of the Securities Exchange Act of 1934. Plaintiffs alleging fraud, deceit, or manipulation must file their lawsuits within two years after discovering facts making up the illegal act. Otherwise, the SOL requires filing of securities lawsuit within five years after the violation occurs.
For many of these cases, it seems success action depends on the section of the law used to bring the claim. These types of lawsuits fall under two categories of SEC regulations. Under 10b-5, of section 10-b of the Securities and Exchange Act of 1934, the plaintiff case alleges fraud in general. Legal requirements make this case difficult to prove. To state a sufficient claim, the plaintiff must provide the details of the allegation in the complaint. Section 11 and 12 (a)(2) of the regulations do not require the plaintiff to demonstrate the bank possess knowledge of the fraud.
Pleading MBS Fraud Cases
Besides running up against the Statues of Limitation, litigants in civil lawsuits must also deal with the stiff requirement for plaintiffs who file cases. The Private Security Litigation Reform Act (PSLRA), passed by Congress in 1995, claims to discourage frivolous litigation intended to force a settlement before going to court. PSLRA places a heavy burden on a claimant to show the defendant had “knowledge of the fraud” for cases based on 10b-5 of SEC rules.
Many plaintiffs present proof in the form of confidential witness statements or show how bankers knew of lower standards for originating underlying mortgages supporting the MBS. The case must demonstrate to the court “a strong possibility” that the defendant possessed knowledge of the fraud prior to pretrial discovery. Failure to meet this obligation has led to case dismissals.
Increasing, plaintiffs have brought their cases under Section 11 and 12 (a)(2) of the Securities and Exchange Act. This section of the regulations does not place as stringent a requirement on the plaintiffs to show that the issuer possess knowledge of the fraud on the part of the issuer – misstatement and omissions
Originally, many of these class-action lawsuits included all investors who bought bonds from a specific issuer. However, some courts have ruled investors must have “standing.” This means investors have to own certificates backed by the underlying mortgages. Investors without standing under class action suits may lose out entirely if the Statutes of Limitation has expired.
MBS Trustees Suing the Banks
One of the more interesting aspects of MBS litigation involves trustees of funds that brought defective investments. Many trustees also work for investment banks embroiled in investigations and litigation for selling similar “toxic investments.” including Citigroup, Wells Fargo, and Deutsche Bank. As a result, trustees have been slow to act on the behalf of investors. However, well-informed investors have joined to coerce trustees into taking action to help their cases.
Only a trustee can request documents from MBS issuers. It takes at least 25 percent of security holders to place demands on fund trustees. Trustees that refuse to cooperate with investors face possible litigation. Earlier this year, Wells Fargo & Co, trustee for Bear Stearns Mortgage Funding Trust 2007-AR2, filed a lawsuit against EMC. Wells Fargo wants the court to order EMC, to turn over the files for 2000 mortgages , backing the bond.
The suit states that EMC has engaged in “rope a dope” and “drag its feet” when it comes to delivering the files that may include appraisals, credit reports, and borrowers’ reported income. EMC operates as a division of JPMorgan Chase & Co.
In April 2010, the SEC filed a lawsuit against Goldman Sachs for activities related to a Collateralized Debt Obligation issue (CDO). CDOs consist of mortgage-backed-securities packaged into another a security. The SEC charged that Goldman Sach did not reveal to investors that Paulson & Co. Inc., a major hedge fund, played a major role in selecting MBSs for the CDO. Paulson selected MBSs that had a losing value. He planned to short the bond.
To cover up Paulson’s involvement, Goldman Sachs represented ACA Management LLC to other investors as the entity choosing the underlying MBSs for the security. Paulson was represented as Paulson as just another investor. Goldman Sach earned a $15 million dollar fee on -- Abacus 2007-AC1 CDOs. Paulson walked away with $1 billion. In July 2010, the SEC settled the case for $550 million.
In the last several weeks, the SEC has served subpoenas on JPMorgan Chase & Co. and Credit Suisse Group AG. Some insiders say the SEC will center investigations on the accuracy of disclosures made by bankers. In addition, the SEC also wants to determine if bankers misrepresented or omitted information in their offering materials.
Another federal case involves the regulatory agency for credit unions, the National Credit Union Administration (NCUA). NCUA, which functions as the “FDIC” for credit unions, filed because it had to put five of its 27 wholesale credit union members under receivership. Wholesale credit unions invest customers’ funds and provide other services. The five wholesale credit unions suffered a combine loss of about $15 billion. NCUA has threatened to file lawsuits against Citigroup Inc., J.P. Morgan Chase & Co, Goldman Sachs Groups Inc, Merrill Lynch and Bank of America, unless the bankers return the money.