Countrywide Mortgage Hustle Turns Out Not to Be Fraud

Being silent and dishonest isn't fraud.

Swim lanes, obviously.

Photographer: Al Bello/Getty Images.

Let's say that there are two kinds of mortgages in the world: Acceptable and Unacceptable. You want to buy Acceptable mortgages, but not Unacceptable ones. I make the mortgages, in my mortgage factory, and I know which ones are Acceptable and which are Unacceptable. But you do not. I sell the mortgages to you.

One day I come to you with 100 mortgages to sell. And you ask: "Are these Acceptable?" And I say: "They sure are." And they are. And you buy them. And it is good. Next week, I come back and sell you 100 more, and promise you that they are all Acceptable, and they are. But later, I decide to change things up. I once again come to you with 100 mortgages and tell you that they are all Acceptable, and you once again buy them. But actually, this time, 30 of them are Unacceptable. And I know that, and you don't. You find out eventually. This is a thing that happens from time to time, in the mortgage market, and elsewhere. We call it Fraud. And if I do it every week for several years, and you end up buying thousands of Unacceptable mortgages before realizing it, we call that Really Quite a Lot of Fraud.

But there is another way to get to a very similar result. Let's say I come to you one day and say: I would  like to sell you mortgages. But instead of just showing up and selling you mortgages every so often, we'll have a formal program, with a written contract. And so we sign a contract saying that I'll sell you 100 mortgages every week, and that they'll all be Acceptable. And I do, and they are, for a while. But one week I decide to change things up: I once again sell you 100 mortgages, but this time 30 of them are Unacceptable. And I know that, and you don't. And then I keep doing that each week, and you end up buying thousands of Unacceptable mortgages. You find out eventually. What do we call that?

Surprisingly, the answer is Breach of Contract, which is to say: Not Fraud. 1

It turns out that fraud isn't just a matter of dishonest intent and selling you the wrong mortgages. It also requires lying: If I don't lie to you, it isn't fraud. And in the second scenario, I haven't -- exactly -- lied to you. I told you that I'd sell you mortgages each week, and that they'd all be Acceptable. And I meant it, at the time. Later I changed my mind. Sure I never told you that I'd changed my mind, which was a bit naughty of me. But you never asked. My only claims about the Acceptability of the mortgages were in the past, and were made with a pure heart. Later, when I sold you the Unacceptable mortgages with an impure heart, I just kept quiet about it. My past statements, which were true when I made them, became false. But that's just breach of contract, not fraud.

That at least is the conclusion reached Monday by a unanimous three-judge panel of the U.S. Court of Appeals for the Second Circuit in a case about mortgages sold by Countrywide Home Loans (now part of Bank of America) to Fannie Mae and Freddie Mac in 2007 and 2008. Countrywide had contracts with Fannie and Freddie in which it promised to sell them only mortgages that were "Acceptable Investments." 2   Then it set up a dodgy mortgage origination program that it called the "High Speed Swim Lane," or "HSSL," pronounced "hustle." "High Speed Swim Lane" doesn't even make any sense! One assumes that the descriptive acronym -- "hustle" -- came first, and then later they figured out what it could stand for.

Anyway, the mortgages were Unacceptable, 2008 happened, the government sued Countrywide for fraud, 3 it went to a jury trial, and the government won, in part because, and I cannot stress this enough, the Countrywide program was literally called "hustle," and it is very easy to explain to a jury why that is bad. The trial judge, Jed Rakoff, ordered Countrywide to pay $1.3 billion in penalties. "While the HSSL process lasted only nine months, it was from start to finish the vehicle for a brazen fraud by the defendants, driven by hunger for profits and oblivious to the harms thereby visited, not just on the immediate victims but also on the financial system as a whole," wrote Judge Rakoff. 

Countrywide appealed. And, on appeal, it won. The appeals court found that, even if HSSL was totally dishonest and the mortgages were unacceptable, that's still not fraud:

In sum, a contractual promise can only support a claim for fraud upon proof of fraudulent intent not to perform the promise at the time of contract execution. Absent such proof, a subsequent breach of that promise -- even where willful and intentional -- cannot in itself transform the promise into a fraud. Far from being an arcane limitation, the principle of contemporaneous intent is, like materiality, one without which “the common law could not have conceived of ‘fraud.’”

