Residential Mortgage Backed Securities Litigation

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Residential Mortgage Backed Securities Litigation 1 By John Graham

Litigation Facing Directors and Underwriters

In the wake of the “melt-down” of the mortgage market, including the market for RMBS, there have been numerous suits brought by investors, whose investments in RMBS suffered either paper or actual losses, against the issuer of the securities and its officers and/or the securities underwriters who participated in the marketing and sale of the securitizations. While some of these suits have been dismissed or settled, many more continue through the legal process: motions to dismiss, class certification, certification , appeals, etc. This note summarizes some of the current litigation issues and allegations facing directors and underwriters of RMBS within the context of mortgage loan underwriting and offering document disclosure.

Litigation against Directors and Officers

Many of the complaints in the RMBS-related litigation allege that the offering materials, prospectuses and related prospectus supplements, contained materially false statements or omitted material facts necessary to make the statements not misleading. Consequently, officers of RMBS depositor entities who signed the registration statements for which the prospectuses provide disclosure are named as defendants in the litigations. These officers can have a variety of titles including Chief Executive Officer, Chief Financial Officer, President, Controller, Director and Vice President; however, regardless of their title, they had been given corporate signing authority to effectuate documents obligating their corporate entity to comply with rules, regulations and laws surrounding the issuance of securities.

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 John Graham is a Managing Director in the FTI Consulting Forensic and Litigation Consulting segment and is based in New York. The views expressed in this paper are solely those of the author himself and should not be attributed to the author’s firm, its other professionals, professionals, or to any of his clients.

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Most frequently included in RMBS-related litigation involving material misstatements or omissions are allegations that the underwriting guidelines disclosed in the offering materials either failed to describe accurately the actual processes involved in extending credit to a borrower or the degree to which exceptions to underwriting guidelines were made in the mortgage loan origination process. In addition, in many instances, the mortgaged property valuation process is also called into question, with claims of understated loan-to-value ratio disclosure and related inadequacy of the mortgaged collateral to offset the corresponding indebtedness. The Securitization Process and Related Disclosure

Mortgage conduits were businesses that aggregated pools of mortgage loans either through direct origination or indirect acquisition. In general, a conduit business model was then to form pools of relatively similar product (Prime, Alt-A or Subprime, as examples) and/or type (Fixed rate or ARM), with potentially further segmentation within type (15-year vs. 30-year maturities, Pay option vs. Hybrid ARMs, for example). Pooling similar types of mortgage loan assets allows for more predictable types of cash flows which then allow for more precise certificate structuring (Sequential-pay, Planned amortization, Interest- or Principal-only certificate classes, etc.). While this process of acquiring and packaging mortgage loans into RMBS may seem rather straight-forward, one complicating fact is the source of the mortgage loan collateral. These sources can range from individual loan-by-loan retail origination to bulk acquisition of mortgage loan pools totalling billions of dollars, as well as everything in between. Either extreme can provide straightforward disclosure of the related underwriting guidelines and origination process, assuming they were originated pursuant to a single program and by a single lender. Challenges arose when a mortgage loan collateral pool came from a combination of sources and/or multiple originators each of which had distinctions to their particular underwriting and origination processes. Further compounding this disclosure challenge was the subjectivity that an originator could employ if a prospective borrower did not precisely meet guideline requirements, but was otherwise deemed to be a satisfactory mortgage loan candidate due to compensating factors. To accommodate these sorts of “aggregation deals” (multiple sources and/or originators), offering document disclosure regarding the underwriting guidelines used to originate the specific mortgage loans included in a particular securitization trust usually provided general descriptive underwriting guideline disclosure for mortgage loans coming from sources comprising less than 5% of a collateral pool and increasingly more robust disclosure for concentrations greater than 5% and finally comparatively detailed underwriting disclosure for mortgage loans coming from

