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Why GE and Citi Settled with FHFA

Time is money, especially with lawyers. Some quick calculations explain why General Electric and Citigroup were the first among 18 bond underwriters to extricate themselves from the protracted litigation involving the sale of residential mortgage bonds to Fannie Mae and Freddie Mac.

For GE and Citi, the potential liability wasn't that large. GE sold the government-sponsored enterprises $550 million in triple-A-rated private label securitizations, which are expected to be repaid in full. Citi sold $3.5 billion in triple-A bonds, of which only $1.5 billion are currently sub-investment-grade. Losses on those bonds, based off Moody's estimates, should be below $300 million. Any legal damages would be a fraction of actual losses. By way of contrast, Bank of America, combined with Merrill Lynch and Countrywide, sold the GSEs more than $40 billion in bonds.

All of the 18 complaints against the bond underwriters, which seem like carbon copies of complaints filed by MassMutual, Allstate, the Federal Deposit Insurance Corp. and others, allege that each and every Securities and Exchange Commission filing made the same false representations: The average loan-to-value in the mortgage pool was materially understated, and the rate of owner occupancy was materially overstated. 

It's hard to come away from reading those complaints and not get the strong impression that the banks' due diligence was a joke. But in fact, that's the argument put forth by bank defense attorneys in an extraordinary petition, with 2,000 pages of attachments, filed last March with the U.S. Court of Appeals for the 2nd Circuit.

Defense attorneys seek to overturn lower court rulings limiting pretrial discovery into Fannie and Freddie's single loan operations.  They are pursuing a dubious theory that the GSEs were "sophisticated investors," who "had to know" that the banks flouted their legal obligations of due diligence.

Our entire system of federal securities laws, and the integrity of our capital markets, is based on the notion that all investors can rely on the accuracy and completeness of disclosures filed with SEC. Defendants' ploy is a backdoor attempt to subvert that basic principle. 

Specifically, the original complaints alleged violations come under Section 11 and Section 12(a) of the Securities Act of 1933, which hold an underwriter liable for the accuracy and completeness of all financial disclosures.  These statutes impose a strict liability standard, meaning the underwriter may be held liable for material falsehoods even if he had no intent to deceive.  However, a defendant can assert a possible defense if he can establish that he performed adequate due diligence as part of his underwriting process. 

Since Fannie, Freddie and other sophisticated investors were aware that underwriting banks are liable for false statements, it was reasonable for them to take the SEC documents at face value.  But the banks' lawyers seek to turn everything around. They contend that defendants may rebut plaintiffs' claims if they are able to conduct discovery into the GSEs own loan purchases, which were subject to completely different underwriting processes. Here's their four part argument before the Court of Appeals for the 2nd Circuit: 

"First, Petitioners [the banks] intend to show there were no material misstatements, based in part on evidence that the GSEs satisfied themselves that loan originators did not in fact systematically abandon their guidelines."

In reality, GSE satisfaction has nothing to do with the accuracy and materiality of a statement, which is a question of fact determined by the Court.

"Second, Petitioners seek to develop evidence about the GSEs' knowledge and notice of the alleged misrepresentations and omissions, the GSEs' assessments of whether they were material, and the standards for diligence conducted by the GSEs."

In reality, the banks owe a duty to provide accurate and complete disclosure to the entire investing public, which is why any insinuation that the GSEs did not believe that the banks were complying with the law is irrelevant. 

"Third, Petitioners seek to develop evidence showing that any losses the GSEs suffered were not caused by the alleged misrepresentations." 

Fair enough, but loss causation has nothing to do with the GSEs.

"Finally, Petitioners seek to develop evidence that FHFA's fraud claims fail because the GSEs did not reasonably rely on any alleged misrepresentations."

This argument is unseemly, because it says that it is not reasonable for the GSEs or anyone else to assume that the world's largest banks made a practice of complying with the Securities Act of 1933.  No wonder GE and Citi chose to walk away from that legal quagmire. 

David Fiderer has previously worked in energy banking for more than 20 years. He is currently working on a book about the rating agencies.

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