Maybe, just maybe there will be justice afterall

How could the Obama White House look at a 50% loss rate on half a trillion dollars’ worth of collateralized debt obligations issued during the housing market madness and not bring prosecutions for securities fraud? Instead, Obama played the role of stooge perfectly. He did nothing just long enough to let the worst offenders on Wall Street walk on acts of securities fraud and other offenses. But maybe, just maybe, there will be justice after all.

During the State of the Union, Obama appointed New York Attorney General Eric Schneiderman head of the “new” Residential Mortgage-Backed Securities Working Group.  When he subsequently took credit for the settlement with the top banks and more than 40 states over foreclosure abuse, President Obama said inaction was “unacceptable.”  As HousingWire noted in previous commentaries, the Obama administration has ignored housing issues such as foreclosure and the refinance blockade by the mega banks going back three years or more until the expediency of election year politics made it attractive to talk about them. He belatedly gave Eric Schneiderman control over federal resources to conduct wider investigations, something that ought to have been done three years ago. 

But Schneiderman has all the legal authority he needs. The role of Schneiderman in investigating fraud and malfeasance in the financial markets needs to be understood separately from Washington agendas. The legal and political mandate of the New York AG is far broader than that of Obama and Treasury Secretary Tim Geithner, whose chief role is to protect the large banks from any accountability. The Department of Justice and the Securities and Exchange Commission, for example, are nowhere to be found when it comes to prosecuting Wall Street executives involved in the creation and sale of fraudulent assets linked to the mortgage markets.

The NY AG inquiry, on the other hand, reportedly focuses on areas such as loan origination and sales, the creation of residential mortgage-backed securities, the change in and perfection of title with respect to mortgages, and the role of the trustees and servicers. Each of these areas of inquiry is separate and apart from the issue of foreclosure abuse. And each carries with it legal and tax consequences that are significantly larger than the $25 billion involved in the foreclosure settlement announced recently.

Last summer Bank of America and other lenders were willing to accept a settlement of foreclosure abuses with the various state AGs in the $13 billion range. Remarkably, $8 billion of this amount would have gone to California alone. The imbalance in terms of the portion of the settlement going to California and the scope of the proposed settlement forced New York to withdraw from the discussions last summer. (The state later opted to take part in the settlement.) But as we’ve noted above, Schneiderman took the proverbial football home. Only New York has the legal weapons to force the large banks to settle and not just with respect to foreclosure abuse claims.

The NY AG’s office, don’t forget, used the threat of the Depression-era Martin Act to force American International Group into management changes shortly after the 2008 rescue by the Federal Reserve Bank of New York and the Treasury.

THE BNY MELLON CASE

Around the time that settlement discussions broke down last summer, Schneiderman intervened in the civil litigation against Countrywide Financial. The extraordinary Martin Act intervention filed by Schneiderman with the New York State Supreme Court alleged that Bank of America and Bank of New York Mellon committed fraud when they failed in their fiduciary duties with respect to the creation and sale of hundreds of RMBS trusts. Less than a month after the NY AG intervened in the Countrywide case, BNY CEO Robert Kelly was abruptly forced out.

The Schneiderman intervention in the Countrywide litigation was significant because almost immediately after the NY AG acted, some of the smaller RMBS trustees such as US Bancorp, Deutsche Bank and others began to sue the Wall Street banks that sponsored bad deals for which they’re cast as custodian. US Bancorp reportedly is actively cooperating with the NY AG and other agencies in terms of identifying potential wrongdoing, essentially acting as an unpaid advocate for bond holders in return for consideration from NY and federal prosecutors.  Nobody pays or indemnifies RMBS trustees to act as advocates for investors.

Of note, with Bank of New York and Bank America, which account for the lion’s share of the RMBS market and trustee billets, there is as yet no litigation by Bank of New York on behalf of investors. When you see Bank of New York sue Bank of America, then you’ll know the mortgage crisis really is headed for a conclusion.  But the calculus going forward with respect to the ultimate fate of Bank of America and Bank of New York is now largely in the hands of Eric Schneiderman and the courts.

