DENISE COTE, District Judge.
This Opinion addresses two motions. One is plaintiff Federal Housing Finance Agency's ("FHFA") motion to exclude the expert testimony of defendants'
FHFA, acting as conservator for Fannie Mae and Freddie Mac (together, the "Government Sponsored Enterprises" or "GSEs"), filed suit on September 2, 2011 against defendants alleging that the Offering Documents used to market and sell seven certificates ("Certificates") to the GSEs associated with residential mortgage-backed securities ("RMBS" or "Securitizations") contained material misstatements or omissions. RMBS are securities entitling the holder to income payments from pools of residential mortgage loans ("Supporting Loan Groups" or "SLGs") held by a trust.
FHFA brought these claims pursuant to Sections 11 and 12(a)(2) of the Securities Act of 1933 (the "Securities Act"), as well as Virginia's and the District of Columbia's Blue Sky laws. This lawsuit is the sole remaining action in a series of similar, coordinated actions litigated in this district by FHFA against banks and related individuals and entities to recover losses experienced by the GSEs from their purchases of RMBS. A description of the litigation and the types of misrepresentations at issue in each of these coordinated actions, including the instant case, can be found in
Broadly speaking, FHFA alleges three categories of misstatements: (i) the Offering Documents misstated the extent to which the loans in the SLGs for the seven Certificates complied with relevant underwriting guidelines; (ii) the loan-to-value ("LTV") ratios disclosed in the Offering Documents were too low because of inflated appraisals of the properties; and (iii) the Offering Documents misrepresented the number of borrowers who occupied the properties that secured the mortgage loans. FHFA alleged as well that credit rating agencies gave inflated ratings to the Certificates as a result of defendants' providing these agencies with incorrect data concerning the attributes of the loans.
On January 15, 2015, FHFA was granted leave to withdraw its claims under Section 11 of the Securities Act. Although neither Virginia's nor the District of Columbia's Blue Sky law provides a loss causation defense to the claims at issue, Section 12 of the Securities Act, as amended by the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737, does.
15 U.S.C. § 77
Defendants retained Vandell to provide expert testimony on loss causation. Vandell is a real estate and financial economist whose areas of research specialization include housing economics and policy, international real estate markets, real estate market dynamics, and mortgage finance, especially mortgage-backed securitization, structured finance, and the pricing of default and prepayment risk. As set forth in his July 9, 2014 expert report, to assess whether the categories of alleged defects in the Offering Documents — as opposed to other factors, such as market-wide economic changes that affected mortgage loans generally — caused losses to the GSEs as holders of the seven Certificates, Vandell conducted regression analyses that compared the performance of the loans backing the Certificates to the performance of three benchmark groups of loans. The idea is to create groups of benchmark loans that lack the problems — such as noncompliance with underwriting guidelines and inflated appraisals — that allegedly plagued the loans comprising the SLGs at issue here.
Vandell's first benchmark (the "Industry Benchmark") consists of loans from other private label securitizations ("PLS")
Vandell's second benchmark (the "GSE Benchmark") consists of loans — comparable to those in the SLGs for the seven Certificates — that were purchased by the GSEs from originators.
Vandell's third benchmark (the "Reunderwriting Benchmark") consists of loans that were reunderwritten by FHFA's experts in other cases, excluding those that were identified by those experts as materially defective. Again, the idea is to test whether the alleged defects caused the GSEs' losses by comparing the loans that formed the SLGs at issue in this action with loans that lack those same alleged defects.
Vandell used a regression analysis to estimate a model of loan performance using the loans in each benchmark. These models include dozens of explanatory variables (depending on the benchmark) and estimate the extent to which each explanatory variable predicts the performance (measured by events of default or delinquency) of the loans in the benchmarks. An "event of default or delinquency" refers to a loan that was delinquent for at least ninety days; was in bankruptcy, liquidation, or foreclosure; or was real-estate-owned
Vandell found that the loans in the SLGs underlying six of the seven Certificates, comprising ninety-eight percent of the loans at issue in this case, performed the same as, or better than, the performance predicted by both the Industry and Reunderwriting Benchmarks. Moreover, loans in the SLGs underlying all seven of the Certificates performed the same as, or better than, the performance predicted by the GSE Benchmark. Vandell used the results from the GSE Benchmark to corroborate his conclusions based on the Industry and Reunderwriting Benchmarks, and he found that the Reunderwriting Benchmark provided additional support to the findings generated by use of the Industry and GSE Benchmarks.