When a court feels the need to defend its conclusion as "far from being an arcane limitation," you know it's a little weird. 4 Again: The thing was called "hustle." It is a basic assumption of the post-2008 financial world not only that bad things happened with mortgages, but also that those bad things were fraud. But Countrywide's hustle, brazen as it was, nonetheless wasn't fraud.

Now this isn't much of a useful road map for bankers looking to get away with fraud in the future. For one thing, Countrywide needed to mean what it had said when it first promised to sell Acceptable mortgages to Fannie and Freddie. If Countrywide had gone into a contract planning to pivot to fraud later, that wouldn't fly.

For another thing, it needed to stop making promises once it pivoted to dishonesty. If Fannie or Freddie had ever called up Countrywide to be like, "Hey guys, just checking in, all these mortgages are still Acceptable, right?" then Countrywide's goose would have been cooked. But the program seems to have operated on autopilot, and no one thought to ask Countrywide if it was still complying with the contract. 5  Lots of contracts require you to deliver, along with the mortgages, a signed certificate saying that the mortgages comply with the contract. If Countrywide's contracts had required that, then this would have been fraud. 6  One lesson of this case is that Fannie Mae and Freddie Mac could have been a bit more careful in structuring and monitoring their deals with Countrywide.

Most notably, the decision is not that useful for fraudsters because it doesn't get them out of liability. If I promise you Acceptable mortgages, and deliver Unacceptable ones, you can sue me for both Fraud and Breach of Contract, and the court can pick whichever fits. Either way I'll have to give you your money back. 7  

Of course, giving the victim its money back is one thing; fraud liability is another. Breach of contract is, you know, a thing that happens. Fraud is bad! Fraud can get you triple damages, punitive damages, collateral consequences, criminal liability. People go to prison for fraud. They don't go to prison for breach of contract.

In a sense this is a pretty narrow decision. Most mortgages that were sold dishonestly were sold with contemporaneous lies, with prospectuses or sales documents that contained the misrepresentations that lead to fraud liability. More generally, many of the big financial-misconduct cases involve, you know, calling people up and lying to them. Not so many involve just signing an honest contract and then later just deciding to perform it dishonestly.

But some do! If you squint, Libor manipulation looks a bit like that. Banks entered into honest contracts (interest rate swaps, loans), and then started performing them dishonestly by manipulating Libor, but without ever going back and lying to the customers again. 8  You could imagine that some market-structure complaints, in which an exchange or dark pool operator promises fairness but then later sets up secret advantages for favored high-frequency traders, could also look more like breach of contract than like fraud. 9  

The court's opinion will be a bit of a shock to people who want every case of dishonesty in financial markets to count -- and be punished -- as fraud. It doesn't work that way. People are dishonest all the time; not every kind of dishonesty amounts to fraud. Even obviously terrible stuff -- even intentionally originating defective mortgages so that you can sell them to ignorant victims to whom you had promised to sell only Acceptable mortgages -- might turn out not to be fraud.

Stopping bad conduct is hard. You need specific rules thoughtfully targeted at the bad conduct, or you need a good culture that doesn't tolerate the bad conduct, or you need careful well-informed customers who can avoid the bad conduct, or you need some combination of all of them. You can't just rely on the simple rule that fraud is bad, and that bad things are fraud, and so bad things will be punished. Not all bad things are actually fraud.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
  1. I bet you know what this footnote is going to say! (It's going to say: Nothing here is ever legal advice, especially the stuff about what isn't fraud. Lots of things that aren't fraud are, somehow, fraud.)

  2. "Acceptable Investment" is the Fannie Mae term; Freddie seems to have used the term "investment quality mortgage." 

  3. Strictly speaking a whistleblower sued Countrywide, and then the government took over the suit:

    This case originated in February 2012 as a qui tam suit under the False Claims Act (“FCA”), 31 U.S.C. § 3729 et seq., commenced by Edward O’Donnell, a former employee of Countrywide. Subsequently, the Government intervened, added claims under section 951 of FIRREA, 12 U.S.C. § 1833a—which imposes civil penalties for violations of the federal mail and wire fraud statutes that “affect[] a federally insured financial institution”—and named Countrywide Home Loans, Inc., Countrywide Financial Corp., Countrywide Bank, FSB, Bank of America Corp., Bank of America, N.A., and Mairone as defendants. As a result of a later motion to dismiss and amended complaint, the FCA claims, Bank of America Corp., and Countrywide Financial Corp. were removed from the case, leaving only FIRREA claims against the remaining defendants. It is on these claims and against these defendants that the case ultimately went to trial.