The placement of Schneiderman atop the RMBS Working Group implied that New York and the other states would cooperate in terms of both settlement discussions with respect to foreclosure abuses like robo-signing and other offenses. And, with the exception of Oklahoma, they did. Sources close to the NY AG’s office, however, tell HW that being back in the fold with respect to the foreclosure settlement process does not mean that New York must or will participate in an omnibus settlement of other issues.

The insider asks how other AGs came to the table after California Attorney General Kamala Harris got such a big piece of the settlement pie, an estimated $18 billion.

The answer, in the case of Eric Schneiderman and the courts in the State of New York, is that there are bigger fish to fry.  While much of the media attention devoted to the housing crisis has been focused on the question of robo-signing and foreclosure abuse, how Eric Schneiderman pursues the other issues currently on the table could have a dramatic impact on the nation’s largest banks.

While AGs such as Harris in California are mostly focused on political outcomes with respect to the foreclosure settlement — AG after all stands for “aspiring governor” — Schneiderman is also concerned with more basic issues of equity for investors, regulated banks, funds and insurance companies which suffered losses, and the public at large.

As the gatekeeper of New York law, the governing template for the global securities markets, Schneiderman has a duty to pursue acts of fraud and negligence to demonstrate that investors may rely upon New York to enforce the rules of the game.

SCHNEIDERMAN IN 2012

What can we expect from Schneiderman in 2012 and beyond? First and foremost, as HW went to press, we got a narrow settlement of the foreclosure mess that allows the various AGs to declare victory, and move people and resources into areas such as loan servicing that directly affect borrowers and investors. This is a bad deal for the banks in one sense, but the banks are already refinancing and modifying loans in a desperate effort to keep visible default rates from rising — and event that will panic Wall Street.  In most cases, the states other than New York, Delaware and Calfornia are primarily focused on consumer facing issues, but the big three states are also focused on issues related to investors and, yes, taxes.

In New York, look for a broad inquiry into the four areas outlined above, with particular focus on the creation of RMBS and the role of trustees and servicers. In the crosshairs are the top four banks along with BNY because of its dominant position as custodian and trustee in RMBS. Also caught up in the dragnet could be Morgan Stanley, Deutsche Bank and Goldman Sachs.  Look for the salvation of US Bancorp for good behavior.  When these inquiries start to become more visible in terms of indictments and settlements, the reasons for the reluctance of Schneiderman to participate in the overbroad state AG settlement last year will become clear.

FUTURE BANK TAX LIABILITIES?

But perhaps the biggest surprise coming from the New York AG is going to be his focus on the issues of taxes, something Schneiderman talks about in media interviews but which the financial press largely ignores. The allegations of wrongdoing against Bank of America and Bank of New York with respect to RMBS raise troubling issues for investors, not the least of which is the tax status of what are arguably busted RMBS REMIC trusts.

There is also the issue of the largest banks counting losses from RMBS trusts as expenses, a maneuver admitted already by Countrywide in court proceedings. This admission not only eviscerates any claim of separateness between the sponsor and the RMBS trust, but may also result in huge future tax liabilities for the banks. By pretending that losses to the RMBS trusts were losses of the bank, Countrywide underpaid state and federal taxes for years and arguably committed tax fraud on a systemic basis.

Just as federal prosecutors used tax law over the years to bring criminals such as Al Capone to justice, Eric Schneiderman seems poised to use the issue of taxes as a club to compel settlements and reparations by the largest banks. While such an outcome may not provide the high profile criminal prosecutions sought by many observers of the housing mess, it will certainly bring the mortgage crisis to an end more quickly. And collecting tens of billions in back taxes certainly won’t hurt Schneiderman’s aspirations to follow Andrew Cuomo into the New York governor’s mansion. 

Christopher Whalen is a regular columnist for HousingWire and senior managing director of Tangent Capital Partners in New York where he provides advisory services focused on companies in the financial services sector. He is co-founder and vice chairman of the board of Lord, Whalen LLC, parent of Institutional Risk Analytics, a provider of bank ratings, risk management tools and consulting services.