Wall Street Law Blog

Major Subprime Decision from SDNY? We think so...

Federal court decision of interest about subprime-related fraud and the financial crisis : In Re Ambac Securities Litigation. 

Federal District Court Judge Naomi Reice Buchwald of the Southern District of New York substantially denied dismissal of federal securities fraud class action claims based based on alleged material misrepresentations by monoline insurer Ambac Financial.  

Ambac sold insurance against possible defaults on mortgage-backed securities and related investment products. According to credit rating agencies, insurance policies issued on MBS-type investments by monoline insurers like Ambac were an important reason many of these complex securities were able to obtain investment grade credit ratings.

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In his excellent blog, the D&O Diary, Kevin LaCroix perceptively identified what he called a "potentially significant February 22, 2010 opinion, [by] . . .Judge Naomi Reice Buchwald."   

While the impact of Judge Buchwald's opinion remains to be seen, the rationale for the decision (in our opinion) is spot-on regarding what we at Wall Street Law Blog have long believed is a core reason why many financial institutions and insurance companies cannot credibly rely on a "once in a lifetime financial crisis" to excuse crippling losses. 

In the Ambac class action complaint, plaintiffs alleged (among other things) that Ambac officers and directors pretended to employ rigorous underwriting standards for residential mortgage backed securities (RMBS) that Ambac insured when, in fact, Ambac allowed its underwriting requirements to deteriorate badly as the housing bubble passed its peak. 

By the mid-2000's, Ambac allegedly knew that many loans being bundled into mortgage-backed securities were of very poor quality.  The reason?  The supply of (relatively) good candidates for new subprime and Alt-A mortgages was nearly exhausted.  

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Although it was certainly apparent to true industry insiders that the housing bubble was in its final phase, many subprime lenders and banks that made the production and sale of RMBS possible proved unwilling to leave potentially massive profits from peddling these products on the table.  Rather than cutting back on subprime lending and production of RMBS, these companies chose to cut back on lending standards. 

To keep RMBS factories humming, lots of new mortgages were always necessary.  Each time the supply of "qualified" borrowers began to dwindle, lending standards were relaxed even more.  By 2006, pretty much anyone - including the worst possible credit risks - could get a mortgage and buy a home with little or no money down.  This was the height of the era of low-doc mortgages, no-doc mortgages, and other funny money mortgage loans.  Eventually, there were no real lending standards left. Most new loans were so risky that very high default rates were inevitable.    

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Ambac did not make home loans or securitize subprime mortgages.  However, Ambac was an important cog in keeping the RMBS machine alive.  Without insurance companies like Ambac to guarantee mortgage securities against default, investment grade ratings would have been more difficult to obtain.  Without an investment grade credit rating, there would have been many fewer investors to buy RMBS and similar products.    

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Insuring RMBS type securities was a very lucrative business.  Plaintiffs in the Ambac class action contend that Ambac continued to insure what the company knew were low quality loans so they could keep earning high premiums.        

Plaintiffs further alleged (correctly in the view of Wall Street Law Blog) that Ambac's decision to keep insuring shoddy loans in order to keep short-term revenues high was fraud, and that this fraud contributed to and exacerbated the financial crisis that ultimately caused Ambac's losses.     

Indeed, in our opinion, the very same argument plantiffs made in the Ambac case should bar a "general economic downturn" defense by lenders like New Century and lenders / investment banks like Bear Stearns.  Officers and directors of these companies made their bed.  There they must sleep.

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From the February 23 D&O Diary post on Ambac:

Judge Buchwald’s decision is particularly noteworthy for her rejection of defendants’ attempts to argue that the company’s woes were not the result of fraud but rather were the result of the global financial meltdown; among other things, she stated that-

"the conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim."

 

Hard to find a hole in the court's analysis, no?

By Brett Sherman, The Sherman Law Firm

Excerpts and analysis from Kevin LaCroix's D&O Diary

The Mortgage Securities Crash of 1994...

1994 - WHEN MORTGAGE-BACKED SECURITIES TURNED ILLIQUID IN THE BLINK OF AN EYE.   

 

In 1994, the market for mortgage-backed securities crashed.  The ensuing liquidity crisis took down investment advisor David Askin's leveraged mortgage securities fund.  Ultimately, the MBS crisis of 1994 led to massive Wall Street losses and the dismantling of investment bank Kidder Peabody.  

By Brett Sherman

What happened to the lessons of 1994? 

That year, a small and unexpected interest rate hike crippled the mortgage-backed securities market with astonishing speeed.  As was the case in mid-2007, the market for mortgage-backed securities virtually disappeared.  Like 2007, investors holding mortgage bonds lost big, and so did the investment banks that sold them.  

Why do so few of us remember the mortgage securities crisis of 1994?  

Because the MBS market was a fraction of the size it was during the recent housing and credit bubbles. In 1994, most people outside the world of finance had even heard of mortgage-backed securities. But Wall Street knew all about them. In the early 1990's, as in recent years, investment banks booked tremendous profits from the sales of MBS.

How significant could the 1994 crash have been? 

Very significant.  

Before the 1994 crash,mortgage-backed securities /CDOs accounted for roughly one-third of the total US bond market. 

The big three Wall Street producers and sellers of mortgage-backed securities were Kidder Peabody, Bear Stearns, and Lehman brothers. All three firms (as well as many others) took big hits when the MBS market evaporated in 1994. 

Kidder Peabody's mortgage-related losses led to the firm's demise.  Kidder's parent company, GE, shut down the legendary firm and sold off pieces of Kidder Peabody to the highest bidders. 

The crisis also ruined hedge fund manager David Askin. Askin ran a leveraged fund that held mortgage-backed securities. When the mortgage securities market started to collapse, Akin's creditors grew uncomfortable accepting nearly illiquid MBS as collateral for the large loans Askin's MBS fund needed to finance its holdings and stay afloat.   

As the 1994 crisis deepened, buyers for mortgage-backed-securities grew more and more scarce. Askin's creditors issued margin calls.  Lenders demanded more and less risky collateral to secure the loans. Askin could liquidate enough of the fund's holdings to meet these margin calls. 

As Askin's clearing agent, Bear Stearns was one of the fund's creditors that demanded additional and higher quality collateral.  Once it was clear that Askin could not meet creditors' demands, the race to seize assets was on and Askin's MBS fund collapsed.  Reportedly, the first firm to seize assets from Askin's mortgage-backed securities fund was Bear Stearns, then in its second calendar year under CEO James E. "Jimmy" Cayne.

The similarities are striking between the collapse of Askin's leveraged MBS fund and the bankruptcy of two Bear Stearns leveraged MBS funds roughly 13 years later (indeed, the collapses of the Askin and Bear MBS funds were microcosms of the subsequent failure of Bear Stearns itself in 2008).  

Although Bear Stearns and Lehman Brothers were prime players during the 1994 mortgage securities crisis, and had front row seats for the demise of Kidder Peabody, Jimmy Cayne and Dick Fuld apparently blocked out painful memories from 1994.

Why did Wall Street ignore the lessons of 1994?

Maybe it had something to do with immense profits and huge compensation...  Ya think?