Wednesday, February 23, 2011

Allstate and others sue banks for toxic MBS. Great summary of the tactics that led to the bubble and the crash.


1. This action arises out of Defendants’ fraudulent sale of residential mortgagebacked
securities in the form of pass-through certificates (the “Certificates”) to Allstate.
Whereas Allstate was made to believe it was buying highly-rated, safe securities backed by pools
of loans with specifically-represented risk profiles, in fact, Defendants knew the pool was a toxic
mix of loans given to borrowers that could not afford the properties, and thus were highly likely
to default.

2. Defendants made numerous material misrepresentations and omissions regarding
the riskiness and credit quality of the Certificates in registration statements, prospectuses,
prospectus supplements, and other written materials (the “Offering Materials”). For example:
(i) Underwriting Guidelines. The Offering Materials represented that a
particular, reasonable underwriting process was followed to ensure that only loans that the
borrower could repay would be included in the pools underlying the Certificates (the “Mortgage
Loans”). In fact, the disclosed underwriting standards were systematically ignored in originating
or otherwise acquiring non-compliant loans. For instance, recent reviews of the loan files
underlying some of Allstate’s Certificates reveal a pervasive lack of proper documentation,
facially absurd (yet unchecked) claims about the borrower’s purported income, and the routine
disregard of purported underwriting guidelines. Based on data compiled from third-party due
diligence firms, the federal Financial Crisis Inquiry Commission (“FCIC”) noted in its January
2011 report:
The Commission concludes that firms securitizing mortgages
failed to perform adequate due diligence on the mortgages they
purchased and at times knowingly waived compliance with
underwriting standards. Potential investors were not fully
informed or were misled about the poor quality of the mortgages
contained in some mortgage-related securities. These problems
appear to be significant.
(FCIC Report at 187 (emphasis added).)
(ii) Percentage of Known Non-Conforming Loans. Defendants fraudulently
omitted the fact that both the underwriters’ internal due diligence, as well as third-party due
diligence firms, had identified numerous loans that did not conform to the stated underwriting
guidelines. Nor did Defendants disclose that many of those very same non-conforming loans
had been “waived” into the collateral pools underlying the Certificates anyway. That high
numbers of rejected loans were knowingly being included in the underlying mortgage pools is
not only a fraudulent omission in its own right, but makes even more misleading Defendants’
disclosures about their underwriting process. Defendants intended for Allstate to understand that
their underwriting and due diligence procedures were being used to keep problem loans out – not
just to go through the motions of appearing to search for such loans only to have them routinely
approved for inclusion anyway.

(iii) Owner Occupancy Statistics. The Offering Materials made specific
representations regarding the percentage of borrowers who would be occupying the property
being mortgaged – a key risk metric given that borrowers are less likely to “walk away” from
properties they live in, as compared to properties being used as vacation homes or investments.
Analytical tools recently made available to investors confirm that, in truth, a far greater
percentage of the loans underlying Allstate’s Certificates than represented were given to
borrowers who lived elsewhere.
(iv) Loan-to-Value Ratios. The Offering Materials represented that the
underlying loans had specific loan-to-value (“LTV”) and combined loan-to-value (“CLTV”)
ratios. These are additional key risk metrics, because they represent the equity “cushion” that
borrowers have, and the likelihood of repayment to lenders upon foreclosure. Analytical tools
recently made available to investors confirm that the Offering Materials vastly overstated the
value of the collateral being included in the loan pools, and hid additional liens that had been
placed on the properties. This falsely reduced the loans’ LTV and CLTV ratios.
(v) Purpose And Use Of Exceptions. The Offering Materials represented
that loans which did not meet certain criteria were approved as “exceptions” only on the basis of
countervailing features of the borrowers’ risk profiles that ‘made up’ for negative aspects of the
risk profile. In truth, however, “exceptions” were used as a way to increase loan volume by
circumventing the applicable underwriting guidelines. For instance, recent reviews of the loan
files underlying some of Allstate’s Certificates reveal that non-compliant mortgage loans did not
have any identified countervailing features, and that various undisclosed procedures were
employed to create loan pools outside of the disclosed underwriting guidelines.

(vi) Credit Ratings. The Offering Materials represented that the Certificates
had specific investment grade credit ratings. Defendants fed the same misrepresentations found
in the Offering Materials to the ratings agencies in an attempt to manufacture predetermined
ratings. The rating agencies relied on this inaccurate loan information when rating the
Certificates, and employed outdated assumptions and relaxed ratings criteria. This not only
rendered false Defendants’ representations about how the ratings process really functioned, but
also assured that the ratings themselves in no way reflected the actual risk underlying the
(vii) Credit Enhancement Features. The Offering Materials represented that
the Certificates had certain “credit enhancements” used to improve the likelihood that holders of
such certificates would receive regular principal and interest payments thereon. “Credit
enhancements” are features designed to reduce the risk of loss to investors in the senior tranches
of certificates. These features can include overcollateralization (i.e., the value of the collateral
underlying the certificates is greater than the principal balance of the certificates), the
subordination in right of payment of junior certificates to senior certificates, the establishment of
reserve accounts, a mortgage pool insurance policy, an interest rate swap agreement, or a
combination of such features.
The level of credit enhancement utilized for each Offering was to be correlated to
the risk associated with the underlying loan pool. However, due to the pervasive underwriting
deficiencies that rendered the Mortgage Loans far riskier and less valuable than disclosed, the
credit enhancements described in the Offering Materials were never adequate to protect
certificateholders from loss. As a result, the purported “credit enhancements” were really no
protection at all.

