DENISE COTE, District Judge:
PROCEDURAL HISTORY ...............................................................453 BACKGROUND .......................................................................458
I. RMBS ......................................................................458 A. Originating a Residential Mortgage Loan ...............................458 1. Credit and Capacity ...............................................458 2. Collateral ........................................................460 B. Overview of the Securitization Process ................................462 1. The Sponsor .......................................................463 2. The Depositor .....................................................463 3. The Underwriter ...................................................463 4. The Servicer ......................................................463 C. Structure of an RMBS Instrument and Credit Enhancement ................464 1. Subordination .....................................................464 2. Overcollateralization .............................................464 D. Securing a Credit Rating ..............................................464 E. "Scratch-and-Dent" Loans ..............................................465 F. RMBS Market Dynamics ..................................................466 II. The Seven At-Issue Securitizations ........................................466 A. Principal and Interest Payments .......................................468 B. Age of Supporting Loans ...............................................468 C. The Certificates' Credit Enhancements .................................469 III. Due Diligence .............................................................469 A. Nomura's Due Diligence ................................................470 1. Bidding Process ...................................................471 2. The Diligence Group ...............................................471 3. Credit & Compliance Due Diligence .................................472 a. Sampling ......................................................473 b. Instructions to Vendors .......................................473 c. Credit and Compliance Vendor Procedures .......................474 d. Nomura's Review of Vendors' Results ...........................475 e. Ignored Warning Signs .........................................477 4. Valuation Due Diligence ...........................................478 a. Valuation Due Diligence Vendors ...............................478 b. Nomura Reviews Results; Broker Price Opinions .................479 5. Reviews ...........................................................479 6. Purchasing the Loans ..............................................480 7. Selecting Loans for a Securitization ..............................480 8. Data Integrity Due Diligence ......................................481 9. Obtaining the Credit Ratings ......................................481 B. RBS's Due Diligence ...................................................482 1. NEHLI 2006-HE3 and NHELI 2006-FM2 .................................482 2. NHELI 2007-1 and NHELI 2007-2 .....................................483 a. Sample Selection ..............................................483 b. Due Diligence .................................................483 3. Fraud Review ......................................................484 C. The Loan Pools for the Seven Securitizations ..........................485 IV. The Offering Documents ....................................................488 A. The Supplements' "Summary" Section ....................................488 B. Collateral Tables .....................................................488 C. Loans "Were Originated" Generally in Accordance with Guidelines........490 D. Risk Advisories .......................................................493 V. Sample Selection ..........................................................494 VI. Appraisals ................................................................497 A. Kilpatrick ............................................................499 1. Greenfield AVM ....................................................500
a. The Mechanics of the Greenfield AVM ...........................500 b. Confirming the Accuracy of the Greenfield AVM .................501 c. Defendants' Criticisms of the GAVM ............................502 i. Daubert Challenge .....................................502 ii. Variable Omission .....................................503 iii. Negative Coefficients .................................504 iv. Inclusion of TAV as a Variable ........................504 v. CV Filter .............................................504 vi. GAVM's Performance Vis-à-vis Four Commercial AVMs .................................................505 vii. Attacks on AVMs Generally .............................506 viii. Statistical Errors ....................................507 2. The CAM ...........................................................508 a. USPAP .........................................................508 b. The CAM Questions .............................................509 c. Gathering CAM Answers .........................................510 d. CAM Scoring ...................................................510 e. Kilpatrick's Conclusions from the CAM Study ...................510 f. Defendants' Critiques of the CAM and its Results ..............511 i. The Failure of Hedden's Project .......................511 ii. Field and Desk Reviews Are Preferable. ...............514 iii. The CAM Is Not Derived from USPAP .....................514 iv. The CAM Weightings Are Flawed and the Threshold of Twenty is "Frivolous." ............................515 v. Errors in Application .................................516 3. Futile Attempts to Discredit Kilpatrick ...........................516 B. Petition ..............................................................517 C. Appraisers Used Sales Amounts for Subject Properties as Predetermined Values for Establishing the Appraisal Value ............517 D. Defendants' Four Appraiser Witnesses ..................................518 E. Defendants' Due Diligence .............................................520 VII. Underwriting Guidelines ...................................................520 A. Hunter's Re-Underwriting Review .......................................522 B. Forester's Audit of Hunter's Work .....................................523 C. Defendants' Objections to Hunter's Re-underwriting ....................525 1. Hunter Applied the Originator's Guidelines Too Strictly............525 2. Minimum Standards .................................................525 3. Using BLS Data to Assess Reasonableness of Income .................527 4. Owner Occupancy ...................................................528 5. Post-Origination Documents ........................................529 6. Originator Deposition Testimony ...................................530 D. The Court's Review ....................................................531 VIII. Credit Ratings ............................................................533 IX. Materiality ...............................................................534 A. LTV Ratios ............................................................535 B. Compliance with Underwriting Guidelines ...............................536 C. Credit Ratings ........................................................536 X. Rise and Fall of the Home Mortgage Market and Its Effect on Losses in the GSEs' RMBS Portfolios ...............................................536 A. Growth in the U.S. Housing Market: Late 1990s Through Early 2006 ......537 B. The Bubble Bursts .....................................................538 C. Causes of Contraction in Housing Market ...............................539 D. Vandell's Study of the Hunter Loans ...................................540 E. GSE Witnesses .........................................................543
XI. Corporate Entities and Individual Defendants ..............................544 A. The Nomura Family .....................................................544 1. NCCI ..............................................................544 2. NAAC & NHELI ......................................................544 3. Nomura Securities .................................................545 4. NHA ...............................................................545 B. RBS ...................................................................546 C. Individual Defendants .................................................546 1. Findlay ...........................................................547 2. Graham ............................................................549 3. LaRocca ...........................................................550 4. Gorin .............................................................551 5. McCarthy ..........................................................551 DISCUSSION .......................................................................552 I. Legal Standards ...........................................................552 A. Law Surrounding RMBS ..................................................552 B. Background and Purpose of the Securities Act ..........................552 C. Securities Act Section 12(a)(2) .......................................553 1. Statutory Seller ..................................................554 2. Material Misrepresentation ........................................555 a. Falsity .......................................................555 b. Materiality ...................................................557 3. Damages ...........................................................559 II. Falsity ...................................................................559 A. Underwritten in Accordance with Guidelines ............................559 1. General Adherence to Process ......................................561 2. Whose Guidelines? .................................................561 3. The Meaning of "Generally" ........................................563 4. Context ...........................................................563 5. ResMAE Bankruptcy Advisory ........................................564 6. Representations of "Belief' .......................................565 7. Due Diligence Confirmation ........................................566 B. LTV Ratios and Appraisals ..............................................566 1. BPO Statistics .....................................................567 2. Text of the Offering Documents .....................................567 C. Owner Occupancy Collateral Tables ......................................568 D. Credit Ratings .........................................................568 E. Excluded Evidence ......................................................568 1. Retention of Residuals .............................................569 2. GSEs' Single-Family Due Diligence ..................................569 III. Materiality ...............................................................570 IV. Control Person Liability ..................................................573 A. Section 15 ............................................................573 1. Control ...........................................................574 a. Nature of the Controlled Entity ...............................575 b. Status of Controlling Entity ..................................575 c. Actions Taken on Behalf of Controlled Entity ..................576 2. Defense ...........................................................578 B. Application ............................................................579 1. NHA ...............................................................579 2. NCCI ..............................................................580 3. Individual Defendants .............................................580 4. Unsuccessful Affirmative Defense ..................................581
V. Damages ...................................................................583 A. Date of Tender ........................................................583 B. Interest Rate .........................................................584 VI. Loss Causation ............................................................585 A. Second Circuit Caselaw ................................................587 B. Zone of Risk ..........................................................588 C. The Seven Securitizations Were Comparatively Small ....................588 D. The Government's Contribution to the Bubble and Recession .............589 E. Admissions by FHFA and the GSEs .......................................589 F. Excluded Evidence .....................................................592 1. Testimony from Niculescu and Cook .................................592 2. Housing Goals and GSE Selection of Loans in Securitizations .......593 VII. Blue Sky Laws .............................................................593 A. Legal Standards .......................................................594 1. Damages ...........................................................595 2. Loss Causation ....................................................595 3. Control Person Liability ..........................................595 4. Jurisdictional Elements ...........................................595 B. Applying the Blue Sky Laws ............................................596 1. Place of Sale .....................................................596 a. Three Freddie Mac Transactions ................................597 b. Fannie Mac Transaction ........................................597 2. The Dormant Commerce Clause .......................................597 CONCLUSION .......................................................................598
This case is complex from almost any angle, but at its core there is a single, simple question. Did defendants accurately describe the home mortgages in the Offering Documents for the securities they sold that were backed by those mortgages? Following trial, the answer to that question is clear. The Offering Documents did not correctly describe the mortgage loans. The magnitude of falsity, conservatively measured, is enormous.
Given the magnitude of the falsity, it is perhaps not surprising that in defending this lawsuit defendants did not opt to prove that the statements in the Offering Documents were truthful. Instead, defendants relied, as they are entitled to do, on a multifaceted attack on plaintiff's evidence. That attack failed, as did defendants' sole surviving affirmative defense of loss causation. Accordingly, judgment will be entered in favor of plaintiff.
In September 2011, the Federal Housing Finance Agency ("FHFA") brought sixteen lawsuits against banks and related entities and individuals to recover damages on behalf of two Government-Sponsored Enterprises, the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") (collectively "GSEs") arising out of the GSEs' investments in residential mortgage-backed securities ("RMBS"), specifically their investment in so-called private-label RMBS ("PLS").
Ultimately, only this lawsuit, one of the sixteen actions, proceeded to trial. This case is referred to as the "Nomura Action."
FHFA alleges that defendants are liable under Sections 12(a)(2) and 15 of the Securities Act of 1933, 15 U.S.C. §§ 77l(a)(2), 77o (the "Securities Act claims"), and parallel provisions of the District of Columbia's and Virginia's Blue Sky laws, D.C.Code § 31-5606.05(a)(1)(B), (c), Va. Code Ann. § 13.1-522(A)(ii) (collectively the "Blue Sky claims"). FHFA alleges that four sets of representations in each of the seven Prospectus Supplements were false. They are representations regarding the origination and underwriting of the loans within the SLGs backing the Certificates; loan-to-value ("LTV") and combined loan-to-value ("CLTV") ratios
In advance of trial several rulings on summary judgment motions, Daubert motions, and motions in limine were issued. Of particular importance are decisions ruling that, as a matter of law, defendants were not entitled to two statutory affirmative defenses — the GSEs' knowledge of falsity, and defendants' due diligence and reasonable care, FHFA v. HSBC N. Am. Holdings Inc., 33 F.Supp.3d 455, 493 (S.D.N.Y.2014), FHFA v. Nomura Holding Am. Inc. ("Due Diligence Opinion"), 68 F.Supp.3d 439, 485-86, 2014 WL 7232443, at *40 (S.D.N.Y. Dec. 18, 2014); decisions excluding evidence of the GSEs'
The parties' pretrial order in the Nomura Action, proposed findings of fact and conclusions of law, and defendants' pretrial memorandum were submitted on February 20, 2015. FHFA submitted an opposition to defendants' pretrial memorandum on February 27; over FHFA's objections, the Court received defendants' response on March 9.
With the parties' consent, the trial was conducted in accordance with the Court's customary practices for non-jury proceedings, which includes taking direct testimony from witnesses under a party's control through affidavits submitted with the pretrial order. The parties also served copies of all exhibits and deposition testimony that they intended to offer as evidence in chief at trial with the pretrial order. Affiants were cross-examined and presented their redirect testimony in court beginning on March 16. Additional witnesses also testified at that time.
Accommodating the Court's request, the parties largely organized the presentation at trial around topics. This meant that plaintiff's and defendants' witnesses on a topic were typically called to the stand right after each other. The nine topics, in roughly the order they were presented at trial, were background to the PLS industry, valuation, data summary, re-underwriting, sampling and extrapolation, diligence, Individual Defendants, materiality, damages, and loss causation. No witnesses were ultimately called for cross-examination on two additional issues: the location of sale, and principal and interest payments.
At trial, FHFA called thirteen fact witnesses and nine experts. FHFA's fact witnesses fell into three categories. FHFA called witnesses to testify about defendants' due diligence practices, including Brian Farrell ("Farrell"), Vice President in the Credit Risk Department at RBS; Joseph Kohout ("Kohout"), former head (until mid-2006) of the Diligence Group at Nomura Securities and later NCCI; Randall Lee ("Lee"), former collateral analyst at Nomura Securities and NCCI; Neil Spagna ("Spagna"), former head (after mid-2006) of the Diligence Group at Nomura Securities and later NCCI; and Charles Cipione ("Cipione"), Managing Director at AlixPartners, LLP, a financial and operational consulting firm, who presented data and summary statistics about defendants' due diligence practices. FHFA also called the five Individual Defendants. In addition, FHFA offered the affidavits of several witnesses to testify to the location of the GSEs' headquarters during the period relevant here. They are Kenneth Johansen, Financial Controller Manager at Freddie Mac, Chaka Long,
FHFA's ten expert witnesses and the principal subjects of their testimony were: Peter Rubenstein, an independent consultant with expertise in residential real estate, who provided background on the PLS and RMBS industry generally; John Kilpatrick ("Kilpatrick"), Managing Director of Greenfield Advisors, a real estate and economic consulting firm headquartered in Seattle, Washington, who testified about property appraisals underlying the sample of loans at issue here ("Sample loans"); Robert Hunter ("Hunter"), an independent consultant with expertise in residential loan credit issues, who testified about the results of his re-underwriting review of the Sample loans; Dr. Charles Cowan ("Cowan"), Managing Partner of Analytic Focus LLC, a statistical research and analysis consultancy firm, who testified about his statistical extrapolations of Kilpatrick's and Hunter's findings; Steven Campo, founder and principal of SeaView Advisors, LLC, a private equity firm, who testified to the role of independent accountants in reviewing representations in Offering Documents; Leonard Blum, a principal at Blum Capital Advisors LLP, an investment banking consulting firm, who testified as to what information those in the RMBS industry considered to be material, as did Dr. William Schwert ("Schwert"), Distinguished University Professor of Finance and Statistics at the William E. Simon Graduate School of Business Administration of the University of Rochester and Research Associate of the National Bureau of Economic Research;
FHFA also offered excerpts from the depositions of Michael Aneiro ("Aneiro"), former Freddie Mac PLS trader; Vicki Beal ("Beal"), corporate representative of Clayton Holdings LLC ("Clayton"), speaking as fact witness and Rule 30(b)(6) designee; Frank Camacho, former Vice President for Credit Risk at RBS; Debashish Chatterjee, Rule 30(b)(6) designee for Moody's Investors Service ("Moody's"); James DePalma, former Director at Nomura Securities; Jacqueline Doty ("Doty"), corporative representative for CoreLogic, Inc. ("CoreLogic"), a valuation diligence firm; David Hackney ("Hackney"), former PLS trader at Freddie Mac; Jeffrey Hartnagel ("Hartnagel"), former member of Nomura's Diligence Group; Tracy Jordan, former due diligence underwriter at Clayton; Steven Katz ("Katz"), former managing director of Nomura's trading desk ("Trading Desk"); Peter Kempf ("Kempf"), Rule 30(b)(6) designee for American Mortgage Consultants, Inc. ("AMC"); Pamela Kohlbek, a former employee of Clayton; Sharif Mahdavian, Rule 30(b)(6) designee for Standard & Poor's ("S & P"); Brett Marvin ("Marvin"), former managing director and head of the Trading Desk at Nomura; Nancy Prahofer, former Head of Litigation at NHA; Shayan Salahuddin, ("Salahuddin"), former
Defendants called seventeen fact witnesses and nine experts. In addition to Kohout, Lee, Spagna, and the five Individual Defendants, defendants' fact witnesses included four residential real estate appraisers who had conducted or supervised some of the appraisals at issue here, Lee Clagett ("Clagett"), Michele Morris ("Morris"), Dan Platt ("Platt"), and William Schall ("Schall"). Defendants also called three former GSE officials, Patricia Cook ("Cook"), former Executive VP of Investments and Capital Markets at Freddie Mac; Daniel Mudd ("Mudd"), former President and CEO of Fannie Mae; and Peter Niculescu ("Niculescu"), former Executive Vice President and Chief Business Officer at Fannie Mae. To testify about third-party due diligence practices, defendants called Derek Greene, Client Services Manager for Nomura at Clayton. And to counter Cipione's statistics on defendants' due diligence, they called David Mishol ("Mishol"), Vice President with Analysis Group, Inc., an economic consulting company.
Defendants' expert witnesses included several who addressed aspects of the analyses conducted by FHFA's expert Kilpatrick. They were Michael Hedden ("Hedden"), a Managing Director at FTI Consulting, Inc. ("FTI"), a business consulting firm; Lee Kennedy ("Kennedy"), Founder and Managing Director of AVMetrics, an automated valuation model ("AVM") testing firm; Dr. Hans Isakson ("Isakson"), Professor of Economics at the University of Northern Iowa; and Dr. Jerry Hausman ("Hausman"), MacDonald Professor of Economics at the Massachusetts Institute of Technology. Michael Forester ("Forester"), co-founder and managing director of CrossCheck Compliance LLC, a regulatory compliance, loan review, and internal audit services firm, testified regarding his review of Hunter's re-underwriting project. Dr. Andrew Barnett ("Barnett"), George Eastman Professor of Management and Professor of Statistics at the Sloan School of Management, Massachusetts Institute of Technology, testified about his analysis of Cowan's extrapolations. John Richard, a portfolio manager and financial consultant, testified about the types of information that reasonable investors in the PLS market considered significant during the period 2005 to 2007. Vandell, Dean's Professor of Finance and Director of the Center for Real Estate at the Paul Merage School of Business, University of California, Irvine testified about defendants' loss causation defense. Dr. Timothy Riddiough ("Riddiough"), E.J. Plesko Chair and Professor in the Department of Real Estate and Urban Land Economics at the Wisconsin School of Business, testified about defendants' loss causation defense as well as the appropriate measure of damages.
Defendants offered their own excerpts from the depositions of Aneiro, Beal, Doty, Hackney, Katz, Kempf, Marvin, Salahuddin, and Syron. In addition, they offered excerpts from the depositions of Clint Bonkowski, former Operations Director and Divisional Vice President at Quicken Loans, Inc., a residential loan originator ("Quicken"); Jeff Crusinberry, Rule 30(b)(6) designee for Fremont Investment & Loan ("Fremont"); Teresita Duran, Rule 30(b)(6) designee for the former Ocwen Financial Corp.; Ashley Dyson, former Senior Trader on Fannie Mae's PLS desk; Natasha Hanson, Rule 30(b)(6) designee for Fitch Ratings ("Fitch"); Tracy Hillsgrove, Rule 30(b)(6) designee for
The bench trial was held from March 16 to April 9, 2015, and this Opinion presents the Court's findings of fact and conclusions of law. The findings of fact appear principally in the following Background section, but also appear in the remaining sections of the Opinion.
The RMBS industry was a major economic force in 2005, 2006, and 2007, when defendants sold the securities at issue to the GSEs. RMBS are intricately structured financial instruments backed by hundreds or thousands of individual residential mortgages, each obtained by individual borrowers for individual houses. The process by which these discrete loans were to be issued, bundled, securitized, and sold is summarized first.
RMBS entitle the holder to a stream of income from pools of residential mortgage loans held by a trust.
Originators issuing subprime loans and Alt-A loans are the entities charged with evaluating and approving would-be borrowers' applications for mortgage loans. While this process inevitably involves judgment, the originator's underwriting guidelines are central to the process of originating mortgages. Underwriting guidelines are intended to ensure that loans are originated in a consistent manner throughout an organization. They assist an originator in assessing the borrower's ability to pay the mortgage debt and the sufficiency of the collateral that will secure the loan; they also help the originator decide the terms on which to approve a loan. To the extent the originator intends to sell the loan, the guidelines also permit the originator to describe the qualifying characteristics for a group of loans and to negotiate a sale based on that description.
Borrowers typically apply for a loan by completing a Uniform Residential Loan Application (known as "Form 1003").
Among other things, originators rely on objective factors, such as a borrower's credit score (often called a FICO score
The amount of information an originator gathers from a borrower depends on the type of loan being issued. A full documentation or "full doc" loan requires the borrower to substantiate current income and assets by providing documents, such as pay stubs, a W-2 form, and bank account statements. Other types of loans require less. Stated income, verified assets ("SIVA") programs do not require a borrower to provide documentation to support her represented income, but do require verification of assets. Stated income, stated assets ("SISA") programs do not require the borrower to provide documentation confirming her claim of either income or assets. And "No income, no assets" ("NINA") programs do not require borrowers even to state an income or their assets, let alone confirm them with documentation.
No matter what the loan program, however, underwriting guidelines require an originator to evaluate the borrower's ability and willingness to repay a mortgage loan. Accordingly, originators assess, inter alia, the reasonableness of disclosed income asserted by the borrower and use a variety of information to verify income and assets. For instance, a written or verbal verification of employment may be obtained and online sources may provide the underwriter with information about salary ranges based on occupation and location.
When a borrower fails to meet the requirements of an originator's underwriting guidelines, many originators permit their underwriters to exercise discretion and allow exceptions to the guidelines. The originators' guidelines typically explain the circumstances under which exceptions may be granted, including how to document any exception that has been made. Exceptions to guidelines are documented in the loan
During the origination process, originators assemble the documents associated with the mortgage loan into a "loan file." The loan file includes, at a minimum, a borrower's completed Form 1003, a property appraisal, a credit report, and legally required documents like HUD-1 forms and TIL disclosures.
During the underwriting process, originators must also determine whether the value of the mortgaged property is sufficient to support repayment of the loan in the event of default. The primary tool for assessing the value of the collateral for the loan is an appraisal of the property. The most common metric for measuring the collateral risk associated with a loan is the LTV ratio. When the mortgage supports the purchase of a property, the value of the collateral is usually measured as the lesser of the sales price or the appraisal value. Appraisals are also prepared in connection with the refinancing of existing debt. Accurate appraisals are particularly important in the case of second mortgages, because an overstated appraisal value increases the likelihood that the liquidated collateral value will be insufficient to cover both the first and second mortgages.
Appraisals are, essentially, an estimate of a property's market value as of a given date. A central component of all residential appraisals is the selection of comparable properties with which to assess the value of the subject property ("comparables"). Appraisers are supposed to select the best comparables — which typically means the geographically closest properties with the most similar characteristics, such as lot size, house size, style, and number of bathrooms — that have been the subject of sales transactions within the past year. Appraisers also consider market conditions, including housing supply and demand in the property's neighborhood.
Appraisers document their work in a formal report, usually using a Fannie Mae Form 1004 or Freddie Mac Form 70 Uniform Residential Appraisal Report ("URAR"). When the appraisal is in connection with a sale of the property, the appraiser is required to analyze the sales contract.
While accuracy and good faith should be the watchwords of appraisers, it is easy for appraisers to inflate their appraisals
Appraisers may inflate their appraisals because of pressure from loan officers. An officer may mention the desired appraisal value he is seeking, ask for the appraiser to call back if she cannot hit a specific value, or send out appraisal assignments to multiple appraisers with the explanation that the assignment will be given to the first one who can find the target value. Appraisers can be made to understand that their ability to receive future assignments depends upon delivery of the desired results.
During the overheated housing market at issue here, residential appraisers felt intense pressure to inflate appraisals. Defendants' appraisal expert, Hedden, observed that such pressure was simply part of what appraisers were faced with "on a regular basis." Defendants' appraiser witnesses acknowledged that they and other appraisers with whom they worked experienced pressure to provide "predetermined appraisal values."
In a national survey of appraisers conducted in late 2006, 90% of the participating appraisers indicated that they felt some level of "uncomfortable pressure" to adjust property valuations.
Indeed, the widespread feelings of discomfort prompted 11,000 appraisers in 2007 to submit a petition to Congress and the Appraisal Subcommittee of the Federal Financial Institutions Examination Council,
The petition requested action. It added, "We believe that this practice has adverse effects on our local and national economies and that the potential for great financial loss exists. We also believe that many individuals have been adversely affected by the purchase of homes which have been over-valued."
It was against this backdrop that in 2008 FHFA announced the Home Valuation Code of Conduct ("HVCC"). See T. Dietrich Hill, Note, The Arithmetic of Justice: Calculating Restitution for Mortgage Fraud, 113 Colum. L.Rev.1939, 1946 & n. 49 (2013). Under the HVCC, the lender, whether it be a bank or a mortgage company, was not permitted to have direct, substantive contact with the appraiser. Even though the HVCC was only briefly in effect, see 15 U.S.C. § 1639e(j) ("[T]he Home Valuation Code of Conduct announced by the Federal Housing Finance Agency on December 23, 2008, shall have no force or effect."), one of the residential home appraisers testifying for defendants indicated that the HVCC had a salutary effect on the practices of lending officers.
The loans at issue here were sold almost immediately after origination. During the period 2005 to 2007, originators sold subprime and Alt-A loans either individually or in the aggregate in what are known as trade pools to sponsors, like Nomura. With these sales, the originators received payments allowing them to originate more loans.
A sponsor could accumulate tens of thousands of loans from scores of originators. Sponsors would then select loans from among those on its books, place the selected loans into groups for securitization, and sell them to depositors, typically a sponsor's affiliate. Depositors would transfer the groups of loans to trusts created specifically for each securitization. These loans formed the supporting loan groups ("SLGs") whose principal and interest payments were channeled to investors. Depositors issued certificates entitling holders to payments; these would then be marketed and sold by underwriters.
When selling a pool of loans, the originator provided a "loan tape" for the loans. Loan tapes are spreadsheets containing 50 to 80 fields of collateral and borrower data for each loan, including the borrower's
Each RMBS needed a sponsor. Sponsors purchase loans from originators or loan aggregators, a transaction that is generally governed by a Mortgage Loan Purchase Agreement, which contains representations and warranties. The sponsor holds title to the loans before they are transferred to the RMBS depositor. During the securitization process, sponsors have access to information about individual loans, including the loan files created at the time the loan was originated and the loan originator's guidelines. As the loans it holds on its books mature, sponsors also have access to information about loan performance from the loan's servicers, such as any delinquency or default history.
Depositors are special purpose vehicles ("SPVs") — essentially shell corporations — that exist for one purpose: to purchase the loans from the sponsor and deposit them in a trust. This step creates a true sale of the assets, thereby protecting certificate-holders against the risk of a subsequent bankruptcy by the sponsor. The depositor establishes a trust and deposits the loans into the trust in exchange for certificates. The depositor also issues Registration Statements, Prospectus Supplements, and other Offering Documents for the securitization. Apart from their directors and officers, SPVs typically have no employees or other business operations.
The RMBS trusts created by depositors are typically established pursuant to a Pooling and Servicing Agreement ("PSA"). The trustee for each trust is generally responsible for maintaining custody of operative documents related to the mortgage loans, receiving the cash flows each month from the entities servicing the loans, and allocating the cash flows to the certificate-holders and others pursuant to the rules laid out in the PSA.
