A US District Judge has crushed the only attempt so far by a bank to challenge rather than settle with the Federal Housing Finance Agency over pre-crisis mortgage-backed securities that were sold to Fannie Mae and Freddie Mac.
The case, which is being heard in the Southern District of New York, has been four years in the making but took just a month to decide. The FHFA filed lawsuits against 17 banks in September 2011, claiming that the risks of RMBS sold to Fannie Mae and Freddie Mac prior to 2008 were not adequately disclosed.
While 16 of those banks have settled, Japanese bank Nomura went to trial on March 16 over the quality of seven MBS deals it sold to the government-sponsored enterprises [GSEs] between 2005 and 2007.
RBS faces a further suit from the FHFA in Connecticut over $32 billion-worth of MBS that it sold to the GSEs prior to the financial crisis.
Closing arguments in Nomura’s case were made on April 9 and Judge Denise Cote delivered her damning written decision on May 12, saying of the offering documents that: "the magnitude of falsity, conservatively measured, is enormous."
The FHFA, which brought the case in an investor capacity, was seeking roughly $1 billion reparation.
This result is far from a surprise. Nomura was always going to face an uphill battle in its quest to avoid settling with the FHFA. Its fortunes took a turn for the worse in January when the FHFA dropped its claim for damages, opting to make an equitable claim against the bank. This meant that part of the settlement would involve Nomura repurchasing the securities that it had sold. However, it also meant that the case would not be heard by a jury but would be a bench trial – heard only by a judge.
The FHFA said that the move was made to “conserve time and assets”, but Judge Cote has long been seen as hostile to the banks over mortgage mis-selling claims. Indeed, in 2013, a group of US banks attempted to sue her in the appeals court for “gravely prejudicial” rulings. They failed.
True to form
In addition to rejecting Nomura’s request for a jury trial Judge Cote barred the bank from presenting evidence of the FHFA’s prior knowledge of the loan quality and issued a series of pre-trial rulings against the bank. While Nomura’s own legal team did not endear itself to the judge by suggesting she was assisting the FHFA with evidence at one point, her decision is true to form.
Given that the FHFA has so far reached $17.9 billion in settlements with banks such as BAML, JPMorgan and Goldman Sachs, Nomura’s decision to challenge it always seemed brave or foolhardy. It may have felt that its position was more defensible as it did not originate the loans, unlike the other large banks that the government targeted in its 2011 lawsuit. Nomura also had a comparatively small RMBS business and, as a non-US bank, may have deemed going up against the US government less of a risk to its reputation.
The seven RMBS transactions under dispute were sold to Fannie Mae and Freddie Mac between 2005 and 2007. Three of the deals were underwritten by RBS.
The government analysed a sample of 250 loans in the deals and found that many didn't follow underwriting guidelines, had faulty appraisals, misrepresented home values and borrower finances or had misleading statements about underwriting criteria. It found that 68% of loans were not underwritten properly and that the appraised values of the properties in the pools were inflated by around 11%. Government lawyers accused Nomura of “colossal incompetence and deceit”.
Voodoo
Nomura, whose lawyers countered that the FHFA was relying on “voodoo science”, argued that the risks in the asset pools were adequately disclosed and not misleading and that any alleged mis-statements did not factor into the agencies’ decision to buy the securities. The bank maintained that the deterioration in value of the deals was due to the wider US house-price collapse after 2008. Indeed, Nomura insisted that Fannie and Freddie wholly understood the risk of the loans they were selecting and that they went through the loan data carefully prior to purchase.
The bank sought to show that the GSEs were looking to meet affordable housing goals set by the US Department of Housing and Urban Development by cherry picking from the pools. Nomura said that the GSEs had loan-level info on the pools and carved out the loans that they wanted. Judge Cote disallowed this evidence.
The case included the now customary litany of embarrassing emails between bankers involved in the RMBS sales – describing the loans as “crap” and warning “Danger, Batman!” – which cannot have helped Nomura’s position.
The bank tried a number of approaches to void the FHFA's claims. It challenged the contention that Fannie and Freddie were oblivious to the condition of these loans prior to September 2008 when the deals were downgraded to sub-investment grade. The aim was to reset the clock on the statute of limitations on bringing the case back to when the deals were bought (a 2008 law extended the statute of limitations for these cases). The statute of limitations, which typically gives prosecutors five years to bring charges after an alleged crime, is pegged to when the wrongdoing is discovered.
Costs
Fitch Ratings has calculated that the net cost of the FHFA's claim would be less than 15% of Nomura's full year pre-provisioned profits, which makes its decision to take on the FHFA in court seem additionally rash. The rating agency calculates that settlement rates elsewhere have been just over 1% to 14% of the original face value of the securities.
Prior to bringing the case, the cost of settling out of court was put at between $100 million and $300 million.
The current value of the securities involved is around $480 million and this would be netted off against the FHFA's $1 billion claim.
The FHFA has until May 15 to submit a proposed updated figure for damages but the judge indicated that it would be entitled to $624 million less $178 million it has received since 2011 when the lawsuit was launched.
Nomura plans to appeal the ruling. It stated that: “While Nomura is still reviewing the court’s ruling, it disagrees with the court’s conclusion and intends to appeal the decision. Nomura is confident that it was consistently candid, transparent and professional in all of its dealings with Fannie Mae and Freddie Mac and looks forward to bringing its case to the US Court of Appeals.”