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“customarily”, “typically contains”, “generally performed”, “generally completed”, “generally must have been made”, etc. In addition, given the both objective and subjective nature of mortgage lending, disclosure regarding exceptions was also included. For example, “exceptions to … underwriting guidelines will be made when compensating factors are present.” This qualified disclosure language made explicit allowance for exceptions to underwriting guidelines. Indeed it has been alleged that underwriting exceptions were tantamount to the abandonment of underwriting guidelines. Alternatively, it has long been common practice to allow subjective flexibility in order to provide mortgage loans to qualified borrowers who cannot be accommodated through strict adherence to the guidelines. These types of underwriting disclosures were drafted to reflect that flexibility. The intent of the disclosures was not to mislead but be inclusive, not to overwhelm investors with detail, but to summarize generally and accurately. It should be noted that the underwriting guideline and origination process disclosure was not static, but evolved over time, not only to accommodate innovation in mortgage loan product types or automated approval methodologies, but also to reflect some characteristics of borrowers in particular programs. For example, one issuer whose collateral pools included mortgage loans underwritten to “stated income” guidelines included the following disclosure: “It is reasonable to assume that the actual income for certain of the borrowers under the stated income documentation program will be less than the stated income as represented by such borrowers.” Complementary to these guideline and process disclosures, the “Risk Factors” section of these RMBS offering documents also addressed the nature of mortgage loan origination and underwriting. For example, many offering documents included language like “…underwriting standards…differ from, and are…generally less stringent than, the underwriting standards established by Fannie Mae or Freddie Mac” and “[a]s a result,…may experience rates of delinquency, foreclosure and borrower bankruptcy that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in strict compliance.” Similar, but product type or program-specific Risk Factor disclosure also included examples such as: “…interest-only loans reduce the monthly payment required by borrowers during the interestonly period and consequently the monthly housing expense used to qualify borrowers. As a result, interest-only loans may allow some borrowers to qualify for a mortgage loan who would not otherwise qualify for a fully-amortizing loan or may allow them to qualify for a larger mortgage loan than otherwise would be the case.” Conclusion

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challenge will no doubt depend on the specifics of the case, the disclosure in question and the sophistication and/or knowledge of the investor.

Litigation against Underwriters

Types of Litigation

Allegations of inadequate due diligence are among the types of RMBS-related litigation investors have brought against underwriters of RMBS. Plaintiffs have alleged that underwriters either performed too little mortgage loan collateral due diligence, disregarded due diligence findings and/or did not demand more robust offering document disclosure to reflect due diligence results. Due Diligence

In the context of financial transactions, the term due diligence refers to efforts by financial intermediaries, including banks or investment banks, to ascertain the accuracy and completeness of information involving a pending transaction. Basically due diligence is the precaution that a reasonable person exercises under the circumstances to avoid harming others and more specifically can involve the analysis of a counterparty or its product done in preparation for a business transaction. Underwriters have powerful legal reasons and reputation incentives to perform thorough due diligence. Recognition by investors that an underwriter’s due diligence is thorough (independent of any investors’ own due diligence) enhances its reputation as a source of high quality offerings. Broadly speaking, due diligence includes those procedures employed and analysis undertaken by all of the parties involved, including counsel and independent public accountants, in any securities offering in order to mitigate liability under the complex provisions applicable to securities offerings.

Types of Due Diligence

Due diligence will vary based on the type of securities offered. Analysis of issuing companies or public entities will rely on audited financial statements, discussion with the issuers, legal assistance concerning corporate documents and other available information. In the case of whole loan pools and RMBS, however, an investor’s return derives not from the financial condition or

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example, bond insurance or corporate guarantees, as well as traditional internal credit enhancement features such as subordination and/or over-collateralization. Accordingly, the due diligence performed for the underwriting of RMBS issuances is distinctly different from due diligence performed for traditional debt or equity issuances. Furthermore, the due diligence performed for whole loan acquisitions is distinctly different from that customarily performed for RMBS issuances. One area in which whole loan mortgage pools and RMBS issuances differ is credit enhancement. An investor in a whole loan mortgage pool does not have all of the credit enhancement protection generally afforded, for example, a senior payment priority or bond-insured RMBS certificate. The investor in a whole loan pool for the most part is directly subject to the performance of individual borrowers and any recovery on liquidated mortgaged properties. Accordingly, due diligence on whole loan pools is broader than would necessarily be needed for underwriting RMBS issuances. Whole Loan Acquisition

While not technically an “underwriting”, it is useful to consider typical due diligence undertaken on pools of whole loans. Mortgage conduits obtained loans to securitize through many channels ranging from direct lending to bulk acquisition. The type and extent of due diligence performed on loans acquired through the various channels will depend on many factors, including: •

The counterparty (for example, a whole loan selling client with proven track record, firsttime whole loan seller, or direct borrower);



The type of collateral (for example, first lien, second lien, or home equity line of credit); and



The perceived credit quality of the collateral (Prime, Alt-A, or Subprime).