3. In reliance on these and the other misrepresentations and omissions, Allstate
purchased over $700 million of Defendants’ mortgage-backed securities, as follows:
Asset Purchase Price
JPMMT 2004-S1, 1A7 $1,882,541.68
JPMAC 2005-OPT2, M1 $4,000,000.00
JPMAC 2005-OPT2, M2 $10,499,630.40
JPALT 2006-A2, 2A1 $12,250,000.00
JPMAC 2006-CH2, AF6 $1,609,954.44
JPMAC 2006-CH2, MF1 $2,069,942.36
JPMAC 2006-CH2, MF2 $6,299,847.81
JPMAC 2006-CH2, MF3 $4,906,527.47
JPMAC 2006-CW2, AF6 $59,780,514.68
JPMAC 2006-FRE2, A3 $20,000,000.00
JPMAC 2007-CH1, MF1 $28,860,355.53
JPMAC 2007-CH1, MF2 $15,117,635.57
JPMAC 2007-CH1, MF3 $5,134,204.59
JPMAC 2007-CH1, MF4 $6,349,473.50
JPMAC 2007-CH1, MF5 $19,352,044.81
JPMAC 2007-CH2, AF6 $24,349,559.17
JPMAC 2007-CH2, MF1 $14,260,028.06
JPMAC 2007-CH2, MF2 $19,621,394.99
JPMAC 2007-CH2, MF3 $28,617,484.45
JPMAC 2007-CH2, MF4 $9,106,844.62
JPMAC 2007-CH2, MF5 $5,300,777.93
WMALT 2005-4, CB11 $7,726,845.31
WaMu 2005-AR2, 2A-1B $50,000,000.00
WaMu 2006-AR1, 2A-1A $22,709,125.17
WaMu 2006-AR5, A1-B2 $13,006,094.40
WaMu 2006-AR9, A1-B2 $8,000,000.00
WaMu 2006-AR11, CA-1B2 $17,050,719.58
WaMu 2007-OA1, A-1B $25,185,695.78
WaMu 2007-OA3, 2A $18,355,168.40
WaMu 2007-HY7, 1-A1 $20,637,626.29
WMHEN 2007-WM1, N1 $6,346,688.52
LBMLT 2006-6, 2A2 $20,000,000.00
BALTA 2005-4 1A2 $19,141,911.07
BALTA 2006-5 11A2 $10,000,000.00
BSABS 2006-HE4, IA2 $20,000,000.00
BSMF 2006-SL1, A $50,000,000.00
BSSLT 2007-SV1A, A1 $25,000,000.00
BSSLT 2007-SV1A, A3 $25,000,000.00

Asset Purchase Price
SACO 2006-3, A1 $40,000,000.00
SACO 2006-6, A $60,000,000.00
Total $757,528,636.58
Exhibits A and B provide further detail on the Certificates. All of the exhibits attached to this
Complaint are incorporated as if set forth fully herein.

4. Allstate invested in the Certificates as part of a broader plan to invest in a diverse
array of mortgage-backed securities. Allstate typically purchased senior classes of mortgagebacked
securities (i.e., those rated AAA/Aaa or AA/Aa by the rating agencies Standard & Poor’s
and Moody’s Investors Service). Allstate purchased the Certificates to generate income and total
return through safe investments. But Allstate also purchased the securities with the expectation
that the investments could be – and indeed some would be – sold on the secondary market.

5. The systemic (but hidden) abandonment of the disclosed underwriting guidelines
has predictably led to soaring default rates in the mortgage loans underlying the Certificates. For
instance, despite the fact that most of the of the Certificates started out with AAA ratings – the
same rating given to treasury bills backed by the full faith and credit of the United States
government – 97% are now not even considered to be investment grade. These problems are so
drastic and their onset was so rapid (in comparison to the long-term security of the investments
Allstate thought it was purchasing) that the Certificates’ poor performance to date is itself
powerful evidence that the Mortgage Loans were not underwritten according to the procedures
represented to Allstate. With the underlying loans performing so poorly, the market value of
Allstate’s Certificates has plummeted, causing Allstate to incur significant losses.

The full complaint can be accessed here.

1 comment:

  1. The outcome is unknown but there are things to be learned here about the pitfalls Bernanke is facing. It is even possible that his confidence is misplace.