To pay for the loans it has purchased, the depositor sells the certificates produced during the trust transaction to the underwriters who will take the securities to market. The lead underwriter for an RMBS often designs the structure of the securitization and coordinates with the rating agencies to obtain credit ratings for the deal. Typically, the lead underwriter is also responsible for performing due diligence to ensure that the Offering Documents are accurate and complete. If an underwriter's due diligence uncovers discrepancies between the loans intended for the RMBS and the description of the loans in the Offering Documents for the securitization, it may choose to eliminate non-conforming loans from the loan pool or to revise the Offering Documents for the securitization so that they accurately describe the loans.
Another entity essential to securitization is the loan servicer. The servicer for the mortgage loans interacts with the individual borrowers on behalf of the trust. It collects monthly mortgage payments and forwards the receipts to a master servicer or trustee. When a loan becomes delinquent, the servicer takes steps to cure the delinquency. These steps may include foreclosure proceedings that may in turn
RMBS certificates are backed by one or more groups of loans that collateralize a certificate. The stream of payments that are made to investors in RMBS over time consist of the principal and interest payments on the certificates. These flow from the underlying principal and interest payments made by the individual borrowers on the mortgage loans within the SLG (or SLGs); the rate at which interest payments are made to investors in an RMBS is referred to as the coupon rate.
The credit profile of RMBS can be improved through "credit enhancement" features. These features are critically important to credit rating agencies, particularly for RMBS supported by subprime and Alt-A loans. Enhancements are designed to protect investors in the more senior certificates — the more expensive, less risky, and higher-rated certificates — from loss. Credit enhancements can be external or internal. External enhancements include bond insurance or financial guarantees. Internal RMBS credit enhancements include subordination and overcollateralization.
Subordination refers to a structure in which each class or tranche of certificates has a different right to the flow of payments and the allocation of losses. Credit risk in the pool is thus distributed unequally among the certificate-holders, usually protecting the senior certificates against losses at the expense of junior certificates. Certificates in senior tranches are given a first claim on cash flows and a last position with regard to losses. Only after senior-tranche certificates have been "filled up" does payment flow to more junior tranches. This pattern is followed for all subordinate certificates; once they are filled up, the next in line receives its payments. This is referred to as a "waterfall," as the payments cascade from the senior tranches to the junior in a fixed order.
Overcollateralization occurs when the total balance on the mortgage loans in the securitization exceeds the total balance on the mortgage loans underlying the certificates issued. This excess collateral insulates the certificates from loss.
Credit ratings for securities reflect a judgment by credit agencies about the credit risk of owning the security. A higher rating signals a less risky security. Senior certificates in RMBS are usually rated AAA (or triple-A), which is the highest rating level. Junior certificates usually have lower credit ratings. Since the rating of AAA conveys the same credit risk regardless of whether the RMBS are
Three rating agencies were principally involved in rating the RMBS at issue here: Moody's, S & P, and Fitch. The sponsor, depositor, or the underwriter of an RMBS provides information to rating agencies so that the agencies can evaluate the risk in the pool of loans and issue appropriate credit ratings for the certificates. Such information was contained on loan tapes.
Of particular importance to agencies providing ratings for subprime and Alt-A RMBS were the LTV ratios of the loans in the proposed securitization. In their view, LTV ratios were "key predictors" of foreclosure rates and an LTV ratio of 80% was a particularly critical threshold. According to S & P's criteria for reviewing subprime transactions, loans with LTV ratios between 80% and 90% are one-and-a-half times more likely to be foreclosed than loans with LTV ratios below 80%. And loans with LTV ratios between 95% and 100% are 4.5 times more likely to enter foreclosure than loans with LTV ratios below 80%. Rating agencies also attached importance to the property's occupancy status, since borrowers are more likely to make payments on their primary residence, and to originators' compliance with their own underwriting guidelines, because agencies viewed compliance with an originator's guidelines as assurance that a loan was legitimate.
To assess a securitization, rating agencies relied on the accuracy of the loan tapes provided by the sponsor or underwriter. The agencies did not have access to the loan files or conduct any due diligence to verify the loan tape data. Using loan tape data, the three credit rating agencies used models to forecast foreclosure frequency, expected losses, and cash flows on the RMBS that they rated. The ratings and loss estimates generated by the models were extremely sensitive to loan-level data; if incorrect data was used — data reflecting more favorable loan characteristics — these models would require less credit support than should have been required of the securitization. At times, rating agencies advised sponsors what degree of subordination would be required to obtain a AAA or equivalent rating. Credit rating agencies reserved the right to request additional information about the loans to maintain their ratings or to withdraw their ratings entirely in the event information supplied to them was inaccurate or misrepresented. Analysts at rating agencies also reviewed Offering Documents to confirm that they included representations and warranties attesting to the accuracy of the loan-level information and that the mortgage loans had been originated in compliance with the originators' underwriting guidelines.
RMBS were only as good as their underlying mortgage loans. When, at the time of securitization, loans were known not to comply with originators' guidelines, to have missing documentation, or to have already become delinquent, the loans were referred to as "scratch-and-dent" loans. To obtain AAA ratings, credit rating agencies would typically demand more credit enhancements and structural safeguards like more overcollateralization or higher levels of subordination. RMBS with scratch-and-dent loans typically traded at discounts to par value.
When loans that were acknowledged as scratch-and-dent loans were securitized and sold, non-compliance was reported in Offering Documents, for instance, by referring to the loans as having impaired loan documentation or as loans that have
During the period 2005 to mid-2007, the supply and demand for RMBS increased significantly, and competition among RMBS sponsors was intense. To function at all, the RMBS market required cooperation between entities at all levels of the process. In particular, issuers of RMBS built and strengthened their relationships with originators, who supplied the loans being bundled and sold.
Participants in a securitization were often vertically integrated, meaning that participants like the sponsor, the depositor, and the underwriter, or some combination thereof, were often related or affiliated. Vertical integration meant that the senior individuals working on a particular RMBS at the sponsor, underwriter and depositor were often the same individuals.
Defendants sold the GSEs seven certificates ("Certificates"),
Each of the seven Securitizations was issued pursuant to one of three shelf registrations.
As the table below shows, Nomura acted as sponsor and depositor for all seven of the Certificates, and as the sole lead underwriter and seller for two of them. RBS was the sole lead underwriter for three of the Certificates and a co-lead underwriter for a fourth.
Securitization Sponsor Depositor Lead Underwriter(s) NAA 2005-AR6 NCCI NAAC Nomura Securities NHELI 2006-FM1 NCCI NHELI Nomura Securities NHELI 2006-HE3 NCCI NHELI RBS & Nomura Securities NHELI 2006-FM2 NCCI NHELI RBS NHELI 2007-1 NCCI NHELI RBS NHELI 2007-2 NCCI NHELI RBS NHELI 2007-3 NCCI NHELI Lehman Brothers Inc.
Securitization Cut-off Date Supplement Date Filing Date NAA 2005-AR6 11/1/2005 11/29/2005 11/30/2005 NHELI 2006-FM1 1/1/2006 1/27/2006 1/31/2006 NHELI 2006-HE3 8/1/2006 8/29/2006 8/30/2006 NHELI 2006-FM2 10/1/2006 10/30/2006 10/31/2006 NHELI 2007-1 1/1/2007 1/29/2007 1/31/2007 NHELI 2007-2 1/1/2007 1/20/2007 2/1/2007 NHELI 2007-3 4/1/2007 4/27/2007 5/1/2007
A summary of the seven Certificates' relevant characteristics, including the Certificates' tranches and their primary SLG, is provided in the table below.
Securitization Tranche SLG Loans in SLG SLG Aggregate Principal Balance NAA 2005-AR6 III-A-1 III 376 $79,889,908 NHELI 2006-FM1 I-A 1 2,532 $405,436,188 NHELI 2006-HE3 I-A-1 1 3,618 $586,249,148 NHELI 2006-FM2 I-A-1 1 3,891 $677,237,695 NHELI 2007-1 II-1-A II-1 474 $108,349,253 NHELI 2007-2 I-A-1 1 3,001 $481,674,027 NHELI 2007-3 I-A-1 1 1,896 $334,386,584
Together, the Certificates had an original unpaid principal balance of approximately $2.05 billion, and the GSEs paid slightly more than the amount of the unpaid principal balance when purchasing them. A Freddie Mac trader located at Freddie Mac's headquarters in McLean, Virginia purchased six Certificates; a Fannie Mae trader located at its headquarters in Washington, D.C. purchased the NAA 2005-AR6 Certificate. The purchase prices paid by the GSEs are listed below.
Securitization Purchase Price NAA 2005-AR6 $65,979,70719
NHELI 2006-FM1 $301,591,187 20 NHELI 2006-HE3 $441,739,000 NHELI 2006-FM2 $525,197,000 NHELI 2007-1 $100,548,000 NHELI 2007-2 $358,847,000 NHELI 2007-3 $245,105,000
The GSEs still hold the seven Certificates and have continued to receive principal and interest payments on them. The coupon rates for six of the seven Certificates were tied to the London Interbank Offered Rate ("LIBOR") rate. Six of the Prospectus Supplements stated that "[t]he per annum pass-through rate on the ... Certificate[] will equal the lesser of (i) the sum of One-Month LIBOR for that distribution date plus" one of two percentages "or (ii) the applicable Net Funds Cap." The exception was NAA 2005-AR6, which provided for an initial fixed interest rate.
The amount of principal and interest on the Certificates received by the GSE from date of exchange through February 28, 2015, as stipulated to by the parties, is provided below.
Securitization Principal Payments Through Interest Payments Through 2/28/2015 2/28/2015 NAA 2005-AR6 $42,801,327 $17,517,513 NHELI 2006-FM1 $282,411,183 $23,756,542 NHELI 2006-HE3 $331,937,382 $34,559,137 NHELI 2006-FM2 $346,402,921 $42,099,996 NHELI 2007-1 $53,271,881 8$8,701,219 NHELI 2007-2 $235,700,674 $29,010,757 NHELI 2007-3 $127,924,783 $19,350,587
There were over 32,000 loans supporting the Seven Securitizations. Of these, 15,806 are in the primary SLGs supporting the seven Certificates. Most of the loans supporting the Certificates were originated months before their securitization.
Securitization Loan 0-30 31 to 60 61 to 90 91 to 120 121 to 150 151 to 180 Greater Count days days days days days days than 180 days NAA 2005-AR6 325 0 29 226 57 0 13 0
NHELI 2006-FM1 2532 0 0 2532 0 0 0 0 NHELI 2006-FM2 3891 0 0 0 0 3891 0 0 NHELI 2006-HE3 3613 0 0 304 1064 538 1201 506 NHELI 2007-1 403 14 125 184 79 1 0 0 NHELI 2007-2 3001 0 1438 0 208 320 458 577 NHELI 2007-3 1914 0 0 35 18 952 61 848 Total: 15,679 14 1,592 3,281 1,426 5,702 1,733 1,931
Each Certificate is in a senior tranche of its Securitization, and each Securitization had several credit enhancements designed to shield senior certificates from losses. Among other things, each of these Certificates was protected by from five to eleven subordinated tranches.
For example, in NHELI 2006-FM1, Freddie Mac purchased a Certificate linked to the senior-most tranche, class I-A-1, which was supported by loans from SLG I. That tranche had an initial principal balance of approximately $428 million; the subordinated tranches had a total principal balance of approximately $220 million. All realized losses on Group I loans were to be allocated to the subordinated tranches, until their $220 million principal balance was reduced to zero. Only then would losses begin to affect the senior tranches. Holding a senior tranche Certificate also entitled the GSE to principal payments from a separate SLG: if payments from Group II were made in full on that SLG's associated certificates, any additional cash flow would go to the GSE's senior certificate.
The table below displays the number of tranches subordinate to the GSEs' Certificates for each Securitization, as well as the face value of those subordinate tranches. In each case, a subordinate tranche designated "Tranche X" represented the Certificate's overcollateralization.
Securitization Number of Subordinate Face Value of Subordinate Tranches Tranches NAA 2005-AR6 6 $64,412,464 NHELI 2006-FM1 1225 $220,837,934 NHELI 2006-HE3 12 $264,970,098 NHELI 2006-FM2 12 $275,696,345 NHELI 2007-1 9 $43,208,528 NHELI 2007-2 11 $237,310,229 NHELI 2007-3 10 $305,662,765
Nomura came late to the RMBS business. It made its first subprime purchase
After it won a bid for a Trade Pool, but before it purchased the Pool, Nomura performed a due diligence review of loans in the Pool. The group designated to conduct due diligence was a small, isolated unit within Nomura that was inadequately integrated into the overall operations of the company. Nomura never created any written due diligence procedures or standards to guide the work of this unit. By and large the unit was beholden to the Trading Desk, which made many of the key decisions that governed the operations of the due diligence unit. And, despite the mistaken assertions of top Nomura officials, the unit responsible for pre-acquisition due diligence had no role whatsoever in reviewing disclosures made in the Prospectus Supplements about the mortgage loans that backed the SLGs.
In conducting its pre-acquisition due diligence, Nomura repeatedly made choices intended to save money and to satisfy the sellers of the loans. Nomura routinely purchased and then securitized loans that had received "failing" credit and compliance grades from its due diligence vendors. It failed to subject thousands of the loans at issue here to genuine credit or valuation diligence, opting instead to use less expensive screening mechanisms. And once the loans were on Nomura's books — with limited exceptions that are immaterial for present purposes — Nomura performed no further diligence. Nomura neither performed credit nor valuation due diligence once it had determined which loans would populate the SLGs supporting its securitizations, nor did it consider the information gleaned from the credit and valuation due diligence that had been performed on any of those loans before Nomura purchased them. Nor did Nomura use crucial information learned through due diligence when composing its descriptions of loans in the Prospectus Supplements.
RBS's due diligence was no better. Despite serving as lead underwriter on three of the seven Securitizations and co-lead underwriter on a fourth, RBS relied almost exclusively on Nomura's pre-acquisition due diligence results for two of the Securitizations, and the diligence it performed on the loans in the other two Securitizations was perfunctory. This section describes these programs and their failures.
At the time that he was Chief Legal Officer ("CLO") for NHA and Nomura Securities, Findlay oversaw the creation of Nomura's due diligence program. But beyond attending some very large meetings with consultants at some point between 2002 and 2004, he remembers nothing about this. And in the period between its creation and its shuttering in 2007, no part of Nomura's due diligence program was ever reduced to writing. Nomura has no written manual or guidelines and no fixed policies to govern its review of loans at either purchase or securitization.
Normura's website posted the terms or pricing matrix that Nomura applied when purchasing individual loans. Among the criteria used in the matrix were the loan's LTV ratio at various points compared to the loan amount, for instance, at five step increments between an LTV ratio of 80 and 95. Other criteria included the FICO score, DTI ratio, and owner-occupancy status. According to the matrix, Nomura would pay more for a loan with a lower LTV ratio, a higher FICO score, a lower DTI ratio or that was owner-occupied. Nomura's matrix reflected its understanding of the models used by credit ratings agencies and how they would grade classes of loans in a securitization. It was Nomura's policy not to purchase loans with an LTV ratio over 100% or a DTI ratio over 55%.
The securitization process at Nomura began with the announcement by an originator or seller that it had a pool of loans for sale. The seller sent an email to potential buyers attaching a loan tape. Using the information on the pool sent by the seller, a collateral analyst at Nomura would stratify the data according to various traits, such as the percentage of loans in the pool that fell within different FICO score ranges, thereby creating what Nomura called "strats." The analyst would also load the loan tape data into a central database to track each individual loan on its journey through purchase and securitization. The Nomura database was called the Loan Management System ("LMS").
The loan tape data describing the characteristics of a loan that was entered into LMS was never altered, although it would be later augmented by servicing information if Nomura purchased the loan. Thus, the originator's description of the borrower's FICO score and DTI ratio, the LTV ratio for the property, and the property's owner-occupancy status would not be changed even if Nomura might learn contrary information during pre-acquisition due diligence or while the loan was on its books.
Traders at Nomura then reviewed the strats, which gave them a rough snapshot of the loan pool, and made a decision whether to make a bid for the pool of loans. Through this process Nomura purchased loans in trade pools, which were classified as "mini-bulk" (balance of less than $25 million) or "bulk" (balance of more than $25 million) lots. Roughly 89% of the loans in the seven SLGs came from bulk Trade Pools.
After Nomura won a bid on a trade pool, it was the responsibility of the Diligence Group, also referred to as the Credit Group or Residential Credit Group,
The Diligence Group was small. For most of the relevant period, it consisted of
The Diligence Group was too small to do an effective job, a point that its first manager repeatedly made in writing and in conversation with his colleagues. The Diligence Group also lacked independence. It was the Trading Desk that made the important structural and methodological decisions. The Trading Desk dictated the size of any due diligence sampling and even, in some instances, which methods would be employed in choosing samples and which tests would be run on the samples. As early as April 2005, Kohout warned that the Trading Desk's decisions resulted in "Credit's role in both the sample selection and management of risk on bulk transactions [being] diminished to the point of that of a non effective entity." The Trading Desk was seemingly oblivious to the very serious risks associated with some of its decisions. For example, it proposed that Nomura purchase loans whose files were missing crucial documents, such as final Form 1003 and HUD-1, and enter a side-letter agreement allowing the seller to produce the missing forms later. Kohout pointed out that this was an invitation to fraud.
As was customary among securitizers, Nomura relied on vendors to perform most of its due diligence work. Nomura's vendors included Clayton, AMC, CoreLogic, and Hansen Quality ("Hansen"). Those vendors sent a continuous flow of voluminous reports to the Diligence Group. The Diligence Group was too leanly staffed to do any careful review of the data. Over and over again, it simply "waived in" and purchased loans its vendors had flagged as defective.
Three types of diligence are of particular importance to the issues in this case, and they are described in detail here. They are credit, compliance, and valuation due diligence. In credit due diligence, the originator's loan files are reviewed to assess whether the loan was originated in compliance with the originator's written underwriting guidelines. Compliance due diligence determines whether the loan was issued in compliance with federal, state, and local laws and regulations. Valuation due diligence assesses the reasonableness of the original appraised value of the underlying property.
Nomura conducted its pre-acquisition credit and compliance due diligence in two
While Nomura witnesses testified that Nomura's Diligence Group could request permission to increase the size of the sample, Nomura presented no evidence of any instance in which such permission was granted. Indeed, the only evidence about a specific request revealed just the opposite. When the Diligence Group asked permission to increase a sample size for a pool of loans originated by Fremont, the Trading Desk refused. Fremont loans were the only loans underlying NHELI 2006-FM1 and NHELI 2006-FM2.
Nomura generally sampled between 20% and 35% of bulk pool loans. Nomura typically used larger samples from bulk pools when it was buying loans for the first time from an originator or where the trade pool included unfamiliar loan products.
When selecting the loans for a sample, Nomura did not use random sampling. This made it impossible to extrapolate to an entire pool the results from conducting due diligence on only a sample of the loans. Nor did Nomura, despite its claim at trial, use truly "adverse" sampling. Instead, at the insistence of the Trading Desk, the Diligence Group used S & P Financial Services LLC's LEVELS software to choose at least 90% of the loans in the sample. The LEVELS program relies solely on loan tape information in making its selection of a sample.
As for the remaining 10% of the sample, however, the Diligence Group did take a stab at using adverse selection. A member of the Diligence Group would look at the loan tape for the trade pool and use his judgment to hand-pick up to 10% of the sample on the basis of characteristics such as high DTI ratios, borrowers' low FICO scores, and low documentation loans.
Clayton and AMC conducted credit and compliance review for Nomura using the originator's loan file, the originator's written underwriting guidelines,
While Clayton also gave its clients the opportunity to create "overlays" for the vendor to use in reviewing the loans, unlike most of its clients, Nomura refused to provide any credit overlays to Clayton. If Nomura had provided overlays, then Clayton would have flagged any non-compliant loans for closer review by Nomura. Nomura's failure to provide credit overlays was striking since Clayton repeatedly asked Nomura to do so, even escalating its requests to supervisors. On six different occasions over a two month period in the early summer of 2005, Clayton implored Nomura to send an overlay.
Not only did Nomura not provide Clayton with overlays to flag loans requiring more careful review, midway through 2006, Nomura told Clayton that it needed to relax its due diligence process. Nomura explained that it was revamping its process to "increase approval rate, improve seller satisfaction with the due diligence process, and decrease efforts all around."
Nomura never provided AMC with overlays either. It gave AMC no special instructions for the review of loan files.
Clayton and AMC hired underwriters to perform the review of and assign a grade to each loan that Nomura sent to it. That review was severely restricted. With one possible exception,
For both credit and compliance, underwriters graded loans on a scale of "EV1" to "EV3." According to Clayton's underwriting manual, loans graded "EV1" for credit were fully compliant "with all specific loan program parameters," which included compliance with the loan originator's underwriting guidelines and Nomura's bid stips. Loans graded "EV2" had "some deviations," but those exceptions were judged to be either immaterial or offset by "sufficient compensating factors." Loans graded EV3 typically had "substantial deviations" with "insufficient compensating factors to offset the overall risk." Nonetheless, the vendor would list any positive aspects of the loan to bring them to the client's attention. According to Kohout, a final EV3 grade was "fatal."
While diligence was underway, Clayton and AMC sent Nomura a constant stream of reports, often on a daily basis. These arrived in the form of event status reports, which were spreadsheets that listed loans and their corresponding grades; exception detail reports, which were omnibus spreadsheets containing summary data on loan defects; and individual asset summaries, which provided in the space of a few pages a description of a loan's characteristics, defects, and potential compensating factors. Nomura's three-man Diligence Group never possessed or reviewed any loan files, and indeed it would not have had time to look at them in any event; it relied solely on the summary documents supplied by its vendors.
The Diligence Group had one of two choices to make with respect to loans flagged as EV3 by a vendor: to override or "clear" the identified exceptions, in which case it would "waive" the loan into the pool, or to reject the loan, in which case the loan was supposed to be "kicked out" of the pool. When Nomura advised Clayton that it had waived the defect in a loan graded EV3, it did not provide Clayton with a reason for the waiver. In these situations, Clayton changed the grade from EV3 to EV2W.
Nomura's policy toward waiving in EV3 loans was lenient in the extreme. Over the course of 2006 and the first quarter of 2007, Clayton graded 38% of the Nomura loans it reviewed for credit and compliance as EV3. Nomura waived in 58% of those EV3-rated loans. Given the large number of loans graded EV3 by Nomura, and the high rate of Nomura waivers, all told, Nomura overruled Clayton's grades and waived in 22% of all of the loans Clayton reviewed. The largest categories of waivers were in connection with EV3 grades assigned by Clayton for missing documents, unacceptable property types, and incomplete appraisals.
Nor is Nomura's waiver rate explained by its bid stips. As already explained, those bid stipulations essentially reflected the rock bottom standards in originators' underwriting guidelines from that period; they did not impose materially more exacting standards. Tellingly, Nomura never provided any loan-by-loan analysis at trial of the loans flagged either EV3 or EV2W to support its suggestion that Nomura loans may have been assigned these grades even though they did not have substantial underwriting defects.
Finally, some of Nomura's witnesses testified that they waived in loans graded EV3 by vendors because of their individualized review of the loans. Among other things, Nomura provided originators with the opportunity to locate missing documents or to explain why there were sufficient compensating factors to override an underwriting defect. This was described as giving originators an opportunity "to tell their story and why they thought this was a good loan." Of course, depending on the nature of the defect and the character of the originator and borrower, this was an invitation for fraud. In any event, there were simply too many waivers to suggest an individualized, merits-based review of each and every waived-in EV3 loan.
But while the Nomura waiver rates were extremely high, so were the kick-out rates. Some of the Trade Pools that contributed loans to the seven SLGs had notably high kick-out rates. For example, the Silver State 66 pool, which supplied loans to NHELI 2007-2, had a kick-out rate of 29%, and the WMC SP01 pool, which supplied loans to NHELI 2007-3, had a kick-out rate of 41%. While one Nomura witness asserted that Nomura could increase the size of the sample or walk away from the trade altogether if a trade pool had a high kick-out rate based on something other than technical errors, Nomura provided no evidence of any occasion when it took either of those actions. In fact, the evidence showed that in at least one case, the contrary was true. Nomura drew a sample of second-lien loans from a Trade Pool purchased from originator OwnIt that had "100% CLTV on just about everything." After discovering high rates of bankruptcies and delinquencies in that sample, Spagna insisted that "we need to upsize the due diligence" on an OwnIt pool designated for securitization. The sample size — 25% — was never upsized. Almost half of the loans in the NHELI 2007-2 SLG were originated by OwnIt.
The upshot of this process was that while many loans were kicked out of the Trade Pools, many others with identified defects were waived in. These numbers are all the more startling since the vendors' credit and compliance review did not involve, with one possible exception, any independent investigation of the loan. It was essentially restricted to a comparison of the loan file to originators' guidelines and Nomura's bid stipulations. From any point of view, the process could not have given Nomura comfort that the Trade Pools largely contained loans that complied, even generally, with originators'
During summation, Nomura chose to address its due diligence program only briefly.
Nomura's confusion is hard to understand. There was no double bind for Nomura. For starters, it could have designed a different due diligence program. It could have instituted a rigorous due diligence program that examined with care a sample of loans, having used a sampling technique that would permit the results to be reliably extrapolated to the entire pool. But even without that approach, when its chosen due diligence program uncovered a disturbing quantity of non-compliant loans it could have kicked them out, increased its diligence with respect to any remaining loans, and, if necessary, chosen not to purchase the loan pool or to describe its loans accurately, including, if appropriate, as "scratch and dent" loans.
The reason for Nomura's lackluster due diligence program is not hard to find. Nomura was competing against other banks to buy these subprime and Alt-A loans and to securitize them. As its witnesses repeatedly described and as its documents illustrated, Nomura's goal was to work with the sellers of loans and to do what it could to foster a good relationship with them.
Given this attitude, it is unsurprising that even when there were specific warnings about the risk of working with an originator, those warnings fell on deaf ears. For example, in May 2005, Hartnagel described evidence of fraudulent loans and inadequate underwriting practices at Silver State. Far from limiting its exposure, Nomura continued to purchase and securitize large numbers of Silver State loans, which contributed 15.4% of the loans securitized into the NAA 2005-AR6 SLG in November 2005.
Similarly, in February 2006, the Diligence Group recommended to the Trading Desk that it remove The Mortgage Store, QuickLoan, and Alliance California, among other sellers, from Nomura's "buy/approved" list. One hundred percent of the loans in the The Mortgage Store pools were "repeatedly ... originated outside of their guidelines." It had "extremely sloppy files"; and its guidelines were no more than "a flux suggestion." Despite these and similar warnings, Nomura continued to buy loans from each of these originators and to securitize them. A few of their loans found their way into each of the seven SLGs backing the GSEs' Certificates, including the five that were securitized after this warning from the Diligence Group.
And in April 2006, Kohout and the Trading Desk exchanged emails about the serious property valuation problems with loans in a People's Choice pool. Nomura had at that point already rejected 90 of the originator's appraised property values, and People's Choice had not even attempted to
There are many more disturbing examples from the files of Nomura reflecting its willingness to securitize defective loans. One more will suffice. In September 2006, Nomura withheld due diligence information from its co-lead underwriter RBS. As Nomura was preparing to send a report to RBS showing the results of AMC's due diligence review of loans that would be securitized in NHELI 2006-FM2, Nomura discovered that there were 19 loans still rated as having material deviations. In an email with the subject line "HUGE FAVOR," Nomura's Spagna requested that AMC act "ASAP" and retroactively regrade the 19 loans as client overrides since Nomura had decided to buy them "for whatever reason." Only after the grades had been altered and the report re-run, did Nomura forward the AMC results to RBS. In a conference call with RBS on that same deal, Spagna reported to a Nomura colleague that he "took the liberty to bullshit" RBS, adding "I think it worked." Spagna could not remember at trial precisely what he had discussed with RBS during that call.
