Judge rules 2 banks at fault in bad loans before '08 meltdown

NEW YORK -- Many on Wall Street have long argued that banks did not generally break the law when they packaged shoddy mortgages and sold them to investors in the lead-up to the financial crisis of 2008.

But on Monday, in the starkest of terms, a federal judge disputed that version of history. She ruled that two banks misled Fannie Mae, the Federal National Mortgage Association, and Freddie Mac, the Federal Home Loan Mortgage Corp., in selling them mortgage bonds that contained numerous errors and misrepresentations.

"The magnitude of falsity, conservatively measured, is enormous," Judge Denise Cote of U.S. District Court in Manhattan wrote in a 361-page decision.

The ruling came in a closely watched case lodged by the government against the Japanese bank Nomura Holdings and Royal Bank of Scotland. They were the only two of 18 financial firms that took their case to trial, arguing that it was the housing crash, and not deceptive loan documents, that caused the bonds to collapse.

The other firms -- including Goldman Sachs and Bank of America -- settled, together paying nearly $18 billion in penalties but avoiding a detailed public airing of their conduct.

The government, under pressure to hold Wall Street accountable after the crisis, has pursued a wide range of actions against domestic and foreign banks. Agencies including the Justice Department and the Securities and Exchange Commission have reached multibillion-dollar settlements.

But some of the government's biggest wins -- including its victory Monday -- have come from an unlikely source: the Federal Housing Finance Agency, a relatively obscure Washington entity set up to oversee Fannie Mae and Freddie Mac, the government-sponsored enterprises rescued by taxpayers in September 2008.

The agency's lawyers have aggressively pursued the banks, helping the government secure big-dollar settlements. But unlike the vague settlements, the trial against Nomura and Royal Bank of Scotland opened a window into the behavior of banks involved in subprime mortgages at the peak of the housing boom.

Cote, and not a jury, decided the case, after the government dropped a claim that would have entitled the banks to a jury trial. After that, legal experts became more pessimistic about the banks' chances: Cote has a reputation for taking a hard line against banks. They also expressed surprise that Nomura and Royal Bank of Scotland did not settle.

Cote has asked the Federal Housing Finance Agency to submit a proposal for damages, which are likely to be about $500 million. "It is clear the court found that the facts presented by [the Federal Housing Finance Agency] were convincing," Alfred Pollard, the agency's general counsel, said in a statement.

A Nomura spokesman, Jonathan Hodgkinson, said the bank plans to appeal. "Nomura is confident that it was consistently candid, transparent and professional in all of its dealing with Fannie Mae and Freddie Mac," he said. A spokesman for Royal Bank of Scotland could not be reached for comment.

Cote's ruling described a dangerous and toxic period in the U.S. economy. As home prices were soaring, Wall Street banks were purchasing high-risk mortgages and then bundling them into bonds that were sold around the world. As this huge mortgage machine churned on, the quality of the loans plunged.

Some financiers and housing industry analysts have since asserted that while Wall Street was acting out of greed and with a disregard for risk, it did not act deceptively. But Cote, in her order, said loan guidelines were "systematically disregarded" and found "disturbing examples" showing that Nomura was willing to package and sell defective loans.

"This case is complex from almost any angle, but at its core there is a single, simple question. Did defendants accurately describe the home mortgages in the offering documents for the securities they sold that were backed by those mortgages?" she wrote in her decision. "Following trial, the answer to that question is clear. The offering documents did not correctly describe the mortgage loans."

The Federal Housing Finance Agency said two-thirds of the mortgage loans underlying the securities had underwriting defects.

"As its witnesses repeatedly described and as its documents illustrated, Nomura's goal was to work with the sellers of loans and to do what it could to foster a good relationship with them," the judge wrote. "Given this attitude, it is unsurprising that even when there were specific warnings about the risk of working with an originator, those warnings fell on deaf ears."

During the trial, expert witnesses performed analyses of some of the loans backing the disputed bonds. The experts brought in by the housing finance agency said far more of the loans than the documents stated had characteristics that made them much more likely to default.

Lawyers for Nomura and Royal Bank of Scotland argued that those experts' analyses were seriously flawed. In his closing argument last month, David Tulchin, a lawyer for Sullivan & Cromwell, representing Nomura, called the experts' methodologies "entirely artificial in the extreme."

Nomura, in its appeal, most likely will continue to argue that the government's losses on mortgage bonds were caused by the wider housing crash, making it a legal stretch to tie the losses on those bonds to flaws in the underlying loans.

Cote, however, said the banks' misconduct exacerbated the collapse in the mortgage market.

"The origination and securitization of these defective loans not only contributed to the collapse of the housing market, the very macroeconomic factor that defendants say caused the losses," she wrote, "but once that collapse started, improperly underwritten loans were hit hardest and drove the collapse even further."

Business on 05/13/2015

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