Banks have been fighting with disgruntled bond investors and insurers for months, arguing that they do not need to buy back soured mortgages they placed inside securities before the financial crisis.
Now, it turns out, some of those banks may have secretly collected partial payments on those same mortgages several years ago and pocketed that money.
At least that is a theory being pursued by plaintiffs’ lawyers in some of the largest mortgage bond lawsuits, in which banks are accused of filling mortgage bonds with loans that did not belong there.
The theory surfaced in a recently unsealed lawsuit against a mortgage unit at Bear Stearns, the failed investment bank that is now part of JPMorgan Chase.
In the suit, the Ambac Assurance Corporation, which insured some mortgage bonds created by Bear Stearns, contends that the bank was partly compensated by loan originators for mortgages that became delinquent shortly after they were packaged into securities. Bear Stearns’s mortgage desk kept the payments, according to the suit, rather than apply them to the bonds that contained the delinquent loans.
Interviews with more than a dozen former workers at several big banks, including Lehman Brothers and Deutsche Bank, suggest that several banks received millions of dollars at a time in such payments, known as early-payment-default settlements.
But the money trail of these settlements is murky. It is unclear how much of the money was added to bankers’ profits — and bonuses — and how much was forwarded to buy out bad loans from mortgage bonds.
Whether or not the settlement payments were shared with mortgage investors, they are likely to be used in court to show that Wall Street banks knew about the growing stream of mortgages that had missed payments within their first 90 days, a common sign of mortgage fraud. That sort of evidence may matter to government investigators at places like the Securities and Exchange Commission, which is looking into whether banks misrepresented the sorts of mortgages placed in bonds.
At Bear Stearns, there seems to have been some knowledge of the failing loans, according to the Ambac case. Ambac says there is evidence of more than 100 early-default settlements for batches of loans that soured quickly. An example in that case describes an $11 million payment for one batch of loans. For another batch of “at least 12 loans,” there was a $2.6 million payment.
Ambac’s case was filed in federal court, but a judge there ruled this week that the case belonged in a different jurisdiction. Erik Haas, a lawyer for Ambac, said the company planned to refile in state court.
JPMorgan Chase, which bought Bear Stearns three years ago, said Ambac was a sophisticated investor that knowingly took risks in its deals.
“We do not believe Ambac’s claims are meritorious and intend to defend Bear vigorously,” said Jennifer Zuccarelli, a JPMorgan spokeswoman. Ms. Zuccarelli would not comment on Bear Stearns’s use of settlement payments.
Banks like JPMorgan face lawsuits brought by insurance companies and large asset managers that had purchased mortgage bonds when housing was booming. These investors want to return the bonds to the banks and get their money back. The banks disagree, saying the buyers of these securities were sophisticated investors who bought the bonds with open eyes and should have understood the risks.
Some lawyers in those cases said the accusation against Bear Stearns, if true, would be a stunning instance of wrongdoing, because it would indicate that its mortgage operation essentially double-dipped: selling a mortgage into a mortgage bond at full price and also pocketing a settlement for that same mortgage when it went sour.
“If they knew the loans were defaulting, the money should have been passed on to investors,” said Jerry Silk, a lawyer with Bernstein Litowitz who is representing numerous mortgage investors in suits against banks. “We’ve heard this a lot, and we’re trying to prove it. It would be a home run for us.”
The search for a home run has compelled mortgage bond investors to look back to when they first bought their investments. Around 2005, the number of mortgages that went bad began rising. Bankers were in the middle, between the firms that originated the loans and the investors who bought bonds with them.
Mortgage originators at that time did not have enough cash to buy back the loans in full. So banks offered a deal: if the originators gave them a partial cash payment, or a discount on future loan purchases, the banks would drop their requests that originators repurchase the delinquent loans.
This helped the mortgage companies preserve cash, and it appeased the bankers. But, in many cases, it is unclear if the partial payments benefited holders of the mortgage trusts that held the relevant mortgages.
It seems there was no standard accounting of the payments among the various banks, particularly in cases where banks received future discounts or other benefits instead of cash.
At the mortgage company New Century, for instance, banks agreed to reduce the number of souring loans they returned to the originator in exchange for the right to buy some of the originator’s next batch of loans, according to testimony given to Michael Missal, a lawyer with K&L Gates who prepared New Century’s bankruptcy report.
That deal with New Century was valuable to banks because they needed more mortgages to keep their lucrative mortgage bond machines going.
It is also unclear whether the banks had a legal obligation to pass the benefits from early-default settlements to the mortgage investors.
Workers who negotiated some of these settlements at Bear Stearns or at other Wall Street firms said last week that they did not know where the payments ended up. “The further and further I get from that business, the more I realized how siloed we were,” said one former mortgage salesman at Lehman Brothers who spoke only on the condition of anonymity. “No one knew what anyone else was doing.”
A former Bear Stearns worker, who negotiated such settlements between it and originators, said: “I was the messenger of the bad news. I was going back to these originators to say ‘Listen, we purchased some of these and they’re having problems.’ ”
“But,” this worker said, after he received the settlements, “I had no visibility into where the money went when I sent it up the food chain.”
Even Ambac’s lawyers at first did not know the extent of the payments at issue, but the company filed an amended complaint describing them after learning some new information from the producer of a coming documentary about Bear Stearns, “Confidence Game.”
Tracing such payments is tricky because of the large number of players in the mortgage machine: mortgage originators sold loans to banks, and then the banks packaged them into mortgage bonds to sell to mortgage investors. The originators did not generally communicate with mortgage investors, so neither side knows exactly what Wall Street’s middlemen did with the money or side agreements.
Tom Capasse, a principal at Waterfall Asset Management in New York, ran models to spot early signs of trouble in the bonds he purchased. He said that about 75 percent of the time that he found a problem, the bank that created the deal came forward without prompting and repurchased the bonds.
But a quarter of the time, Mr. Capasse said, he had to report a missed payment and raise questions about the loans for them to be repurchased by the bank. Banks, he said, might not have minded if other investors did not report such problems. “Banks were facing a death spiral in terms of early mortgage defaults,” he said, “so they just didn’t buy them back.”