In another part of its due diligence program, Nomura's vendors analyzed the collateral for the subprime and Alt-A loans. But, here too, Nomura's due diligence program was far from rigorous. Nomura contends that over 90% of the loans it purchased received valuation due diligence. But, in fact, Nomura's vendors performed valuation diligence on fewer than half of the loans that later found their way into the SLGs for the Certificates.
Nomura relied on two vendors, CoreLogic and Hansen, to perform its valuation due diligence. The loans would go to one of these two vendors, each of which used different methods. While Hansen performed valuation due diligence on almost all of the loans Nomura sent to it, CoreLogic did not.
Using the loan tapes provided by Nomura, Hansen ran the data for most of the loans submitted to it through its PREVIEW system, which contained an AVM. AVMs are computer programs that compute an appraisal value for a property based on a database of real estate transactions, taking into account factors like recent nearby sales of similar property.
Unlike Hansen, CoreLogic did not run an AVM for most of the loans that Nomura sent it for review. Instead, it used a less expensive, proprietary risk assessment program called HistoryPro to screen loans for further review.
Typically, if a vendor's AVM produced an estimated value for a property that was greater than Nomura's designated tolerance threshold — 10% for subprime loans and 15% for Alt-A loans — or if a loan had received a CoreLogic F-Score of 10 or higher, Nomura sent the loan to another third-party vendor for further review. That further review was a broker price opinion ("BPO") from a real estate broker who typically performed an exterior inspection of that property (a "drive-by")
Nomura received notice from two reviews that its due diligence procedures were faulty. In August 2006 — after Nomura had issued three of the seven Securitizations and shortly after it changed the head of its Diligence Group — Nomura hired IngletBlair, LLC ("IngletBlair") to audit its due diligence process. IngletBlair reviewed 189 loans for which Clayton or AMC had already performed credit and compliance review.
In July 2007, shortly after Nomura had sponsored the last of the seven Securitizations, Nomura commissioned a post-closing credit and valuation fraud review on the loans underlying NHELI 2007-1. NEHLI 2007-1 had issued about six months earlier. The review focused on 104 loans that were in default, half of which came from just one originator: Silver State. The review found that almost 20% of these troubled loans exhibited a "high probability" of fraud.
After Nomura had completed its diligence review, it created a spreadsheet for the trade pool listing the loans that Nomura planned to purchase and those that it was kicking out. As discussed above, originators were given an opportunity to convince Nomura to purchase a loan despite its identified defects.
Once it made its final decision about which loans to purchase, Nomura updated its LMS database to identify the loans it had purchased. During the time Nomura owned the loans, it also continued using the LMS system to track basic information regarding the servicing of the loans, including such things as prepayments of mortgages and delinquency rates. The data for the Prospectus Supplements' Collateral Tables
Nomura's Trading Desk bundled together loans from among those that Nomura had purchased and placed them into securitizations to sell to investors. The Trading Desk pulled together loans that were on Nomura's books based on collateral type, such as subprime or Alt-A, and then used a computer program to predict what rating the rating agencies would give each tranche of the Nomura-pooled loans.
The Trading Desk would then notify Nomura's Transaction Management Group, which would begin preparing marketing documents for the securitization. With the help of outside counsel, the Transaction Management Group drafted Offering Documents for the securitization, including its Prospectus Supplement. Despite speculation by a few Nomura witnesses at trial that the Diligence Group may have been consulted in some undefined way during the securitization process, the Diligence Group had no role whatsoever in the securitization process and did not review or approve the information included in the Prospectus Supplements.
Indeed, there would have been little to be gained by consulting anyone from the Diligence Group. After all, no diligence information about a particular loan was ever entered onto the LMS system. Nomura has shown no evidence of a separate system for tracking the due diligence done
Again, after taking loans from various trade pools and bundling them into a securitization, Nomura did not conduct additional credit or valuation due diligence. It did, however, check the data disclosed in the Supplements against the data stored in the LMS database.
In addition, Nomura retained Deloitte to compare, for a sample of the securitized loans, the data in the LMS system to the information in that loan's loan file.
Deloitte's AUP reviews typically identified around ten percent of the loans in each sample with discrepant data or that were missing documentation necessary for review. Once Deloitte's review was complete, however, Nomura did not extrapolate its findings regarding data errors in the sample to the securitization's SLG as a whole.
Nomura's Transaction Management Group was responsible for obtaining credit ratings from the three major rating agencies. The Transaction Management Group sent loan tapes with data drawn directly from LMS to the rating agencies for analysis. In other words, key data points, such as LTV ratios, owner-occupancy status, DTI ratios, and FICO scores, were those supplied by originators. Ratings agencies did not test the accuracy of the information on the loan tapes and relied on it as accurate.
In conducting their ratings analysis, the rating agencies incorporated loan tape data into their models and produced a rating for each tranche of the securitization. At times, a rating agency might indicate to Nomura that in order for a
RBS served as the sole lead underwriter for three of the seven Securitizations and as the co-lead underwriter for a fourth. Because RBS did not purchase these loans from the originators, its only opportunity for performing due diligence on the loans arose when it joined the securitization as an underwriter. But, RBS did not perform its own credit or valuation due diligence on NHELI 2006-HE3 or NHELI 2006-FM2, the first two Securitizations that RBS entered with Nomura.
With respect to NEHLI 2006-HE3, where RBS served as co-lead underwriter with Nomura Securities, Nomura sent RBS one page with summary statistics regarding some Trade Pool due diligence. This document included four lines of data from Nomura's pre-acquisition due diligence on Trade Pools for the two largest originators for the Securitization.
In its second transaction with Nomura, NHELI 2006-FM2, the SLGs were populated exclusively with loans from Fremont. Despite being the sole lead underwriter, and despite being aware of a "big spike" in repurchasing activity for Fremont loans (suggesting Fremont was originating a substantial number of defective loans), RBS performed no credit or valuation due diligence whatsoever on this Securitization.
For the two Securitizations upon which it actually did credit and valuation due diligence — NHELI 2007-1 and NHELI 2007-2 — RBS served as lead underwriter. The RBS diligence review for these two Securitizations resembled the Nomura pre-acquisition due diligence program in certain critical respects. Like Nomura, RBS had no written due diligence guidelines and provided no formal training program for its due diligence employees. It typically conducted due diligence on a sample of the loans, but had no reliable basis for extrapolating the results of the due diligence review to the entire population from which the sample was drawn, and never made any attempt to do so. Nor did RBS integrate its due diligence with the disclosures in the Prospectus Supplements. Its due diligence team had no role in reviewing the accuracy of representations in Prospectus Supplements and did not understand that its work was in any way connected to the representations that would be made in Prospectus Supplements. As was true for Nomura, there was no one at RBS who acted to ensure that the representations in the Prospectus Supplements that are at issue in this case were truthful.
The RBS Diligence Group was responsible for proposing samples on which to conduct due diligence. In making those proposals, it used what it termed adverse sampling,
The Diligence Group had the ability to request an "upsize" of samples, but there is no evidence that such a request was ever made and approved. For example, Farrell did request permission in January 2007 from an RBS banker to select a due diligence sample of 25% of the loans from NHELI 2007-2 because the loans in the Securitization were "crap." But that upsizing did not happen; only a 6% sample was taken. As an RBS banker explained, RBS "didn't own the pool."
Any due diligence review of the samples that was done was performed by RBS
With respect to NEHLI 2007-1, the time stamps on Clayton reports indicate that Farrell took just over an hour to waive in all but three of the thirty-three loans that Clayton graded EV3. Farrell has no recollection of this transaction. It appears Farrell reviewed the Clayton spreadsheet and quickly made his choices.
If Farrell had chosen to do an individualized assessment of the loans, he would not have had any loan files or originator guidelines to review. Instead, he would have relied on the Clayton-prepared individual asset summaries ("IAS") for a loan. These documents, running typically two to four pages, describe material features of a loan, its defects, and its potential compensating factors. As he demonstrated at trial, Farrell liked to work with a physical copy of the IAS and circle any compensating factors with pen in hand. Leaving aside whether Farrell would have immediately noticed the email and printed the documents IAS forthwith, whether he would have had the opportunity to work exclusively on this project during the hour, and whether it is even possible to individually review thirty-three IASs in an hour without working with an uncommon ferocious intensity, Farrell's testimony left no doubt that his wholesale waiver was not the result of careful consideration.
With respect to NEHLI 2007-2, RBS's treatment of the vendor reports was much the same. All of the 50 loans designated EV3 by Clayton for credit deficiencies were waived in.
RBS also performed restricted valuation diligence. It commissioned "drive-by" appraisals on properties for a sample of loans for both of the Securitizations. For the nine such appraisals of properties whose loans appeared in the relevant SLG in NHELI 2007-1, eight had lower appraisal values than the originators' values, five had recalculated LTV/CLTV ratios that moved above 80%, and one had a recalculated LTV ratio of 116%. Despite these results, the originators' LTV ratios appeared in the Offering Documents.
For NHELI 2007-2, drive-by appraisals were performed on forty-four properties whose loans appeared in the relevant SLG. The results of the drive-by appraisals indicated that thirty-one of the forty-four properties were initially overvalued, nine had recalculated LTV/CLTV ratios that moved above 80%, and ten had recalculated LTV/CLTV ratios over 100%. Again, each of these loans was securitized, and no representations in the Supplements were changed.
In 2007, RBS commissioned a fraud review on one of the four Securitizations, NHELI 2006-HE3. This was a Securitization for which RBS did no independent credit and valuation due diligence. In February 2007, about six months after the
Since a decision in this case must be reached separately for each GSE Certificate, it is useful to look at the results of any due diligence performed on loans that found their way into the SLGs supporting the seven Certificates.
Altogether, just under 40% of the loans in the SLGs received credit due diligence. The figures per SLG are as follows:
Securitization Loans SLG Loans Subject to Percentage of SLG Loans in SLG Credit Due Subject to Credit Due Diligence Diligence NAA 2005-AR6 376 252 67.02% NHELI 2006-FM1 2,532 669 26.42% NHELI 2006-HE3 3,618 1,967 54.37% NHELI 2006-FM2 3,891 837 21.51% NHELI 2007-1 474 335 70.68% NHELI 2007-2 3,001 1,346 44.85% NHELI 2007-3 1,914 756 39.50% TOTAL 15,806 6,162 38.99%
Of those loans that received credit due diligence, roughly 73% were graded EV1
Securitization EV2W Credit Grade EV3 Credit Grade (Count/Percentage) (Count/Percentage) NAA 2005-AR6 21 / 8.33% 6 / 2.38% NHELI 2006-FM1 38 / 5.68% 0 / 0.00% NHELI 2006-HE3 150 / 7.63% 59 / 3.00% NHELI 2006-FM2 14 / 1.67% 18 / 2.15% NHELI 2007-1 12 / 3.58% 38 / 11.34% NHELI 2007-2 109 / 8.10% 33 / 2.45% NHELI 2007-3 29 / 3.84% 14 / 1.85% TOTAL 373 / 6.05% 16861 / 2.73%
As for valuation due diligence, roughly 57% of the loans received no AVM review, no BPO, or had no "post-review value," referring to the value Nomura selected after the BPO reconciliation process. This was principally due to the fact that CoreLogic performed the bulk of the valuation due diligence for Nomura and it assigned an F-Score of "0" to almost 60% of the loans. The numbers per SLG are as follows:
Securitization SLG Loans in DB 62 Loans with No AVM, Percentage BPO, or Final Value NAA 2005-AR6 325 134 41.2% NHELI 2006-FM1 2,532 1,604 63.3% NHELI 2006-HE3 3,617 1,942 53.7% NHELI 2006-FM2 3,891 2,433 62.5% NHELI 2007-1 403 104 25.8% NHELI 2007-2 3,001 1,603 53.4% NHELI 2007-3 1,914 1,187 62.0% TOTAL 15,683 9,007 57.4%
Nomura had set a 10% tolerance threshold for appraisals of properties supporting subprime mortgages. Over 38% of the subprime loans in five of the SLGs that were subjected to an AVM and had an AVM outside the 10% threshold, received no BPO review.
Securitization AVM Values Below 10% AVM Values Below 10% Percentage Threshold with No BPO NAA 2005-AR6 n/a n/a n/a NHELI 2006-FM1 329 161 48.9% NHELI 2006-HE3 470 178 37.9% NHELI 2006-FM2 487 178 36.6% NHELI 2007-1 n/a n/a n/a NHELI 2007-2 344 115 33.4% NHELI 2007-3 148 47 31.8% TOTAL 1,178 679 38.2%
Taking the AVM values and BPO values obtained by Nomura from its vendors-that is, the two independent valuation assessments available to Nomura before it determined its final values — and using those values to recalculate the LTV ratios for just those loans within the SLGs, over 19% of the loans that received AVM or BPO values had LTV ratios greater than 100%. The numbers per SLG are as follows:
Securitization Loans with AVM & BPO AVM & BPO LTV Over Percentage Values 100 NAA 2005-AR6 35 1 2.9% NHELI 2006-FM1 170 29 17.1% NHELI 2006-HE3 299 79 26.4% NHELI 2006-FM2 348 41 11.8% NHELI 2007-1 22 4 18.2% NHELI 2007-2 264 70 26.5% NHELI 2007-3 115 18 15.7% TOTAL 1,253 242 19.3%
Each SLG also had loans with Nomura post-review values whose recalculated LTV ratios exceeded 100. The number per SLG are as follows:
Securitization SLG Loans with Final Final Value LTV Over Percentage Values 100 NAA 2005-AR6 63 0 0.0% NHELI 2006-FM1 303 8 2.6% NHELI 2006-HE3 613 43 7.0% NHELI 2006-FM2 626 26 4.2% NHELI 2007-1 56 4 7.1% NHELI 2007-2 452 46 10.2% NHELI 2007-3 265 24 9.1% TOTAL 2,378 151 6.3%
The results found in the database created by defendants' expert Mishol in this regard were less conservative: he found that of the 2,119 SLG loans with "final values," 211 — or 10% — had final value LTV ratios over 100.
Each of the seven Certificates was sold to the GSEs by means of two documents: a Prospectus and a Prospectus Supplement.
Each of the seven Prospectus Supplements begins in its first few pages with the instruction that investors "should rely only on the information contained in this document." Similarly, each Supplement states on its final page that potential investors "should rely only on the information contained or incorporated by reference in this prospectus supplement and the accompanying prospectus."
After these introductory pages, the Supplements provide a "Summary" that offers "a very broad overview of the certificates offered by [the] prospectus supplement and the accompanying prospectus." Among the information included in this Summary are the date the Supplement was issued; the Cut-off Date for fixing the composition of loan pools in the Securitization; the identities of the depositor, the seller, and other key figures in the transaction; and the names of specific originators. The Summary section also states that the senior tranche certificates described in the Supplement — including the seven Certificates at issue here — "will not be offered unless they receive ratings at least as high as" AAA ratings or their equivalent from third-party rating agencies such as S & P and Moody's. They further explain that "[i]n general, ratings address credit risk" and that "[t]he ratings of each class of Offered Certificates will depend primarily on an assessment by the rating agencies of the related Mortgage Loans ... and the subordination afforded by certain classes of certificates." The Summary section concludes with one or more pages that report summary statistics for various attributes of the loans in each SLG, as well as aggregate statistics for the Securitization as a whole.
Each Prospectus Supplement then supplies sets of tables with statistics ("Collateral Tables") that disclose the "Characteristics of the Mortgage Loans" in each of the SLGs supporting that Securitization. The Collateral Tables provide data on more than a score of features of the loans
Original Loan-to-Value Ratio of the Group I Mortgage Loans
Weighted
% of Average
Aggregate Aggregate Weighted Nonzero Weighted Stated
Number of Remaining Remaining Average Weighted Average Remaining
Original Mortgage Principal Principal Mortgage Average Original Term Full/Alt
Loan-to-Value Ratio (%) Loans Balance Balance Rate (%) FICO LTV (%) (Months) Doc (%)
Less than or equal to 50.00 100 $ 15,620.836 2.31% 8.878% 585 40.49% 354 57.24%
50.01 - 55.00 40 7,755,893 1.15 8.143 609 53.08 355 65.88
55.01 - 60.00 76 14,401,288 2.13 8.806 577 57.66 355 48.05
60.01 - 65.00 122 24,549,828 3.62 8.978 576 63.55 355 47.30
65.01 - 70.00 157 32,313,906 4.77 8.828 579 69.12 355 49.30
70.01 - 75.00 212 44,141,324 6.52 8.734 577 74.06 355 54.88
75.01 - 80.00 1,531 324,418,693 47.90 8.134 633 79.85 356 51.15
80.01 - 85.00 221 48,119,274 7.11 8.291 607 84.65 355 73.49
85.01 - 90.00 387 78,315,654 11.56 8.535 619 89.70 355 79.10
90.01 - 95.00 127 23,093,603 3.41 8.608 630 94.67 354 76.62
95.01 - 100.00 918 64,507,394 9.53 10.734 650 99.90 350 53.87
_____ ____________ _______ _______ ___ _______ ___ ______
Total/Weighted Average: 3,891 $677,217,695 100.00% 8.590% 620 80.58% 355 57.36%
Occupancy Status of the Group I Mortgage Loans
Weighted
% of Average
Aggregate Aggregate Weighted Nonzero Weighted Stated
Number of Remaining Remaining Average Weighted Average Remaining
Mortgage Principal Principal Mortgage Average Original Term Full/Alt
Occupancy Status Loans Balance Balance Rate (%) FICO LTV (%) (Months) Doc (%)
Owner-Occupied 3,628 $630,190,865 93.05% 8.569% 619 80.72% 355 56.90%
Investor 247 43,162,888 6.37 8.932 635 78.51 355 64.63
2nd Home 16 3,883,941 0.57 8.099 637 80.99 355 49.95
_____ ____________ _______ ______ ___ ______ ___ _____
Total/Weighted Average: 3,891 $677,237,695 100.00% 8.590% 620 80.58% 355 57.36%
As the tables demonstrate, Supplements disclose the principal balance and percentage of loans in the relevant SLG with LTV ratios below 50% and in five point increments up to 100%. In no case was there a disclosure of LTV ratios greater than 100%. The Collateral Tables also provided the percentage the mortgage loans in the relevant SLG for residences that were "owner-occupied," an "investment," and a "second home."
The Supplements explicitly provide that the characteristics of the loans listed in the Collateral Tables, including LTV ratios and owner-occupancy status statistics, are correct as of each Supplement's "Cut-off Date."
SECURITIZATION CUT-OFF DATE SUPPLEMENT DATE NAA 2005-AR6 11/1/2005 11/29/2005 NHELI 2006-FM1 1/1/2006 1/27/2006 NHELI 2006-HE3 8/1/2006 8/29/2006
NHELI 2006-FM2 10/1/2006 10/30/2006 NHELI 2007-1 1/1/2007 1/29/2007 NHELI 2007-2 1/1/2007 1/30/2007 NHELI 2007-3 4/1/2007 4/27/2007
All seven of the Supplements explain that "[m]ortgage loans with higher loan-to-value ratios may present a greater risk of loss than mortgage loans with loan-to-value ratios of 80% or below." All seven indicate whether loans with LTV ratios above 80% were insured or not.
The Prospectus for each Securitization explains that for purposes of determining the LTV ratio, "[t]he `Value' of a Mortgaged Property, other than for Refinance Loans, is generally the lesser of (a) the appraised value determined in an appraisal obtained by the originator at origination of that loan and (b) the sales price for that property." The Prospectus adds that "[u]nless otherwise specified in the prospectus supplement, the Value of the Mortgaged Property securing a Refinance Loan is the appraised value of the Mortgaged Property determined in an appraisal obtained at the time of origination of the Refinance Loan." Finally, according to the Prospectus, "[t]he value of a Mortgaged Property as of the date of initial issuance of the related series may be less than the Value at origination and will fluctuate from time to time based upon changes in economic conditions and the real estate market."
The Prospectus Supplements also include representations that "[t]he Mortgage Loans ... were originated generally in accordance with the underwriting criteria described in this section."
The sections of each Prospectus Supplement addressed to underwriting describe both the process by which a borrower applies for a mortgage loan and the process through which the application is reviewed and approved. For example, the Prospectus Supplement for NAA 2005-AR6 describes the information the borrower must supply to the loan's originator as follows:
The Supplements then explain that the originator, having received an application with the pertinent data and authorizations, proceeds to review the application. This analysis includes a determination that the borrower's income will be sufficient to carry the increased debt from the mortgage loan. The Prospectus Supplement for NAA 2005-AR6 explains in pertinent part:
The section of the Supplements addressed to the underwriting process used by loan originators also explains the process used to ensure that there is security for the issued loans, for instance by requiring some borrowers to obtain hazard or title insurance or because an appraisal has shown that the mortgaged property itself provides adequate security. For instance, the Supplement for NAA 2005-AR6 states:
Six of the Supplements disclosed that loans might have been originated under "modified standards," which relaxed certain documentation requirements:
Six of the seven Supplements note that "certain exceptions to the underwriting standards" described would be "made in the event that compensating factors are demonstrated by a prospective borrower"; the seventh said substantially the same.
If specific originators contributed more than 20% of the loans in any RMBS, six of the Prospectus Supplements also described in considerable detail the underwriting guidelines of those originators.
When an individual originator's guidelines are extensively described, that description also typically includes the statement that the loans were "generally" originated in accordance with those guidelines or otherwise states that the originator did not necessarily follow its guidelines for every loan. The Supplements for both Fremont-backed Securitizations — NHELI 2006-FM1 and NHELI 2006-FM2 — state, "All of the mortgage loans were originated or acquired by Fremont generally in accordance with the underwriting criteria described in this section. The following is a summary of the underwriting guidelines believed by the depositor to have been applied with some variation by Fremont." A few paragraphs later, the Supplements for NHELI 2006-FM1 and NHELI 2006-FM2 list compensating factors that may warrant exceptions on a case-by-case basis to the Fremont guidelines when the borrower does "not strictly qualify[] under the risk category guidelines" but is nonetheless
Along these same lines, the Supplement for NHELI 2007-2 states that Ownit, which originated 42.38% of the loans in that Securitization, "provides loans to borrowers... in accordance with" the guidelines described, but that the guidelines were "designed to be used as a guide ... [and] no single characteristic will approve or deny a loan." The Supplement for NHELI 2007-3 similarly represents that with respect to originator ResMAE a "substantial portion of the Mortgage Loans represent such underwriting exceptions" where compensating factors exist.
The Supplements also periodically provide advisories about the nature of the Securitization and its risks. Each, for example, contains the admonition to "consider carefully" or "carefully consider" the risk factors described in the Supplement.
(Emphasis added.)
The Prospectus Supplements also contain various warnings to potential investors that poor performance of the underlying loans could cause losses. For example, each Supplement states that "[i]f substantial losses occur as a result of defaults and delinquent payments [on the underlying loans], you may suffer losses." Five of the seven Supplements add that
The remaining two Supplements contain a slightly different version of this language, stating that investors "could lose all or a portion of the money you paid for your certificates." (Emphasis added.)
Six of the seven Supplements further caution that variability in property prices for these non-prime loans may affect the Securitizations' performance:
And each Supplement notes that, in certain specified states or regions that have "a significant concentration of properties underlying the Mortgage Loans," "economic conditions ... may affect the ability of borrowers to repay their loans on time" and that "declines in the residential real estate market ... may reduce the values of properties located in those" states or regions, "which would result in an increase in the related loan-to-value ratios."
The Supplement for NHELI 2007-3 contains a specific disclaimer regarding the loans originated by ResMAE, which contributed 77.6% of the loans to the relevant SLG, and which filed for bankruptcy shortly before the issuance of the Supplement:
As mentioned above, there are almost 16,000 loans in the seven SLGs supporting the GSEs' Certificates in the Nomura Action. The Nomura Action was one of the smallest among the sixteen coordinated FHFA actions and FHFA requested approval early in this litigation to proceed to trial based on an analysis of a sample of the loans supporting the Securitizations. Having given the parties an opportunity to test FHFA's proposed sample selection procedures under Daubert standards, approval was given to FHFA to proceed to trial in the sixteen coordinated actions with an analysis of a representative sample drawn from the loans in each Certificate's SLG. See FHFA v. JPMorgan Chase & Co., No. 11cv6188 (DLC), 2012 WL 6000885, at *4-11 (S.D.N.Y. Dec. 3, 2012). A sample of 100 loans for each SLG permits results to be stated with a 95% confidence level, i.e., with maximum margins of error of +/10 percent. Id. at *5.
Cowan selected the loans that composed the seven Samples, relying largely on the loan tapes. Using a technique known as stratification, Cowan used each loan's FICO score to sort each SLG's loan population into four strata, and then drew 25 loans at random from each stratum. Cowan tested his Samples against the corresponding SLGs on eleven separate metrics to ensure that they were adequately representative of the relevant loan populations.
Defendants argue that Cowan's sampling methodology is unreliable because it necessarily excluded loans from some originators. They contend that he should instead have performed his sampling originator-by-originator. Defendants have not shown that such an approach would have been either feasible or particularly informative. After all, the claims in this case are not organized by originator; they rely on defendants' representations regarding different characteristics of all the loans within an SLG, such as LTV ratios and owner-occupancy status. In addition, many originators contributed only a handful of loans to a Securitization. Cowan's random sampling insured that originators contributing many loans — and thus with a comparatively major influence on the quality of the SLG — had many loans represented in the Sample; conversely, originators contributing few loans — and thus with a comparatively minor influence on the quality of the SLG — had few if any loans represented. Because FHFA aimed to assess the quality of the SLGs generally, Cowan's sampling was appropriate to that task.
For six of the seven Samples, the parties were able to find a sufficiently complete loan file for all or almost all of the Sample loans to permit a re-underwriting of the loan.
While sufficiently complete loan files to permit re-underwriting were located for 723 of the 796 Sample loans, FHFA's appraisal expert Kilpatrick lacked sufficient information to assess the appraisals for 124 of the 796 Sample loans. The number of loans for which Kilpatrick analyzed the appraisals for each of the Samples is as follows:
SECURITIZATION SLG ORIGINAL SAMPLE SIZE AVM ESTIMATE AVAILABLE NAA 2005-AR6 III 196 129 NHELI 2006-FM1 1 100 94 NHELI 2006-HE3 1 100 88 NHELI 2006-FM2 1 100 95 NHELI 2007-1 II-1 100 92 NHELI 2007-2 1 100 88 NHELI 2007-3 1 100 86 TOTALS - 796 672
After FHFA's re-underwriting and appraisal experts performed their analyses, Cowan extrapolated those experts' findings to the relevant SLG. Defendants challenged several of Cowan's extrapolations, arguing that the analyzed Samples were not representative of the corresponding SLGs' populations. FHFA has shown that the final Samples are sufficiently representative to produce results from the sampling that may be reliably extrapolated to the entire SLG population.
With respect to FHFA's re-underwriting evidence, defendants challenge as unrepresentative only the Sample for the NAA 2005-AR6 SLG. This was the Sample that was expanded because so many of the files for the original Sample loans could not be located. Cowan ensured that both the initially selected loans and the supplemental loans were randomly selected and subjected to the same representativeness tests. To the extent that any bias might have been introduced into the final 2005-AR6 Sample, it was to make the expert's findings more conservative.
