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Case Offers Peek Behind the Curtain of a Security

nytimes.comFebruary 1, 2013

By Floyd Norris

The private mortgage-backed securities market grew to be a virtually inscrutable giant. Each securitization contained thousands of mortgages and as many as dozens of different securities, some of which could emerge unscathed even if others produced total losses for investors.

Five years after it began to blow up, that market can be seen as having failed twice — once before the housing crisis began and again when the crisis was at its peak. Investors put money into deals that never should have been financed, then panicked when the credit crisis arrived and dumped securities that really were likely to pay off. A market that had been full of foolish buyers had no buyers. The banks loudly proclaimed that prices were irrationally low, but few if any of them were willing to buy.

It was the government that stepped in and saved the market, in a program — called PPIP, for Legacy Securities Public-Private Investment Program — that has turned out to be a success. The government put up most of the money to enable money managers to buy distressed merchandise. This week the Treasury Department reported that it had recovered all of the money it invested, with much more likely to come.

That report came a couple of days after the Justice Department and the Securities and Exchange Commission filed criminal and civil charges against a former securities salesman who was accused of defrauding the institutional investors who invested their own and the government’s money in PPIP. He did that, the government said, by lying to them.

Mortgage-backed securities “are generally illiquid and discovering a market price for them is difficult,” the S.E.C. said in its civil case against the broker, Jesse Litvak, who formerly worked for Jefferies & Company. “Participants trading in the M.B.S. market must rely on informal sources, including their broker, for this information.”

How, I wondered, can that be? The corporate bond market used to be like that. But after Arthur Levitt, the S.E.C. chairman in the 1990s, complained, steps were taken to rectify the situation. Now you can learn from the Trace system operated by Finra, the Financial Industry Regulatory Authority, about trades in any bond.

But no one at Finra seems to have given the mortgage-backed securities market even a moment’s worth of attention until 2009, when the market crashed. Even then, it was not until 2011 that Finra began to require brokers to submit every trade. Now if the S.E.C. wants to see every trade in a particular security, it can do so.

But you and I cannot.

Starting in July, more information about trading in mortgage securities guaranteed by Fannie Mae and Freddie Mac will become available, which is good but not nearly as important. We already have a pretty good idea of how those securities trade. But private-label securities — backed only by the mortgages in each securitization — are different from one another, and it is not as easy to estimate the value of one based on trading in a different one.

Had trading data on such securities been public, institutional investors such as the ones that the government claims were defrauded would have been able to see the trades Jefferies made when it acquired the bonds it marked up and sold to them. Any lies, like those Mr. Litvak is accused of telling, would have been unmasked immediately.

The Dodd-Frank law, by the way, requires more disclosure of trades in all kinds of swaps, including swaps based on mortgage-backed securities, and those disclosures are starting to appear as the Commodity Futures Trading Commission writes rules. But that law completely ignored the mortgage-backed securities themselves, so trading in them remains secret.

Now that the S.E.C. and the Justice Department have officially asserted that investors in such securities are at the mercy of their brokers, perhaps they will press Finra to require release of the information.

Doing so would be almost costless, since the data is already being gathered.

But such a move would be fiercely resisted both by Wall Street and by some of the institutional investors that would be protected. The brokers’ opposition is easy to understand: profit margins always fall when the customers have better information. The brokers have also persuaded some money managers to oppose release, on the ground that their strategies would be revealed if everyone could see that there was more activity in a particular type of security.

“We have not made a final determination of what we should put out that would be helpful for market participants in these private-label securities,” Steven Joachim, Finra’s executive vice president for transparency services, told me this week. He said there was no timetable on when any decision would be made.

Perhaps more public information about the mortgage-backed securities market might have prevented the market’s second failure.

By the time the market crashed in 2009, there was plenty of information available about specific issues — about the mortgages behind them and about how rapidly defaults were mounting. Analyzing that information was not easy, and many of the traditional players in that market — the banks — were short of capital anyway.

The interesting question is whether easily available information about price and volume of individual securities would have led hedge funds and other sources of private capital to seek out relative bargains, and thus bring support to the market.

As it was, the market was in chaos until Uncle Sam stepped in. PPIP provided capital to nine money managers, which put up 25 cents in capital for every 75 cents the government put up. Half the government capital was treated as debt, meaning it would be paid back before the fund manager got anything. No additional leverage was allowed, giving those funds the ability to hang tough if securities they bought continued to lose value. There would be no margin calls.

It worked. The managers followed differing strategies, some buying quickly and some slowly, some focusing on residential mortgage-backed securities — the type that Mr. Litvak was selling — and some on commercial securities. All of them seem to have made good money. Over all, the government put up $18.6 billion, has gotten back $18.8 billion and seems likely to get at least another $3 billion.

“The program helped to stabilize and restart markets that froze up during the crisis,” said Timothy G. Massad, the Treasury Department’s assistant secretary for financial stability. Now the program is being wound down, and most of the securities have been sold.

The civil and criminal charges against Mr. Litvak provide insight into prices in some securities during the crisis. With that list in hand I was able to get the prices that one service advises its clients the securities are worth now. All have recovered some value, even though the news in some cases has continued to be bad.

One example of how a mortgage securitization could have been a horrid one — and still work out O.K. for those who bought in 2009 — was a security known as INDX 2007-AR7 2A1.

Here’s the bad news: It was backed by mortgages written by IndyMac Bank, a California institution whose 2008 failure cost the Federal Deposit Insurance Corporation more than any other. Most of the loans required no principal repayments for five years and were made to borrowers whose income no one bothered to check. (In some cases, the bank did not even ask how much the borrower made.) The loans were concentrated in California, but there were also sizable blocks in Arizona and Florida — all areas where home values fell sharply. Defaults and foreclosures have been plentiful.

On the other hand, these were “supersenior” securities that had been rated AAA when issued, in part because more junior securities would take the first losses. While the senior securities have now taken some losses, and are likely to take more, they are not going to become worthless. The current estimated value is around 66 percent of par value, far above the price of 42.25 percent that Mr. Litvak’s client paid in May 2009. The government claims that Mr. Litvak bought the security for 41.13 percent but lied to the customer by saying he actually paid a full percentage point more. Mr. Litvak’s lawyer says he did nothing wrong.

It will be interesting to see if the government can persuade a judge and jury that, in the words of George Canellos, the deputy enforcement director at the S.E.C., “Brokers must always tell their customers the truth, particularly in complex securities transactions in which it is difficult for investors to determine market prices on their own.” It will also be interesting to see if the commission forces Wall Street to disclose those market prices.


Back to February 2013 Archive

CFLA was founded by the Nation's Leading Foreclosure Defense Attorneys back in 2007 to serve the Foreclosure Defense Industry and fight pervasive Bank Fraud. Since opening our virtual doors, CFLA has rapidly expanded to become the premier online legal destination for small businesses and consumers. But as the company continues to grow, we're careful to hold true to our original vision. For us, putting the law within reach of millions of people is more than just a novel idea—it's the founding principle, just ask Andrew P. Lehman, J.D.. With convenient locations in Houston and Los Angeles, you can contact Our National Account Specialist and General Manager / Member Damion W. Emholtz at 888-758-2352 for a free Mortgage Fraud Analysis or to obtain samples of work product, including cutting edge Bloomberg Securitization Audits, Litigation Support, Quiet Title Packages, and for more information about our Nationally Accredited and U.S. Department of Education Approved "Mortgage Securitization Analyst Training Certification" Classes (3 days) 24 hours for approved CLE & MCLE Credit (Now Available Online).

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