BofA Put Toxic Debt in Bond as Staff Resisted, U.S. Says

Bank of America Corp.’s traders fought off efforts by the firm in 2007 to include risky Alt-A mortgages in a securitization. That wasn’t enough to spare investors from being cheated, according to the U.S.

The Department of Justice accused the company in a lawsuit yesterday of misleading investors about the quality of loans tied to $850 million in mortgage-backed securities. The complaint chronicles friction among bank staff in 2007 and 2008 as they excluded risky Alt-A loans while leaving in wholesale debts once scorned as “toxic waste” by the firm’s then-chief.

“None of these loans are suitable for a prime jumbo A-credit securitization,” one trader wrote in an e-mail, expressing discomfort with adding the low-documentation Alt-A debts to the pool. “Like a fat kid in dodgeball, these need to stay on the sidelines,” another trader wrote, according to the Justice Department’s complaint.

The exchanges spotlight the mounting tension within Bank of America as it sought to sell mortgages months before credit markets froze and sliding real estate values sparked taxpayer bailouts of the industry. The Justice Department suit and a related U.S. Securities and Exchange Commission claim threaten to hinder Chief Executive Officer Brian T. Moynihan’s efforts to put the 2008 financial crisis behind the firm.

Stock Reacts

Bank of America led today’s decline in the 30-company Dow Jones Industrial Average, dropping 1.7 percent to $14.39 at 2:23 p.m. in New York. Litigation expenses may reduce second-half earnings, Charles Peabody, an analyst at Portales Partners LLC, wrote in a note dated yesterday. He rates the shares “sell.”

The new cases, filed in federal court in the company’s home town of Charlotte, North Carolina, focus on a securitization known as BOAMS 2008-A.

While the bank had portrayed the bond as backed by prime loans vetted by its staff, most were riskier wholesale mortgages, meaning they were originated by outside brokers, the Justice Department wrote. Some were “PaperSaver” loans that hadn’t required proof of borrowers’ income, the U.S. said.

Buyers were capable of assessing the risks, and no internal concerns were raised about loans included in the securitization, said Bill Halldin, a Bank of America spokesman.

“These were prime mortgages sold to sophisticated investors who had ample access to the underlying data,” he said in a statement. “The loans in this pool performed better than loans with similar characteristics originated and securitized at the same time by other financial institutions.”

Riskiest Tier

Bank of America wanted to rid itself of the mortgages because the company was on the hook for losses if they defaulted, according to the government. Alt-A is a designation between prime and subprime, sometimes indicating that borrowers didn’t document their stated income.

One securities trader who objected to the deal stood to lose because he traded the riskiest slices of the bond that would get hit first by losses when the mortgages defaulted, hurting his compensation, according to the suit. The staffer was also responsible for reselling the assets to investors.

The lender closed the wholesale channel amid concern those loans were too often flawed. In a July 2007 conference call with analysts, then-CEO Kenneth D. Lewis said debt from that source “tends to be toxic waste.” Months later, the firm put remaining wholesale loans into the bond with inadequate disclosure, the government said.

“Put simply, investors did not know that they were getting the last scraps of this discarded, poorly performing channel,” the Justice Department wrote.

Price Clash

Traders and their corporate managers also clashed over valuations for mortgages and related securities in late 2007, with the bank’s finance department saying that market prices could be abandoned because they were “distressed,” the Justice Department said.

Bank of America, the second-biggest U.S. lender by assets, disclosed last week that federal authorities had warned they might bring claims over securities backed by jumbo mortgages.

The suits filed yesterday seek to show a pattern of intentional acts by executives to disguise the risks of mortgages in disclosures to the SEC and investors. No employees were named as defendants. The complaints identify people only by their positions.

The Justice Department estimated that investors in the securitization deal would incur losses exceeding $100 million. It alleged violations of the Financial Institutions Reform, Recovery and Enforcement Act. The SEC in its own lawsuit said the firm committed fraud.

Quantity First

Bank of America failed to disclose that about 22 percent of the mortgages in the pool were made to borrowers who were self-employed and that its own standards weren’t followed to verify income and assets, the Justice Department said.

More than 40 percent of the 1,191 mortgages in the pool didn’t “substantially comply” with the bank’s underwriting standards, the Justice Department said in the complaint. Employees who worked on the origination of the mortgages said that the bank “emphasized quantity over quality” and that they were instructed by supervisors that it wasn’t their job to discover mortgage fraud, according to the complaint.

Bank of America decided not to conduct loan-level due diligence on the mortgages used as collateral in the securitization, in part to save about $15,000 in expenses, according to the complaint.

Federal Home Loan Bank of San Francisco bought about $600 million of the pool while Wachovia Bank purchased about $235 million, according to the complaint.

Amy Stewart, a spokeswoman for the Federal Home Loan Bank, and Mary Eshet, a spokeswoman for Wells Fargo & Co., which bought Wachovia in 2008, declined to comment on the suit.

‘Liar Loans’

As of June, at least 23 percent of the mortgages in the pool had defaulted or were delinquent, which the government called a high ratio that can’t be explained solely by the slump in the real estate market. The defaults have led to about $70 million in losses so far with an additional $50 million estimated by Fitch Ratings, according to the U.S.

“These mortgages share many of the same characteristics of the now infamous ‘Liar Loans,’ although defendants misleadingly referred to them as ‘PaperSaver’ mortgages,” according to the complaint.

The Justice Department case is U.S. v. Bank of America Corp., 13-cv-00446; the SEC case is Securities and Exchange Commission v. Bank of America NA, 13-cv-00447, U.S. District Court, Western District of North Carolina (Charlotte).

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