Black Swans*, Fraud by hindsight, and Mortgage-Backed Securities. (greatest hits collection)

Events are not unforeseeable merely because they are unprecedented... 

One of the primary arguments upon which Wall Street firms rely to defend themselves from securities fraud allegations is something like this -

We could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of "fraud by hindsight." 

The fraud by hindsight defense is pretty much automatic in securities fraud cases.  The meaning of the defense is, as it sounds, that there is no fraud if the alleged deceit can only be discerned after the fact. Hindsight is, after all, 20/20.  The legal issue is foreseeability.  

In financial crisis litigation, Wall Streeters insist that their actions (like marketing CDOs stuffed with subprime mortgages as ultra-safe investments) are not fraudulent because banks that sold toxic waste allegedly could not reasonably foresee the housing and credit bubbles or the consequences that would rain down when the bubble inevitably ruptured.

Further, Wall Street execs insist that mass defaults of subprime mortgages were not foreseeable simply because (they contend) the U.S. has never experienced a nationwide housing slump.  Presumably, these same Wall Street executives would argue that they cannot foresee the possibility that they will one day die because they haven't yet been dead.*     

OK, Wall Street:  From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  From 1995 through 2006 alone - even after adjusting for inflation - housing prices rose by more than 70%.  That type of housing growth certainly is unprecedented.  Why shouldn't such an unprecedented "up-cycle" in the housing market end in an unprecedented way?  The answer is that there is no reason.  

In fact, the housing boom was so far out of line with any previous housing cycle that one could easily argue that a reasonable economist, real estate professional, or CEO of an investment bank should have anticipated that a the story of housing's record-smashing growth would eventually come to a very ugly ending.   

The fact is that a huge number of respected experts from private industry and academia publicly warned of a huge housing bubble that could only end badly.  Certainly, many others kept quiet, wary of rocking the boat while the profits poured in, even though they too foresaw the end of the housing bubble and predicted its devastating impact on mortgage-backed securities.  

The fact is that, once the MBS industry became dependent on subprime mortgages, an eventual disaster was unavoidable.  Until the bubble popped, however, Wall Street was raking in far too much money to worry about the ramifications of the immense risks banks were taking.  

Fraud by hindsight is inapplicable in most financial crisis litigation.  Why?  Because choosing to ignore the apocalypse is far different from failing to foresee it.

      

*Inspired in part by the writings of Nassim Nicholas Taleb.

By Brett Sherman, The Sherman Law Firm

Comments

[mortgage long island]

What do you mean by mortgage backed securities? Is it similar to asset backed security or different?

[Per Kurowski]

In May 2003 the Financial Times posted a letter I wrote that ended with “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

So do not tell me this crisis was unpredictable… on the contrary it was doomed to happen.
http://bit.ly/gNemy

[Ashish S. Joshi]

The lynchpin of defense in a white-collar prosecution is usually intent. Litigating intent is one of the most complex part of a white collar defense case. Check out this article that I wrote some time a go for a national journal - http://www.lorandoslaw.com/CM/Articles/Articles3.asp

However, your comments are accurate - "choosing to ignore the apocalypse is far different from failing to foresee it." And, this has led the prosecutors to go for the "willful blindness" jury instructions. White collar defense practitioners must be prepared to address the charge of willful blindness.