The New York lawsuit over mortgage-backed securities against JPMorgan Chase & Co., the biggest U.S. bank, will serve as a template for suits against other issuers, state Attorney General Eric Schneiderman said.
Schneiderman alleged that the Bear Stearns business that JPMorgan took over in 2008 deceived mortgage-bond investors about the defective loans backing securities they bought, leading to “monumental losses,” according to a complaint filed yesterday in New York State Supreme Court.
The Bear Stearns mortgage unit packaged $212 billion in mortgage bonds from 2003 through 2006, according to the complaint. Losses on $87 billion of those bonds packaged during just two of those years total $22.5 billion so far, it estimated. Schneiderman said he wants the bank to disgorge all money it obtained in connection with or as a result of the alleged fraud.
“This is a workable template for future actions against issuers of residential mortgage-backed securities that defrauded investors and cost millions of Americans their homes,” Schneiderman said in a statement. “We need real accountability for the illegal and deceptive conduct in the creation of the housing bubble in order to bring justice for New York’s homeowners and investors.”
New York hasn’t fully identified the losses in the JPMorgan case, Schneiderman said at a teleconference today.
Schneiderman is the co-chairman of a state-federal group formed to investigate misconduct in the bundling of mortgage loans into securities leading up to the financial crisis. The group includes officials from the U.S. Justice Department, the Securities and Exchange Commission, the FBI and other federal and state officials.
“Defendants systematically failed to fully evaluate the loans, largely ignored the defects that their limited review did uncover, and kept investors in the dark about both the inadequacy of their review procedures and the defects in the underlying loans,” Schneiderman’s office said.
Joe Evangelisti, a JPMorgan spokesman, said the New York-based bank would contest the complaint, which is “entirely about” conduct by Bear Stearns. JPMorgan acquired Bear Stearns in March 2008 after a run on what was then Wall Street’s fifth-largest securities firm.
“We’re disappointed that the NYAG decided to pursue its civil action without ever offering us an opportunity to rebut the claims and without developing a full record -- instead relying on recycled claims already made by private plaintiffs,” Evangelisti said in an e-mail.
While Schneiderman said he had not spoken “recently” to JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon, he said the bank’s lawyers and his office have been holding discussions since a subpoena was issued in June 2011.
“We’ve had quite a lively interchange, shall we say,” Schneiderman said at a press conference at the Justice Department today. He said he is “confident” the group’s work “will result in more cases going forward.”
JPMorgan was among 17 financial firms sued last year by the Federal Housing Finance Agency over losses incurred by Fannie Mae and Freddie Mac on mortgage securities. Others companies that have sued the bank over mortgage securities include Syncora Guarantee Inc., Ambac Assurance Corp., DZ Bank AG, and Stichting Pensioenfonds ABP.
“Fannie Mae and Freddie Mac purchased residential mortgage-backed securities from the defendants and were allegedly misled about the quality of the loans supporting those securities,” FHFA Inspector General Steve Linick said in the statement released by Schneiderman’s office “Actions like this contributed to the financial crisis and those who engaged in such activities should be held accountable.”
Schneiderman earlier this year sued JPMorgan, Bank of America Corp. and Wells Fargo & Co. over their use of a mortgage registry known as MERS.
The top subprime MBS issuers in 2006 included Countrywide, now owned by Bank of America, Washington Mutual, absorbed by JPMorgan, and Lehman Brothers Holdings Inc., which emerged from bankruptcy earlier this year, according to a study by the Federal Reserve Bank of New York using 2007 data from Inside Mortgage Finance, a publication that tracks such data. Subprime issuance by just those three banks that year topped $90 billion, according to the publication.
JPMorgan may pay as much as $3 billion if it seeks to settle Schneiderman’s claims, according to an estimate from Charles Peabody, a bank analyst at Portales Partners.
“Litigation costs are likely to remain high for the foreseeable future,” Peabody wrote in a note to clients today. A settlement could be reached for as little as $2 billion, he said. He raised his estimate for JPMorgan’s third-quarter litigation costs to $1.6 billion from $500 million and cut his estimate for the bank’s earnings 17 percent to 95 cents a share.
“Clearly, this higher cost structure, against a still soft revenue picture, is going to put a squeeze on JPMorgan Chase’s operating margins,” Peabody said. JPMorgan said yesterday it will contest the state’s claims.
