RBS Was Pretty Relaxed About Selling Bad Mortgages
While the Justice Department is putting its finishing touches on the slow-moving 13 billion-ish JPMorgan mortgage settlement, the SEC lobbed in a little $150 million mortgage settlement with RBS Securities Inc. just to keep everyone entertained while we wait for the JPMorgan one.1 The stylized facts from the complaint are that in 2007, RBS (then Greenwich Capital Markets) bought and securitized 11,000 subprime loans from Option One (then part of H&R Block), picked a sample of 1,000 loans to do due diligence on, and found that 300 of those loans didn't meet the advertised underwriting standards. So very sensibly it kicked those loans out of the securitization and sent them back to Option One in disgrace. Good job!
Unfortunately for RBS, a subsidiary of the Royal Bank of Scotland, the SEC thinks, with the benefit of hindsight and/or a basic understanding of statistics, that RBS should have thought something along the lines of "well, if 30 percent of those 1,000 sample loans were bad, then it stands to reason that 30 percent of the other 10,000 loans would be bad, maybe we should check." They did not check. The securitization went ahead, they sold the loans to investors, lots of the loans were bad, you know the rest, $150 million settlement.
This is just one more boring bad-mortgage-securitization data point but each of them adds, if not exactly an understanding, at least a little texture about what happened. So part of the diligence involved reviewing an "adverse sample" of loans with red flags, low credit scores, high loan-to-value ratios, whatever. RBS decided on this sample that being a first-time home buyer would not be such a red flag, even though it knew that a lot of loans to first-time buyers were problematic. Then this happened:
After viewing the proposed adverse sample, the Diligence Lead sent an e-mail to his RBS colleague who declined to select first time home buyers as an adverse criteria, asking: “You like it when I’m fired up, do you? [Be]cause I’m p!ssed right now.” Evidently frustrated that first-time home buyers (“FTHBs”) were not included as an adverse criteria in the sample, the Diligence Lead further wrote: “I’m kicking out FTHBs like they had smallpox over here and we’re spending 60% of a limited diligence on 8 month old loans, which will require probably 5 or 6 sets of guidelines just to underwrite . . . Who (sic) got Jameson’s?”
Look, I'm not saying I understand what the guy was talking about; the point is he was p!ssed. And he was p!ssed because he really wanted to do some awesome diligence. He was fired up for some diligence. He was gonna kick out those deadbeat first-time buyers like they had smallpox. He was probably walking around high-fiving people every time he found a badly underwritten loan. Possibly he kicked out loans by physically kicking the file folders out of his cubicle.
He might not have been fun to work with, is what I'm saying. But he's definitely the guy you'd want doing diligence, if you were a mortgage-backed security investor. He cared about getting it right, and he got angry when anyone stood in the way of getting it right.
Meanwhile, in another part of town, just before the final meeting to discuss diligence and go ahead with the deal, this happened:
The Lead Banker, the Head of Credit, an RBS attorney, and others received the diligence results. On Friday, April 27, before the meeting occurred, the Lead Banker stated in an e-mail to other RBS employees involved in the Subprime Offering that one diligence summary “doesn’t help.” However, RBS was out of time to conduct more diligence before the April 30th deadline to complete the purchase of the Option One loans.
On information and belief, the Lead Banker, along with Credit and Legal staff at RBS, justified proceeding with the Subprime Offering without more due diligence or disclosure about conformity to underwriting guidelines in part because Option One was taking the “residual” on the deal – meaning, an investment in the lowest tranche of the Subprime Offering – and because the deal had some protection for RBS investors in the case that certain of the loans defaulted within the first 45 days after the deal closed.
Did that reasoning make sense? In hindsight, no, of course not. At the time, I mean, substantively I don't know if you could reasonably have thought "well there's an equity cushion, and house prices only ever go up, so it's probably fine that these loans are all fraudulent." Obviously some people did think that. But the point is: If you think that, why do the diligence at all? Why write a prospectus saying that the loans were underwritten in accordance with underwriting standards? Why not just say "meh, here are some scraps of paper, but house prices only go up, good luck"?
That intense sweaty guy in the basement of the diligence building, or whatever, pounding his Jamesons and kicking his folders -- that guy's terribly damning report filtered up to the banker in charge of approving the deal. And that banker held that report at arm's length with two fingers and said "well, this doesn't help." Then he just ignored it completely. Thank you for your help, Diligence Lead, now go away. Back to the basement with you. Let us never speak of Diligence Lead again.
I don't know what to tell you. As I said about JPMorgan, it is very hard to weigh the culpabilities of all the banks with their mortgage lawsuits: Everyone did some flavor of this. This is egregious but I don't know that it's more egregious than anyone else's. Everywhere the commercial side -- the guys who got fees for buying and packaging and reselling loans -- was in charge. Everywhere the credit and diligence side -- the guys in charge of making sure that those loans were what the bank said they were -- sat in basements and complained. Everywhere the commercial side ignored them.
It's an obvious and hard-to-solve cultural problem: The commercial side makes the money and gets to yes, the diligence side makes the problems and gets to no.2 This RBS settlement is a particularly stark illustration of how it works, but it's far from the only one. In 2007 or, I suspect, in 2013.
1 Oh, if you find this stuff entertaining, apparently Brian Moynihan said yesterday that JPMorgan is not a role model for settling mortgage litigation and that "no one is more educated about these cases unfortunately" than Bank of America, which makes me love Brian Moynihan even more than I already did, which was a lot.