Can JPMorgan Settle the Entire Financial Crisis?
I like to think I have a pretty good sense of humor about these things, but the JPMorgan Chase mortgage settlement stuff bores me to tears. Part of it is just that there's no settlement yet so, like, OOH LET'S TALK ABOUT WHAT WE THINK IT MIGHT BE. But it's also just such a mess of squish and who likes squish really.
Now the financial crisis has given rise to some basically entertaining -- matter of taste, but I am entertained -- scandals. There's Libor, where more or less every bank had a bunch of traders sending each other horrible ungrammatical emails about how they should manipulate the London interbank offered rate. And there are the CDO cases, where every bank sold synthetic collaterized debt obligations without telling the buyer who the seller was, which turned out to be illegal for some reason.
These scandals are scandalous but they are not important. Wait I know! They cost bazillions of dollars and destroyed reputations and blah blah blah. Important, fine. But here we are, five or six years later, hunting for The Causes of the Financial Crisis, and these ain't them. Libor manipulation nominally cost some people let's say billions of dollars, and redistributed most of those dollars to other people, but on balance didn't leave the world all that much worse off. Telling people that some hedge fund was long a synthetic CDO when it was actually short that synthetic CDO is just not a category of thing that could possibly have caused a financial crisis.*
The mortgage mis-selling stuff -- the JPMorgan any-day-now settlement, the Countrywide lawsuit that Bank of America lost yesterday, and equivalent investigations and private suits against other banks -- seems to me to be important. There are, I dunno, half a dozen plausible theories of what the financial crisis was, but you wouldn't be laughed out of too many rooms if your theory was, "banks gave mortgages to corpses because they could sell those mortgages on to investors (private and Fannie Mae/Freddie Mac) by lying about their quality, and they did, and then those mortgages all went bust and so did those investors and the economy."
These lawsuits are that theory, precisely: They come after banks for doing shoddy mortgage underwriting, lying about it, and so causing billions of dollars of investor losses. They're a real thing.
But they're so boring! Read some of the complaints -- Countrywide, say, or the Federal Housing Finance Agency suits -- and you'll see a mix of bloodless programmatic stuff ("they decided to have each file reviewed by one officer with bad incentives rather than two with good incentives," etc.) and purely anecdotal badness ("they gave this one mortgage to a stripper with an inflated income," etc.). There's no smoking gun -- no email along the "let's manipulate Libor today!" lines -- just a steaming pile of mush.
What can you make of this? I have an essentially aesthetic view of financial regulation, and if I were philosopher-king** what I would make of it would go something like this:
1. Banks -- all of them! -- underwrote some mortgages in ways that were Bad, and then sold them on to investors -- Fannie, Freddie, private buyers -- claiming that the underwriting was Good.
2. The mortgages were sold at, say, $100 and are now worth, say -- just to pick a number -- $70.***
3. So some set of investors lost $30 among them. Investor A bought the mortgages from the bank for $100, then a year later sold to Investor B for $80, and then Investor B sold to Investor C for $70, which is where they're now marked on Investor C's books.
4. Some of that $30 loss was The Banks' Fault; that is, it was attributable to various specific misrepresentations about underwriting, etc.
5. Some of the losses were due to the sorts of macroeconomic and credit risks that the investors intended to assume.****
6. You can try to find out which is which, though it's not easy.
7. Conceptually you could build a regression that is like: Loans for investment properties suffered X% greater losses than loans for primary residences, so if you sold the former saying it was the latter then you're on the hook for X%. Loans to unemployed people suffered Y% greater losses than loans to employed people, so if you etc. etc. etc. This -- and the related effort to figure out how often banks sold the bad thing saying it was the good thing -- is a thing people try to do; see, for instance,this paper.
8. But there'll be tons of loan-level factual disputes there; who knows who was employed six years ago. Plus, there's just some base level of investors saying, "well if I knew you were lying about 10 percent of your underwriting I wouldn't have bought anything and would have avoided the whole mess," and banks saying, "no, come on, if you knew the true facts of our underwriting you would have bought exactly as much RMBS at exactly the same prices."*****
9. You could also just be like "hey guys, as philosopher king, I'm saying that it's all 20 percent the banks' fault because that is a round number."******
10. Or combine approaches, like the losses are 20 percent the banks' fault, but you adjust up or down for individual bank culpability based on some sort of rough regression model of how much lying they actually did.