Defendants' damages expert, Riddiough, relied in part on Vandell's opinions to determine the portion of any alleged damages attributable to factors other than the alleged misrepresentations in the Offering Documents.
FHFA retained Saunders to provide rebuttal expert testimony that seeks to undermine the reliability of Vandell's Industry and GSE Benchmarks. According to his November 10, 2014 report, Saunders's testimony seeks to demonstrate that these two benchmarks contain loans with the same problems as are alleged to plague the loans constituting the SLGs at issue here. In other words, Saunders seeks to demonstrate that these two benchmarks are not "clean," and thus do not serve as reliable comparators.
On January 8, 2015, (1) FHFA moved to exclude Vandell's expert testimony and those aspects of Riddiough's loss causation damages calculation that rely on Vandell's analysis, and (2) defendants moved to exclude Saunders's expert testimony. The motions were fully submitted on February 2. FHFA's motion is discussed below, and, as a result of the outcome of that discussion, defendants' motion is rendered moot.
In its motion, FHFA makes several arguments in support of its position that the testimony of Vandell and Riddiough should be excluded. To resolve this motion it is only necessary to address FHFA's arguments that relate to the "reliability" prong of the analysis under Fed. R. Evid. 702 and
The applicable rules of law pertaining to exclusion of expert testimony under Fed. R. Evid. 702 and
The "scientific method" is defined as "the process of generating hypotheses and testing them through experimentation, publication, and replication." Black's Law Dictionary 1547 (10th ed. 2014). As explained in the Federal Judicial Center's
Federal Judicial Center,
Indeed, it is axiomatic that, when designing an experiment to test whether an observed result was caused by given variable, the control or benchmark group must lack that variable. That is the whole point of a control group. If a scientist wanted to prove that Medicine X causes rashes, she might design a study wherein she would observe two patients: Patient 1, who had taken Medicine X, and Patient 2, who had not. It would be rather important to the reliability of her experiment that Patient 2 not also have taken Medicine X. Indeed, someone assessing the validity of her methodology would quite reasonably want assurance that Patient 2 had not been exposed to Medicine X. If the only assurance the scientist could provide was an assumption that Patient 2 had not taken Medicine X, it would raise the specter of junk science.
This idea is so fundamental that, unsurprisingly, there are few cases in which a court has been forced to exclude an expert study because the expert was unable to demonstrate that the control group lacked the very variable requiring isolation.
As the proponents of Vandell's testimony, defendants bear the burden of "establishing by a preponderance of the evidence that the admissibility requirements of Rule 702 are satisfied."
Here, defendants have not carried their burden. One way of ensuring clean benchmarks would have been to reunderwrite a set of loans and to select compliant loans to use as comparators. Indeed, a sample of the loans that Vandell selected to populate his benchmarks could have been, but were not, reunderwritten by defendants. After a February 14, 2013 conference that addressed defendants' potential use of an alternative set of loans for purposes of loss causation analysis, a February 27, 2013 Supplemental Expert Scheduling Order set a schedule under which defendants could have identified any such loans. Defendants opted not to do so. Similarly, while defendants have no doubt reunderwritten the sample of loans that FHFA identified for use in this coordinated litigation, defendants decided not to make use of any of their reunderwriting for purposes of loss causation.
It is worth pausing to note that, because the problems that allegedly plagued the loans in the SLGs at issue — such as noncompliance with underwriting guidelines and inflated appraisals — seem to have been widespread in the residential lending market during the relevant period, absent affirmative representations of cleanliness, it is difficult to feel confident about the cleanliness of any untested group of loans. The
Due to the apparent prevalence of these loan defects, it may have proved difficult to create a clean benchmark set of loans to use as a control group. Despite, or perhaps because of, that difficulty, in the absence of independent reunderwriting, defendants claim to be able to infer sufficient cleanliness based on the way in which Vandell constructed his benchmarks. As for the Industry Benchmark, Vandell simply excluded loans that were part of securitizations at issue in any of the RMBS cases brought by FHFA, and, subsequently, removed more loans that were the subject of other RMBS litigations not involving FHFA. Excluding loans that have been the subject of lawsuits may be a good start for creating a clean benchmark, but it does little to ensure the quality of the loans remaining in the group.
