Government Going After Banks for Shoddy Mortgage Securities

Megan McArdle Sep 2 2011, 3:25 PM ET

The New York Times reports that our government is going to file suit against a bunch of major banks, alleging fraud in the mortgage securitization process. Apparently, the statute of limitations expires in a few days, so the Federal Housing Finance Agency is expected to slip the suit in just under the wire.

The suits will argue the banks, which assembled the mortgages and marketed them as securities to investors, failed to perform the due diligence required under securities law and missed evidence that borrowers' incomes were inflated or falsified. When many borrowers were unable to pay their mortgages, the securities backed by the mortgages quickly lost value.

Fannie and Freddie lost more than $30 billion, in part as a result of the deals, losses that were borne mostly by taxpayers.

In July, the agency filed suit against UBS, another major mortgage securitizer, seeking to recover at least $900 million, and the individuals with knowledge of the case said the new litigation would be similar in scope.

The details are rather sketchy, and I am not a securities lawyer, but I expect that this is going to be a fairly difficult case to make. Fannie and Freddie already have the right to force banks to take back loans with obvious underwriting flaws, or that go bad too quickly, and my understanding is that they've been doing just that.

Securities cases are hard to prove in the best of circumstances--even Eliot Spitzers' famous crusade against Wall Street consisted of getting fairly minor settlements from most of the big fish he went after . . . and losing every case he took to court. The first mortgage securities case to go to trial, with two Bear Stearns bankers, likewise returned a "not guilty" verdict. Many of these same banks got themselves in serious financial trouble by gorging on their own toxic mortgage securities, which dims the fraud angle. Unfortunately, being arrogant idiots with the risk appetite of a coked-up skydiver is not a crime.

On the issuance side, most of the knowing, obviously provable fraud seems to have been at the mortgage broker level, or in mortgage mills that are now out of business. Proving that someone ought to have known that they were being scammed is harder--especially since they can argue that if they ought to have known, so should the GSEs.

But it's easy to understand why the government wants to preserve its option--if nothing else, the political pressure to bring cases like this is enormous. It will be interesting to see where this goes, and if they can actually prove malfeasance rather than gross stupidity.