Mortgage-Backed Securities Offering Fraud: The Trust Kept the Loans, the Firm Kept the Cash

In mortgage-backed securities offering fraud, the firm selling the securities hides the condition of the mortgage loans or misstates the protections promised to investors. The loan file may show missed payments that the offering leaves out. A repurchase team may collect money over a defective loan while the trust keeps the loan and receives nothing. If you worked on the loan data, quality reviews or repurchase decisions, you may know how the story changed before investors saw it.

This page follows residential mortgage-backed securities, from the loan pool’s quality to the repurchase promises and the money collected when loans failed. Our broader securities offering fraud page follows the investor pitch, the assets and the use of investor money across other offerings.

How Mortgage Loans Become a Residential Mortgage-Backed Securities Offering

Residential mortgage-backed securities turn a pool of home loans into investments whose payments depend on those loans. A sponsor buys mortgages from originators, passes them through an intermediate company called a depositor, and transfers them to a trust. An underwriter sells the securities to investors. Servicers collect borrowers’ payments and pass them to the trust for distribution.

The Securities and Exchange Commission’s complaint describing Bear Stearns’ securitizations identifies investors including banks, pension funds, credit unions and mutual funds. It also explains the documents behind the sale: the prospectus supplement describes the particular pool and payment structure, while the pooling and servicing agreement sets out the participants’ responsibilities and the sponsor’s promises about the loans. For someone reviewing mortgages, a failed underwriting check can therefore reach well beyond the original lender. It can contradict the quality and protections described to the people buying the securities.

J.P. Morgan’s Delinquency Disclosure Left Hundreds of Loans Out

The Securities and Exchange Commission alleged that J.P. Morgan misrepresented loan delinquencies in a $1.8 billion mortgage-backed securities offering in December 2006. According to the complaint, the firm disclosed only four loans as 30 to 59 days delinquent despite information showing more than 620 loans were, and had been, in that category. Even the disclosed loans were further behind: the Commission alleged that they were actually 60 to 89 days delinquent.

The complaint alleged that an investment banker raised the delinquency question, delaying printing of the preliminary prospectus supplement. In that account, a proposed disclosure that a significant percentage of borrowers had missed their first payment disappeared when the repurchase section containing it was removed. The final issuance tape, an internal loan-by-loan data file, carried next-payment-due dates that could be compared with the disclosure.

That comparison mattered because mortgage payments supplied the money to repay investors. The Commission’s complaint attributed at least $37 million in actual and projected losses to undisclosed delinquent loans that remained in the trust. Its announcement put J.P. Morgan’s fees at more than $2.7 million. The fee came from selling the offering; the investors carried the loans.

Who Kept the Mortgage-Backed Securities Repurchase Settlements?

Bear Stearns allegedly kept most of the cash it collected from originators over defective loans already sold to mortgage-backed securities trusts. Originators usually had agreed to buy back loans with early payment defaults or other defects. When an originator agreed to take a trust-owned loan back, Bear Stearns first repurchased it from the trust, making the trust whole. According to the Commission, discounted cash settlements changed that outcome: the firm collected money while most affected loans stayed in the trusts.

The Securities and Exchange Commission alleged that the practice reached loans in 156 mortgage-backed securities transactions issued from 2005 through 2007. In its account, Bear Stearns repurchased about 13% of the defective loans covered by bulk settlements, compared with nearly 100% when originators agreed to buy the loans back. For most bulk-settlement loans, the Commission said, the trusts received nothing.

The complaint alleged that when an originator agreed to repurchase a loan, a further review almost always found a breach of Bear Stearns’ promises to the trust that allowed the loan to be removed. For loans covered by cash settlements, the alleged approach changed. The complaint quotes the head of quality control at EMC Mortgage, Bear Stearns’ mortgage company, describing what the firm wanted when the originator would not repurchase:

If you worked in loan review or repurchases, you may recognize the importance of who set the review criteria and who changed them. In the Commission’s account, quality control had a preferred answer.

Credit Suisse’s Repurchase Promises Met a Different Internal Practice

The Securities and Exchange Commission’s settled order against Credit Suisse describes bulk settlements affecting 75 mortgage-backed securities trusts. The agency found that Credit Suisse kept settlement proceeds without disclosing the practice to investors. In nine transactions, the order also identified offering provisions requiring repurchase of certain early-defaulting loans that Credit Suisse left in the trusts.