As for the GSE Benchmark, presumably Vandell decided to use, or was asked to use, the benchmark on the theory — nowhere supported in Vandell's report or any of the accompanying documents — that loans purchased by the GSEs from originators would be less likely to have the problems that allegedly plagued the loans comprising the SLGs at issue. One cannot know for sure, however, why Vandell decided to use the GSE Benchmark, as he provides no reasons for believing that the loans in the benchmark are free of the defects whose impact his analysis attempts to measure. Vandell himself provides no expert opinion as to the quality of the loans in the GSE Benchmark, and defendants proffer no additional expert in support thereof. Vandell removed no loans from the pool that he used to populate the benchmark and, apparently, assumed their quality simply because they were purchased by the GSEs.
It is true, as defendants say in their opposition to FHFA's motion to exclude Vandell's testimony, that the GSEs adhered to processes that were meant to ensure a certain quality in the loans they purchased, but a loan's having been purchased by the GSEs is, standing alone, insufficient to demonstrate a lack of the defects at issue here. A statement from defendants' brief is telling: "There is no evidence that a significant number of the loans purchased by Freddie Mac and Fannie Mae were not originated generally in accordance with originator underwriting guidelines." The absence of evidence of noncompliance is not evidence of compliance. The loans comprising Vandell's GSE Benchmark have never been certified to be free of the defects relevant to this specific action; Vandell simply assumes the cleanliness of the benchmark. Under
Defendants complain that there was no method for Vandell to commission a reunderwriting of the loans in the GSE Benchmark because FHFA has "steadfastly refused in this case to provide discovery concerning `single-family' loans" purchased from the GSEs. As a result, say defendants, Vandell was forced to obtain the loan data for the GSE Benchmark from CoreLogic's Loan-Level Market Analytics database, which does not identify the originator or servicer of the loans. In this coordinated litigation, defendants were granted extensive discovery of the GSEs' business, including its PLS operations and the committees overseeing the operations of both the Single Family and PLS operations.
As for the Reunderwriting Benchmark, Vandell states that it consists of loans that, "according to [FHFA]'s reunderwriting experts, were underwritten entirely or substantially in accordance with underwriting guidelines or deviated from guidelines only in a manner that did not substantially increase their credit risk." Vandell has mischaracterized FHFA's reunderwriting experts' conclusions. According to Vandell's description of how he populated the Reunderwriting Benchmark, he "beg[a]n with the samples of loans that were reunderwritten by FHFA experts Richard W. Payne, Robert W. Hunter, and Steven I. Butler," and then, as is relevant here, "[e]xclude[d] all reunderwritten loans that were identified by FHFA reunderwriting experts as Materially Defective." Vandell defines as "Materially Defective" "loans for which the three experts concluded: `It is my opinion, to a reasonable degree of professional certainty, that this loan was originated with one or more underwriting defects that meaningfully and substantially increased the credit risk associated with the loan.'" In other words, Vandell took the loans that these reunderwriting experts started with, removed the worst loans (those the reunderwriting experts concluded were meaningfully defective and had a substantially increased credit risk), and now proclaims that FHFA's reunderwriting experts concluded that the non-excluded loans were underwritten entirely or substantially in accordance with underwriting guidelines or deviated from guidelines only in a manner that did not substantially increase their credit risk.
Defendants have not shown, however, that FHFA's reunderwriting experts reached any conclusion about the loans that Vandell retained in his Reunderwriting Benchmark that would permit those loans to serve as an appropriate benchmark for Vandell's study. The loans examined by FHFA's experts were a sample of loans taken from each Supporting Loan Group backing a Certificate purchased by one of the GSEs. FHFA has used its analysis of those sample loans to support its claims in these coordinated litigations that the Offering Documents contained the material misrepresentations described above. In the January 17, 2014 Corrected Expert Report of Robert W. Hunter Regarding the Underwriting of Mortgage Loans Underlying the Ally Securitizations, Hunter "rendered one of the following conclusions for each Mortgage Loan in the sample":
Before presenting the number of loans falling into the first enumerated category, Hunter explicitly states, "It is
The three potential conclusions enumerated above appear effectively verbatim in the October 25, 2013 Corrected Expert Report of Richard W. Payne III Regarding the Underwriting of Mortgage Loans Underlying the Merrill Lynch Securitizations. Attached to the third conclusion — "Based on the documents provided to me, I did not find any underwriting defects in the origination of this Mortgage Loan." — is a footnote that reads, "Based on the evidence currently available to me, I did not identify defects in the remaining Mortgage Loans that substantially increased their credit risk. If, however, additional data subsequently become available to me, I may identify further defects that increase the credit risk of these loans."
