Chart From NCUA complaint, actual losses (dark curve at top) in J.P. Morgan Mortgage Acquisition Trust 2007-HE1 compared to anticipated losses (bottom curve)

The National Credit Union Administration filed a complaint against JPMorgan Chase for using misleading offering materials in the sale of 29 real estate mortgage-backed securities sold to failed credit unions. The credit unions paid a total of $1.81 billion for the RMBSs. The complaint seeks rescission under the Securities Act of 1933. If successful, JPMorgan would have to buy the securities back, or pay damages in the amount of the loss. The NCUA has standing to sue because it is the Liquidating Agent for four failed credit unions that bought the garbage. The point of the suit is to collect money to pay off the losses of those failures. That way, the losses won’t fall on Credit Union insurance funds or on the taxpayer.

The complaint specifically says that the NCUA is not alleging fraud; this is not a case under Rule 10b-5 of the Securities Act of 1934. This is a case of non-disclosure of material information in violation of the requirements of the Securities Act of 1933 and regulations under it. Because this is not a fraud action, the NCUA does not have to plead fraud with detailed facts in order to get past a motion to dismiss, or allege intent to defraud. It is enough to show that the seller had material information and did not disclose it, or that the seller made misleading or materially incomplete statements.

The factual basis for the suit is as follows:

6. The Offering Documents represented that the Originators adhered to the underwriting guidelines set out in the Offering Documents for the mortgages in the pools collateralizing the RMBS. In fact, the Originators had systematically abandoned the stated underwriting guidelines in the offering documents. Because the mortgages in the pools collateralizing the RMBS were largely underwritten without adherence to the underwriting standards in the Offering Documents, the RMBS were significantly riskier than represented in the Offering Documents. Indeed, a material percentage of the borrowers whose mortgages comprised the RMBS were all but certain to become delinquent or default shortly afterorigination. As a result, the RMBS were destined from inception to perform poorly.

7. These untrue statements and omissions were material because the value of RMBS is largely a function of the cash flow from the principal and interest payments on the mortgage loans collateralizing the RMBS. Thus, the performance of the RMBS is tied to the borrower’s ability to repay the loan.(continued…)

The complaint describes three kinds of circumstantial evidence showing that the loans did not meet underwriting guidelines:

1. Very high early defaults.
2. Actual losses exceed the expected losses.
3. The loans were originated for distribution, rather than to be held by the original lender,

Early defaults are a sign of poor underwriting. All over the country, loans originated for distribution were made without regard to any underwriting guidelines, and specifically by the originators in these RMBSs.

As to the second, RMBSs expect some losses, so the sellers build in credit enhancement to protect the AAA tranche. One form of credit enhancement is called structural subordination. Payments go to the top slice of the bonds, and only after those are paid are lower slices paid, each in order. If there are defaults, the junior tranches eat the first losses. Other credit enhancements include overcollateralization, letters of credit, and insurance from an outside company.

Credit enhancement is calculated based on the expected losses in the mortgage pool. If the pool is $100 million, and losses are anticipated to be $1 million, the RMBS must include $5 million of credit enhancement if it wants to get an AAA rating. By looking at the structure of the bonds, you can work backwards to figure out the losses that the underwriter expected. If the credit enhancement is $25 million dollars, you divide by five to find the expected losses, in this case, $5 million. At least that is what the underwriter reported to the credit rating agency, like Moody’s or Standard and Poor.

The complaint states that losses were far in excess of those amounts. For example, in one AAA rated bond, the credit enhancement indicates anticipated losses of $2 million, but the losses in the first 12 months were over $166 million. The complaint also shows the almost immediate defaults in the pools. The chart at the top shows that aggregate losses on one pool exceeded the anticipated total losses after only three months.

I bet the NCUA’s lawyers are salivating at the prospect of discovery, where they will be able to see records of the due diligence done by JPMorgan Chase, and their internal evaluations of these RMBSs. Even better, the NCUA promises to sue more underwriters, as dday reports.

It would sure help the NCUA if the US Attorneys for New York, LA and Seattle, Preet Bharara, André Birotte, Jr., and Jenny Durkhan, would rouse themselves from deep slumber to investigate.