A Repurchase Demand Took a Loan Out of Quality Review

The order found that, beginning at least in late 2007, Credit Suisse excluded a loan from its quality review process when it sent the originator a repurchase demand. That meant the review no longer looked for breaches of Credit Suisse’s own promises on those loans. The firm also adopted a practice of repurchasing securitized early-defaulting loans only when the originator paid it the full repurchase amount.

An internal email, the Commission found, acknowledged that bulk settlements would surprise and concern mortgage-backed securities investors. When investors asked about early payment defaults, Credit Suisse described repurchasing loans to enforce its rights against originators but omitted that it sometimes enforced those rights without buying the loans back.

First Payment Default Protection Had a Backstop

In two separate mortgage-backed securities offerings, the Commission found that Credit Suisse marketed protection that removed “all First Payment Default Risk.” The originator was supposed to repurchase or substitute qualifying loans that missed payments around securitization. If the notified originator failed to meet that obligation, Credit Suisse’s sponsor company had to step in.

The order found that Credit Suisse began limiting repurchase demands after learning of the originator’s deteriorating finances. A revised demand dropped 85 mortgages that had qualified as first payment defaults and had appeared in the earlier demand. Investors were not told that Credit Suisse had stopped demanding repurchase of every qualifying loan. Credit Suisse’s backstop promised investors protection. The undisclosed change left them holding the loans.

What Evidence Shows Mortgage-Backed Securities Offering Fraud?

For mortgage-backed securities offering fraud, useful evidence connects what investors were told with the loan facts, the repurchase decisions and the destination of the money. Our work on securities fraud evidence starts with that connection and the people who can explain it. A loan’s next-payment-due date, the offering’s cutoff date and the method used to label delinquency can explain how a pool’s reported condition changed.

For repurchases, the chain runs from the loan defect and the originator’s promise to the demand, the settlement and the trust’s accounting. A quality review can show whether the firm identified a breach of its own promises. The originator’s payment and the trust’s receipts show who received the benefit. Draft disclosures and investor questions can then show what the firm told investors about the same practice.

Loan quality extends beyond missed payments. In its October 2010 disclosure letter, the Securities and Exchange Commission’s Division of Corporation Finance identified mortgage representations covering ownership, underwriting standards and delivery of documents to the trust. The letter also addressed repurchase requests and changes in repurchase reserves. Someone in underwriting or accounting may understand why a defect appeared in an internal review but never reached the description investors received.

Who Investigates Mortgage-Backed Securities Offering Fraud?

The Securities and Exchange Commission investigated and brought the J.P. Morgan and Credit Suisse mortgage-backed securities actions described here. It coordinated with the federal-state Residential Mortgage-Backed Securities Working Group, which included the Justice Department, the FBI and state attorneys general. We assess how your evidence fits the authorities responsible for the conduct as part of building the whistleblower matter with you.

Mortgage-Backed Securities Settlements and Whistleblower Rewards

In November 2012, J.P. Morgan agreed to pay $296.9 million to settle the Commission’s charges concerning the delinquency disclosures and Bear Stearns’ bulk settlements. Credit Suisse agreed to pay $120 million for its bulk-settlement and first-payment-default practices. The Commission announced plans to distribute money to harmed investors through Fair Funds.

The sums the firms collected from originators explain another part of the stakes. The Commission put proceeds from Bear Stearns’ bulk-settlement practice at no less than $137.8 million, and Credit Suisse’s profits and avoided losses from its practice at $55.7 million. We see settlements worth hundreds of millions and not an admission between them.

Whistleblower rewards have a separate purpose from money returned to investors. A Securities and Exchange Commission whistleblower award can be 10% to 30% of the sanctions collected. For fraud against government money, a separate whistleblower case under the False Claims Act can pay 15% to 30% of what the government recovers. We assess the conduct and the money involved with you to identify the program that fits.

You Know Why the Loan Stayed in the Pool

If you know why a delinquent loan disappeared from a disclosure, why a review changed or where a repurchase payment went, speak with our whistleblower experts about the RMBS offering. We work beside you to build the case around the loan records, the investor promises and the decisions you understand. We bring in securities fraud whistleblower lawyers who understand mortgage securitizations and stay with you as the case develops.