Similarly, in both the March 7, 2014 Expert Report of Steven I. Butler Regarding the Underwriting of Mortgage Loans Underlying the HSBC Securitizations, and the March 11, 2014 Expert Report of Steven I. Butler Regarding the Underwriting of Mortgage Loans Underlying the First Horizon Securitizations, after presenting a chart reflecting the number of loans from each securitization that had an increased credit risk as a result of the underwriting defects found during the review, Butler stated, "At this point in time, based on the evidence currently available to me, I did not identify defects in the remaining Mortgage Loans that substantially increased their credit risk. If, however, additional data subsequently becomes available to me, I may identify further defects that increased the credit risk of these loans. It is
Stating that, based on the information provided, underwriting defects were not found for a given loan is not the same thing as affirmatively certifying that the loan was free of defects. Put differently, contrary to Vandell's assumption, the fact that a loan was not placed by a reunderwriting expert into the "materially noncompliant" category does not, of necessity, mean that the reunderwriting expert concluded that the loan was "materially compliant."
And what ultimately dooms the Reunderwriting Benchmark is that there will be no opportunity at trial to explore what these FHFA experts meant when they reached something along the lines of the third conclusion enumerated above. FHFA will proffer Robert Hunter in this case but to testify to his reunderwriting of the loans in this case;
Defendants argue that the findings of FHFA's reunderwriting experts' are not hearsay because they are admissions of a party opponent under Fed. R. Evid. 801(d)(2). Defendants cite no controlling law for this argument; in the principal case on which they rely,
Here, there has been no showing that FHFA's reunderwriting experts were agents of FHFA authorized to speak on its behalf. Accordingly, Rule 801(d)(2) does not provide a solution to the hearsay problem presented by Vandell's reliance on FHFA's experts' reports.
Nor does Rule 703. For while, under that Rule, "[a]n expert may base an opinion on" inadmissible evidence "[i]f experts in the
Defendants could have avoided this hearsay problem by offering their own reunderwriting experts from these coordinated actions, who may have been able to make the affirmative representations that FHFA's experts are unwilling to make about the positive quality of a subset of the sample of loans on which FHFA has litigated its claims. Had defendants done so, the reliability of the conclusions drawn by defendants' experts on the absence of underwriting defects, and the admissibility of their testimony generally under Rule 702, could have been tested. Indeed, this would have provided the corpus of data to which Vandell could have applied his econometric expertise. For reasons that may only be guessed at, defendants opted not to take this tack.
In sum, defendants and Vandell have failed to demonstrate that the benchmarks are sufficiently clean to serve as reliable control groups. This "flaw is large enough that [Vandell] lacks good grounds for his . . . conclusions," such that his testimony must be excluded.
In light of the conclusion that Vandell's testimony must be excluded under Rule 702 and
FHFA's January 8 motion to exclude the expert testimony of Vandell and those aspects of Riddiough's calculation that rely on Vandell's analysis is granted. Defendants' January 8 motion to exclude the expert testimony of Saunders is denied as moot.
SO ORDERED.
Fannie Mae purchased subprime and Alt-A loans to hold, not to securitize, and it had the ability — which it exercised — to monitor loan performance and "put back" defective loans to the seller.
Neither GSE purported to exercise due diligence or reasonable care under Sections 11 or 12(a)(2) of the Securities Act or under the Blue Sky laws.
To populate the GSE Benchmark, Vandell selected loans with the same collateral types as the at-issue loans by making use of two categories that he defines: (1) First-Lien, Non-Negatively Amortizing, Fixed Rate, and (2) First-Lien, Non-Negatively Amortizing, Hybrid. It appears that these categories captured Alt-A and subprime whole loans. Again, FHFA does not appear to dispute the comparability of these loans.
The Piskorksi Article compares "loan-level data on mortgages from BlackBox with data on consumer credit files from Equifax, to construct two measures of misrepresentation regarding the quality of mortgages backing the RMBS pools. The mortgage-level data include characteristics of loans that were