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Bid-and-comp (or third-party) underwritings involve a bidding group of securities firms who are asked to price all or a portion of a securitization that a non-affiliated mortgage conduit is proposing to issue through its own shelf registration within the following few days or few months. Security underwriting firms have the opportunity to bid on the entire deal (from AAA to unrated certificate classes), or portion(s) of the deal (AAA certificates only, subordinate certificate classes only, private certificate classes only, etc.). The bidder with the highest price wins which ever portion of the issuance they bid on and earns as compensation any positive difference between its purchase price and the price paid by an investor. Proprietary underwritings involve a securities firm underwriting the securitization for a mortgage conduit corporate affiliate. The type of underwriting will largely dictate the form and extent of due diligence performed including: counterparty due diligence, credit due diligence, and “tape-to-file” data integrity due diligence. Underwriter due diligence usually includes: •

Counterparty due diligence, which is normally performed at the beginning of a relationship between the underwriter and issuing client. Cumulative knowledge is developed through subsequent monitoring and review of collateral performance over time, perhaps with further counterparty due diligence undertaken if collateral performance trends are poor, or if there is a corporate-level event or a change at the counterparty;



Credit due diligence, performed to determine collateral credit conformity to the underwriting guidelines used at origination;



Legal compliance due diligence, performed to determine collateral compliance with

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Review for evidence of predatory lending; and



Appraisal analysis.

The analysis of the results from the third-party credit due diligence provider would enable the RMBS underwriter to determine whether the mortgage loans in the sample pool were originated or acquired generally in compliance with related underwriting guidelines, or if not, had compensating factors that would mitigate default risks, and confirm that any notable exceptions were not indicative of negative origination or underwriting trends. Subsequently, this analysis is the basis for the underwriter reconciling with the issuer as to which mortgage loans should be removed from the collateral pool. For RMBS, tape-to-file due diligence was performed by a recognized accounting firm which issued an “Agreed upon Procedures” or “comfort letter” regarding the accuracy of any collateral numeric data disclosed in the offering document as compared to its sampled source data. In addition to underwriter’s due diligence on collateral and/or counterparty, and data integrity analysis by accountants, underwriter’s counsel also reviewed the offering documents and provided an opinion stating its role in the transaction, actions taken during the course of the transaction and belief that the offering documents did not contain untrue statements of a material fact or omit to state any material fact required to make statements not misleading. Due Diligence Scope

The scope and extent of credit due diligence depended on the type of RMBS issuance being underwritten. The underwriter selected a sample from a preliminary collateral pool composed of both randomly selected and adversely selected mortgage loans. The objective of random sampling is to obtain a broad overview and assessment of an originator’s consistency of its collateral when compared to the relevant underwriting guidelines. The objective of adverse sampling is to target certain mortgage loans that have characteristics found most frequently in

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mortgage conduit’s securitization was mitigated by the fact that a significant percentage of the acquired (or originated) whole loans underwent credit due diligence immediately prior to acquisition. Typically, the time between acquisition and securitization was brief, normally ranging from a few days to a few months. Regardless of the amount of any credit due diligence undertaken, tape-to-file data integrity due diligence was always performed. Forensic Due Diligence

For litigation involving underwriter due diligence, the analysis of what due diligence was performed on specific securitization collateral pools could include examination of whether: •

Statistical sample sizes were adequate to determine meaningful conclusions as to compliance or non-compliance with underwriting guidelines;



Strict compliance with underwriting guidelines equated to mortgage loan performance;



The reasons for removing mortgage loans for non-compliance with underwriting guidelines followed any identifiable or consistent trend;



Servicing comments for delinquent mortgage loans reflected macro-level circumstances impacting borrowers; and



Any mortgage loans coded for removal from a securitization collateral pool because of negative due diligence findings still remained after the deal’s closing, and if so, how those mortgage loans performed.

Conclusion

For underwriters now facing litigation brought by investors alleging the underwriters due

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