With respect to FHFA's appraisal evidence, defendants challenge Cowan's extrapolations for four of the seven SLGs.
Finally, it is telling that defendants presented no evidence that a bias actually existed in the Samples that were used for the re-underwriting or for the appraisals. For instance, defendants' statistics expert Barnett did not conduct any representativeness tests at all or apply any established methodology for correcting bias and
One of the categories of misrepresentations alleged by FHFA pertains to LTV ratios. These ratios were reported in the Collateral Tables of the Prospectus Supplements and are also a component of any analysis of whether the originators complied with their underwriting guidelines in issuing the mortgage loans. LTV ratios are calculated in the Supplements by dividing the amount of the residential mortgage loan by the value of the property that collateralized the loan, which is defined in each Prospectus as the lower of the sales price or the appraised value.
According to federal regulations governing appraisal standards for federally related transactions, "[a]ppraisal means a written statement independently and impartially prepared by a qualified appraiser setting forth an opinion as to the market value of an adequately described property as of a specific date[], supported by the presentation and analysis of relevant market information." 12 C.F.R. § 225.62(a). According to the same regulation:
Id. § 225.62(g). Even though these regulations did not govern the appraisals at issue here, the parties relied on these and similar standards when describing the requirements for an appraisal.
As will be explained in more detail below, to establish a misrepresentation with respect to the LTV ratios set forth in the Prospectus Supplements, FHFA bore the burden of establishing both that the original value derived from an appraisal (and hence an LTV ratio based on that appraisal) was inflated (objective falsity), and that the appraiser did not believe the original appraised value to be accurate (subjective falsity). The Court finds that FHFA carried this burden with respect to at least
First, there was strong evidence that a significant percentage of the original appraisals for the Sample properties did not reflect the actual values of the properties. To the extent they could be measured, the original appraisals for the Sample properties had an upward bias of 8.92%, on average. There were more than three times as many inflated appraisals as understated appraisals. This means that the original appraisals systematically overvalued the properties, and that the overvaluation was not due to random chance. The average inflation bias per SLG ranged from over 5% to over 15%.
Of the 672 Sample loans, FHFA proved that at least 208 of their appraisals (or approximately 31%) were materially inflated (using an inflation threshold of 15.1%), and that for at least 184 of these inflated appraisals (or approximately 27% of the 672), the appraisals were non-credible. The table below shows the breakdown for each of the seven SLGs. The final column reflects non-credible appraisals. "Credibility" is a term of art in the appraisal industry, as further discussed below.
Securitization (SLG) Number of Sample Loans Number of Sample Non-Credible Appraisals in Securitization Appraisals Inflated Inflated by at Least 15.1% by at Least 15.1% NAA 2005-AR6 (3) 129 27 (21%) 25 (19%)NHELI 2006-FM1 (1) 94 29 (31%) 26 (28%)NHELI 2006-HE3 (1) 88 30 (34%) 27 (31%)NHELI 2006-FM2 (1) 95 38 (40%) 34 (36%)NHELI 2007-1 (2) 92 19 (21%) 17 (18%)NHELI 2007-2 (1) 88 37 (42%) 31 (35%)NHELI 2007-3 (1) 86 28 (33%) 24 (28%)Total 672 208 (31%) 184 (27%)
The Court finds that a showing of an appraisal's non-credibility is strong circumstantial evidence that at the time the appraiser prepared the appraisal she did not believe in the value reflected therein. That strong circumstantial evidence has been buttressed by other evidence, also described below.
As discussed above, the Offering Documents highlighted the percentage of the underlying loan pools that had LTV ratios at or below 80%. It was well understood at the time that LTV ratios over 80% signaled a substantial increase in risk. An LTV ratio over 100% indicates that the property was "underwater" at the time of its sale. The Supplements overrepresented the number of loans with LTV ratios below 80%, underrepresented the number of loans with LTV ratios over 80%, and falsely represented that none of the loans had LTV ratios over 100%.
As set forth in the table below, extrapolating the impact of the inflated and non-credible appraisals to each SLG, substantially more loans had LTV ratios above 80% and above 100% than originally represented in the Offering Documents.
SLG Less Between 80 Between 80 and 100 LTV Over 100 LTV Original Extrapolated Original Extrapolated Original Extrapolated NAA 2005-AR6 (3) 100.0% 82.2% 0.0% 8.5% 0.0% 9.3%NHELI 2006-FM1 (1) 79.8% 61.7% 20.0% 28.7% 0.0% 9.6%NHELI 2006-FM2 (1) 80.0% 62.1% 20.0% 25.3% 0.0% 12.6%NHELI 2006-HE3 (1) 62.5% 46.6% 37.5% 36.4% 0.0% 17.0%NHELI 2007-1 (2) 89.1% 73.9% 10.9% 16.3% 0.0% 9.8%NHELI 2007-2 (1) 61.4% 50.0% 38.6% 29.5% 0.0% 20.5%NHELI 2007-3 (1) 65.3% 51.2% 33.7% 33.7% 0.0% 15.1%Total 78.6% 62.5% 24.4% 24.4% 0.0% 13.1%
The extrapolations
To prove both the extent to which appraisals were inflated and the extent to which appraisers subjectively disbelieved the figures they rendered, FHFA relied principally on Kilpatrick, whose findings the Court substantially adopts here, as described in more detail below. Kilpatrick's testimony was corroborated in several ways by other trial evidence. After Kilpatrick's evidence and defendants' criticisms of it are discussed, that additional evidence is summarized.
Kilpatrick concluded that he had sufficient information to evaluate the original appraisals for 672 of the 796 Sample properties.
Kilpatrick further evaluated 205 of the 208 inflated appraisals with his credibility assessment model ("CAM") to determine whether the original appraisals were "credible." That an appraisal is non-credible is, in at least this case, circumstantial evidence that the appraiser did not believe her appraised value for the property to be accurate. Kilpatrick concluded that, at a conservative credibility threshold, 184 of the 205 original appraisals were non-credible.
In the first stage of his analysis, Kilpatrick used the GAVM to identify inflated appraisals. As explained above, an AVM is a computer program that employs statistical models to ascertain estimates of the market value of real property. AVMs draw from a larger pool of comparable property sales than traditional appraisal methods by culling information from databases and analyzing many sales observations. AVMs are commonly used as screening tools to identify appraisals that warrant closer review. Indeed, defendants' due diligence vendors used AVMs in screening the appraisals of some of the properties in the Trade Pools to target appraisals for further investigation. Defendants' AVM expert, Kennedy, explained that "an AVM can be used as a sorting tool to get to a group of properties that you want to take a more in-depth look at."
Kilpatrick designed and built the method and code for the Greenfield AVM. The Greenfield AVM consists of two valuation sub-models, which are separately run and whose results are compared to arrive at a single final value.
The GAVM served as a reliable gating mechanism to identify a set of materially inflated appraisals. Its reliability as a screening tool and its accuracy were confirmed through a series of tests.
In one test, Kilpatrick compared the GAVM estimated values with the actual sales prices of subject properties. Focusing on the middle 90% of the subject sales (in other words, excluding the 5% of the subject sales at the low tail of the distribution and the 5% of the subject sales at the high tail of the distribution), the GAVM predicted the sales price to within 1.26% on average.
In another series of tests, Kilpatrick compared the performance of four commercially available AVMs used by defendants' expert Kennedy to the performance of the Greenfield AVM, again using the middle 90% of the subject sales. The Greenfield AVM was conservative and predicted slightly higher market values than each of the four commercial AVMs used by Kennedy.
Moreover, when applied to all of the Sample loans' appraisals, each of the four commercial AVMs predicted higher average inflation of the original appraisals than the GAVM predicted. The four commercially available AVMs reported average appraisal errors exceeding 10%, as compared to the more conservative 8.92% calculated by the Greenfield AVM. That comparison is reflected in the following chart
Appraisal Error: Greenfield Collateral Real Info DataQuitk DataQuick (Appraisal — AVM) AVM Analyrics AVM CMV-P CMV-AE /AVM AVM AVM AVM Properties Valued 672 662 496 669 670
Average Appraisal S.92% 10.14% 12.30% 1024% 12.62% Error Median Appraisal 6.28% 5.86% 7.99% 5.99% 6.27% Error Standard Deviation of 23% 26% 22% 21% 36% Appraisal Error
The median appraisal error was essentially consistent across all five AVMs, between 5.88% and 7.99%, with the Greenfield AVM calculating a median appraisal error of 6.28%.
The defendants did not ask their expert Kennedy to defend the credibility of the 208 appraisals identified by the GAVM as suspect. Of the 208 appraisals that the GAVM found to be at least 15.1% inflated, Kennedy had results from at least one of the four commercial AVMs for 181 of them. For 180 of the 181, the commercial AVMs that evaluated them also estimated values that were lower than the original appraised values.
On December 5, 2014, defendants moved pursuant to Fed.R.Evid. 403, 702, and Daubert v. Merrell Dow Pharm., 509 U.S. 579, 113 S.Ct. 2786, 125 L.Ed.2d 469 (1993), to exclude Kilpatrick's testimony. The motion was granted in part, excluding Kilpatrick's opinions regarding the subjective beliefs of appraisers. FHFA v. Nomura Holding Am., Inc. ("Kilpatrick Opinion"), No. 11cv6201 (DLC), 2015 WL 353929, at *6 (S.D.N.Y. Jan. 28, 2015). The Opinion noted that defendants' attacks on the reliability of the GAVM and CAM methodologies went only to the weight, not the admissibility, of the proffered testimony. Id. at *4. The trial evidence has confirmed that finding.
At trial, defendants renewed their Daubert motion directed to the reliability of Kilpatrick's methods. As explained below, none of defendants' multilayered attacks on the GAVM (or the CAM) succeeds in showing that Kilpatrick's tools for analyzing appraisal inflation and the credibility of the original appraisals were unsound. Kilpatrick's testimony "both rest[ed] on a reliable foundation and [wa]s relevant to the task at hand." Daubert, 509 U.S. at 597, 113 S.Ct. 2786. When subjected to close examination at trial, his tools were shown to be conservative, careful instruments that were well-designed to ferret out appraisal bias and to be of assistance to the finder of fact in making assessments about appraisals. At heart, the ultimate test for the Greenfield AVM is whether it succeeded in isolating a subset of inflated appraisals for more in-depth analysis. It did, and none of defendants' criticisms contends otherwise. In fact, Nomura's own AVM results (from Nomura's limited valuation diligence) found average appraisal error in the Nomura loans at essentially the same rate as did the GAVM.
Defendants note that the Greenfield AVM was developed recently and has not been made available to the appraisal industry.
In response to a question from the Court, Kilpatrick explained that he did not use a commercially available AVM for his work in this case because he knew that, at the end of the day, he would have to testify and would be called upon to explain his valuation process: He wanted to use a valuation model that he understood and would be able to explain under oath. In fact, Kilpatrick explained that he reads USPAP Standard Rule 6 to oblige an appraiser to be familiar with an AVM's inputs, filters, calibration, and with the statistical characteristics of its outputs. Kilpatrick explained that he would not have been able to speak to any of those topics with regard to the commercial, "black box" AVMs. By contrast, Kilpatrick developed the GAVM himself and used its underlying hedonic and automated valuation models throughout his academic and professional careers.
Defendants offered many attacks against the mechanics of the GAVM, the most significant of which are addressed below. None of their arguments or evidence, however, succeeded in showing that the GAVM was an unreliable screening tool. The GAVM performed reliably as a gating mechanism for sending suspect appraisals on for closer review under the CAM, and those aspects of its design and performance criticized by defendants do not ultimately impact its ability to perform that basic function. The closer review under the CAM confirmed that it had performed as intended, indeed admirably. In the overwhelming majority of cases, the inflated appraisals flagged by the GAVM were indefensible and provide strong circumstantial evidence of impropriety by the appraisers who performed them.
Defendants assert that the Greenfield AVM suffers from omitted variable bias. When important variables are omitted from a regression analysis, the analysis loses its predictive value. See, e.g., Freeland v. AT & T Corp., 238 F.R.D. 130, 145 (S.D.N.Y.2006) (noting effect of omitting variable from regression analysis). Defendants' experts, Hausman and Isakson, identified several variables including views, swimming pools, school quality, access to public transportation, number of bedrooms, garage size, and lot size, which they asserted had been improperly omitted.
This argument was not persuasive. It is true that "[f]ailure to include a major explanatory variable that is correlated with the variable of interest in a regression model may cause an included variable to be credited with an effect that actually is caused by the excluded variable." Federal Judicial Center, Reference Manual on Scientific Evidence 314 (3d ed.2011). But, as significantly, "[p]erforming a multiple regression analysis requires selecting only some of the multitude of characteristics that are possible trial predictors because including too many variables can preclude measurement of the characteristics that are valid predictors." Leandra Lederman, Which Cases Go to Trial?: An Empirical Study of Predictors of Failure to Settle, 49 Case W. Res. L.Rev. 315, 327 n. 49 (1999).
Defendants' expert incorrectly identified lot size as an omitted variable. As explained above, lot size is already one of the
Defendants' expert Isakson claimed that the GAVM often produces regression coefficients for its housing characteristic variables that violate implicit price theory, because in some regressions the sub-models have coefficients that are less than zero for key housing characteristics. This would appear to be inconsistent with a characteristic that represents a feature of a house that buyers desire, such as extra bathrooms. The four variables to which Isakson pointed are year built, living area, lot size, and number of bathrooms.
Kilpatrick explained, however, that a coefficient for a variable might be negative in a given case to counterbalance an exaggerated TAV coefficient. Kilpatrick offered the following persuasive example: A local tax assessor might say that each additional bathroom beyond the first one in a house adds $1,000 in value. Kilpatrick's data, however, might show that each additional bathroom actually adds only $800 in value. In that scenario, the coefficient for the number-of-bathrooms variable would be negative to reflect the marginal adjustment.
Defendants vigorously attack the GAVM's use of TAV as a variable. Among other things, as they point out, there is no uniform system employed by local jurisdictions for tax assessments, some jurisdictions do not update TAVs frequently, and some jurisdictions base TAVs only on an external review of the property. Moreover, the GAVM included TAV data that post-dated the original appraisal that the GAVM was evaluating.
The TAV served as a proxy variable for hard-to-measure aspects of property value, such as the view and the general upkeep and condition of the house and property. Kilpatrick was able to allay the specific concern about TAV data post-dating the original appraisal by filtering the data to exclude any house rebuilt after 2009 and by testing for "regime shifts" in tax assessment that may be linked to rebuilding that occurred before 2009 by correlating TAV to sales prices of the comparables within one year prior to the time of the original appraisal.
Tellingly, defendants conducted no robust test to affirmatively show that TAV was not an appropriate variable. In contrast, Kilpatrick conducted statistical analyses on each and every TAV data point to determine the degree to which it was correlated with actual sales prices.
Defendants levy criticism against Kilpatrick's use of one of his several data filters, the Cross-Validation Filter ("CV Filter"). The CV Filter turned the GAVM sub-models on each of the 100 to 2,000 comparables, using all of the remaining comparables in the same county to estimate the value of the comparable under review. If the log of the predicted value of the comparable property under review deviated from the log of the actual sales price by at least 25%, Kilpatrick excluded that comparable from his dataset before running his regression models on the subject property. In Kilpatrick's judgment, the deviation reflected that the sales price for that comparable was "not consistent with the hedonic characteristics reported in the available data."
Isakson makes several criticisms of the use of the CV Filter. But, again, defendants have done nothing to convince the Court that the GAVM's use of the CV filter biased it to reach more aggressive results. As explained by Kilpatrick, the CV Filter is a type of well-recognized leave-one-out statistic, routinely used to eliminate outliers in econometrics. Defendants' econometrics expert, Hausman, did not argue that as a matter of principle the use of such a filter was improper here. Additionally, Kilpatrick consistently used the CV Filter without alteration throughout the duration of the various proceedings in these coordinated actions.
Responding to the evidence that the GAVM performed well when compared to the four commercial AVMs on which defendants' experts had relied, defendants sought to undermine that comparison with expert testimony. To do so, however, their expert presented misleading testimony. He chose to use a faulty dataset and omitted a key comparator on which he had previously relied but which undermined his thesis. When the correct dataset is used, and all reliable measurements are considered, the evidence shows that the GAVM performs well as a gating mechanism and produces, if anything, conservative results.
Defendants' expert purported to compare the GAVM with four commercial AMVs and to determine that the GAVM was the poorest-performing AVM across six of eight metrics.
Moreover, whereas in the expert's earlier work in this case he presented "median error" as a relatively reliable measure of predicative error, and as one that "provide[s] clear definition to overall performance above/below the benchmark value," he omitted that metric when constructing his comparisons for this trial. It turns out that the median error of the GAVM when it was used to value the same properties as the other four AVMs was the lowest of the five. While the expert had performed that head-to-head comparison in charts that he had created before trial, he chose not to submit that comparison as part of his direct testimony.
Considering all of the expert testimony, and the several ways in which one may compare AVM performance, FHFA succeeded in showing that the GAVM was a reliable AVM and that it performed well when compared to commercially available AVMs. Indeed, the GAVM presented a more conservative assessment of appraisal inflation.
In another attempt to undermine the soundness of the GAVM, defendants argued that AVMs generally are unreliable. Defendants introduced a document setting out Fannie Mae's current position on using AVMs as a substitute for an appraiser's individual inspection and appraisal of a property. This argument is largely a red herring. FHFA has not relied, and the Court does not rely, solely on the GAVM to assess the original appraisals of the Sample properties that it contends have inflated appraisal values. Kilpatrick did an intensive review of each of those properties using his CAM methodology before making his final assessment of the reliability of their original appraisal values. In any event, Fannie Mae's cautionary language does not suggest that the GAVM fails as a reliable gating mechanism here.
Fannie Mae's document states, "At present
AVMs have three principal limitations:
Fannie Mae's document, however, also acknowledges the "strengths" of AVMS relative to traditional real estate appraisals. Those strengths are "speed, reduced costs, consistency, and objectivity.... [A]n AVM can significantly reduce the time it takes to obtain an estimate of value and reduce the costs associated with the traditional appraisal process."
Moreover, as discussed above, defendants' own expert, Kennedy, noted the virtues of using an AVM as a sorting tool. And Kennedy was even quoted in a 2007 article in the Magazine of Real Estate Finance as saying that "[t]here is going to be a backlash against traditional appraisal processes because of inherent biases as this meltdown continues forward. This will probably mean more volume for AVMs because of its [sic] unbiased nature."
Finally, defense expert Hausman offered several statistical attacks on the calculations Kilpatrick made using the GAVM results, including that Kilpatrick used an unreliable level of statistical significance in comparing the original appraised value to the Greenfield AVM value, and that Kilpatrick erred in the method he used to transform a natural logarithm of the sales price into a predicted value in dollar terms.
At the end of the day, however, it is unnecessary to confront with specificity Hausman's criticisms. Hausman acknowledged that his academic work has not focused on AVMs, that he has never constructed an AVM, that he is not a participant in the AVM industry, and that his testimony was not based on a comparison of the GAVM to any other AVM, including the four commercial AVMs discussed by the other experts for defendants. Nor does his statistical critique relate to the core functionality of the GAVM as used in this litigation. The GAVM was used in the first instance to identify those properties whose appraisals deserved closer review, and it is
To sum up, the Greenfield AVM succeeded in identifying a subset of the 672 appraisals that deserved further review. While defendants have mounted a vigorous attack against the Greenfield AVM, there is no evidence that any AVM currently used in the field would have performed better when assessed with the rigor applied by the impressive array of experts assembled by defendants. It is telling that defendants themselves have historically relied upon AVMs to identify a set of appraisals deserving further scrutiny. FHFA has shown that Kilpatrick's AVM has performed at least as reliably as those on which defendants and others in business typically rely in making important decisions.
There were 208 properties in the Sample whose original appraised values were at least 15.1% higher than the value estimated by the Greenfield AVM. These 208 original appraisals were directed to the CAM, which Kilpatrick created to evaluate the degree to which the original appraisals were "credible," which is a term of art under the USPAP. The CAM is a deterministic scoring methodology designed to evaluate the degree, if any, to which the appraisals deviated from USPAP and what Kilpatrick describes as applicable appraisal standards and practices. Because Kilpatrick did not have sufficient information to do his CAM evaluation for three of the 208 properties, 205 appraisals were evaluated with the CAM. Kilpatrick concluded that 184 of the 205 properties had appraisals that were not only inflated, but also non-credible. The Court adopts Kilpatrick's assessment. Coupled with other evidence explored below, these findings of non-credibility under the CAM present sufficient circumstantial evidence of bias to permit a determination that the appraisers produced appraisals that they knew did not accurately describe the value of these properties.
Appraisals are based on a comprehensive set of prescribed procedures performed by licensed and certified appraisers. The procedures are developed and monitored by the Appraisal Institute and are contained in its Code of Professional Ethics ("Code of Ethics") and in the USPAP. Although not in effect during the time period at issue in this action, under current law, as enacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), Pub.L. No. 111-203, 124 Stat. 1376 (2010), "appropriate standards for the performance of real estate appraisals ... shall require, at a minimum — that such appraisals shall be subject to appropriate review
Even during the relevant time period, USPAP constituted the generally accepted professional appraisal industry standards. USPAP first went into effect in 1989 and has been revised regularly since that time. The appraisals at issue here were performed between 2003 and 2006, and Kilpatrick relied principally on the 2005 USPAP, in particular its Standards 1 and 2,
USPAP Standard 1 is entitled "Real Property Appraisal, Development," and provides: "In developing a real property appraisal, an appraiser must identify the problem to be solved and the scope of work necessary to solve the problem, and correctly complete research and analysis necessary to produce a credible appraisal." The Rules accompanying Standard 1 refer to credible appraisals and the credibility of the appraisal results. Appraisal Found., Uniform Standards of Professional Appraisal Practice and Advisory Opinions 17-22 (2006 ed.).
USPAP Standard 2 is entitled "Real Property Appraisal, Reporting," and provides: "In reporting the results of a real property appraisal, an appraiser must communicate each analysis, opinion, and conclusion in a manner that is not misleading." The Rules accompanying Standard 2 dictate what an appraisal report must contain in order not to be "misleading." Id. at 23-31.
The 2006 USPAP defined the term "credible" as "worthy of belief." Its comment explains that "[c]redible assignment results require support, by relevant evidence and logic, to the degree necessary for the intended use." The definition was added to the 2006 USPAP because the concept of credibility is "central" to USPAP. As the Appraisal Standards Board explained in its published answers to the "most common questions" about the changes it made to the 2006 USPAP, the term "credible" had been a central concept in USPAP prior to 2006, and the definition added to the USPAP in 2006 "is not really different from common usage." Appraisal Found., 2006 USPAP and Scope of Work 2, available at http://www.ncua.gov/Legal/Documents/Regulatory%20Alerts/RA2006-04Encl2.pdf; see also Appraisal Inst., The Dictionary of Real Estate Appraisal 49 (5th ed.2010).
Kilpatrick attempted to distill the USPAP's requirements and the appraisal industry's standards into a series of thirtyone questions, which were designed to evaluate whether an appraisal complied with the fundamental requirements of USPAP and other standards of practice applicable at the time the original appraisals were performed. Because of the quantity of appraisal reviews that had to be conducted over the breadth of this coordinated litigation, the distillation of pertinent appraisal requirements into a series of concrete, pointed questions made sense. It permitted Kilpatrick's team to gather relevant data for many different properties using uniform standards and permitted Kilpatrick to supervise and review that work effectively. There is no suggestion that Kilpatrick failed to supervise and review that work with care.
Kilpatrick's thirty-one CAM questions pertain to five general topics: reporting, transaction history, analysis, market trends, and comparables. The questions essentially track the information that appraisers are required to include on the URAR, one of the most common forms used for real estate appraisals, which has sections devoted to the subject property, sales contract, neighborhood, site, improvements, appraiser's approach, and any additional information. The thirty-one CAM questions are anodyne and factual. For instance, the first question is: Are the legal address and parcel ID sufficient to identify the subject?
To obtain answers to the CAM questions, Kilpatrick relied principally on his staff at Greenfield and on research provided by licensed appraisers associated with two appraisal firms who worked in the vicinity of the Sample properties. Kilpatrick instituted quality-control checks and appended the collected data to files for each of the examined properties.
The researchers were provided the first page of the original appraisal report. The first page provides identifying information about the subject property and neighborhood, but it does not include the actual analysis or opinion of value. The researchers were directed to gather from local Multiple Listing Services ("MLS") real estate data regarding the nearest nine comparable sales, in terms of time and distance, to the original appraisal. Appraisals typically use information regarding three or four comparables. The Greenfield staff gathered additional data from both the original appraisal reports and loan files, and from public sources, such as tax assessment data, maps, and aerial and street-level photographs.
Kilpatrick applied a score to each of the thirty-one CAM questions when answered in the negative. Kilpatrick chose scores that he believed reflected the importance of the question to an appraisal's credibility and the degree to which a negative response evidenced a deviation "from appraisal standards, guidance, and practice." For instance, Kilpatrick identified six questions to which a negative answer amounted to a substantial major error under USPAP Rule 1-1(b),
Even though Kilpatrick believed that a negative answer to any one of these six questions, standing alone, could raise serious questions about the credibility of the appraisal, he set a credibility threshold above that point. After performing a number of calculations, and choosing to be conservative, Kilpatrick selected a credibility threshold of 20.
Setting the threshold at 20, Kilpatrick concluded that 184 of the 205 appraisals failed. For the sake of argument, Kilpatrick also accepted all of defendants' expert Hedden's specific criticisms of the
As reported in the table presented at the outset of this section of the Opinion, looking just at the universe of appraisals deemed non-credible by the CAM, and recalculating their LTV ratios by using the lesser of the original appraised value, the GAVM estimated value, or the sales price in the denominator of the ratio, there was a sizeable shift in those ratios. There was a significant migration of the recalculated ratios to LTV ranges above 80% and above 100%.
Defendants, through Hausman and Isakson, contend that Kilpatrick's method of populating the LTV denominator — taking the lesser of the Greenfield AVM value, the original appraised value, or the sales price of the property — reflects an error known in econometrics as censoring. Hausman suggests that the preferred course would have been the use of only the Greenfield AVM value in the denominator. This would result in a balancing out of any negative and positive errors in the Greenfield AVM values.
But Kilpatrick's approach, taking the lesser value, is standard industry practice, and is similar to the formula described in each Prospectus as the basis for their reported LTV ratios. As explained in those documents, the denominator was generally the lesser of the sales price or the original appraised value.
Defendants made a limited effort to defend the 184 original appraisals identified by the GAVM and CAM as inflated and non-credible. They offered virtually no affirmative evidence to suggest that these were defensible appraisals. For instance, they did not conduct appraisal reviews, a traditional tool used in the appraisal industry to review the reliability of original appraisals. Nor did they elect to perform anything like the comprehensive CAM analysis, which brought together a wealth of data about each of the subject properties and their comparables. Defendants chose instead to launch a general attack on the validity of the CAM, and to take issue with CAM findings in the case of 114 of the 184 properties. They principally relied on a single expert and four testifying appraisers to cast doubt on the reliability of Kilpatrick's CAM analysis. None of these efforts was successful.
