The statute of limitations for securities fraud is five years (18 U.S.C. § 3282). That means that the statute of limitations for criminal prosecution of securities fraud has expired for almost all real estate mortgage-backed securities created and sold in 2005, and is quickly running out for those created and sold in 2006. Prosecutors in the Obama Administration are intentionally letting the clock run out on all that fraud that the Financial Crisis Inquiry Commission says it referred to prosecutors. That is straight out of the administration playbook on touchy issues, like illegal wire tapping.
This isn’t penny ante stuff. Moody’s reports that losses are increasing:
As a percentage of original balance, cumulative losses from December 2009 to November 2010 for the 2005-2008 vintage deals grew to 14.9% from 11.8% for subprime pools, to 9.5% from 5.7% for Option ARM pools, to 7.9% from 5.2% for Alt-A pools, and to 1.4% from 0.6% for Jumbo pools.
That is to be expected. The Final Report of the FCIC discusses the due diligence done by the investment banks that bought the mortgage loans from originators like Countrywide or New Century and created the RMBS. Due diligence is a term of art that underwriters use, derived from the idea that if you do “due diligence,” you have a defense to civil and criminal fraud charges. There are no written guidelines for the due diligence that an underwriter would have to do to protect itself in a specific offering, and there is little guidance from the SEC. (See SEC Rule 176.) The burden is on the underwriter to prove up the defense.
The FCIC says that all firms it checked did due diligence or hired others to do it in preparation for the offering of RMBSs. They negotiated the extent of the due diligence to be done with the originators of the mortgages. (Final Report [hereafter FR] at 193 (references are to the .pdf page, not the page in the printed text.)) At first underwriters were examining up to 30% of the offered loans, but that dropped as low as 2-3% in later years. One outside firm providing due diligence services was Clayton Holdings, which told the FCIC that it did not try to identify loans as good or bad, but against criteria set by the underwriter.
The review fell into three general areas: credit, compliance, and valuation. Did the loans meet the underwriting guidelines (generally the originator’s standards, sometimes with overlays or additional guidelines provided by the financial institutions purchasing the loans)? Did the loans comply with federal and state laws, notably predatory-lending laws and truth-in-lending requirements? Were the reported property values accurate? And, critically: to the degree that a loan was deficient, did it have any “compensating factors” that offset these deficiencies?
(FR at 194.)
These reports served as plausible due diligence, but as the Final Report says, they were used “. . . in some measure, to enable clients to negotiate better prices on pools of loans.” Clayton filed summary data with the FCIC describing the results of its reviews. In the first quarter of 2006, Clayton reviewed 105,791 loans. Of those, 59% met the underwriting standards which the originator claimed it used. Another 16% had sufficient compensating circumstances acceptable to the originator or the underwriter to pass. The underwriter accepted another 9% despite the absence of compensating factors accepted by Clayton. The other 15% were rejected.
The implications of this are staggering. [cont’d.]Suppose the underwriter specified that Clayton was to review 15% of the loans in the pool, selected at random. There is no reason to think that the other 85% of the loans were different from the random sample. That means that 24% of the loans did not meet the underwriting standards, and it is reasonable to believe that at least 15% would have been rejected had they been reviewed. That’s pretty close to current default rates, and it isn’t a coincidence.
The underwriter had these figures at hand. The FCIC says simply:
Prospectuses for the ultimate investors in the mortgage-backed securities did not contain this information, or information on how few loans were reviewed, raising the question of whether the disclosures were materially misleading, in violation of the securities laws.
(FR at 198.)
Preet Bharara, the US Attorney for the Southern District of New York, is very busy with Insider Trading cases (think Martha Stewart). The only people damaged by insider trading are people who would not have sold if they had had insider information. There may be a mutual fund or a pension plan in that number, and maybe a retail investor. The rest are the hedge funds that make all the money anyway.
And what is Bharara doing instead of prosecuting real securities fraud? Matt Taibbi has the answer: Bharara is out chumming around with the lawyers who put these deals together, and who passed on the decisions about what was to be disclosed. Once upon a time, they were called aiders and abettors, but the Supreme Court fixed that in 1994. Now they are just called Very Rich People.