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

Comments

[Per Kurowski]

Kyle Blade writes “the companies that made subprime loans, made mbs and cdos, and insured the mbs and cdos caused the subprime crisis - the subprime crisis”

Absolutely but do not forget the following:

1. Were it not because the badly awarded mortgages to the subprime sector had been packages in securities that obtained a triple-A rating there would have been no buyers at all for them. No one was going to give bad loans if they were not certain of being able to unload them at a profit.

2. Were it not because the bank regulators had reduced the capital requirements for banks on these triple-A rated security to an absurd low 1.6 percent, which implied authorizing a leverage of 62.1 to 1, we would never have seen such an incredible demand for these and which naturally attracted those willing to bend what needed to be bended in order to keep the customer satisfied, and, of course, make a tidy profit doing it.

And so, as I see it, the final responsibility lies squarely on that bunch of inept, gullible, naïve and innocent regulators who believed (and unfortunately still do) in the extremely dangerous fairytale that there are enough safe-havens and AAAs to go around for all, and that it is in safe havens you can generate real growth and development.

[Kyle Blades]

So basically the point is that the companies that made subprime loans, made mbs and cdos, and insured the mbs and cdos caused the subprime crisis - the subprime crisis caused the credit crisis - the credit crisis caused the financial crisis - and the financial crisis caused the Ambacs and the Bear Stearns and the Lehman Brothers and the New Centurys and so on and so on to collapse? Funny, but that is the first thing I've heard about the financial crisis in the last year or two that makes any sense.