There were several problems with the testimony of defendants' appraisal expert Hedden. One was his lack of engagement with the assignment. Another is the very limited scope of the testimony that he provided. And a third is the standard that he
In contrast to Kilpatrick's hands-on engagement with his work in this case, Hedden did not devote the time or care necessary to this assignment to provide reliable opinions. It appears that one of Hedden's colleagues at FTI was responsible for organizing the work that was performed on this project and for supervising the FTI employees who worked on this engagement. That colleague was the person who chose which of Kilpatrick's CAM analyses would be subjected to fieldwork. That colleague decided to study only 40 of the 184. Given this lack of involvement, it was not surprising that Hedden had difficulty answering many of the very legitimate questions posed at trial and had to admit that he had not examined critical documents.
The second overarching failure with Hedden's testimony was its limited scope. Hedden did not offer any testimony to defend even one of the 184 appraisals. Instead, he limited his testimony to a generalized critique of the CAM and, although Hedden's team at FTI evaluated every single one of Kilpatrick's 1,428 CAM findings, Hedden's trial testimony addresses findings relating to only 114 of the 184 appraisals deemed non-credible by the CAM. That meant that Hedden made no specific criticism of the CAM results in the case of 70 of the 184 appraisals.
Moreover, many of the loans "discussed" in Hedden's direct testimony simply appear in one or more of three tables in his affidavit that list the appraisals that failed Questions 29, 30, and 31 by what Hedden deemed to be insubstantial margins. Notably, only one of these questions, Question 29, is one of the six "major error" questions. These three questions read:
These questions provided relatively easy fodder for Hedden's attacks: Because they ask whether one average number is less than or equal to another average number, Hedden, through his tables, could simply point out that even very small differences in the numbers could cause an appraisal to fail a particular CAM question.
To assist in his critique of the 184 appraisals, Hedden's colleague at FTI retained the services of iMortgage Services ("iMS") to answer a limited set of questions concerning the original appraisals for just 40 of the 184 inflated appraisals.
Even in those instances in which Hedden relied on information developed from the iMS reports, that work was far less illuminating than the detailed and rigorous reports returned by Kilpatrick's researchers. iMS represented that it hired licensed appraisers to fill in responses to roughly eight questions.
Hedden and defendants argue that Hedden limited his discussion of the CAM results to 114 of the 184 appraisals for the sake of brevity. This rings hollow. No page limitations were placed on witnesses' trial affidavits and defendants had every incentive to mount the most comprehensive attack possible against the CAM. There is a far more likely explanation for Hedden's limited testimony: He in fact found very little that he could say in defense of the 184 appraisals and in criticism of the CAM findings. This conclusion is supported by the very structure of Hedden's testimony. In no instance does Hedden present a holistic examination of a property, its original appraisal, and the CAM results. Instead, he makes scattershot arguments about particular aspects of the CAM and refers to a portion of a CAM report about an appraisal to support his theme.
The decisions regarding the credibility of the 184 appraisals, and the states of mind of their appraisers, must be made on each appraisal and for each appraiser, even if that is not the approach taken by defendants. Therefore, to review Hedden's analysis with care, the Court pulled together from every portion of Hedden's testimony, including from each of his three tables, the comments he made about each original appraisal and its CAM analysis. At the Court's request, FHFA provided the Court binders containing each of the 205 appraisals reviewed by the CAM. The Court went through each appraisal, one by one, and evaluated Hedden's criticisms, if any, of Kilpatrick's CAM finding for that appraisal. In only a handful of instances did the Court have any doubt about the substance of Kilpatrick's findings. Were the Court to perform its own extrapolation, it would use at least 180 of Kilpatrick's 184, dropping at most four as a result of Hedden's criticisms. But a maximum of a four-appraisal disparity is too small to make a material difference in the Court's findings.
In performing the above-described analysis, the Court did not consider itself bound by Kilpatrick's twenty-point threshold.
As they did elsewhere in this case, defendants aimed to present the Court with a single choice: adopt Kilpatrick or adopt Hedden. If confined to defendants' choice, the Court would unhesitatingly adopt Kilpatrick over Hedden. Kilpatrick's work was far more rigorous and complete and his testimony was far more credible. But, as noted, the Court also found that its own loan-by-loan analysis confirmed Kilpatrick's analysis in the overwhelming majority of appraisals even after each of Hedden's criticisms regarding an appraisal was examined with care.
Finally, the value of Hedden's testimony was severely undercut by his testimony that it is the job of an appraiser to start with a presumption that the sales price is the right price and to try to find comparables to support that presumption. Operating from such a presumption runs a serious risk that the appraised value will not be legitimate. Indeed, the practice of backing into the sales number may explain why, as noted below, so many of the appraisals for the purchase money mortgages in the Sample were identical to the sales price and why upon careful examination they appear to be inflated appraisals. As is discussed further below, some of defendants' own witnesses rejected Hedden's notion that an appraiser should begin with a presumption in favor of the sales price; they bemoaned the practice of backing into the sales price as a systemic problem in the industry.
Hedden attacked the CAM as unnecessary since, according to him, there are well-accepted alternative methods for evaluating appraisals, specifically field and desk reviews.
On direct, Hedden argued that "none" of the thirty-one CAM questions "are based on USPAP requirements." He also pointed
The CAM is sufficiently tethered to the USPAP and the principles that guide appraisals and appraisal reviews to be useful here. Kilpatrick explained in detail the bases for his formulation of the thirty-one questions, and those explanations were successful in supporting the use of the CAM as a means of measuring the reliability of scores of appraisals.
Hedden maintained at trial that the CAM was too rigid and mechanistic. He contended that the weightings and scores of the CAM are illogical for two principal reasons. First, according to Hedden, the design and application of the CAM's scoring methodology fail to differentiate between minor and major errors, such as the degree to which an appraiser errs in reporting comparable sales transaction data. But this appears to be mainly a theoretical problem; Hedden identifies only two such errors, pointing to instances where an original appraiser misreported a comparable sales price by less than 1%.
Second, according to Hedden, because several CAM questions are interrelated, the CAM may fail an appraisal on multiple questions, even though the reason for those failures depends on the same data. This double counting could inflate the number of appraisals found to be non-credible. As is the case with many of Hedden's criticisms, the force of this one is dampened by the fact that even when it is accepted, an immaterial number of Kilpatrick's evaluations are affected. In other words, double counting was not a real issue in Kilpatrick's actual results. In conducting its review of the 184 appraisals that Kilpatrick says failed the CAM, the Court was on the lookout for errant double counting.
Beyond these problems, Hedden contends that the threshold of twenty for a non-credible appraisal is frivolous. He points out that the maximum negative score, 186.11, is far above 20. Hedden notes that USPAP does not impose any rigid threshold and says that there is no uniform, one-size-fits-all approach to appraisal review.
As explained above, however, Kilpatrick has justified his use of the twenty-point threshold, as it corresponds to a negative response to no less than a minimum of three questions of the CAM: one of the major error questions and two of the other questions. And, as is also explained above, setting the bar at this level is conservative under the USPAP, which would consider one major error in the appraisal to be problematic. Moreover, as has been noted, the Court did not consider itself bound by Kilpatrick's twenty-point threshold when it pulled together each of Hedden's analyses and examined them on a loan-by-loan basis. It is also worth observing, that many of the appraisals were so error-ridden that their CAM score was far above 20. Indeed, the mean score among the 205 appraisals was 43.67 with a median of 44.12. The vast majority of the appraisals that scored more than 20 scored more than 30, and more than half of the appraisals that scored more than 20 scored more than 40.
Hedden's team also identified errors in the application of the CAM questions. Hedden lists four types of errors: mathematical errors in calculating percentage thresholds; mathematical errors in determining whether a number is within a particular range; overlooking accurate information; and faulting an appraisal for not containing information required by the CAM in instances where the requisite information does not exist.
As noted above, Kilpatrick's results and conclusions do not materially change even accepting all of Hedden's specific criticisms of the CAM findings. The majority of Hedden's criticisms are directed at just three questions — Questions 29, 30, and 31 — only the first of which is graded "8" under CAM. Questions 30 and 31 were graded 5.015 and 4.64, respectively.
Even when a specific attack made by Hedden was well taken — and the Court examined each of them — they only made a difference on the margin for any particular appraisal. Hedden acknowledged during his cross-examination that throwing out the findings he specifically challenged in his direct testimony moved the CAM score from above to below the twenty-point threshold in just a small number of the 184 appraisals. Hedden's individual complaints are ultimately of little importance since the appraisals were so deeply flawed and error-ridden.
In addition to the criticisms of Kilpatrick discussed above, during cross-examination defendants spent a surprising amount of time eliciting testimony about some of Kilpatrick's past mistakes. To render his expert opinions in these coordinated actions, Kilpatrick endeavored to become a certified appraiser in all fifty states. As part of certain states' applications that he signed under oath, Kilpatrick answered "no" to questions about whether he had ever been charged with a criminal offense and certified that he had never had a civil judgment entered against him, when, in fact, he has faced civil judgments and a criminal charge in the past. The civil judgments grew out of events from the 1980s, and the criminal charge arose in connection with a payment dispute from twenty-five years ago between Kilpatrick, who was building houses at the time, and one of his subcontractors.
Kilpatrick has taken steps to remedy false answers on any applications he submitted, including writing letters to each state on whose application he made a false statement. Kilpatrick seemed genuinely remorseful for not having disclosed in the first instance details of his past that he wishes to forget. The Court found this entire line of cross-examination to be unhelpful in determining whether the 184 appraisals are credible as measured by USPAP and in determining the weight to give to Kilpatrick's expert testimony — specifically, to his GAVM methodology and his CAM findings.
The CAM findings were not the only circumstantial evidence of subjective falsity offered by FHFA. The above-mentioned 2007 petition sent to Congress by approximately 11,000 appraisers complained of perceived pressure to produce inflated appraisals and represented their belief that great damage was being done to the economy and homeowners. The petition is an extraordinary document. Eleven thousand citizens were willing to affix their signatures to a document to bring a problem in their very profession to the attention of their national legislature. The reputational risk of signing such a document was enormous. Of the 11,000 signatories, there were 33 appraisers who had conducted 35 of the appraisals on the Sample properties. Of the 35 appraisals, 11 were subjected to the CAM methodology and 10 of the 11 were determined by Kilpatrick to be non-credible.
Notably, Hedden had been aware of the petition when it was circulated in 2007 and reported that he was not surprised when he learned of its existence, because pressure from interested parties is simply "part of what appraisers are faced with on a regular basis." Indeed, Hedden commented that the signatories "were right to have gone to Washington to say there is pressure out here and it's not a good thing." That being said, Hedden like every other appraiser at trial testified that he had "yet to find any real evidence" of people having "actually succumbed to the pressure." The 184 appraisals are evidence to the contrary.
Defendants' expert Kennedy also testified that it was general knowledge in the field that pressure was exerted on appraisers to inflate their appraisals during the time period relevant to this case. In fact, pressure on appraisers was discussed at conferences at which Kennedy spoke, and, as noted above, in 2007 he was quoted in the Magazine of Real Estate Finance as saying that "[t]here is going to be a backlash against traditional appraisal processes because of inherent biases as this meltdown continues forward."
The widespread phenomenon of shifting appraisal values up to at least match sales prices functions as further confirmatory evidence of pervasive pressure in the industry leading to bad faith appraisals. According to the USPAP itself, "accepting an assignment with the price in an agreement of sale, option, or listing or a sale price in a settled transaction as a predetermined value in the assignment violates USPAP." Where an appraiser is performing an appraisal in connection with a sales transaction in which a property is being purchased (as opposed to the refinancing of an existing loan), although the appraiser is required to receive and analyze the sales contract, the appraiser is expected to perform his or her own objective assessment of the true market value of the property and should not "back into" a sales number.
Despite that principle, the appraised value exactly matched the sales price for 97 of the 306 (or 32%) purchase-money mortgages in the Sample. This high proportion of appraisals matching perfectly with the predetermined sales amount is confirmatory circumstantial evidence that appraisers failed to provide truly independent valuations,
In an effort to diminish the probative value of FHFA's appraisal evidence, defendants called four appraisers. The idea, presumably, was to show that, although the CAM labeled these appraisals "non-credible," the appraisals were defensible and the appraisers honestly believed in the appraised values at the time they were rendered. This project largely backfired. Taken together, the testimony from the four appraisers actually had the effect of confirming the reliability of the CAM and the evidence that the appraisers who performed the 184 appraisals did not actually believe in the valuation work reflected in their reports. Thus, their uniform testimony that they stood behind their appraisals counted for little.
Two of the four witnesses did not actually conduct the appraisals; their role was to review the work of less experienced appraisers. Schall is the owner of Island Preferred Inc. Appraisal and Marketing Solutions, located in New York.
Like Schall, it turned out that Clagett, from Berlin, Maryland, did not perform the original appraisal at issue.
The two witnesses who actually performed the appraisals at issue were from Florida. Morris is from Homestead, Florida and performed one of the 184 appraisals that failed the CAM. She explained that the contract price for the property was $310,000, but that she offered a lower appraised value — $305,000. The GAVM estimated the value of the property at the relevant time as $217,952.
Platt, from Melbourne, Florida, also completed one of the 184 appraisals that failed the CAM analysis. Platt appraised the property at $170,000, whereas the GAVM estimated the value at $93,314.
The appraiser witnesses confirmed the existence of pressure on appraisers in the period at issue to reach predetermined values of properties. Schall identified three of the signatories on the petition as appraisers who had once been associated with his company; he admitted that both he and his staff "experienced pressure to provide predetermined appraisal values." For his part, Platt had been trained by an appraiser who signed the petition. At the time that Platt performed the appraisal here, he worked for a company at which 90% of the appraisal work was conducted for mortgage lenders and financial institutions. Morris testified to having experienced, throughout her whole career, pressure to provide predetermined value opinions to avoid being blacklisted. Morris added, however, that adoption of the Home Valuation Code of Conduct, described above, helped reduce this pressure. When questioned by defense counsel, however, Morris backtracked and explained that the pressure was "not very extensive at all." Not altogether surprisingly, each of the witnesses who described this pervasive pressure to deliver a predetermined appraisal figure, adamantly denied that he or she had ever succumbed to that pressure or knew anyone who had.
The credibility of their work as appraisers and their testimony as witnesses was undercut by other exaggerations. They performed hundreds of appraisals apiece each year during the housing boom, but assured the Court that they never took shortcuts and in fact spent many hours on each and every appraisal. Clagett reported that he performed more than 700 appraisals each year in the period of 2005 to 2008, and took about five to six hours on each of them. Platt performed about 300 to 400 appraisals each year in 2005 and 2006, taking a minimum of four to five hours to perform each one despite the fact that he was also working fulltime as a fireman. For the period of 2004 through 2008, Morris conducted approximately 600 appraisals per year, which is about 12 per week. To justify those numbers, Morris claimed to have worked long hours seven days a week.
Finally, it is worth noting that Morris provided testimony that directly contradicted defendants' expert Hedden's characterization of the function of an appraisal. Morris readily agreed that "it is important for an appraiser to reach an independent valuation of the subject property," that an appraiser is not meant to start with the presumption that the sales price is the price at which she should arrive, and that it would be improper for an appraiser to simply "back into" the sales price. Confronted with Advisory Opinion 19 of the 2006 edition of USPAP, Morris finally agreed that USPAP itself provides that "accepting an assignment with the ... sale price in a settled transaction as a predetermined value in the assignment violates USPAP." Similarly, Morris agreed with the following statement from the Appraisal Institute: "We take offense with the notion that an appraisal is only good if it happens
As explained above, during the securitization process defendants performed valuation diligence on some of the properties by running an AVM and/or using a BPO. As noted, defendants' expert Mishol found that 10% of all the loans in the SLGs that were actually tested through a full valuation review had a final LTV ratio of more than 100%. Although this figure cannot be extrapolated, it provides further confirmatory evidence of the Court's findings with respect to appraisal defects.
Yet even when defendants arrived, following those processes, at a "reconciled value" different from the original appraised value, defendants never entered such values in the LMS system, and never relied on such values in creating disclosures for the Prospectus Supplements. The Prospectus Supplements informed investors that the LTV ratios were calculated using "the lesser of (a) the appraised value determined in an appraisal obtained by the originator at origination of that loan and (b) the sales price for that property." To avoid relying on a number they had reason to believe was false, defendants could have also included the reconciled value as a third option if it was lower than either the original appraised value or the sales price. They chose not to do so.
In sum, FHFA proved that 184 appraisals did not accurately reflect the value of the appraised property and that the appraisers who conducted them did not subjectively believe in the values they rendered. The appraisal evidence showed a substantial increase in the number of LTV ratios appearing above both 80% and 100% compared to the figures disclosed in the Collateral Tables of the seven Prospectus Supplements.
A second category of misrepresentations alleged by FHFA concerns representations regarding the origination and underwriting of the loans within the SLGs backing the Certificates. FHFA established that the originators deviated significantly from their own underwriting guidelines when approving the loans in the SLGs, and that those deviations were not offset by factors that compensated for the deviations. For this reason, the representations in the Supplements regarding underwriting were false.
The deviations FHFA established were not trivial. They went to the heart of the underwriting process. Because of these deviations, originators had no adequate basis to find, for far too many of the borrowers, that the borrower was credit-worthy, had the ability and desire to make the mortgage payments, or that the collateral for the loan was adequate, among other things. The loan files and other documents demonstrate just the opposite. Borrowers misrepresented their income, credit history and assets, and their relationship to the property, or originators ignored obvious red flags that, when investigated, would have led to a denial or modification of the loan.
Measured conservatively, the deviations from originators' guidelines made anywhere from 45% to 59% of the loans in each SLG materially defective, with underwriting defects that substantially increased the credit risk of the loan. The table below shows, by Securitization, the Court's conclusions regarding the proportion of
SECURITIZATION SAMPLE SIZE NUMBER MATERIALLY DEFECTIVE PERCENTAGE MATERIALLY DEFECTIVE NAA 2005-AR6 131 61 47% NHELI 2006-FM1 100 59 59% NHELI 2006-HE3 99 50 55% NHELI 2006-FM2 100 53 53% NHELI 2007-1 98 46 47% NHELI 2007-2 98 49 50% NHELI 2007-3 97 44 45% TOTAL 723117 362 50%
The principal trial evidence from which these conclusions and data are drawn are the loan files for the 723 Sample loans, associated documents, and the parties' expert analyses.
After a description of the process that FHFA's expert used to conduct his analysis of the loans, defendants' principal critiques of that process will be discussed. Then, the process the Court used to arrive at the calculations described above will be explained.
Before embarking on these descriptions of the evidence and process, however, it is important to observe that defendants' response to Hunter mirrors their response to Kilpatrick. Defendants have not presented affirmative evidence that the originators of the loans actually complied with their own underwriting guidelines when originating loans, or with even the more summary descriptions of the underwriting process contained in the Prospectus Supplements. They did not identify their own sample of loans drawn from the SLGs and have an underwriting expert assess the originators' compliance with underwriting guidelines; and they did not have their own expert re-underwrite FHFA's Sample loans.
Hunter conducted a forensic re-underwriting review of 723 of the 796 Sample loans. The number 723 includes either 100 or close to 100 of the Sample loans for six of the seven SLGs, and 131 Sample loans for the relevant SLG in NAA 2005-AR6.
In his review, Hunter compared the loan file for each loan to the originator's guidelines and, in some instances, to minimum industry standards ("Minimum Standards") that Hunter distilled from the many guidelines he examined and from his professional experience. Hunter's review was holistic, taking into account both the ways in which a loan application did not meet an originator's underwriting guidelines and any factors that might excuse or compensate for that failure. Even when there was no documentation in the loan file that reflected compensating factors considered by the originator, Hunter made his own examination and would not enter a finding of a defect where he determined that adequate compensating factors existed. After completing each review, Hunter determined the impact of any identified underwriting defects on the credit risk of the loan, ultimately identifying a subgroup of 482 loans that were, in his judgment, materially defective.
Where FHFA and defendants stipulated that a set of documents was the best representation of a Sample loan file, Hunter used that file for his review. Where there was no stipulation, Hunter pursued a re-underwriting review if the file contained at least 100 pages and a significant number of seven core documents.
Where the parties did not stipulate to an applicable set of underwriting guidelines, Hunter attempted to use originators' guidelines that were dated between 30 to 90 days prior to the closing of the loan. In the case of 37 loans, the originators' relevant guidelines were unavailable, and Hunter relied exclusively on the Minimum Standards to re-underwrite the loan. On occasion, Hunter used the Minimum Standards to supplement an originator's guidelines. In total, Hunter used the Minimum Standards in re-underwriting 180 of the 723 loans; only 240 of Hunter's 1,998 defect findings are premised on the Minimum Standards.
Hunter's 59 Minimum Standards were the most lenient standards employed for subprime and Alt-A loans between 2002 and 2007.
Hunter concluded that 87% of the 723 Sample loans that he examined had at least one guideline defect, and almost 66% had an increased credit risk because of the defects.
Defendants' principal attack on Hunter's findings came in the form of expert testimony from Forester. Based on his teams' audit of Hunter's findings,
Forester made several critical choices that weakened the value of his testimony. The most prominent of these errors was his choice to ignore available documentation outside the loan file because such documentation was not in the loan file. Forester took this position even when the documents demonstrated that the borrower had lied to the originator and a diligent originator could have uncovered the deceit.
A second major flaw is related to the first. Forester presumes that the originator investigated all red flags appearing in the loan files. This is true even when such an investigation should have prevented the loan from issuing because the investigation would have disclosed that the borrower was not being truthful, had substantial additional debt, was not going to occupy the home despite representing that it would be her primary residence, or was not currently living in the home she was seeking to
Forester's presumption that the originator must have investigated the red flags in the loan file, even when there is no evidence that the originator did so, rests on defendants' assertion that the passage of time has made it difficult to locate a complete loan file. It is certainly true that the collection of loan files in 2012 and 2013 for loans originated between 2005 and 2007 has proven to be challenging. Even when it was the practice to image loan files and store them electronically, pages may be missing. Handwritten notes made at the time of origination on the back of a document before the document was imaged could also be missing. But Forester essentially presumed that all originators were diligent even when there is overwhelming evidence to the contrary.
This approach fails to grapple with two critical points. Underwriting guidelines required that red flags be investigated and that exceptions to underwriting criteria be documented. Documentation was critical so that supervisors and each of the units within an originator, including its auditors, could examine the file and determine what had been done. Documentation was also critical because these loans were originated to be sold, and the file would be leaving the originator's offices. It is, therefore, improbable in the extreme — and untenable to presume — that every originator diligently followed up on all red flags and merely failed to document its efforts. Moreover, Forester's presumption fails to survive Hunter's careful analysis showing not just the existence of red flags, but also the existence of material information that would have been available to the originator if those red flags had been investigated and that would have led in the ordinary course to the loan being issued (if at all) on different terms.
A third overarching problem with Forester's analysis relates to missing underwriting guidelines. Although it is undisputed that every originator had written underwriting guidelines, Forester refused to offer any substantive critique of Hunter's findings emanating from his use of the Minimum Standards. Instead, Forester automatically "cleared" all associated defects. For similar reasons, Forester cleared defects associated with some loans underwritten under Nomura's own guidelines.
Another overarching problem is that Forester (as was also true for Hedden's testimony regarding appraisals) did not make a holistic evaluation of each loan. It is not uncommon for a loan with one serious defect to have several serious defects, reflecting a wholesale abandonment of any genuine underwriting effort. Thus, considered in the context of Hunter's entire analysis of a defective loan, many of Forester's
Defendants have made many objections to Hunter's analysis. The five most important of those objections are addressed below.
Defendants argue that Hunter applied the originators' guidelines too strictly. Defendants assert that, in doing so, Hunter improperly substituted his own judgment for the judgment of the originators, who were applying the "customs and practice" of their industry in the "real world" as it existed in 2005 to 2007. Defendants point to the emphasis in certain originator's guidelines that loans should be originated using a "common-sense approach," that brokers should originate "loans that make sense," and that the objective of underwriting should be evaluation of "the borrower's overall credit and capacity."
Defendants are wrong for many reasons. First, they mischaracterize Hunter's methodology: Hunter did not "nitpick"; rather, he consistently applied the originators' guidelines as written. And "common sense" is, in virtually every instance, on Hunter's side when one examines a specific loan. Repeatedly, the borrower lacks "overall credit and capacity," there are so many red flags or deficiencies that common sense counsels against origination, or there are defects that cannot be cured, such as a borrower's misrepresentation of income or debt. It is also no criticism of Hunter to say that he was stricter in applying an originator's guidelines than the originator itself where the originator ignored its guidelines. Tellingly, if defendants believed that a more flexible re-underwriting approach would have been tenable and productive for them, they had the opportunity to conduct such a review and present their findings.
Defendants object to Hunter's reliance on Minimum Standards in his re-underwriting. But it is undisputed, even if they cannot now be located, that each of the originators had written underwriting guidelines at the time that they issued the loans. Underwriting guidelines gave structure to the inquiries conducted by many individual underwriters in the many offices of an originator and allowed originators to sell mortgage loans in pools with a single set of representations about the quality of the underwriting process and the loans' characteristics.
Where an originator's guidelines had not been located by the parties, or where an originator's located guidelines assumed (in Hunter's view) that a particular step in the underwriting process had been taken, Hunter relied on the Minimum Standards. With perhaps a single exception,
The confirmation of the existence of the 59 Minimum Standards came from every conceivable source, including from defendants' trial witnesses, defendants' business records, and the many origination guidelines received into evidence and relied upon by the trial witnesses, including the guidelines from the ten originators that
For example, in February 2006, Nomura's due diligence unit identified subprime originators' "common Mortgage Underwriting criteria" as including DTI ratio over 55%, FICO scores over 500, and LTV ratios less than 100%. These same criteria showed up in Nomura's 2006 bid stipulations. At trial, the head of a Nomura unit confirmed the existence of every Minimum Standard on which he was questioned, which was dozens.
At trial, defendants largely confined their attack on the 59 Minimum Standards to just three. Defendants focused most of their attention on the Minimum Standard that provides that a borrower's DTI ratio may not exceed 55%. Nomura's bid stipulations required exactly that, as did the guidelines of many originators. Five of the Prospectus Supplements explain, however, that some originators permitted on a case-by-case basis DTI ratios of up to 60%.
A second Minimum Standard on which defendants focused requires an underwriter to examine "payment shock," which is defined as existing when a borrower's new payment obligation will exceed "150 percent of the borrower's current housing expense." Some originators' guidelines, however, permitted payment shock of up to 200%, while others included nothing on the issue at all. But the guidelines permitting a 200% payment shock did so only when compensating factors existed. In any event, Hunter used the Minimum Standard regarding payment shock as a red flag to trigger a close examination for compensating factors.
Finally, defendants were critical of the Minimum Standard that a "lender must investigate whether the borrower sought (and/or obtained) credit that was not listed on the borrower's origination credit report," and that such "investigation include an inquiry into any credit inquiries within 90 days preceding the loan application." (Emphasis added.) But, it was a universally acknowledged requirement in the relevant period that originators had to obtain a borrower's credit report before issuing a subprime or Alt-A loan, examine it, and investigate red flags. Defense counsel admitted as much at summation. Boiled down to its essence, the parties' disagreement was limited to whether originators had to examine every credit inquiry made close to the time a borrower applied for the mortgage loan, since some of those inquiries may reflect no more than a borrower
Many of the loans within the SLGs were "stated income" loans. This fact was so significant to investors that the Prospectus Supplements presented data regarding the proportion of such loans in the SLGs. Defendants contend that Hunter should not have rejected the stated income as unreasonable for 75 such loans. They principally complain that in doing so Hunter relied on historical data from the U.S. Bureau of Labor Statistics ("BLS"), which the originators did not use.
