protester at Occupy Philly photo by rob kall
Rep. Scott Garrett of New Jersey seeks to gut many of the investor protections of the Securities Act of 1933, at least as they apply to mortgage-backed securities. Wait, you didn't notice that little detail last week, when he rolled out his Private Mortgage Market Investment Act for The Wall Street Journal , American Banker , Reuters , and CNBC ? Well, Garrett's contempt for transparency shows up in his press release on "mortgage finance reform." If you look at his actual proposal, you see a craven maneuver to remove transparency from the marketplace and to short-circuit the rule of law, so as to insulate Wall Street fraudsters from accountability.
To appreciate Garrett's broad-based scheme, you need to understand what's going on with the largest Wall Street banks right now. All of a sudden, their complicity in the systemic mortgage fraud that continues to cripple our economy is being exposed to the light of day. How many subprime loans were tainted by fraud? The answer, according to a multitude of sources, is: The majority of them. Back in 2007, Fitch's survey of subprime loan files showed that virtually all of them were tainted by some type of fraud. One of the most prevalent forms of fraud was occupancy fraud, where a borrower falsely claims that the mortgaged property is his primary residence, instead of a property in a flipping scheme. Nobody gets hurt until home prices stop rising, and then the flippers hand over the keys and walk away. A new survey by the New York Fed shows that about half of all subprime mortgages financing home purchases involved a buyer who didn't reside at the property, meaning that a whole lot of occupancy fraud was going on. Which in no way diminishes the prevalence of appraisal fraud and documentation fraud, which were also found by Fitch.
Check out the complaints alleging fraud in the sale of mortgage securities that were recently filed by Allstate , AIG , MBIA , MassMutual , TIAA-CREF, New York Life , by the FHFA ( here , here , here , and elsewhere, ) and by a multitude other investors . All of these suits set forth substantially identical fact patterns concerning fraud involved in the sale of the same types of mortgage-backed securities. It's impossible to read those filings and not be struck by all the damning evidence of the banks' complicity, as underwriters subprime and Alt-A mortgage securities, in promoting massive fraud throughout the loan distribution chain.
All of these lawsuits involve false and misleading statements made in documents filed under the Securities Act of 1933. Everyone benefits from the Act's filing requirements, which constitute a powerful enforcement mechanism for keeping people honest, and for promoting transparency. Even if you don't invest in a particular securitization, your access to that publicly available information gives you a better sense of the goings on in the marketplace. These lawsuits echo the findings of massive fraud uncovered by the Attorney General of the State of New York , by the Justice Department and by intrepid reporters . But that's not the half of it.
You may have read stories concerning putback claims pertaining to breeches of the representations and warranties in contracts to sell pools of mortgages. Putbacks are generally synonymous with fraud, either fraud committed as part of the loan origination, or fraud committed by the seller of the pool, who misrepresented the attributes of the loans being sold. Almost every deal involving the sale of a mortgage pool includes a rep and warrant that the individual loans comply with all state and Federal laws. Check out the schedule of violations of reps and warrants disclosed by U.S. Bank National, as Trustee for investors in a single Countrywide mortgage bond deal, (Exhibit D). The vast majority of those breeches involved fraud at the origination, or false claims about the mortgages themselves. Among the individual loans it reviewed, U.S. Bank National found that the reps and warrants were violated 66% of the time. That's pretty much in line with what others have found. A year ago, John Carney of CNBC reported on Citigroup's findings with regards to loans it purchased from other originators, who were tasked with reviewing the underwriting and documentation; the defect rate ranged as high as 60 to 80%.
The efficacy of these reps and warrants, and the legal obligation to assure that the information disseminated in documents filed under the 1933 Act is accurate and complete, is essential to any effective market for mortgage securitizations. No investor can perform the necessary due diligence to review every single loan file prior to the purchase of a mortgage security to assure the accuracy of the issuer's claims.
Why is all the evidence emerging now, five years after these bad loans were originated? Because of the obstacles faced by private investors who wanted to access the loan information. As Isaac Gradman explains in The Subprime Shakeout:
"One reason [for the relatively small number of putback claims] may be the procedural hurdles that investors face when pursuing rep and warranty put-backs or repurchases. In general, they must have 25% of the voting rights for each deal on which they want to take action. If they don't have those rights on their own, they must band together with other bondholders to reach critical mass. They must then petition the Trustee to take action. If the Trustee refuses to help, the investor may then present repurchase demands on individual loans to the originator or issuer, but must provide that party with sufficient time to cure the defect or repurchase each loan before taking action. Only if the investor overcomes these steps and the breaching party fails to cure or repurchase will the investor finally have standing to sue."
Garrett wants to prevent investors from ever banding together in the future. Under the guise of "protecting investor rights," his proposed law expressly forbids the trustee to a mortgage securitization from disclosing the identities of investors to one another. He wants to add another layer of secrecy to the credit markets.
Secrecy was the essential ingredient in the most toxic instruments of the mortgage bubble: CDOs and credit default swaps. Nobody, aside from a handful of Wall Street insiders, had a clue about the big picture: The nature of the risks, the cumulative size of the risks, or who was buying or selling the risks. These investment vehicles exploded on to the marketplace because these secretive instruments were sold to an army of suckers who were legally designated as "sophisticated investors." An issuer of a privately placed transaction, which is not subject to the registration requirements of the 1933 Act, can go a long way toward misleading the buyer without facing any legal consequences, thanks in large part to a 20-year-old Supreme Court case, Gustafson v. Alloyd . (This is one of many cases that exemplify the Court's philosophy of Defining Deviancy Down , when it comes to interpreting Federal securities laws.) The secrecy regarding credit default swaps is an enduring legacy of the Enron Loophole , which prohibited regulatory oversight of the vast majority of derivatives. Garrett wants to make sure that all sellers of mortgage securities attain the same insulation from liability as that afforded John Paulson or Magnetar.
Arbitration adds another layer of secrecy to the credit markets and subverts the checks and balances of our legal system. Garrett wants to limit investors ' constitutional rights to legal redress in courts, where everything is out in the open. He wants to prohibit any rep and warrant claims from being adjudicated in the courts, even though, in a free market, sophisticated investors should be afforded the opportunity to decide on a forum for resolving disputes. All rep and warrant claims must be resolved through an arbitrator under garrett's proposal. Almost everything about arbitration proceedings is kept secret. Frequently, arbitrators ignore the law, and even if they claim to be following the law when they ' re actually bending it, no one would know, because almost nothing about an arbitration proceeding happens out in the open. Arbitrator decisions cannot be appealed. And the financial industry has set up a framework to exempt arbitrators from ethical standards. If you ' re an arbitrator, you ' re put in the same position as a property appraiser or a ratings agency ; that is, you ' re concerned about displeasing the people who might keep you from getting hired again.
And Garrett wants to emasculate the legal protections afforded by the 1933 Act. He proposes to exempt mortgage securities from the filing requirements of the 1933 Act, which means that an issuer no is longer obligated to certify as to the accuracy and completeness of his filings. An investor might try and bring a case for fraud, which is extremely hard to sustain, thanks to the Private Securities Litigation Reform Act of 1995, which requires a plaintiff to come close to proving what the defendant knew, when he knew it, and that such knowledge caused a material fraud, in his initial complaint, before he has the opportunity to conduct any discovery. This legislation gave Wall Street bankers the enhanced comfort they needed to sell all those toxic securities without fear of getting caught.