Bear Stearns Purchase
JPMorgan bought Bear Stearns after the investment bank ran out of cash. The transaction was urged by former Treasury Secretary Henry Paulson, his successor Timothy Geithner, who was head of the Federal Reserve Bank of New York at the time, and Fed Chairman Ben Bernanke. Dimon told the trio that he would only do such an emergency deal if the government was willing to take the risk on the most toxic Bear Stearns assets. The Fed agreed to take over $30 billion of mortgage-related securities to placate him.
Paulson also directed Dimon to keep his price offer low to make it clear to the public that shareholders of the defunct firm were being punished for the management errors. That produced a $2.52 per share offer, which Bear Stearns management had no choice but to accept.
Dimon had to raise his offer to $10 a few weeks later because of a legal loophole in documents rushed out initially that gave Bear Stearns shareholders an opportunity to hold out on approving the sale while JPMorgan was left on the hook for potential losses of the smaller rival.
“JPMorgan Chase stands behind Bear Stearns,” Dimon said at the time. “Bear Stearns’s clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns’s counterparty risk. We welcome their clients, counterparties and employees to our firm, and we are glad to be their partner.”
Soon after the takeover of Bear Stearns, Dimon grew concerned the public may perceive the deal as a gift to JPMorgan by the government, according to Andrew Ross Sorkin’s 2009 book “Too Big to Fail.” JPMorgan’s communications advisers suggested Dimon explain that the bank was taking on risks of unknown size, Sorkin wrote.
JPMorgan initially said it would set aside $6 billion for potential legal costs and losses that could come from Bear Stearns’s assets. That’s how the firm explained why it paid $1.5 billion for a company that had $11 billion of common equity on its books. In JPMorgan’s annual report at the end of that year, Dimon said all the equity in Bear Stearns had been used up by litigation costs and losses from legacy assets bought from the smaller firm. Because such losses exceeded the equity of the purchased entity, JPMorgan booked losses on its second half income statement related to Bear Stearns, he said in the report.
Geithner also had pressed Dimon to consider acquiring Morgan Stanley as Lehman Brothers Holdings Inc. collapsed in 2008, according to Sorkin’s book. While Dimon protested initially, he still held meetings with Morgan Stanley executives for a potential hookup. Morgan Stanley converted to a bank holding company, raised capital and remains independent.
JPMorgan slipped 17 cents, or 0.4 percent, to $40.80 at 12:14 p.m. in New York. The stock had advanced 23 percent this year through yesterday.
New York’s complaint names J.P. Morgan Securities, JPMorgan Chase Bank and JPMorgan’s EMC Mortgage unit as defendants.
Schneiderman said they failed to abide by claims that they were ensuring the quality of loans backing the securities and “routinely overlooked defective loans” identified during due diligence reviews. The misconduct in due diligence and quality control “constituted systemic fraud on thousands of investors,” the attorney general said.
According to the complaint, the current cumulative realized losses on more than 100 subprime and Alt-A securitizations that the defendants sponsored and underwrote in 2006 and 2007 total about $22.5 billion, or about 26 percent of the original balance of about $87 billion.
JPMorgan, with Bear Stearns and Washington Mutual, are facing lawsuits and claims against mortgage-related deals totaling $120 billion, the bank said in a regulatory filing. In the first quarter, JPMorgan had a $2.5 billion pretax expense for additional litigation reserves, mostly mortgage related, a charge that knocked 39 cents a share off its profit. The quarter’s actual litigation expense was $2.7 billion.
As of March 31, the bank estimated its outstanding mortgage repurchase liability at $3.5 billion, an amount already recognized in earnings, according to the quarterly filing. Litigation reserves may need to be increased, although probably not this year, the bank said.
Ex-Bear Stearns hedge-fund managers Ralph Cioffi and Matthew Tannin were acquitted in 2009 in federal court in Brooklyn, New York, of charges they misled investors who lost $1.6 billion on investments tied to subprime mortgages. It was one of only a handful of criminal prosecutions tied to that market.
Julian Tzolov and Eric Butler, two former Credit Suisse Group AG brokers, were convicted in 2010 of a scheme to fraudulently sell subprime securities to corporate clients that cost investors $1.1 billion in losses.
Tzolov and Butler were convicted of falsely telling clients the products were backed by federally guaranteed student loans and were a safe alternative to bank deposits or money market funds.
The case is People of the State of New York v. J.P. Morgan Securities, 451556-2012, New York State Supreme Court (Manhattan).