If a mortgage loan was issued pursuant to a stated-income program, then the borrower did not have to provide documentation, such as tax returns or pay stubs, to verify her report of income. But that did not relieve originators of their obligation to assess whether the borrower was credit-worthy and capable of repaying the loan. Therefore, originators' guidelines required underwriters to verify the reasonableness of the stated income by, for instance, verifying employment.
During the period between 2005 and 2007, there were some online tools with local wage data for certain occupations that were available to originators. Those databases contain only current data, however, and do not permit a search to be conducted in 2015 to confirm wage rates eight to ten years ago. Accordingly, as part of his examination of the reasonableness of stated income, Hunter relied on historical BLS data.
BLS data is collected by the federal government based on survey responses from employers. The reported statistics come from a large sample collected over three years; data from the previous three years are combined annually to estimate salaries for the previous year. BLS data are extremely granular: They provide by percentile the salaries for a vast number of specific occupations in various industries, and the salaries are available on a national, regional, state, or county-wide basis. The BLS statistics do not reflect salary ranges above $187,200 and do not include categories of earnings other than wages, such as bonuses and tips. As defendants point out, the Commissioner of the BLS has stated that BLS data is not a tool for establishing "prevailing wages" — the average salaries actually paid to workers in a given occupation and region — and cannot identify any particular employer's wage rates.
Defendants overstate Hunter's reliance on BLS data. To assess the reasonableness of borrowers' income, Hunter examined all of the information in the loan file about a borrower's education, employment, and duration of employment, and reviewed the borrower's assets, liabilities, and disposable income.
One of the alleged misrepresentations on which FHFA relied in filing this action was the representation in the Prospectus Supplements that a reported percentage of the properties were owner occupied as of the Cut-off Date. Defendants assert that, for several reasons, the Court should ignore Hunter's analysis of borrowers' occupancy status.
It is universally recognized that owner occupancy is a critical factor in assessing credit risk. Mortgage lenders and investors understand that borrowers have a greater incentive to make their mortgage payments when the failure to do so risks the loss of the family home. Thus, originators offer loans for borrowers that are or will be using the property as their primary residence on different terms than borrowers who own or seek to own the property as a second home or as an investment. For example, an originator might have a lower LTV/CLTV ceiling for investment properties. Accordingly, a borrower's statement that she is living in the home she seeks to refinance or that she intends to live in the home she is buying with the mortgage money are important representations and originators may not ignore red flags indicating that a borrower is misrepresenting owner-occupancy status.
Defendants do not take issue with any of these observations. They did attempt at trial, however, to demonstrate that Hunter misidentified five of forty-two loans as loans reflecting owner-occupancy misrepresentations. In fact, defendants succeeded in raising serious questions about only one of the five.
Defendants have a second, more theoretical complaint about Hunter's analysis of owner occupancy. For those mortgages that were being used to buy a primary residence (as opposed to refinance one), defendants contend that everyone, including investors, understood that the data in the Collateral Tables referred to nothing more than a borrower's "intent" to occupy the property at the time a loan is originated. There are two observations to be made about this.
First, defendants do not indicate how many of the forty-two loans with identified owner-occupancy defects were "purchasemoney" loans. Most of the examples they used at trial in examining Hunter were refinancing loans. As defendants admitted at trial, originators should have verified that borrowers were actually occupying the properties they were seeking to refinance as their purported primary residence.
Second, defendants are wrong about the import of the representation in the Prospectus Supplements. As previously explained, the Supplements represent owner-occupancy status as of the Cut-off Date. FHFA v. Nomura Holding Am., Inc. ("Owner-Occupancy Opinion"), No. 11cv6201 (DLC), 2015 WL 394072, at *3-4 (S.D.N.Y. Jan. 29, 2015). The Supplements do not represent only a borrower's intention at the time the borrower applied for the mortgage. Id. At the time of securitization, this statement of fact is made by those issuing and underwriting the securitization. Id. Defendants do not dispute that originators had an obligation to chase down any red flags indicating that a borrower
Finally, Forester argues that the evidence that originators chased down all the red flags and confirmed occupancy status may simply be missing from the loan file. A determination of whether red flags regarding occupancy status existed and whether they were investigated may be made only on a loan by loan basis, and this the Court has done.
Defendants object to Hunter's consultation of documents that were not in existence at the time of loan origination. Defendants calculate that Hunter's reliance on such documents "affected" 289 loans. It was entirely appropriate for Hunter to rely on post-origination evidence when making a finding of an underwriting defect.
Broadly speaking, there are two kinds of post-origination evidence at issue here. One kind is documents generated in the present containing the very same information that an originator could have been obtained or generated back in 2005 to 2007. A credit report is an example of such a document; a report generated in 2015 contains entries dating back years that would have been seen in a credit report printed out then.
With respect to this category of documents, defendants emphasize that at least some of the post-origination documents contain disclaimers regarding accuracy. For example, the LexisNexis Accurint reports — which Hunter uses for 15 loans — compile data from third party sources and contain the following disclaimer:
Such stock disclaimers, however, do not render these reports devoid of evidentiary value or make them inadmissible. Indeed, defendants themselves routinely rely on such reports. Forester also relies on such reports in conducting post-origination loan reviews as part of his ordinary business.
A second kind of post-origination evidence is information that came into existence after the origination and securitization of the loan and that would not have been available to even the most diligent underwriter. For example, a 2014 bankruptcy filing may contain a list of residences and be compelling evidence that the borrower never occupied the property for which the mortgage loan was issued. Defendants contend that the Prospectus Supplements only referred to an originator's process of adhering to its underwriting guidelines and did not assure investors that the loans actually met the criteria within those guidelines. Accordingly, they argue, a statement cannot be shown to be false based on evidence unavailable to the originator.
It was entirely appropriate for FHFA to rely on such post-origination evidence. As previously explained in addressing a Daubert motion, FHFA has the burden to prove the falsity of the representations it
Hunter Opinion, 74 F.Supp.3d at 653, 2015 WL 568788, at *10. If defendants had been able to present an affirmative defense of due diligence at trial, then the historical unavailability of the information would be relevant.
In an attempt to cast doubt on Hunter's analysis, defendants also offered, through current and former employees, the deposition testimony of four originators regarding their underwriting practices. They are Fremont, Quicken, Wells Fargo, and WMC.
Three originators were only minor contributors of loans to the relevant SLGs. When the record of Nomura's own due diligence performed on the originators' Trade Pools is examined, there is no reason to believe that these loans were any more free of defective underwriting than the other loans in the SLGs. Wells Fargo, for example, contributed only 8 loans to the NHELI 2007-2 SLG. None of these received credit and compliance due diligence, and of the two that received valuation due diligence, one original appraisal was deemed unreliable. WMC contributed 148 of the loans in the NHELI 2007-3 SLG. WMC's sole Trade Pool had a kick-out rate of approximately one-third. Quicken contributed 129 loans to the SLGs in NHELI 2006-HE3 and NHELI 2007-2. Almost half of the Quicken loans subjected to credit and compliance due diligence by Nomura were waived in by Nomura after an initial finding of credit defects. Confirming Quicken's poor underwriting practices, Hunter found numerous serious defects in those Quicken loans that were sampled. Under these circumstances, it is impossible to credit Quicken's assertion that "overall we had a very low defect rate."
The remaining originator is Fremont, which is the sole originator for NHELI 2006-FM1 and NHELI 2006-FM2. The Fremont deponent was not an underwriter but a securitization structurer working in the capital markets group. His sanguine descriptions of Fremont's quality-control processes are starkly contradicted by the results of not only FHFA's re-underwriting review of the Fremont SLGs, but by defendants' own experience with Fremont.
As just described, defendants made a strategic choice to present a series of discrete attacks on Hunter's methodology. They sought to so thoroughly undermine confidence in Hunter's re-underwriting program that it could be rejected wholesale. By the time of summation defendants made their position explicit. They argued that the Court should reject Hunter's analysis in its entirety because he had not sufficiently disaggregated his findings. According to defendants, only an expert can make a judgment about whether there was increased credit risk as a result of defects in loan origination. That, they say, is a task that may not be performed by the fact finder.
If limited to the stark choice between Hunter's expert testimony and Forester's, the Court would unhesitatingly accept Hunter's. Hunter engaged in a careful loan by loan analysis. His methodology was essentially sound. He was an impressive witness, with intimate familiarity with the task he had undertaken and the reasons for his decisions. He responded forthrightly to defense counsel during cross examination. In contrast, Forester was not as well-informed about the files at issue here or even all aspects of his teams' work. Many of his critiques of Hunter's analysis failed because Forester imposed too narrow a scope on his assignment. Finally, because Forester did not take a holistic approach and examine loan-by-loan the credit risk associated with all re-underwriting defects, his potshots at Hunter's methodology made it impossible to evaluate their actual impact on the material defect rates for an SLG.
But there is no need to limit artificially a fact finder's review of record evidence. A defective loan could have so many separate underwriting defects that it would still be materially defective even if one or more of Forester's arguments was compelling. The Court's review of the record evidence has confirmed that Hunter's analysis was essentially sound.
Informed by the testimony given by both Hunter and Forester and other trial evidence, the Court reviewed each of Forester's Dashboard Reports for the 482 loans that Hunter determined was materially defective. A Dashboard Report, which Forester's teams created for each loan, consists of a cover page describing significant characteristics of the loan and several additional pages in which Hunter's detailed findings — reproduced verbatim in the Dashboard from the spreadsheet Hunter created — are juxtaposed with the detailed responses from Forester's teams. The Dashboard Reports also list all potential compensating factors identified by Forester and his teams. These documents — along with the original loan files and underwriting guidelines — were available for the Court's loan-by-loan, defect-by-defect review.
Each Dashboard Report was reviewed, and the merit of each of the experts' arguments about the compliance or non-compliance of each loan with the originator's underwriting guidelines was assessed. The Court made several assumptions, however, in performing this review. First, only the 184 loans that Kilpatrick concluded failed the CAM were considered to have appraisal defects, as opposed to the larger number identified by Hunter as defective based on the GAVM. Second, Hunter's
During the loan-by-loan analysis, the Court was alert to any assertion in the Dashboard Reports that Hunter had made calculation errors,
When the Court's review was complete, the Court was able to confirm, as reported in the beginning of this section of the Opinion, Hunter's findings of material credit risk due to deviations from originators' guidelines for approximately 50% of the loans in the SLGs. For 44 of these loans, the material defects confirmed by the Court were violations of Minimum Standards. Of these 44, Hunter relied exclusively on his Minimum Standards in the case of just 13. For the rest, Hunter used the Minimum Standards to supplement an originator's located guidelines. Hunter's findings of a material failure to comply with Minimum Standards were entirely appropriate in each of these instances, and defendants' Dashboard Reports identified no compensating factors that could have permitted a reasonable originator to find the borrower credit-worthy.
Similarly, defendants' complaints about owner-occupancy defects proved to be largely irrelevant. Hunter's owner-occupancy defect finding was a decisive factor for only two of the loans supporting the Court's findings. While valid owner-occupancy defects were present in other loans, those findings by Hunter were just one of several serious problems with the loan that contributed to its risk. The breakdown by SLG of all owner-occupancy defects as found by the Court was as follows:
SECURITIZATION SAMPLE SIZE NUMBER WITH OWNER-OCCUPANCY PERCENTAGE DEFECT WITH OWNER-OCCUPANCY DEFECTS NAA 2005-AR6 131 0 0.00% NHELI 2006-FM1 100 3 3.00% NHELI 2006-FM2 100 3 3.00% NHELI 2006-HE3 99 1 1.01% NHELI 2007-1 98 0 0.00% NHELI 2007-2 98 1 1.02% NHELI 2007-3 97 3 3.09% TOTAL 723 11 1.52%
The contention by defendants during summation that the Court should not examine their Dashboard Reports to ascertain the extent to which their generalized, thematic attacks on Hunter's work had any impact on Hunter's evaluation of credit risk of a particular loan is not surprising.
Whether one accepts Hunter's conclusion that 66% of the Sample loans had underwriting defects that materially affected credit risk, or the Court's more conservative, confirmatory review that indicated that at least 45% per SLG did, the only possible conclusion is this: The Certificates sold to the GSEs were supported by loans for which the underwriting process had failed. Guidelines were systematically disregarded. These loans could not be accurately described as having been "originated generally in accordance" with originators' guidelines.
FHFA also alleges misrepresentations regarding the credit ratings of the Certificates. FHFA has shown falsity on this claim as well.
According to FHFA, the AAA or equivalent credit ratings assigned by the rating agencies were inflated and did not in fact apply to each Securitization's collateral, since defendants provided the rating agencies incorrect data regarding the loan population. As this Court has previously remarked, FHFA's claim "is not that the ratings themselves were false. [Instead,] FHFA challenges representations in the Offering Materials that the reported credit rating related to the actual loan collateral for the securitization." FHFA v. Merrill Lynch & Co., 903 F.Supp.2d 274, 276 n. 2 (S.D.N.Y.2012).
As noted above, Nomura provided rating agencies with pre-closing loan tapes created from Nomura's LMS database, which reported data for each loan, including characteristics such as FICO score, DTI ratio, LTV/CLTV ratio, loan purpose, property type, interest rate, owner-occupancy status, documentation program, and presence of mortgage insurance. The ratings and loss estimates generated by the rating agencies' models were extremely sensitive to the data on these loan tapes; if incorrect data were used — data reflecting
FHFA's allegation regarding credit ratings is largely derivative of its claims with respect to LTV ratios and guideline compliance. FHFA v. Ally Fin. Inc., No. 11cv7010 (DLC), 2012 WL 6616061, at *1 n. 2 (S.D.N.Y. Dec. 19, 2012). As a result, the Court's findings above with respect to those categories of misrepresentations greatly impact its findings here. The number of misreported LTV ratios per SLG ranged from 18% to 36%. Many of these misrepresented LTV ratios moved the ratio into a range between 80% and 100% or even above 100%. Similarly, the Court's findings of a rate of 45% or higher material underwriting defects in each SLG cast serious doubt on the accuracy of the loan tape data provided to the rating agencies regarding such critical data points as the DTI ratio, among other things.
Moreover, the Deloitte AUP reviews put defendants on notice that around 10% of the loans in each sample that Deloitte reviewed had discrepant loan tape data or were missing documentation necessary for the review. Hunter also performed a pre-closing loan tape review, comparing the information in the loan file against the information contained in the pre-closing loan tapes. He found that of 723 total loans reviewed, 321 (or 44%) had pre-closing loan tape defects and substantially increased credit risk. The breakdown per SLG ranged from 36% to 52%.
With this much inaccuracy in the loan tapes, FHFA has easily shown that the Prospectus Supplements misrepresented that the reported credit ratings related to the actual loan collateral for the Securitizations. As discussed next, those misrepresentations were material.
The representations in the Prospectus Supplements regarding both the LTV ratios for the loans within an SLG and the extent to which those loans were originated in compliance with underwriting guidelines, were each false and materially so. The Supplements contained utterly misleading descriptions of the quality and nature of the loans supporting the GSEs' Certificates. The LTV ratios for 18% or more of the loans within the relevant SLG were misrepresented in each of the seven Prospectus Supplements. The compliance with underwriting guidelines for 45% or more of the loans within the relevant SLG was misrepresented in each of the seven Prospectus Supplements. Because, as explained above, the data on the loan tapes reporting LTV and DTI ratios, among other data points, was significantly misstated, the credit rating agencies received materially false information that had a direct impact on their assignment of credit ratings to each of the Certificates, causing the Prospectus Supplements to make material misrepresentations about credit ratings as well. But while FHFA succeeded in showing that each of these three sets of misrepresentations was material, it has not shown that the misrepresentations regarding owner occupancy were material.
The standard for assessing materiality in connection with these claims can be found in the Offering Documents. All seven Prospectus Supplements provided that
There is no real dispute that the 5% materiality threshold has been exceeded here. Defendants' own witnesses confirmed misstatements at or above the 5% threshold. Forester essentially conceded that Hunter's findings of material underwriting defects appeared appropriate for slightly more than 5% of the loans in the Sample, and, according to defendants' data, used by Mishol, 10% of all the loans in the SLGs that were actually tested through a full valuation review had a final LTV ratio of more than 100%.
Reasonable investors in the PLS market during the period 2005 to 2007 considered a broad range of information prior to purchase. But an essential component of any analysis was the characteristics of the collateral, as described by sponsors and underwriters in the Offering Documents. Among the key characteristics were LTV ratios and compliance with underwriting guidelines.
It is not disputed that LTV ratios were critical to PLS investors in evaluating the risk profile of a loan. In fact, as Nomura's LaRocca explained, information like LTV ratios was included in the Offering Documents because investors and rating agencies requested that specific information from Nomura. The most important LTV thresholds were the 80% and 100% thresholds. Nomura witnesses testified that Nomura would not buy or securitize loans with LTV ratios greater than 100%; they understood that RMBS investors during the 2005 to 2007 period found such loans unacceptable. Similarly, loans with an 80% or higher LTV ratio presented a greater risk of loss than loans with lower LTV ratios; reflecting that increased risk, borrowers were required to obtain mortgage insurance. Here, the Offering Documents not only misstated LTV ratios, they made dramatic misrepresentations regarding the number of loans with ratios above 80% and above 100%.
Investors were not the only parties relying on LTV disclosures. The credit rating agencies used these same statistics to assess credit risk and determine the minimum levels of required subordination for AAA ratings.
Schwert's regression analysis confirmed the significance of LTV data to the structural subordination of RMBS. Schwert's model demonstrated the intuitive proposition that if the underlying collateral is
As defendants' witnesses also acknowledged, whether loans were actually underwritten in compliance with guidelines was extremely significant to investors. Compliance with underwriting guidelines ensures, among other things, an accurate calculation of the borrower's DTI ratio, which is a critical data point in the evaluation of a loan's risk profile. As defendants' expert Vandell admitted, the very purpose of loan origination guidelines is to control the risk of default in an appropriate fashion. Forester, for his part, conceded that there is a higher likelihood of default for loans that do not meet guidelines unless sufficient and appropriate compensating factors are present.
Not surprisingly, rating agencies require representations about guideline compliance to ensure that the loans supporting a securitization are legitimate and qualified. According to credit rating company witnesses, the representation that the loans were originated in accordance with guidelines was and still is standard in the industry.
In deciding whether to purchase a PLS, the credit rating of a certificate is highly important to investors. Investment-grade securities such as those at issue here are predominantly held by investors that tend to be averse to the risk of portfolio losses. Indeed, many institutional investors have internal investment requirements that prohibit them from investing in securities that are not rated investment-grade. A Freddie Mac policy required that PLS be rated by at least two of four named rating agencies as AAA. Fannie Mae had a similar policy, providing that PLS must have a minimum rating of AAA by at least one of S & P or Moody's.
During summations, defendants noted that the relevant question on materiality is not whether particular attributes, such as LTV ratios, are material, but rather whether the difference between the actual disclosures about those attributes and what FHFA alleges should have been disclosed is material. In other words, the question is whether the "delta" — the difference between what was reported and what was true — would have been viewed by a reasonable investor as having significantly altered the total mix of information made available. In this case, there was overwhelming evidence of materiality when viewed as the delta between the representations and the facts established at trial.
Defendants offered at trial a loss causation defense. They argued, in essence, that any losses experienced by the Certificates were caused by market factors and not by any misrepresentations in the Offering Documents.
To support the defense, defendants offered evidence regarding the rise and decline in housing prices and other economic conditions at the beginning of this century, and it is to that chapter of American history that this Opinion now turns. The evidence at trial, including expert testimony, as well as common sense drive a single conclusion. Shoddy origination practices that are at the heart of this lawsuit were part and parcel of the story of the housing bubble and the economic collapse that followed when that bubble burst. While that history is complex, and there were several contributing factors to the decline in housing prices and the recession, it is impossible to disentangle the origination practices that are at the heart of the misrepresentations at issue here from these events. Shoddily underwritten loans were more likely to default, which contributed to the collapse of the housing market, which in turn led to the default of even more shoddily underwritten loans. Thus, the origination and securitization of these defective loans not only contributed to the collapse of the housing market, the very macroeconomic factor that defendants say caused the losses, but once that collapse started, improperly underwritten loans were hit hardest and drove the collapse even further. The evidence at trial confirms the obvious: Badly written loans perform badly. In short, defendants could not propound a cause unrelated to the alleged misrepresentations.
From the closing years of the twentieth century until early 2006 or so, there was extraordinary growth in the number of homebuyers and issued mortgages and in housing construction. These phenomena were intertwined with historically low interest rates, an increase in the use of adjustable-rate mortgages ("ARM") and other mortgage products, low unemployment, and government policies encouraging homeownership. With high employment rates and low interest rates, the pool of eligible borrowers increased, and they purchased homes.
During this same period, there was a relaxation of underwriting standards for residential mortgages. Among other things, lenders issued loans to borrowers with lower credit scores and without the down payment or documentation traditionally required. Reflecting these changes, the volume of subprime lending increased dramatically. During the period 2003 to 2005 alone, the number of subprime loans nearly doubled, from 1.1 million to 1.9 million. By 2005, subprime loans represented 20% of all new mortgage loans.
The total dollar amount of outstanding PLS grew from just over $1 trillion in the first quarter of 2004 to almost $3 trillion in the second quarter of 2007. At its peak, PLS represented $2.8 trillion in outstanding RMBS.
Beginning in 2004, Freddie Mac and Fannie Mae significantly increased their own purchases of PLS. From 2003 through 2007, the two GSEs purchased more than $593 billion of subprime and Alt-A PLS. The total volume of subprime PLS during these years was close to $1.7 trillion.
The increased demand for homes led to a boom in the construction of new houses. And, during these years, housing prices soared. From January 2000 to May 2006, average home prices rose by 125%.
But these trends did not continue: The housing bubble burst. Beginning in mid-2004, the Federal Reserve began steadily increasing the targeted federal funds rate and over time mortgage interest rates rose. By mid-2006, many potential buyers could no longer afford homes. And, at least in some areas of the country, housing construction outstripped demand. By early 2006, the increase in housing prices stalled. After peaking in April 2006, housing prices began a decline and ultimately fell sharply. From April 2007 through May 2009, house prices in the United States fell by nearly 33%.
No one can forget the recession that followed and lasted one-and-a-half years, from December 2007 to June 2009, making it the longest recession since the Great Depression. GDP contracted by approximately 4.3%. Unemployment rose from 4.4% in May 2007 to 10% in the fourth quarter of 2009. Some of the headline-making events during this period were the run on Bear Stearns, which led to a government-organized rescue attempt in March 2008, and the collapse of Lehman Brothers on September 15, 2008.
These historic events, however, had roots in the contraction of the housing market, and in particular in investors' loss of confidence in the credit quality of the mortgage loans that served as collateral for their investments. On May 4, 2007, UBS shut down its internal hedge fund Dillon Read after it suffered approximately $125 million in subprime-related losses. That same month, Moody's put 62 tranches of 21 U.S. subprime deals on review for a possible downgrade. On June 7, 2007, Bear Stearns Asset Management informed investors that it was suspending redemptions from a leveraged fund that had invested in collateralized debt obligations backed by subprime loans. In June, S & P and Moody's downgraded over 100 bonds backed by second-lien subprime mortgages. And the list of negative events related to subprime investments
In retrospect, of critical importance was the August 9, 2007 announcement by BNP Paribas that it had temporarily suspended redemptions for three of its investment funds that had invested in subprime RMBS. It explained that "[t]he complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating. The situation is such that it is no longer possible to value fairly the underlying U.S. ABS assets." BNP Press Release, Aug. 9, 2007, available at http://www.bnpparibas.com/en/news/pressrelease/bnp-paribas-investment-partners-temporaly-suspends-calculation-net-asset-value-fo. Following this announcement, money market participants became reluctant to lend to each other and short-term rates increased on instruments that had previously been considered safe.
The factors contributing to the contraction of the housing market and the decline in house prices were numerous and mutually reinforcing: Higher prices and higher interest rates led to a softening of demand for homes; falling demand, coupled with oversupply, put downward pressure on house prices; and falling prices led to negative equity, which together with newly tightened underwriting standards limited the ability of homeowners to refinance existing loans. As the economy soured and unemployment soared, defaults and foreclosures increased; with the increase in defaults, investor demand for securitized mortgages collapsed.
Shoddy underwriting practices (as opposed to relaxed underwriting standards) like those at issue here contributed to both the spectacular expansion of the subprime mortgage and securitization markets and their contraction. The ability of originators to quickly sell and shift the risk of subprime loans off their books reduced their incentive to carefully screen borrowers. They approved loans that did not comply with stated underwriting guidelines and they misrepresented the quality of those loans to purchasers. Appraised values were overstated, owner occupancy was misreported, credit risk was hidden, and second liens were undisclosed. In short, these shoddy practices contributed to the housing price boom.
And, of course, those who had purchased homes during the boom years were most at risk of finding their homes "underwater" when the housing bubble burst. Their mortgage balance was greater than the sharply declining value of their home. By the end of 2009, approximately 24% of all mortgaged residential properties in the U.S. had negative equity. Defaults on mortgage obligations became more rampant. This was particularly true for subprime mortgages, where serious delinquencies increased by more than five times from mid-2005 to late-2009. At the end of that period, about 30% of subprime mortgages were delinquent.
As the following chart illustrates, the decline in housing prices was steep.
The financial crisis and recession exacerbated the housing crisis. With the increase in unemployment, the demand for housing fell and the incidence of delinquencies and defaults rose. The tightening of lending standards and the collapse of the PLS securitization market reduced the supply of credit for would-be borrowers.
Just as the shoddy and unscrupulous origination practices contributed to the housing boom, they contributed to the collapse in prices after the housing bubble burst. Originally understated LTV ratios necessarily increased the rate of defaults, as did the misrepresentations about credit status and owner occupancy. Not surprisingly, Barth found support in academic studies for his opinion that misrepresented PLS securitized loans had higher delinquency and default rates than other loans. With high delinquency and foreclosure rates, and the re-sale of foreclosed properties, more housing stock was placed on the market and housing prices became even further depressed.
Many of these problems and processes were interconnected and the cross-currents among them were numerous. They fed upon each other to create a housing boom, and they interacted to create and exacerbate the economic decline that followed that boom. The origination and securitization of shoddy mortgages — mortgages that did not meet their originators' guidelines — were among the drivers of both phenomena. As recognized by defendants' expert Vandell, to whom the Opinion now turns, the bursting of the housing price bubble triggered a financial crisis and an ensuing recession, which, in turn, further exacerbated the housing crisis.
To support their contention that it made not one whit of difference to the value of the Certificates if the Offering Documents misrepresented the quality of any or even all of the loans supporting the Certificates, given the drastic decline in housing prices and the deep recession, defendants offered benchmarking analyses. Three of those analyses were excluded prior to trial as unreliable under Daubert and Fed.R.Evid. 702. In none of the three analyses did defendants compare the performance of a
In place of the excluded analyses, the Court permitted defendants to substitute a different test. Vandell, using a multinomial cross-sectional logit model,
Another of defendants' experts, Riddiough, reviewed Vandell's analysis and opined that, after accounting for loss causation, FHFA's recovery would be equal to $0. In other words, defendants' expert evidence on loss causation presented the Court with yet another all-or-nothing proposition: Losses on the Certificates were or were not caused entirely by factors other than any material misrepresentations. Defendants made no attempt to tease out a portion of any losses.
