President’s Financial Fraud Task Force Brings Action for Deceit in Sale of Residential Mortgage-Backed Securities

The Residential Mortgage-Backed Securities Working Group of the President’s Task Force on Financial Fraud Enforcement filed an action against large financial institutions for allegedly making fraudulent misrepresentations to in the sale and promotion of residential mortgage-backed securities to investors. The enforcement action, brought under the New York Martin Act, claims that the financial firms deceived investors as to the care taken in evaluating the quality of mortgage loans packaged into residential mortgage-backed securities. SEC Enforcement Director Robert Khuzami is a co-chair of the Working Group; and the SEC made crucial contributions in sharing its expertise with working group members and giving them access to substantial evidence in its investigations.

According to the complaint, one financial institution led its investors to believe that the quality of the loans in its mortgage-backed securities had been carefully evaluated and would be continuously monitored. Instead, the firm systematically failed to evaluate the loans, largely ignored defects that its limited review did uncover, and kept its investors in the dark about the inadequacy of the review procedures and defects in the loans. Even when senior officers of the firm were made aware of these problems, said the complaint, the company failed to reform its practices or disclose material information to investors. As a result, the loans in the mortgage-backed securities included many that had been made to borrowers who were unable to repay the loans, were very likely to default, and ultimately did default in large numbers.

As explained in the complaint, filed in New York State Supreme Court, residential mortgage­-backed securities were pools of mortgages deposited into trusts. Shares of the RMBS trusts were sold as securities to investors, who were to receive a stream of income from the mortgages packaged in the RMBS. In registration statements, prospectuses, prospectus supplements, term sheets, and other securities filings and marketing materials, said the complaint, defendants led investors to believe that they had carefully evaluated, and would continue to monitor, the quality of the loans in the RMBS.

The action charges that the firms failed to abide by representations that the loans underlying their RMBS were originated in accordance with the applicable underwriting guidelines, i.e., the standards in place to ensure, among other things, that loans were extended to borrowers who demonstrated the willingness and ability to repay. Further, while the defendants claimed that they undertook due diligence to ensure that the loans they purchased from originators complied with the relevant guidelines, they routinely overlooked defective loans that were identified through the due diligence review and ignored deficiencies that they knew existed in the due diligence review process itself.

According to the complaint, the firm was aware that its due diligence processes were fundamentally compromised by the massive number of loans that the company sought to have reviewed in very short periods of time. The corporation’s need to maintain business relationships with mortgage originators created a strong incentive for it to limit the number of defective loans that were eliminated from any given pool. Even when these flawed processes did identify defective loans, it was alleged that the firm nonetheless routinely overlooked negative findings and continued to package the loans into securities for sale to investors.

Although the firm operated a quality control department that was supposed to detect red flags in the loans post-securitization and determine whether the loans complied with underwriting guidelines,  noted the action, the department was so overwhelmed that it essentially could not function. The firm was aware that the QC department was in crisis, alleged the regulators, but took no action to reform the quality control process. In addition, even when the QC department identified serious problems, the firm entered into settlements that benefited loan originators at the expense of investors.