11. So the banks pay $6 of the losses.
12. And then the investors split that $6 based on how much they lost: Investor A gets $4, Investor B gets $2, Investor C -- who lost nothing -- gets $0.*******
None of that is particularly novel or insightful or anything, sorry.
But look for a minute at what the court system makes of it. Look at Countrywide, for instance: There was a jury trial to decide whether Countrywide Did or Did Not commit fraud. That's a binary with weird consequences: If it committed fraud -- if it exceeded some threshold of materiality and loss causation and all that good stuff -- then it's tempting to hold it responsible for all of the losses. That seems to be the prosecutors' view anyway, even though the macro-y stuff probably mattered too. If its misrepresentations weren't material enough for a jury to hold it liable, then it pays zero of the losses -- even if there were some misrepresentations that mattered somewhat.
Or there's JPMorgan: No jury trial, just bargaining in the shadow of jury trial. And in the shadow of politics and theDaily Show and Madoff and whatever else. And alsohelping homeowners because that's what you do, even though there's no obvious connection to the losses suffered by investors.
Or! Here is some magic: See how I parceled out the banks' payments to the investors who lost money? The law doesn't work that way. Instead there are two ways to get money:
1. If you bought the mortgage bonds from the banks, in the original offering, you can sue for fraud.
2. If you own the mortgage bonds now, you can sue for a "putback" under the reps and warranties in the bonds.
The magic is that those two categories can both sue, though they won't necessarily win. So in my example Investor A can sue for its losses of $20. Investor C can sue for -- $30! The full loss! Even though it lost no money. Maybe a judge or jury or settlement will do the right thing to prevent double-dipping by A and C, but maybe not. Meanwhile, Investor B, who lost $10 but neither bought from the bank nor holds the bonds now, is hosed.
It's all just mush: Taking anecdotal instances of fraud, and specifics of negotiating power, turning them into dollars that I guess are supposed to reflect culpability but don't in any satisfying or explainable way, and then giving those dollars to people who may or may not be the people harmed by the fraud. (Homeowners!)
Of course lots of legal proceedings are unsatisfying, particularly in the effort to hold banks and people responsible for the financial crisis. Everyone did their bit, and the legal process is hit-or-miss. Sometimes a jury finds that Fab Tourre caused the financial crisis, and sometimes a jury finds that some other guy didn't cause the financial crisis but sends the Securities and Exchange Commission a note encouraging them to keep looking.
That's usually pretty easy to live with: None of those cases really caused the financial crisis, so the social harm of being wrong or inconsistent or inappropriately binary is small-ish. But these mortgage cases are a real thing! They're at the core of the financial crisis, not the amusing periphery. It'd be nice to get them right, consistently, with appropriate nuance and weighing of what matters and how much. Maybe the JPMorgan settlement will be a step in that direction. Or maybe it'll be mush.
* I mean, something to do with CDO mis-selling is a plausible culprit for part of the crisis. But not the Abacus-y stuff.
** Aesthetician-king, natch.
*** Here's a thing saying that private-label MBS losses were around 20 percent of original principal.
**** Though I mean plausibly those are also The Banks' Fault, in some sort of feedback loop where macroeconomic badness was caused by the underwriting thing, but let's stipulate that that's not a legally cognizable fault.
***** My hindsighty bias is more toward "you'd have bought it anyway," though the legal and moral relevance of that is not super clear even if I'm right.
****** A Barclays Securitization Research piece yesterday did some math on "payout ratios" finding that Countrywide paid around 10.5 percent of losses and that a potential JPMorgan $5.75 billion settlement with private investors would be anywhere from 6 to 17 percent of losses, depending on exactly what was settled. How you pick this round number could be based on, I mean, whatever you like, you're a philosopher. But like: ability to pay, right? Deterrence? (However: That's tricky.) Your regression? Something.
******* Ooh we could also parcel it out based on their innocence -- like, if you bought when you should have known better you get less -- but this seems like a bridge too far. Market prices proxy for innocence. If you bought at par and it went to 70, then you by-sort-of-definition shouldn't have known better. If you bought at 75 then you knew, like, 25 worth of better.
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Matthew S Levine at firstname.lastname@example.org