There are at least three independent failures in Vandell's analysis. First, and much like the problem that saw his three other analyses excluded, Vandell claimed to be comparing defective loans against non-defective loans, but did not. He admitted at trial that he took no steps to ensure he actually had a "clean" set of loans for his comparison. Vandell was unaware of Hunter's testimony that the level of underwriting defects in the Sample was so severe that it was unlikely that any of the loans in the seven SLGs — including the ones for which Hunter had not identified defects — was actually free of defects. Additionally, Vandell included in his "non-defective" comparator set loans that Hunter had actually labeled defective (though not in a way that materially increased credit risk).
Second, Vandell misreported the results of his own model. The dependent variable in Vandell's multinomial logit model is
Nevertheless, Vandell only reported the estimates of the effect of defects on the likelihood of default relative to remaining current; he omitted the estimates of the effect of defects on the likelihood of prepayment relative to remaining current. Schwert reran Vandell's model to take into account both legs. The corrected analysis showed that the probability of default is, on average, nearly 10% higher for the loans that Vandell labeled "Hunter defective loans" as compared to the loans that Vandell labeled the "Hunter non-defective loans," and that the difference in default rates is statistically significant.
Vandell sat in the courtroom and listened as Schwert explained this problem with Vandell's analysis. When it came time for him to take the stand, Vandell admitted that his direct testimony was misleading. Vandell reversed himself and said that the purpose of his model was not to show the "probability" of default. When confronted with his chart entitled, "Effect of Hunter Defect on Probability of Default and Serious Delinquency," (emphasis added) Vandell admitted that "[t]hat's what it says. That's not, however, what it means."
A third failure in Vandell's analysis is that he failed to consider the impact of subordination on the losses incurred by the GSEs' Certificates. If the true characteristics of the loans had been disclosed, the Certificates would have issued with AAA ratings, if at all, only if the subordination levels had been higher than they in fact were. This bears directly on any loss causation analysis, but was ignored by Vandell.
Indeed, Schwert's testimony that there is a significant relation between AAA subordination levels of securitizations and the reported characteristics of the underlying loan collateral, including LTV ratios, went effectively unrebutted. While defendants' expert Riddiough attempted to undermine the statistical significance of Schwert's conclusion, Riddiough used the wrong method to assess statistical significance.
Defendants attempted to buttress their loss-causation defense by calling to the stand three senior GSE executives: Niculescu, Mudd, and Cook. Their testimony confirmed the obvious: The decline in housing prices was correlated with losses in the GSEs' PLS portfolio. In Mudd's view, PLS values were affected by both macroeconomic factors such as employment rates, home prices, geography, and interest rates, as well as security-specific effects, such as the underlying structure, rating, or composition of individual securities. Mudd testified that "generally the movement of housing prices downward would have a negative impact on the general value of mortgage-related assets."
Mudd was shown and agreed with a September 18, 2009 memorandum of law that was filed on behalf of Fannie Mae as a defendant in the unrelated litigation, In re Fannie Mae 2008 Securities Litigation, No. 08cv7831 (PAC) (S.D.N.Y.), which is one of several cases further discussed below. The memorandum states:
Cook testified to understanding that certain levels of losses in the underlying collateral could cause the subordination in PLS securitizations to be pierced and, if that happened, could cause Freddie to lose money. According to Cook, defaults in the underlying loans was one of the factors ultimately related to the risks of the PLS that Freddie purchased.
None of this testimony, or similar statements in documents admitted into evidence, such as motion papers filed by the GSEs and FHFA in other cases,
As already described, there was no entity or person responsible within Nomura for ensuring the accuracy of the representations in the Offering Documents that are at issue here. Each of the Nomura corporate defendants played an integral role in a seamless securitization process. They shared offices in the same headquarters in Lower Manhattan and were bound together by interlocking ownership, directors, and officers. The Individual Defendants, all of whom were Nomura officers or directors (or both), held titles of significance at the corporate defendants and signed the Registration Statements through which the Certificates were sold, but none of them understood the aspects of the securitization process that created Nomura's legal exposure in this case or took responsibility for the false statements in the Prospectus Supplements displayed so graphically at trial.
Each of the five Nomura entity defendants — NHA, Nomura Securities, NCCI, NAAC, and NHELI — were involved in the assembly, structuring and/or sale of one or more of the seven Securitizations. All are Delaware corporations with their principal places of business in New York City. FHFA seeks to hold NHA and NCCI responsible as control persons; it seeks to hold the remaining Nomura corporate entities (as well as RBS) liable as primary violators of the securities laws.
NCCI was the sponsor for all seven Securitizations, and housed Nomura's Diligence Group, the Trading Desk, and Transaction Management Group.
NHA established NCCI, and from 2005 through October 2006 wholly owned it. After October 2006, NHA owned NCCI through a new subsidiary corporation, NAMF. NCCI's directors were appointed by NHA, and those directors in turn appointed its officers.
NCCI and Nomura Securities were closely intertwined. All of NCCI's officers were also officers or employees of Nomura Securities. NCCI and Nomura Securities shared directors, officers, and employees, many of whom were also directors and officers of both NAAC and NHELI. Individuals with positions in more than one Nomura entity had identical responsibilities at each entity, and when the Due Diligence and Transaction Management Groups shifted formally to NCCI in 2006, it was without interruption or change.
NAAC and NHELI are special-purpose vehicles established for the sole purpose of participating as depositors in the RMBS process; they had no business operations
NHA indirectly wholly owned NAAC and NHELI, first through NACC and, after October 2006, through NAMF.
Nomura Securities was the underwriter or co-underwriter of three of the Securitizations: NAA 2005-AR6, NHELI 2006-FM1, and NHELI 2006-FM2. As such, it purchased the Certificates for the three Securitizations from NAAC and NHELI and sold them to the GSEs. As an underwriter, it was responsible for the accuracy of the Offering Documents prepared by NCCI, and for distributing these to the GSEs.
Nomura Securities was, from 2005 to 2007, a wholly owned subsidiary of NHA and an affiliate of NAAC and NHELI. Nomura Securities' directors were appointed by NHA, and those directors in turn appointed its officers.
NHA is a holding company that holds the stock of its subsidiaries and receives its revenue from those subsidiaries. All of the other corporate defendants were directly or indirectly wholly owned by NHA. NHA, in turn, is owned by Nomura Holdings International, which is not a defendant here.
NHA oversaw and set policy for its subsidiaries' activities in the RMBS industry. During the relevant period, NHA interfaced with Nomura Securities through NHA's Credit Department, Risk Management Group, and Risk Credit Committee ("RCC"). The Credit Department provided services to Nomura subsidiaries; it also set applicable credit policies and established procedures for approving originators to do business with Nomura. Among other things, the Credit Department participated — along with the RCC and Risk Management Group — in deciding when to initiate and when to discontinue business with originators.
NHA's Credit Department also set limits on the amount of RMBS and whole loans that Nomura Securities could hold at any given time, and it policed those limits. NHA decided whether it or Nomura Securities would hold residuals in issued securitizations. NHA's Risk Management Group monitored the extent of these holdings, modeled associated credit and default risk, and conducted periodic "stress tests."
NHA could also exercise influence, one step removed, over NAAC and NEHLI through its subsidiaries NACC and NAMF. NHA appointed the directors of these subsidiaries; the subsidiaries in turn appointed the directors of NAAC and NHELI. Those directors were charged with managing and directing the "business and affairs" of NAAC and NHELI. As noted, there was substantial overlap between the directors and officers of NHA, NAAC, and NHELI.
RBS is a Delaware corporation with its principal place of business in Stamford, Connecticut. RBS served as the lead or co-lead underwriter on four of the Securitizations. As such, it was responsible for the accuracy of the statements in the Offering Documents and actually sold four Certificates to Freddie Mac.
Five defendants are individuals associated with the Nomura entity defendants.
Findlay, Gorin, and McCarthy signed each of the Registration Statements and their amendments pursuant to which the Securitizations were issued. LaRocca signed the Registration Statements and their amendments for each of the six NHELI Securitizations; Graham signed the Registration Statement and its amendment for the single NAAC Securitization.
Each Individual Defendant made a point of highlighting the aspects of Nomura's RMBS business for which he claimed to have no responsibility. None of them identified who was responsible for ensuring the accuracy of the contents of the Prospectus Supplements relevant to this lawsuit, and, as this group of Individual Defendants furnished the most likely candidates, the only logical conclusion is that no one held that responsibility.
Findlay held critical roles in several of the Nomura entities responsible for the securitization of RMBS. He was responsible for setting up its due diligence practices when it entered the RMBS business. Because of his responsibility for managing risk at NHA, he was informed that Nomura's Securitizations were performing poorly, but took no steps to improve any of its processes. In short, if there was one Individual Defendant most responsible for the poor design and execution of Nomura's due diligence processes and the creation of misleading Offering Documents, it was Findlay.
Findlay joined NHA in October 2000 as CLO. At some point or another, Findlay has sat on the board of directors of NHA and at least seventeen other Nomura entities. He has served as an officer of a number of them as well. In 2012, he became President and CEO of NHA, while continuing to serve as CLO.
During the 2002 to 2012 period, Findlay was CLO of Nomura Securities as well.
Findlay testified to having reviewed the seven Prospectus Supplements before they were issued. It appears as though the extent of Findlay's review consisted of verifying that the documents had redlining on them, so that he could assure himself that others were in fact making changes to the documents. He did not verify the data reflected in the documents.
During the 2002 to 2004 period, as Nomura prepared to enter the RMBS business, Findlay participated in the establishment of NCCI's processes for pre-acquisition
Findlay testified that he believed (and still believes today) that Nomura had a robust due diligence process and that the Offering Documents were materially true, correct, and complete; he provided no reasonable basis for those beliefs. Instead, he had a profound misunderstanding about the processes in place at Nomura. Although Findlay was involved in creating Nomura's due diligence processes, Findlay could not recollect that Nomura in fact had no written due diligence policies and procedures with respect to its RMBS business. In fact, Findlay has no present recollection of what the due diligence program focused on. He could not recall the identities of the members of the due diligence team, or whether Nomura used sampling in its pre-acquisition diligence. Similarly, Findlay testified that he would have thought that Nomura's due diligence team should have been able to draw reasonable extrapolations from the samples that they reviewed on a pre-purchase basis. He was not aware of the fact that Nomura's Diligence Group was unable to perform such an extrapolation. Findlay stated that he was surprised to learn during cross-examination that Kohout regarded the use of adverse sampling, as Nomura did it, to diminish the role of the Diligence Group to that of a noneffective entity. Findlay was not aware of the IngletBlair quality control review of Nomura's due diligence process in the summer of 2006, nor was he aware that Nomura's Diligence Group concluded that many of its originators were responsible for originating defective loans.
At one point, Findlay testified that he believed the due diligence team reviewed the Prospectus Supplements and checked the accuracy of the representations against the actual characteristics of the loans. Moments later, however, Findlay backtracked and said that the due diligence team was charged with preparing, not reviewing, the Prospectus Supplements. Both statements were incorrect. In short, Findlay had faith in a process that he could not recall and did not understand, despite his role in its creation.
There were at least two instances in late 2006 at which the poor quality of Nomura's securitizations was brought to Findlay's attention. From 2005 to 2007, Findlay sat on the RCC, the NHA committee designed to assist management by giving risk and credit advice, including with respect to aspects of the RMBS business, to NHA's subsidiaries, such as Nomura Securities and NCCI. In his capacity as a member of the RCC, on December 7, 2006, Findlay, along with other RCC members, was told that the originator, Ownit, had been forced to shut down "due to continued pressure from the softening of [the] subprime mortgage market." Findlay was told that Ownit's position was "[l]ike many other originators" in that it was suffering decreasing profits from a "cooling housing market" and "mounting EPD claims."
In November 2006, Findlay received an email with the subject line, "Request from Wall Street Journal," and an attached report entitled "How Bad is 2006 Subprime Collateral?" The Wall Street Journal was inquiring about a report put out by UBS
Findlay forwarded the report to what he referred to as "risk legal." In his email doing so, he expressed that the approval of a Mr. Kashiwagi would be required before any response was sent to the Wall Street Journal. At trial, Findlay testified that he thinks Kashiwagi was the CEO.
Graham was employed by Nomura Securities from April 2005 to October 2006 and by NCCI from October 2006 to October 2007. Shortly after joining Nomura in 2005, Graham became President and CEO of NAAC and, in the 2005 to 2007 time period, was also an officer of NHELI.
When hired by Nomura Securities, Graham's title was Managing Director, and he was the head of the Transaction Management Group. When Graham became employed by NCCI, his title and job responsibilities remained the same.
Graham had direct responsibility for the content of the Prospectus Supplements. Graham's Transaction Management Group was responsible for preparing the transaction documents for the acquisition of loans that would be securitized and for preparing the Offering Documents that would be used to market the Securitization to investors. It would also assist in obtaining ratings for Securitizations. Graham, or another member of his group, would review the Offering Documents, including the Prospectus Supplements, and make edits or comments about the language.
In April 2007, Graham became aware that a fraud review on a NHELI transaction revealed that 43 of 263 loans that had passed Nomura's diligence processes were found to "have fraud." Graham could not recall Nomura taking any action to modify its diligence process in response to this finding.
LaRocca was employed by Nomura Securities from February 2001 to October 2006 and by NCCI from October 2006 to May 2008. He was also an officer of NCCI — he testified that he believed, but could not be sure, that he was a Vice President. As of July 2006, LaRocca was additionally a director of NCCI. During the 2005 to 2007 period, LaRocca was also the President and CEO of NHELI.
Before Graham joined Nomura in April 2005 and began reporting to LaRocca, LaRocca served as the head of the Transaction Management Group.
During cross-examination, it was revealed that LaRocca misunderstood the role of Nomura's outside counsel, accountants, and the rating agencies in the securitization process and the extent to which he
Unlike the first three Individual Defendants, each of whom had a level of responsibility for Nomura's due diligence program, neither of the final two Individual Defendants did. Each of the five Individual Defendants, however, had responsibility as an officer or director of NAAC and/or NHELI for the actions taken by the depositors.
In July 2004, Gorin was hired by Nomura Securities as a Controller. Ultimately, in addition to serving as Controller, Gorin also became Chief Financial Officer ("CFO") at Nomura Securities and NHA.
Despite being a signatory, Gorin was unfamiliar with the contents of the Offering Documents, the type of security to which they related, and the role of NAAC and NHELI in the RMBS industry. Gorin did not review the Registration Statements and did not know what those documents were or even understand what an RMBS was.
McCarthy became an independent director of NAAC and NHELI in January 2004 and still holds those positions today. Along with the other two members of the two boards — Findlay and Ito — McCarthy approved the issuance of certificates for securitizations, including those at issue in this case, that McCarthy understood would later be sold to investors. McCarthy's primary responsibility with respect to those transactions was to ensure that they did not impair NAAC's or NHELI's statuses as bankruptcy-remote entities, a status that guaranteed that nothing could be clawed back from RMBS investors in a bankruptcy proceeding.
From time to time, Juliet Buck ("Buck"), an attorney who McCarthy understood to have been employed by Nomura Securities and later by NHA, would contact McCarthy when something arose that needed his attention with respect to his role at NAAC and NHELI, such as signing a Registration Statement. McCarthy stated that he
In his role as a director of NAAC and NHELI, McCarthy signed Registration Statements and a resolution of the board of directors allowing each Securitization to go forward. McCarthy contends that given his review of the Offering Documents for the Securitizations, he had no reason to doubt that the documents were materially accurate. But during cross-examination, McCarthy admitted that his review was limited to ensuring that a given deal would not jeopardize the bankruptcy-remote status of the two depositors; he did not review the Prospectus Supplements to verify the accuracy of the representations. Furthermore, he had no knowledge of Nomura's diligence activities in connection with any RMBS issued by NAAC or NHELI.
Still remaining in this action are FHFA's claims under Sections 12(a)(2) and 15 of the Securities Act, and parallel provisions of Virginia's and D.C.'s Blue Sky laws. Following a description of the legal standards governing these claims, this Opinion will apply those standards to the facts found above.
As has previously been explained in this case:
Hunter Opinion, 74 F.Supp.3d at 649-50 & n. 19, 2015 WL 568788, at *7-8 & n. 19.
The Securities Act of 1933 "emerged as part of the aftermath of the
Knowledge and care, Congress determined, were the surest path to a properly functioning market. The Securities Act aimed "to provide investors with full disclosure of material information concerning public offerings of securities in commerce, to protect investors against fraud, and, through the imposition of specified civil liabilities, to promote ethical standards of honesty and fair dealing." Hochfelder, 425 U.S. at 195, 96 S.Ct. 1375; see also Pinter v. Dahl, 486 U.S. 622, 638, 108 S.Ct. 2063, 100 L.Ed.2d 658 (1988) (Securities Act was intended "to protect investors by requiring publication of material information thought necessary to allow them to make informed investment decisions concerning public offerings of securities in interstate commerce"). It was, therefore, no accident that Congress chose to place a heavy burden on the parties with superior access to, and control over, information about securities: those who offered them.
The legislative history of Section 12(a)(2) in particular emphasizes that major market participants were not expected easily to evade the liability the Act imposed:
Gustafson v. Alloyd Co., 513 U.S. 561, 581, 115 S.Ct. 1061, 131 L.Ed.2d 1 (1995) (quoting H.R.Rep. No. 73-85, at 9 (1933)). Congress observed that this was a standard that "the history of recent spectacular failures overwhelmingly justifie[d]." H.R.Rep. No. 73-85, at 9. A heavy burden, Congress explained, was an indispensable means of maintaining the integrity of the market:
Id. at 9-10.
The private rights of action in the Securities Act were "designed to assure
By its terms, Section 12(a)(2) imposes liability on
15 U.S.C. § 77l(a)(2). The elements of a claim under Section 12(a)(2) are:
In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 359 (2d Cir.2010) (citation omitted). FHFA must make out its case by a preponderance of the evidence. See Huddleston, 459 U.S. at 390, 103 S.Ct. 683. "Neither scienter, reliance, nor loss causation is an element of ... § 12(a)(2) claims...." NECA-IBEW Health & Welfare Fund, 693 F.3d at 156. It has already been determined that the sales of the seven Certificates at issue here were made "by means of" the Prospectus Supplements effectuating those sales. See FHFA v. Nomura Holding Am., Inc., 68 F.Supp.3d 499, 507-08, 2014 WL 7229446, at *8 (S.D.N.Y. Dec. 18, 2014).
FHFA seeks to hold the two depositors — NAAC and NHELI — and the two underwriters — Nomura Securities and RBS — liable as statutory sellers.
This Court has already determined that a depositor can constitute a statutory seller:
FHFA v. UBS Americas, Inc. ("UBS II"), 858 F.Supp.2d 306, 333-34 (S.D.N.Y.2012), aff'd, 712 F.3d 136 (2d Cir.2013) (citation omitted).
As for underwriters, the Securities Act defines that term as
15 U.S.C. § 77b(a)(11). The parties stipulated that it does not remain to be tried whether Nomura Securities sold the NAA 2005-AR6 Certificate to Fannie Mae, whether Nomura Securities sold the NHELI 2006-FM1 Certificate to Freddie Mac, and whether RBS sold the NHELI 2006-HE3, NHELI 2006-FM2, NHELI 2007-1, and NHELI 2007-2 Certificates to Freddie Mac. This answers the question whether these underwriters were statutory sellers here, as they passed title for value. It was Nomura Securities and RBS that solicited the GSEs' purchase of the Certificates by, among other things, providing them with collateral information and preliminary offering materials in the course of underwriting the public offerings through which each of the Certificates was sold.
With respect to the third element, "[i]n many cases — including this one — two issues are central to claims under section[]... 12(a)(2): (1) the existence of either a misstatement or an unlawful omission;
"[W]hether a statement is misleading depends on the perspective of a reasonable investor: The inquiry (like the one into materiality) is objective." Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, ___ U.S. ___, 135 S.Ct. 1318, 1327, 191 L.Ed.2d 253 (2015) (citation omitted) (Section 11 claim).
Kleinman v. Elan Corp., plc, 706 F.3d 145, 153 (2d Cir.2013) (citation omitted) (Section 10(b) claim). "The literal truth of an isolated statement is insufficient; the proper inquiry requires an examination of defendants' representations, taken together and in context. Thus, when an offering participant makes a disclosure about a particular topic, whether voluntary or required, the representation must be complete and accurate." Meyer v. Jinkosolar Holdings Co., 761 F.3d 245, 250-51 (2d Cir.2014) (citation omitted).
Although Section 12(a)(2) forbids untrue statements of fact, false statements of opinion or belief are also actionable under Section 12(a)(2) in at least two ways. First, "every such statement explicitly affirms one fact: that the speaker actually holds the stated belief." Omnicare, 135 S.Ct. at 1326. For that reason, statements of opinion can be untrue statements of fact if the speaker does not actually hold the opinion-if, in other words, the statement falsely describes the speaker's state of mind. Id. The Second Circuit recognized this basis for holding statements of opinion actionable under Section 12(a)(2) in Fait v. Regions Fin. Corp., where it explained that the plaintiff would need to show both that the statement was "objectively false" and "disbelieved." 655 F.3d 105, 110 (2d Cir.2011). It was based on the Second Circuit's analysis in Fait that the Court, throughout this coordinated litigation, explained that, to satisfy the falsity element with respect to alleged misrepresentations of LTV ratios that use an appraised valuation, FHFA would be required to establish both that the original value derived from an appraisal, and thus the LTV ratio based on that appraisal, was inflated (or objectively false), and that the appraiser did not believe the appraised value to be accurate (in other words, that it was subjectively false).
The Supreme Court issued the Omnicare opinion while trial was ongoing in this action.
Id. at 1328-29.
Id. at 1330.
FHFA bore the burden of proving that any misrepresentations in the Offering Documents were material. "For a misstatement or omission to qualify as material, there must be a substantial likelihood that a complete and truthful disclosure would have been viewed by a reasonable investor as having significantly altered the total mix of information made available." N.J. Carpenters Health Fund v. Royal Bank of Scotland Grp., PLC, 709 F.3d 109, 126 (2d Cir. 2013) (citation omitted). "[T]he total mix of information relevant to the question of materiality can include publicly available information." Id. at 127. "The test for whether a statement is materially misleading under Section 12(a)(2) is ... whether representations, viewed as a whole, would have misled a reasonable investor." Rombach, 355 F.3d at 178 n. 11.
"Materiality is determined in light of the circumstances existing at the time the alleged misstatement occurred." Ganino v. Citizens Utils. Co., 228 F.3d 154, 165 (2d Cir.2000). "[A] material fact need not be outcome-determinative; that is, it need not be important enough that it would have caused the reasonable investor to change his vote. Rather, the information need only be important enough that it would have assumed actual significance in the deliberations of the reasonable [investor]." Folger Adam Co. v. PMI Indus., Inc., 938 F.2d 1529, 1533 (2d Cir.1991) (citation omitted). "Materiality is an inherently fact-specific finding that is satisfied when a plaintiff alleges a statement or omission that a reasonable investor would have considered significant in making investment decisions." Litwin, 634 F.3d at 716-17 (citation omitted). "[I]n the context of this case, materiality is an objective standard, determined with reference to a reasonable PLS trader-not a reasonable GSE, or a reasonable PLS trader with
The SEC has explained that "[a]sset-backed securities and ABS issuers differ from corporate securities and operating companies. In offering ABS, there is generally no business or management to describe. Instead, information about the transaction structure and the characteristics and quality of the asset pool ... is often what is most important to investors." Asset-Backed Sec., Securities Act Release No. 8518, 84 SEC Docket 1624 (Dec. 22, 2004).
"[A] court must consider both quantitative and qualitative factors in assessing an item's materiality, and that consideration should be undertaken in an integrative manner." Litwin, 634 F.3d at 717 (citation omitted). The Second Circuit
Hutchison v. Deutsche Bank Sec. Inc., 647 F.3d 479, 485 (2d Cir.2011) (citation omitted).
In this case, each of the Prospectus Supplements at issue states that no substantial changes to any SLG are expected after the Cut-off Date and sets a 5% change as the relevant threshold.
The 5% figure comes directly from SEC guidance. Pursuant to Regulation AB, Item 6.05 to SEC Form 8-K requires disclosures "if any material pool characteristic of the actual asset pool at the time of issuance of the asset-backed securities differs by 5% or more ... from the description of the asset pool in the prospectus." Asset-Backed Sec., Securities Act Release No. 8518, 84 SEC Docket 1624. And in 1999, long before Regulation AB was promulgated, SEC Staff Accounting Bulletin No. 99, cited by the Second Circuit in Hutchison, explained that "[o]ne rule of thumb ... suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances." 64 Fed.Reg. 45150-01 (Aug. 12, 1999) (citation omitted).
Under Section 12(a)(2), once a prima facie case is made out, the plaintiff is entitled "to recover the consideration paid for [the] security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security." 15 U.S.C. § 77l(a)(2). In other words, where a plaintiff still owns the security, its remedy is rescission. Commercial Union Assur. Co., plc v. Milken, 17 F.3d 608, 615 (2d Cir.1994) (construing identical language in predecessor Section 12(2)). Under the rescissory measure of damages, FHFA would be entitled to a return of the consideration paid for the Certificates, plus prejudgment interest, less any income received on the Certificates. Id. The amounts of the consideration paid and the income received on the Certificates are not in dispute. See FHFA v. Nomura Holding Am., Inc. ("Riddiough Opinion"), No. 11cv6201 (DLC), 2015 WL 640875, at *1 (S.D.N.Y. Feb. 16, 2015).
The parties dispute the rate of prejudgment interest that should apply. In a lawsuit to enforce a federal right, the rate of prejudgment interest rests in this Court's discretion, as guided by "(i) the need to fully compensate the wronged party for actual damages suffered, (ii) considerations of fairness and the relative equities of the award, (iii) the remedial purpose of the statute involved, and/or (iv) such other general principles as are deemed relevant by the court." Gierlinger v. Gleason, 160 F.3d 858, 873 (2d Cir.1998). The parties also dispute the date of tender, as discussed below.
FHFA alleges that four sets of representations in each of the seven Prospectus Supplements were false. They are representations regarding the origination and underwriting of the loans within the SLGs backing the Certificates; LTV ratios and appraisals, including compliance with USPAP; occupancy status; and the credit ratings of the Certificates. FHFA has proven that all four sets of representations in each of the seven Prospectus Supplements were false.
As described above, each of the Prospectus Supplements includes a representation that "[t]he Mortgage Loans ... were originated generally in accordance" with originators' guidelines, or, in the case of NHELI 2006-FM1, the equivalent of this language in reference to the guidelines of the Securitization's sole originator. These representations were false.
