Wall Street bankers have argued since the beginning of the 2007-8 financial crisis that they did not break the law when packaging sub-prime mortgages into bonds and selling them to institutional and retail investors. But in a devastating precedent that could redefine history, a Manhattan federal judge ruled that Nomura Bank and Royal Bank of Scotland willfully misled Fannie Mae and Freddie Mac into purchasing mortgage bonds that contained numerous fraudulent misrepresentations and underwriting errors.
Judge Denise L. Cote of the Federal District Court in Manhattan wrote, in a blistering 361-page decision: “The magnitude of falsity, conservatively measured, is enormous.”
Facing an enormous public backlash, the U.S. government pressured Wall Street subsidiaries of domestic and foreign banks to be accountable for actions that it claimed, at a minimum, contributed to the crash. A string of major Wall Street firms–including Goldman Sachs and Bank of America–settled similar underwriting cases to avoid publicly airing the details of their actions, and paid about $18 billion in penalties to the Justice Department and the Securities and Exchange Commission.
Monday’s legal ruling had been highly anticipated, because Nomura and RBS were the only two of 18 financial firms that had refused to pay hundreds of millions of dollars and settle with the U.S. government. Both banks went to trial arguing that it was the housing crash, not their loan documents, that caused the sub-prime bonds to collapse.
Unlike the relatively opaque settlements, the trial against Nomura and R.B.S. opened a window into the behavior of banks heavily involved in subprime mortgages at the peak of the housing boom, according to the ‘DealBook’ financial blog.
Judge Cote, who operates out of Courtroom 15B in the Lower Manhattan U.S. District Courthouse just a short walk from many Wall Street firms, has built a history reputation for taking a hard line against the banks.
In her decision, Judge Cote described 2007 and 2008 as a “dangerous and toxic period in the American economy.” With house prices soaring, Wall Street banks were purchasing bundles of high-risk mortgages and packaging them into bonds they marketed to buyers around the world. Judge Cote determined that as the size of the bond market surged, the quality of the loans plunged.
Senator Elizabeth Warren (D-MA) has been targeting Wall Street after Congress passed a government spending bill late last year that weakened a provision of the “Dodd–Frank Wall Street Reform and Consumer Protection Act.’ Warren has been the fiery leader of progressive Democrats that believe that “Many Wall Street institutions have exerted extraordinary influence in Washington’s corridors of power.” She argues the banks “grip over economic policymaking in the executive branch is unprecedented.”
Wall Street’s own analysts asserted, after many banks settled, that the banks may have been acting out of “greed and with a cavalier disregard for risk,” but did not act deceptively.
Judge Cote’s decision blasts that cover story. She said that the bank’s advertised loan underwriting guidelines were “systematically disregarded” and found “disturbing examples” showing that Nomura was willing to package and sell defective loans.
“This case is complex from almost any angle, but at its core there is a single, simple question. Did defendants accurately describe the home mortgages in the offering documents for the securities they sold that were backed by those mortgages?” she wrote in her decision. “Following trial, the answer to that question is clear. The offering documents did not correctly describe the mortgage loans.”
Nomura was described as a late-to-the-party participant to the mortgage boom and allegedly cut corners to win more business and take billions of dollars in market share in bond sales. Judge Cote agreed with testimony by the Federal Housing Finance Agency that two-thirds of the mortgage loans underlying the securities sold to Fannie Mae and Freddie Mac had serious underwriting defects.
The government’s expert witnesses performed analyses of some of the loans backing the disputed bonds and said that far more of the loans than the documents stated had characteristics that made them much more likely to default.
Lawyers for Nomura and RBS argued that the experts’ analyses were seriously flawed. Attorney David B. Tulchin of Sullivan & Cromwell, for example, called the experts’ methodologies “entirely artificial in the extreme.”
The most damaging line in Judge’s Cote decision involved her determination that the banks’ misconduct exacerbated the collapse in the mortgage market. She wrote that “once that collapse started, improperly underwritten loans were hit hardest and drove the collapse even further.”
The penalty phase of the trial will probably start later this week. Given the breadth of the findings by Judge Cote against the two banks, the size of the financial judgment could involve $1 billion in damages to the Federal Home Finance Agency, and more if Nomura and RBS have to take back the bonds they sold Fannie Mae and Freddie Mac.
Nomura spokesman Jonathan Hodgkinson said the bank plans to appeal the decision. He stated, “Nomura is confident that it was consistently candid, transparent and professional in all of its dealing with Fannie Mae and Freddie Mac,” according to DealBook.