  4. One weird aspect that is perhaps more of interest to lawyers than to regular people: When did Countrywide make all those promises to Fannie and Freddie? The obvious answer is "when it signed the contracts." But lawyers hate obvious answers, and love legal fictions, so there is an argument that Countrywide actually made its promises each time it delivered mortgages. So here the government " argued that the contractual representations were 'made' not at contract execution but at the point of sale." The court disagreed (citations omitted):

    The plain language of the contracts does not admit this characterization. In the relevant contractual provisions, Countrywide “makes” or “warrants and represents” certain statements (i.e., present-tense acts), including that the future transferred loan will be investment quality “as of” the transfer or delivery date. The use of a present-tense verb in a contract indicates that the parties intend the act—here, the making of the representation— to occur at the time of contract execution, not in the future. Similarly, the phrase “as of” is “used to indicate a time or date at which something begins or ends.” As these definitions indicate, “as of” describes the timing of a state of affairs, and a state of affairs—i.e., the investment-quality status of particular loans—is precisely what is being represented in the contracts at issue.

    Accordingly, the only reasonable interpretation of the contracts is that the date contained in the “as of” clause identifies the moment at which the promised fact will exist—i.e., when the representation becomes effective. Where a party makes a contractual representation of quality that is effective as of a future date rather than the time of contract execution, the date of future effectiveness determines the date of performance (and, thus, breach), but the promisor’s intent to perform on that promise is fixed as of contract execution. The Government urges us to read the relevant contract provisions as, in essence, promises at execution to make future representations as to quality. The language of the provisions, however, constitutes a present promise, made at the time of execution, to provide investment-quality loans at the future delivery date. The plain and objective meaning of the contract simply does not support the Government’s contention that Countrywide actually made these representations—rather than merely set their performance date—at the time of the subsequent sales of loans. Thus, to the extent its fraud claim is based on these contractual representations of quality, it necessarily fails for lack of proof that, at the time of contract execution, Defendants had no intent ever to honor these representations.

    As a former writer of contracts, I am maybe a little more sympathetic to the government's reading than the court is, though I can't quite say that the court is wrong.

  5. By which I mean: There is no evidence, in the trial record, that anyone asked. There's no evidence that they didn't, either. I like to imagine that some low-level Fannie or Freddie employee asked some low-level Countrywide mortgage deliveryman if the mortgages he was delivering were still good, and he said "sure are," and that's enough to establish fraud, if anyone had ever thought to record it. But in the absence of proof we have to assume no one asked.

    I realize that Countrywide didn't actually employ mortgage deliverymen to deliver mortgages to Fannie and Freddie.

  6. From the opinion:

    The Government argues that any contractual relationship between the defendant and an alleged fraud victim is “irrelevant,” citing as examples decisions in which this Court and others recognized a fraud claim where the parties were engaged in a contractual relationship. Gov’t Br. 43–44. These cases are distinguishable, however, in that none recognize a contract breach, by itself, to constitute fraud. Rather, in each, the defendants made affirmative fraudulent misrepresentations to their contractual counterparties in the course of performance or to feign performance under the contract. See, e.g., United States v. Naiman, 211 F.3d 40, 44, 49 (2d Cir. 2000) (submitting false certifications of compliance required by contracts with the government).

    The compliance certificates mentioned in that last parenthesis are how you make sure that dishonesty becomes fraud.

  7. I mean it's possible that the remedies are somewhat different, but the gist is that either way I probably have to pay you the difference between the value of the Acceptable mortgage I promised and the Unacceptable one I delivered.

  8. I wouldn't press this argument too hard. The banks were lying about Libor, and those lies made their way indirectly to the customers, I guess. In any case, though, there have been breach-of-contract cases brought over Libor. Also of course the Second Circuit ruled on Monday that Libor manipulation might be an antitrust problem, which isn't fraud, but which is also bad.

  9. Though in practice there usually seem to be enough marketing materials, ongoing discussions, etc., that they can count as fraud. The Securities and Exchange Commission's announcement of its settlements with Barclays and Credit Suisse uses words like "misrepresented" and "did not adequately disclose," not words like "breached."

To contact the author of this story:
Matt Levine at

To contact the editor responsible for this story:
Francis Wilkinson at

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