Four years past the beginning of the collapse of the U.S. housing market, there are scores of class action and individual lawsuits involving the origination and securitization of residential mortgage-backed securities (RMBS).
Monoline insurers and private RMBS investors are filing individual and class actions against issuers of securities, loan originators, and securities underwriters; in other cases, government-sponsored entities are doing the filing. The U.S. Federal Housing Finance Agency, for instance, sued 18 of the world’s largest banks on behalf of Fannie Mae and Freddie Mac, claiming the financial institutions misstated or omitted material information concerning $200 billion worth of securities sold to Fannie and Freddie.
The RMBS securitization process is complex, involving a chain of transactions and multiple players, including loan originators, securities issuers and underwriters, due-diligence service providers, credit-rating agencies, and insurers. In RMBS disputes, litigators and economic experts must not only isolate the factors that are relevant for determining liability and damages, and, in the event of class actions, for addressing certification issues, but also consider those factors within the context of varying industry practices, disclosures in offering documents, levels of investor sophistication, and U.S. housing, mortgage, and RMBS markets.
Analysis Group has a long history of working on complex securities and mortgage-backed securities matters. Recently, we have been working on a range of RMBS cases related to the financial crisis and housing market collapse, including
New Jersey Carpenters Vacation Fund, et al. v. The Royal Bank of Scotland Group, plc, et al., a matter in which certification was denied to a putative class of institutional investors in part because experts were able to point out the disparity of investor sophistication and knowledge among members of the class. While the parties, circumstances, and amounts vary from case to case, there are two primary issues in RMBS matters:
Allegations of misrepresentation. In many of these cases, there are claims that the banks’ offering documents have omitted information or contain false or misleading statements about the underlying collateral – for instance, whether the loans were originated in accordance with stated underwriting guidelines and whether information about property appraisals, loan-to-value ratios, or borrower incomes is accurate. These sorts of allegations were central to RMBS litigation involving The Royal Bank of Scotland, IndyMac Bank, Merrill Lynch, Washington Mutual, Countrywide, and others. For instance, the IndyMac plaintiffs, a putative class of investors in mortgage pass-through certificates publicly offered by IndyMac between 2005 and 2007, contended that the offering documents for the certificates did not provide adequate information about Indy-Mac's underwriting practices. IndyMac "relied upon faulty appraisals of the underlying real estate that were not made according to [industry standards] and oftentimes grossly overvalued the property/collateral," they alleged.
The role of economic conditions. Another central point of analysis in RMBS-related cases is the macroeconomy – more specifically, the effects of significant changes in real estate, financial, and other markets on the performance of the underlying loans and the value of securities within a given time frame. Since 2007, these changes have included the greater than 30% average decline in housing prices nationwide, with larger declines in some regions; increases in the unemployment rate; the drying up of liquidity in capital markets; and the overall defaults in the mortgage market, which have reached unprecedented levels. As the number of actual and expected defaults increased, the prices of many RMBS fell precipitously. "Real estate economists have attributed the downturn in the mortgage market predominantly to the deterioration in the macroeconomic environment and ... to the unprecedented fall in home prices," one expert explained in a recent report.
There are several approaches that economic experts can take to present a complete picture of industry practices and market conditions. They include:
Performing risk-exposure analysis. It is relatively early in the life span of RMBS cases, so it is still unclear whether these matters are more likely to be settled by parties, or fully litigated in court. A first step is to understand the damages that parties are likely to claim based on publicly available pricing data and the payment history of the certificates at issue. We have estimated damages using trading assumptions before taking into account the impact of loss causation on Section 11 and 12 claims. Again, this is a starting point; it does not factor in the economic conditions that affected the performance of loans or the causes of RMBS price declines.
Analyzing the performance of securities. Using regression analyses and data from a variety of sources, including internal and external databases, we have helped economic experts perform loan- and deal-level comparables analyses. For instance, we have estimated how various deals at issue performed relative to the rest of the industry after controlling for relevant loan and borrower characteristics (such as loan-to-value ratios, documentation type, and FICO score) as well as changes in macroeconomic performance. We have also analyzed the impact of alleged loan defects to determine if they were associated with increased defaults and losses and could have contributed to losses. The results of these analyses have provided insights into whether there were factors specific to the deals that may have caused performance that was different from that of the market as a whole.
Assessing the use of statistical sampling. The volume of loans at issue in RMBS litigation may sometimes favor a cost- and time-sensitive analytical approach: statistical sampling. A subset of loans are selected and analyzed, and inferences about the entire population of loans are drawn from the assessment of this subset (the sample). Experts can analyze whether and which sampling methodologies might be appropriate. They can also re-underwrite the loans to determine if they were defective. In the re-underwriting process, experts perform an after-the-fact review of the loans to determine whether they were underwritten in accordance with stated guidelines.
These and other sophisticated analytical approaches can help litigators reach appropriate solutions to RMBS disputes. ■
Managing Principals Mark Howrey and Adam Decter are in the Boston office.
This feature appeared in the Fall/Winter 2011 issue of Forum.