Banks and Banking & Finance and Lawsuits and Mortgages and Law

Federal Home Loan Bank suing major players

November 20, 2010

The Federal Home Loan Bank of Indianapolis has filed suit against some of the nation’s largest financial institutions, including Bank of America, Wells Fargo and J.P. Morgan Chase, to recover losses on a $3 billion portfolio of mortgage-backed securities.

The federally chartered wholesale bank, one of 12 such institutions formed in 1932 to save the housing market during the Great Depression, wants the defendants to buy back money-losing packages of loans the banks sold as safe investments from 2005 to 2007.

The 300-page lawsuit, filed last month in Marion Superior Court and moved this month to U.S. District Court for the Southern District of Indiana, names 37 defendants including Goldman Sachs, Citigroup and Credit Suisse that sold the Federal Home Loan Bank of Indianapolis 32 issues of mortgage-backed securities with a total face value of $3 billion.

Chart of total U.S. mortgage debtThe case is one of dozens nationwide seeking so-called put-backs of soured mortgage loans. The cases—brought by government-sponsored enterprises such as Fannie Mae and Freddie Mac and private investors including Pimco, which runs the world’s largest bond fund, and Blackrock, the world’s largest investment manager—point to omissions and inaccurate statements in offering materials and shoddy loan underwriting as a rationale for refunds.

Put-backs could cost the banking industry as much as $52 billion, the Congressional Oversight Panel estimated in a Nov. 16 report. Fannie Mae and Freddie Mac have already forced banks to buy back $12.4 billion in loans, and the nation’s four largest banks have set aside another $9.9 billion for future put-backs.

The Federal Home Loan Bank of Indianapolis, also a government-sponsored enterprise, says in its lawsuit that banks selling mortgage-backed securities were so eager to unload the mortgages and collect commissions that they “did not tell the truth” about what they were selling, causing FHLBI to suffer “substantial losses.”

The suit does not say how much the bank has lost on its mortgage purchases, but a Securities and Exchange Commission filing shows FHLBI had $128 million in unrealized losses in its private-label loan portfolio as of Sept. 30.

“The offering documents contained serious misstatements and omissions with respect to the mortgage pools, the creditworthiness of the borrowers, the quality of the collateral, and the underwriting standards employed in originating the mortgage loans,” according to the lawsuit, filed by locally based Cantrell Strenski & Mehringer.

Officials at the Federal Home Loan Bank of Indianapolis declined to comment. Like the other home loan banks, the Indianapolis institution’s primary business is making advances for home mortgages. Its customers—and its owners—are more than 400 banks, credit unions and insurance companies in Indiana and Michigan.

The defendants, who have not yet filed an answer to the charges, had requested the change in venue to the U.S. District Court for the Southern District of Indiana.

Private entities seeking put-backs have a higher legal burden than government-sponsored enterprises in proving they should get money back, said Doug Braunstein, the chief financial officer of J.P. Morgan Chase, at an investor conference Nov. 17.

Banks have to warrant to Fannie Mae and Freddie Mac that loans are free from borrower fraud, a guarantee rarely extended to privately held buyers of mortgage securities. The GSEs also have direct access to loan files, making it easier for them to mount challenges.

“The burden of proof for an underwriting breach has to be material and it also has to be shown to have adversely affected the value of the loans,” Braunstein said, according to a transcript.

The lawsuits demanding buybacks of bad loans are just one more potentially disastrous variable for a banking industry struggling to regain its footing, said John Reed, a banking industry expert with the local office of Chicago-based investment firm David A. Noyes & Co.

Banks—already facing questions about foreclosure procedures and regulatory reform—these days are looking like a critical patient “on the way to the ER for treatment of some dire situation and the ambulance crashes into a train carrying toxic chemicals that spill all over,” Reed said.

“Any one of these things could become major and bring the industry to its knees,” he said. “The combination of them all has taken a bunch of banks out already, and who knows what’s next.”

One risk is that the disputes over whether banks must buy back loans will drag on for years, muting the likelihood of a strong real estate recovery, said Randy Wilson, a retired banking attorney in Indianapolis.

He’s not convinced banks committed fraud, or even if they did, that the investors who bought up the securitized mortgages can prove it. The securitized loan offerings included extensive disclosures about the quality of included mortgages.

“Nobody thought these loans were going to go bad—they thought the prices of the houses were going up and the mortgages would be solid gold,” Wilson said. “It’s stupidity. It’s a mistake. It’s greedy. But I’m not sure it’s fraud.”

The Federal Home Loan Bank’s mortgage portfolio consists primarily of what previously were considered the safest tranches—those last in line to absorb losses—of prime loans underwritten at too high a face value for Fannie Mae or Freddie Mac backing, and Alt-A loans with adjustable rates or reduced documentation, the suit says.

Each of the investments had triple-A ratings from Moody’s, Standard & Poor’s or Fitch that historically yielded a loss rate of less than 0.05 percent. The same ratings agencies began downgrading the securities to below investment grade in 2008.

IBJ.COM EXTRA
Click here to see how a mortgage-backed security is created.

The suit alleges that offering materials made several misstatements. Among them: overstating the number of securitized loans with full borrower documentation as much as 30 percent; understating the percentage of loans for a non-primary residence up to 10 percent; and understating the portion of loans with a more than 90 percent loan-to-value ratio up to 46 percent.

The Congressional Oversight Panel said legal complexities and the number of parties involved in such disputes mean litigation over put-backs could drag on for years. That’s potentially an advantage for banks, which would be able to keep the loans off their books longer as they recover.

“The foreclosure documentation irregularities unquestionably show a system riddled with errors,” the report says. “But the question arises: Were they merely sloppy mistakes, or were they fraudulent? Differing answers to this question may not affect certain remedies available to aggrieved parties—put-backs, for example, are available for both mistakes and for fraud.”

One thing is certain: The lawsuit brought by the Federal Home Loan Bank of Indianapolis is a bonanza for Indianapolis law firms, which have joined on as local counsel for the deep-pocketed banks.

Goldman Sachs signed up Barnes & Thornburg, J.P. Morgan enlisted Baker & Daniels, and Credit Suisse hired Hoover Hull. Countrywide Financial chose Bose McKinney & Evans, RBS Securities paired with Bingham McHale, Bank of America signed Frost Brown Todd, and Ally Financial brought on Riley Bennett & Egloff.•

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