FHLB Suit Against Wall Street Could Be the First of Many
The Federal Home Loan Bank of Seattle-once a major buyer of private-label MBS-wants its money back from the Wall Street firms that sold it the product.
The bank is suing a host of underwriters in a case that is being closely watched by other financial service firms-and their attorneys.
The fear-for Wall Street, at least-is that it could open the door for other banks and investors to pursue new claims against them for packaging and selling bonds backed by alt-A and subprime mortgages.
Several investors have already sued subprime issuers like Merrill Lynch & Co., but the FHLB of Seattle case is one of the first involving claims brought by a government-sponsored enterprise.
During the housing boom, the Seattle bank purchased $4 billion of private-label MBS from Morgan Stanley, Goldman Sachs and others. Now with the securities in default, the GSE wants the underwriters to repurchase the bonds.
It has lawsuits pending against 16 entities in King County (Wash.) Superior Court, including one against Bear Stearns, which is now the property of JPMorgan Chase. The Seattle bank is seeking jury trials. All of the companies named in this story declined to comment on the legal actions against them.
"The complaints seek to exercise the Seattle bank's rights to rescind transactions in which underlying loans did not have the characteristics described in the prospectuses," the FHLB says in its complaint.
"It generally takes a couple of years after a major financial crisis, like the savings and loan debacle, for the litigation phase to develop," said Ronald Glancz, who chairs the financial services group at the Venable law firm in Washington. "I think this is just the beginning of what I think will be a tidal wave."
In the lawsuits, the Seattle bank alleges that the issuers mislead it about the quality of the underlying mortgages. It claims the appraisals and credit scores were inflated and the issuers allowed lenders to make numerous "exceptions" to their underwriting guidelines.
In the MBS prospectuses, the issuers would claim that exceptions could be made on a case-by-case basis when there are compensating factors. "Based on information and belief, these statements were untrue and misleading," the FHLB charges, adding that Morgan Stanley was making frequent and wholesale exceptions with no compensating factors.
Morgan Stanley also was failing to follow "qualify assurance practices intended to detect and prevent fraud," the lawsuit says.
The Seattle FHLB charges the issuers did not disclose that the loan performance of each year's MBS issuance steadily declined from 2005 through 2007 - even though the products had similar reported loan-to-value ratios and credit scores.
Loans securitized by Bear Stearns "performed worse if they were originated in 2007 than if they were originated in 2006, worse if made in 2006 than if made in 2005 ... ," the complaint says. (The FHLB uses the percentage of loans 60 days or more past due six months after origination to show the alleged deterioration in performance.)