Banks have been fighting with disgruntled bond investors and insurers for months, arguing that they do not need to buy back soured mortgages they placed inside securities before the financial crisis.
Now, it turns out, some of those banks may have secretly collected partial payments on those same mortgages several years ago and pocketed that money.
At least that is a theory being pursued by plaintiffs’ lawyers in some of the largest mortgage bond lawsuits, in which banks are accused of filling mortgage bonds with loans that did not belong there.
The theory surfaced in a recently unsealed lawsuit against a mortgage unit at Bear Stearns, the failed investment bank that is now part of JPMorgan Chase .
In the suit, the Ambac Assurance Corporation, which insured some mortgage bonds created by Bear Stearns, contends that the bank was partly compensated by loan originators for mortgages that became delinquent shortly after they were packaged into securities. Bear Stearns’s mortgage desk kept the payments, according to the suit, rather than apply them to the bonds that contained the delinquent loans.
Interviews with more than a dozen former workers at several big banks, including Lehman Brothers and Deutsche Bank , suggest that several banks received millions of dollars at a time in such payments, known as early-payment-default settlements.
But the money trail of these settlements is murky. It is unclear how much of the money was added to bankers’ profits — and bonuses — and how much was forwarded to buy out bad loans from mortgage bonds.
Whether or not the settlement payments were shared with mortgage investors, they are likely to be used in court to show that Wall Street banks knew about the growing stream of mortgages that had missed payments within their first 90 days, a common sign of mortgage fraud. That sort of evidence may matter to government investigators at places like the Securities and Exchange Commission, which is looking into whether banks misrepresented the sorts of mortgages placed in bonds.
At Bear Stearns, there seems to have been some knowledge of the failing loans, according to the Ambac case. Ambac says there is evidence of more than 100 early-default settlements for batches of loans that soured quickly. An example in that case describes an $11 million payment for one batch of loans. For another batch of “at least 12 loans,” there was a $2.6 million payment.
Ambac’s case was filed in federal court, but a judge there ruled this week that the case belonged in a different jurisdiction. Erik Haas, a lawyer for Ambac, said the company planned to refile in state court.
JPMorgan Chase, which bought Bear Stearns three years ago, said Ambac was a sophisticated investor that knowingly took risks in its deals.
“We do not believe Ambac’s claims are meritorious and intend to defend Bear vigorously,” said Jennifer Zuccarelli, a JPMorgan spokeswoman. Ms. Zuccarelli would not comment on Bear Stearns’s use of settlement payments.
Banks like JPMorgan face lawsuits brought by insurance companies and large asset managers that had purchased mortgage bonds when housing was booming. These investors want to return the bonds to the banks and get their money back. The banks disagree, saying the buyers of these securities were sophisticated investors who bought the bonds with open eyes and should have understood the risks.
Some lawyers in those cases said the accusation against Bear Stearns, if true, would be a stunning instance of wrongdoing, because it would indicate that its mortgage operation essentially double-dipped: selling a mortgage into a mortgage bond at full price and also pocketing a settlement for that same mortgage when it went sour.
“If they knew the loans were defaulting, the money should have been passed on to investors,” said Jerry Silk, a lawyer with Bernstein Litowitz who is representing numerous mortgage investors in suits against banks. “We’ve heard this a lot, and we’re trying to prove it. It would be a home run for us.”
The search for a home run has compelled mortgage bond investors to look back to when they first bought their investments. Around 2005, the number of mortgages that went bad began rising. Bankers were in the middle, between the firms that originated the loans and the investors who bought bonds with them.
Mortgage originators at that time did not have enough cash to buy back the loans in full. So banks offered a deal: if the originators gave them a partial cash payment, or a discount on future loan purchases, the banks would drop their requests that originators repurchase the delinquent loans.