The Mortgage Litigation Hangover (and who knew what, when)

Aside from the relatively new foreclosure disputes, including those relating to MERS, the big banks continue to suffer the ill-effects of lawsuits relating to their original portfolio selection and sale of mortgage-backed securities (and derivatives thereof, like ABS CDOs).

A number of these cases were dismissed last year, as judges often failed to sympathesize with the plaintiff's arguments that they were "duped." On the back of Congressional and FCIC-related testimony, plaintiffs have been able to strengthen their arguments as they search for viable legal theories that satisfy these, potentially higher, pleading standards.

Today's two cases filed today focus on the what they believe were material informational asymmetries between the buyers and sellers, and possible scienter on the side of the sellers.

In John Hancock Life Insurance Co. v. JPMorgan Chase & Co., 650195/2012, New York state Supreme Court (Manhattan), the complaint argues that:

Defendants JPMorgan, Bear Stearns, WaMu, and Long Beach knew about the poor quality of the loans they securitized and sold to investors like Plaintiffs, because in order to continue to keep their scheme running, they completely vertically integrated their RMBS operations by having affiliated entities at every stage of the process. In addition, Defendants JPMorgan, Bear Stearns, WaMu, and Long Beach were aware of lending abuses on the part of the third party originators they purchased loans from due to, inter alia, their financial ties to the third party originators and their reviews of loan documentation and performance.

In Sealink Funding Ltd. v. Morgan Stanley, 650196/2012, New York state Supreme Court (Manhattan), the plaintiff contends that because the seller never disclosed certain of its practices to the investors, the "investors were not compensated for the additional risks that they unknowingly took on in purchasing those Morgan Stanley RMBS."

Morgan Stanley knew or recklessly disregarded that those lenders were issuing high-risk loans that did not conform to their respective underwriting standards. Morgan Stanley did, in fact, conduct extensive due diligence on the loans it purchased for securitization, as represented in the Offering Materials. In the course of that extensive due diligence process, which, in many instances, included an extensive re-underwriting review of the loans it purchased by an independent third-party due diligence provider, Clayton Holdings, Inc. (“Clayton”), Morgan Stanley learned that the originators routinely and flagrantly disregarded their own underwriting guidelines, originated loans based on wildly inflated appraisal values, and manipulated the underwriting process in order to issue loans to borrowers who had no plausible means to repay them. Indeed, both the President of Clayton and the head of Morgan Stanley’s own due diligence arm testified as to the extensive deficiencies identified through Morgan Stanley’s due diligence. Specifically, over one-third of the loans Morgan Stanley evaluated for purchase and securitization at the height of the mortgage boom (from 2006 through mid-2007) failed to meet the originators’ own underwriting guidelines.

We concentrated on the effectiveness of the Clayton due diligence sampling in ar piece late last year. (See Analysis of the Shortcomings of Statistical Sampling in the Mortgage Loan Due Diligence Process.)

But watch this space for more coverage on how legal teams representing investors seek to survive threshold challenges by showing that – even if their client is or was a sophisticated investor – they may not have been privy to the types of information available to the structuring banks.