At rates ranging from 45% to 59%, the loans within the SLGs had a substantially increased credit risk associated with a failure in the origination process. This number of loans, at a minimum, was not underwritten in compliance with their originators' guidelines and there were no compensating factors identified by the originator or the experts at trial to excuse that failure. This rate of issuance of defective loans reflects a wholesale abandonment by originators of their underwriting
The due diligence program run by Nomura, and, in the case of two of the Securitizations by RBS, were entirely inadequate to protect against false statements in the Offering Documents. But even with their many serious limitations, those programs provide striking confirmation of the deeply flawed nature of the originators' underwriting programs and the falsity of defendants' descriptions of the origination process. The serious limitations in defendants' due diligence programs were legion. Among other things, Nomura only conducted pre-acquisition due diligence, and did not do so in a manner that permitted it to extrapolate results to the SLGs backing any securitization. Nomura repeatedly made decisions when conducting due diligence to save money and satisfy sellers of mortgage loans. As a consequence, it failed to subject most loans it purchased to genuine credit or valuation due diligence, and waived in far too many loans that were evaluated and found seriously wanting. Nomura had no system for analyzing the impact of its pre-acquisition due diligence program on the loans it later selected, often from many different originators, for inclusion within an SLG and made no effort to conduct such an analysis.
Despite the amount of due diligence not done, there is significant evidence from its due diligence program that the loans Nomura purchased and securitized were not as described in their Prospectus Supplements. The database created for this litigation determined that less than 40% of the loans within the SLGs for the Certificates were subjected to credit due diligence, and 9% of the loans subject to diligence either had a final grade of EV3 or had been waived in by Nomura despite being assigned an EV3 grade by the due diligence vendor. Just over 40% of the loans within the SLGs for the Certificates were subjected to valuation due diligence, and of those that did receive valuation due diligence many showed evidence that the origination appraisals were unreliable. Both Nomura and RBS conducted after-the-fact fraud inquiries that pointed to the existence of fraud and serious deficiencies in originators' underwriting practices.
Today, defendants do not defend the underwriting practices of their originators. They did not seek at trial to show that the loans within the SLGs were actually underwritten in compliance with their originators' guidelines. At summation, defense counsel essentially argued that everyone understood back in 2005 to 2007 that the loans were lousy and had not been properly underwritten.
Given the exceedingly poor quality of the SLGs' loans, it is perhaps not surprising that defendants' expert Forester neither properly re-underwrote the loans nor met the FHFA re-underwriting findings head on. Instead, he unreasonably cabined his review of the findings of FHFA's expert. Even then, however, he admitted that, for roughly 5.5% of the loans, there was a "[p]otential significant defect" and that "it cannot be confirmed that a reasonable underwriter at the time of origination could have found that this loan satisfied the applicable guidelines." After examining each of Forester's specific responses to Hunter's findings, the Court confirmed that FHFA had indeed succeeded in proving
In opposing a finding of falsity, defendants largely rely on their proposed reading of the Prospectus Supplement language. Each of their arguments is addressed in turn.
Defendants argue that the Supplements' representations regarding compliance with underwriting guidelines refer to originators' underwriting processes and describe only general but not perfect adherence to those processes. Defendants emphasize that underwriting is a matter of judgment and the Supplements spoke of exceptions to and deviations from underwriting guidelines.
Defendants are correct that many of the originators' guidelines allowed underwriters to make exceptions to guidelines if the exception could be justified by compensating factors and was documented. They are also correct that underwriting entails the exercise of judgment, at least within the parameters permitted by an originator's guidelines. But Hunter's review of the Sample loans entailed just that nuanced view of the underwriting process. He accepted any indication in a loan file that an underwriter had exercised such judgment, conducted his own search for compensating factors, and considered each of the instances in which Forester identified another possible compensating factor to excuse a lack of compliance with guidelines. This Court's review of the Dashboard Reports was similarly alert to any compensating factors or grounds for exceptions identified by Forester and his teams. At the end of the day, the defect rates recited above cannot be explained away through the play-in-the-joints of the underwriting process.
Defendants contend that no analysis may be done of the extent to which the loans within an SLG were underwritten in compliance with originators' guidelines for five of the seven Securitizations since, in making representations about compliance with underwriting guidelines, the Supplements were referring only to loans from those originators that contributed over 20% of the loans to the SLG and whose guidelines were described in some detail in the Supplements. This argument has already been rejected once, and it is rejected again. Hunter Opinion, 74 F.Supp.3d at 653-56, 2015 WL 568788, at *11-13.
If this were a genuine argument, one would have expected it to be raised at the outset of this litigation. But it was not. Not by Nomura or RBS, and not by any other defendant in these sixteen coordinated actions. Instead, all the parties in this coordinated litigation expended years of effort and vast sums of money to collect and analyze the loan files and underwriting guidelines for every Sample loan to assess the extent to which each loan had been originated in compliance with its originators' guidelines. Thus, defendants are judicially estopped from making this argument, which was raised on November 25, 2014. Id. at 654-56, 2015 WL 568788, at *12-13.
As described above, Regulation AB required, "[t]o the extent material, a description of the originator's origination program" for "any originator ... that originated, or is expected to originate,
The Court rejected this argument in an opinion of February 11, which is reproduced in pertinent part below.
Hunter Opinion, 74 F.Supp.3d at 654, 2015 WL 568788, at *11-12.
Responding to the Court's reasoning that the Supplements' general description of the origination process is too vague to be complete, defendants now argue it would be "much more vague to disclose merely that loans complied generally with the unknown guidelines of unknown originators." There is no reason to think so. The disclosure is a summary prepared by Nomura of the common characteristics of the origination process employed by various originators. It provides assurance that Nomura investigated the guidelines and practices of all originators, whether
Defendants make much of the fact that the representations in the Supplements only attest to "general" compliance — that loans were "originated generally in accordance" with the relevant guidelines. But the word "generally" must be understood in its context. As this Court has explained,
Due Diligence Opinion, 68 F.Supp.3d at 485, 2014 WL 7232443, at *39.
This plain and contextually appropriate reading of the term "generally" finds confirmation elsewhere. At the time these Supplements were issued, there was also a market for "scratch-and-dent" loans. The Offering Documents for the securitizations of such loans explained that a percentage of loans had not been originated in accordance with their originators' guidelines. This kind of direct disclosure of defective underwriting was required if defendants wished to sell defective loans.
Second, the use of the word "generally" can't bear the weight defendants wish it to bear in this case. It could not and did not convey that roughly half the loans had substantially increased credit risk because they were not originated in compliance with their originators' guidelines, even after one accounts for exceptions to guidelines justified by compensating factors. Defendants' other argument — that the word "generally" makes a statement that plainly reads as an assertion of fact an "opinion" — does not alter its plain meaning, especially given that, as discussed below, Nomura indicated its opinions and beliefs explicitly when it chose to state them.
In summation, defense counsel argued that when the Prospectus Supplements are read "holistically" and "in context," their representations about the extent to which loans were originated in compliance with originators' underwriting guidelines were "true and not misleading." They are wrong.
Defense counsel pointed to two disclosures in the Supplements in particular. Most of the Supplements warned that the underwriting standards for the loans were "generally less stringent than the underwriting
None of these disclosures nor the existence of relaxed underwriting standards for subprime loans constitute notice, however, that originators of subprime loans had failed to adhere to their underwriting guidelines. They refer to something else.
The subprime market was booming in 2005 to 2006 because originators of subprime loans had adopted relaxed standards that allowed borrowers with low credit ratings and few assets to obtain mortgages. As the Supplements say, these standards were less rigorous than those adopted by the GSEs, but they were standards nonetheless. And some of the features of those new, relaxed standards were quantified and disclosed. For instance, the Collateral Tables listed the number of loans whose borrowers had certain FICO scores and the number of full documentation, partial documentation, or no documentation loans.
But the Supplements also assured investors that all of the loans within the SLGs were underwritten generally in compliance with their originators' standards. They did not suggest that originators had ignored their own standards. Similarly, while Supplements included notice that exceptions to the standards may have been made for some loans, or even many loans, they explained that exceptions were given only in the presence of compensating factors and after scrutiny of the individual loan. And to provide protection to investors purchasing Certificates backed by these less credit-worthy loans, securitizers structured their offerings with credit enhancement features to provide AAA securities to risk-adverse investors. In sum, notice that loans were now being extended to borrowers who had a less-than-perfect credit history through the adoption of relaxed underwriting guidelines was not notice that originators would ignore even those guidelines.
Defendants stress that one of the Securitizations provided a pointed warning to investors. The Prospectus Supplement for the last Securitization at issue, NHELI 2007-3, states that ResMAE had "filed for bankruptcy protection under the United States Bankruptcy Code," and therefore
(Emphasis added.) ResMAE contributed 77% of the loans to the SLG at issue here.
Later in the Supplement, during the discussion of underwriting standards, there is the typical declaration that the mortgage loans in the SLGs were "generally originated in accordance" with originators' underwriting criteria. There is also a four-and-a-half-page description of the underwriting guidelines "used by ResMAE." It included representations like the following: "The underwriting staff fully reviews each loan to determine whether ResMAE's guidelines for income, assets, employment
Hunter found that 66.67% of the loans for this Securitization's SLG had substantially increased credit risk associated with a failure to adhere to underwriting guidelines. The Court found that, conservatively, this was true for 45% of the loans. These percentages are too large to find that they were adequately disclosed by the warning that ResMAE "may" have been affected in its origination of loans by its bankruptcy, particularly when that warning is read in context.
In summation, defendants advanced an argument previously dismissed by the Court but newly grounded in the Supreme Court's recent Omnicare decision. 135 S.Ct. 1318. Because two Supplements state that Fremont's guidelines were "believed" by the depositor to have been applied "with some variation, by Fremont," defendants contend that FHFA must prove for those two Securitizations that that statement was not only objectively false but also subjectively false.
The language on which defendants focus is in the second of the following two sentences. The first paragraph in the Supplement section addressed to Fremont underwriting standards reads as follows:
Following this paragraph, there are over four pages describing Fremont's underwriting criteria.
Read in context, the use of the word "believed" does not transform defendants' representation regarding Fremont's compliance with its underwriting guidelines into a statement of opinion. The first sentence is a straightforward statement of fact. The reference to defendants' belief in the second sentence is little more than a statement of assurance by defendants that they are correctly summarizing Fremont's guidelines — "little more than a reference to the depositor's exercise of its due diligence function and a further endorsement of the quality of the offering." SG Americas, 2012 WL 5931878, at *2. These "statements of belief about a matter of objective fact ... [do] not impose upon the plaintiff the duty to [prove] that the defendants did not hold their expressed belief." Id. at *3.
In any event, Nomura may be held liable under the Securities Act and Omnicare for the statement in the second sentence without any showing regarding its scienter. 135 S.Ct. 1318. Nomura's statements of belief implied that defendants knew "facts sufficient to justify" forming the opinion they expressed. Id. at 1330 (citation omitted). The record is replete with evidence that it "lacked the basis for making those statements that a reasonable investor would expect." Id. at 1333. Indeed, defendants were aware of information contradicting the representations in the Supplements: RBS, for example, became
Finally, defendants contend that the results of Nomura's preacquisition due diligence review are more consistent with Forester's conclusion that only 5.5% of the Sample loans had "[p]otential serious defect[s]," than with Hunter's far larger number. They are wrong.
Defendants are apparently referring to their expert's calculation that, of the loans within the SLGs that had been subjected to pre-acquisition credit and compliance due diligence, 6.6% were rated EV3. But, as explained above, Nomura's due diligence program was seriously flawed. Among other things, it failed to scrutinize most loans, and results from any review it did perform cannot be fairly extrapolated to an SLG population. In addition to finding credit defects, other due diligence found serious valuation defects. Thus, this single-digit percentage of credit defects cannot independently confirm the accuracy of Forester's numbers. The Nomura due diligence program was not designed to, and did not, ensure that the Prospectus Supplements accurately described the extent to which an SLG's loans were underwritten in accordance with originators' guidelines.
Each Prospectus Supplement included Collateral Tables reporting the average LTV ratios and percentage of LTV ratios in certain ranges for each SLG. To show that the appraisals — and thus the LTV ratios — were false, FHFA was required to show both objective and subjective falsity. FHFA did so.
For at least 184 of the loans, FHFA established both that the appraisal value was false and the appraisers rendering those appraisal opinions did not believe that the values they reported were the true values of the properties. The proportion of such loans per SLG ranged from 18% to 36%. This had important consequences for the accuracy of the LTV ratio Collateral Tables. For example, the Prospectus Supplements all represented that there were no loans in the SLGs with LTV ratios of over 100; the actual figures ranged from 9.3% to 20.5%. Every LTV ratio Collateral Table contained statistics that were false.
FHFA has proved that LTV ratios were false in the sense of containing opinion statements about property values that were both objectively wrong and subjectively disbelieved. In addition, the record supports a finding of falsity based on the omission doctrine described in Omnicare, 135 S.Ct. 1318. USPAP requires an appraiser to conduct an investigation and to create a record of that investigation in support of the opinion of value reflected in the appraisal. Each Supplement assured investors that "all appraisals" of the mortgaged properties supporting the loans "conform to [USPAP]." Kilpatrick's CAM demonstrated that this, too, was false; because the CAM was firmly grounded in USPAP requirements, a failing grade on the CAM also indicated a failure to conform
In defending against this claim, defendants did not choose to conduct any study of the original appraisals, either through an appraisal review or otherwise, to confirm their accuracy. Instead, defendants principally relied on their multi-faceted attacks on Kilpatrick's methodology. Those have been addressed above. In addition, they offered two other kinds of evidence that they contend undermine Kilpatrick's conclusion. They called appraisers who performed two of the 184 non-credible appraisals to testify at trial. For the reasons explained above, their testimony failed to suggest that their appraisal values were either reliable or reflected honestly held beliefs, and failed to undermine Kilpatrick's work or the variety of evidence that confirmed his conclusions. Finally, defendants point to the valuation due diligence that they performed and the text of each Prospectus. It is to those arguments that this Opinion now turns.
Defendants contend that only 162 loans, or roughly 1% out of the 15,806 loans in the SLGs, were found during their due diligence review "to be outside the BPO tolerance thresholds." They assert that this is strong evidence that original appraisals were "well-supported" value estimates.
There are several problems with defendants' calculation. First, they did not subject 15,806 loans to due diligence. As explained above, roughly 57% of the loans in the SLGs had no real valuation due diligence performed. Therefore, it is not appropriate to claim that only 162 out of over 15,000 loans were out of tolerance. Nor does the figure 162 reflect the total universe of out-of-tolerance appraisals discovered during Nomura's due diligence review. Many loans that received an out-of-tolerance AVM value were never sent for a BPO review. When the LTV ratios are recalculated for those loans with out-of-tolerance AVM and BPO numbers, taken together, the story is a very different one than that suggested by defendants. Taking the AVM values and BPO values obtained by Nomura from its vendors, and using those values to recalculate LTV ratios, substantially more than 162 loans — 242 — in the SLGs had LTV ratios of over 100%. Nor does the number 162 take into account the 962 loans in the SLGs whose AVM values were outside tolerance thresholds yet had no BPO done at all. And, of course, because of the way Nomura conducted its due diligence, there is no reliable way to extrapolate any of the results from its due diligence program to the entire SLG population. As explained above, the results obtained in Nomura's due diligence program strongly confirm Kilpatrick's conclusions.
Defendants appeared to argue in an opening statement that FHFA cannot use any evidence, except perhaps an admission of fraud from the original appraiser, to prove that the reported LTV ratios were false. For this argument, they rely of the following formulation in the Prospectuses. Each Prospectus explained that, for purposes of the Prospectus and Prospectus Supplement, "[t]he `Value' of a Mortgaged Property ... is generally the lesser of (a) the appraised value determined in an appraisal obtained by the originator at origination of that loan and (b) the sales price for that property." (Emphasis added.) Defendants argue that this language forecloses any independent assessment of the appraisals underlying the loans — and
Section 12(a)(2) imposes strict liability for statements that are materially false. The relevant question is whether the appraisals, and the LTV ratios upon which they were built, were false or not; the fact that FHFA identified with precision which appraisal values it used to construct the LTV ratios cannot and does not inoculate defendants from liability for reproducing false information in the Prospectus Supplements.
FHFA has also claimed that defendants made false statements about the number of mortgage loans issued to borrowers for properties they were occupying. The Collateral Tables for each Prospectus Supplement listed the percentage of loans within an SLG for owner-occupied properties, as well as for second homes and investment properties. These statistics were provided as of the Cut-off Date for the Supplement. Owner-Occupancy Opinion, 2015 WL 394072, at *3-4.
Conservatively, FHFA has shown that the owner-occupancy figures were false in each Supplement. The false statements affected from 1% to 3% of the loans within each SLG.
Finally, FHFA alleges the falsity of "representations in the Offering Materials that the reported credit rating related to the actual loan collateral for the securitization." Merrill Lynch, 903 F.Supp.2d at 276 n. 2.
It is undisputed that in assigning ratings to the Certificates, the credit rating agencies relied on the data contained in the loan tapes that Nomura provided to them. Those loan tapes contained data stored on Nomura's LMS system. Putting aside transcription errors and the addition of servicing information, the LMS data was the data provided by the loans' originators, including FICO scores, DTI ratios, LTV ratios, and owner-occupancy status. FHFA has shown that that data did not accurately reflect those characteristics of the loans within the SLGs.
Given the enormity of the misdescriptions shown, defendants' representation that the ratings "will depend primarily on an assessment ... of the related Mortgage Loans" is false. The rating agencies could not, and did not, assign ratings to the mortgage loans Nomura was securitizing because the data provided by Nomura did not accurately describe those loans.
On April 1, while trial was ongoing, defendants submitted, purportedly pursuant to Fed.R.Evid. 103, what is styled an "Offer
Defendants sought to introduce evidence that Nomura retained a residual interest in the lowest subordinate tranche of each Securitization and that it lost money as a result. This evidence, they contended, attests to Nomura's stake in the Securitizations, its confidence in its due diligence process, and its motivation to perform adequate due diligence.
Having granted summary judgment against defendants on their affirmative defense of due diligence, see Due Diligence Opinion, 68 F.Supp.3d at 485-86, 2014 WL 7232443, at *40, the Court excluded evidence of Nomura's motivation to create an adequate due diligence program.
Defendants also sought to offer evidence of Fannie Mae and Freddie Mac's due diligence processes performed in the part of their businesses in which they purchased whole loans. As expressed in Nomura's Offer of Proof, defendants sought to present evidence of the GSEs' due diligence and the findings from that program, including the exceptions they made to deviations from originators' underwriting guidelines, the GSEs' disclosures in their own securitizations, and the GSEs' communications with and evaluations of originators. With this evidence, defendants say, they would have shown that the GSEs employed due diligence processes similar
For many reasons, this evidence was largely excluded at trial. See FHFA v. Nomura Holding Am., Inc. ("Single-Family Due Diligence Opinion"), No. 11cv6201 (DLC), 2014 WL 7234593, at *4 (S.D.N.Y. Dec. 18, 2014); Single-Family Activities Opinion, 2015 WL 685153, at *4. It is useful to repeat at least a few of the reasons for excluding that evidence here.
Defendants were never able to explain adequately why this evidence of what the GSEs did or did not do in their own businesses was relevant to the issues being tried. If a due diligence defense remained to be tried, and defendants believed that evidence of an industry standard in performing due diligence would be helpful to them, then the obvious comparators and standard setters would be the other defendants in this coordinated litigation who sold far larger quantities of PLS than did Nomura. But defendants' expert took the position that there was no industry standard for conducting due diligence, undercutting any reason to offer any other institution's practices. See Due Diligence Opinion, 68 F.Supp.3d at 484-85, 2014 WL 7232443, at *39.
Second, for many reasons, evidence of the GSEs' due diligence practices and their disclosures in their own Offering Documents would have been highly prejudicial, wasteful, and misleading. The GSEs bought different loans, under different standards, and securitized different loans through an instrument with different risks and guarantees. See Single-Family Due Diligence Opinion, 2014 WL 7234593, at *3-5. Nor is the fact that the GSEs used identical due diligence vendors relevant. As Nomura stressed at trial, since each client had the opportunity to create its own set of review standards or overlays (although Nomura declined the requests to create credit overlays), conclusions drawn based on a comparison of waiver rates alone would be misleading.
In evaluating materiality, each Prospectus Supplement is to be read "as a whole," "holistically and in [its] entirety." ProShares Trust Sec. Litig., 728 F.3d at 103, 105. As noted, numerous factors support setting the quantitative materiality threshold in this case at 5%. Those factors include statements in Second Circuit opinions, SEC regulations, and the Offering Documents themselves. In addition, as noted, when RBS asked for a complete list of the originators of the loans in a Securitization, and for statistics including LTV ratio, FICO score, and DTI ratio, Nomura refused to identify originators contributing fewer than 5% of the loans. This is further confirmation that those in the industry viewed it as important if 5% or more of the collateral was misrepresented across such metrics.
As for qualitative factors, there was overwhelming, and essentially undisputed, evidence that the features that would be viewed by the reasonable PLS investor as significantly altering the total mix of information available included collateral characteristics such as LTV ratios, compliance
Combining these quantitative and qualitative analyses, FHFA showed that the separate misrepresentations within each of the seven Prospectus Supplements on LTV ratios, compliance with underwriting guidelines, and credit ratings were all material in and of themselves. FHFA failed to prove that the materiality threshold was met with respect to the Prospectus Supplements' reporting of owner-occupancy statistics when those representations are taken alone. Only when combined with one of the other misrepresentations do the owner-occupancy statistics add to the showing of materiality.
Little needs to be said in favor of the Court's finding of materiality with respect to the misrepresentation of LTV ratios aside from directing the reader to the chart presented above that demonstrates the differences between what was reported in the Prospectus Supplements regarding LTV ratios (the columns marked "Original") and what was true (the columns marked "Extrapolated"). At least 18% of the loans per SLG had origination appraisals that were non-credible and inflated by over 15%; for five of the SLGs, the percentages ranged from 28% to 36%. These non-credible, inflated appraisals had a dramatic impact on the reporting of LTV ratios in the Collateral Tables, moving 37% of the ratios in the Securitizations over 80%, instead of the 21% reported. And, examining solely those LTV ratios that moved over 100%, none of the Supplements reported that any loans fell in that range, while the actual LTV ratios above 100% fell somewhere between 9.3% and 20.5% for each SLG.
Similarly, little needs to be said in favor of the Court's finding of materiality with respect to guidelines compliance. As explained, at least 45% of the loans per SLG had underwriting defects that materially increased credit risk.
With respect to credit ratings, each Prospectus Supplement represented that the Certificate would not issue without AAA (or equivalent) ratings from S & P or Moody's. The Prospectus Supplements misrepresented that the reported credit rating related to the actual loan collateral for the Securitization. Through the loan tapes, defendants provided the rating agencies with faulty descriptions of the loan populations of each SLG, and those misrepresentations affected the ratings given by the agencies to these securities, causing them to be inflated and not to reflect the quality of the underlying collateral. Worse LTV ratios and failures to comply with underwriting guidelines would have increased the level of subordination required to achieve AAA ratings. In other words, had defendants provided the rating agencies with correct loan-level information, the Certificates would have lacked the level of subordination necessary to be rated as AAA (or its equivalent).
Defendants offer essentially six attacks against the conclusion of materiality here. They complain that, to prove materiality, FHFA relied on experts, and did not call as a fact witness any PLS investor or someone from the GSEs. There is no reliance element in FHFA's claims, however; materiality is an objective test. What the GSEs themselves viewed as significant is relevant only to the extent that it sheds light on what reasonable investors in the PLS market generally viewed as significant.
Defendants argue that reasonable PLS investors understood that collateral characteristics in Prospectus Supplements could not be read in isolation. But the Court's finding of materiality with respect to LTV ratios, guideline compliance, and credit ratings are not based on isolated readings. Rather, they are based on the totality of the information available to reasonable investors during the period 2005 to 2007, the value placed on those characteristics by such investors, and the magnitude of misrepresentations with respect to those characteristics.
Defendants also maintain that investors knew that appraisals reflected the subjective judgments of individual appraisers and might vary by 10-15% from values produced by AVMs. The appraisals that the Court found false, however, varied by more than 15% from the GAVM estimate, and were separately and individually found to be non-credible after an intensive review. Investors of course understood appraisals to be statements of opinion, but that does not mean investors expected or would tolerate statements of opinion that were wildly inflated, not supported by a USPAP-compliant investigation, and not sincerely held by those who rendered them.
Another point made by defendants is that investors recognized that underwriting determinations were inherently subjective and subject to exceptions. Even assuming this is true as a general proposition, it does not undermine the finding of materiality here, where a minimum of 45% of the loans per SLG had underwriting defects that materially increased credit risk. Defects on this scale cannot be explained away by mere reference to "subjectivity" or "exceptions." At this point they reflect a wholesale abandonment of underwriting guidelines.
Finally, with respect to credit ratings, defendants contend that typical RMBS investors during the relevant time period were large institutions that conducted sophisticated pre-acquisition analyses and that used the credit ratings, at most, to confirm the validity of their own models. The record does not support this assertion. Testimony from defendants' own witnesses confirmed the high importance of credit ratings, and the GSEs' own written policies restricted their purchasing decisions based on the credit rating of a security.
FHFA alleges control person liability on the parts of NHA, NCCI, and each Individual Defendant, for controlling one or more of Nomura Securities, NAAC, and NHELI, the primary violators. Pursuant to Section 15 of the Securities Act:
15 U.S.C. § 77o(a) (emphasis added). In other words, Section 15 imposes joint and several "control person" liability. See Lehman, 650 F.3d at 185.
"To establish § 15 liability, a plaintiff must show a primary violation of § 1[2] and control of the primary violator by defendants." Id. (citation omitted). Given the statutory language and the Supreme Court's acknowledgment, when considering Section 15 in conjunction with its affirmative defense, that the claim imposes a negligence standard only, Hochfelder, 425 U.S. at 208-09 & n. 27, 96 S.Ct. 1375, Section 15 is not read to include a "culpable participation" requirement. See In re WorldCom, Inc. Sec. Litig., No. 02cv3288 (DLC), 2005 WL 638268, at *16 n. 20 (March 21, 2005); see also In re MF Global Holdings Ltd. Sec. Litig., 982 F.Supp.2d 277, 308-09 (S.D.N.Y.2013).
The content of both the "control" element and the affirmative defense are informed by the structure of the larger regulatory framework in which Section 15 sits. As noted above, the Securities Act, of which Section 15 is a part, was passed to provide investors with accurate, honest information, by imposing liability on major market participants — "the persons signing the registration statement, the underwriters, the directors of the issuer, the accountants, engineers, appraisers, and other professionals preparing and giving authority to the prospectus" — for misrepresentations. Gustafson, 513 U.S. at 581, 115 S.Ct. 1061 (citation omitted). As noted above, the federal securities laws were "designed to assure compliance with disclosure provisions ... by imposing a stringent standard of liability on the parties who play a direct role in a registered offering," thus placing responsibility on directors and officers for public disclosures. Litwin, 634 F.3d at 716 (quoting Huddleston, 459 U.S. at 381-82, 103 S.Ct. 683).
SEC v. Mgmt. Dynamics, Inc., 515 F.2d 801, 812-13 (2d Cir.1975) (citation omitted).
Congress did not define the terms "control," "controlled," or "controlling person," that appear in Section 15 of the Securities Act and in the companion Section 20 of the Exchange Act. The legislative history of these statutes makes it clear that Congress deliberately left the concept of control undefined:
H.R.Rep. No. 73-1383, at 26 (1934) (citation omitted).
While Congress did not define "control" under the Securities Act or the Exchange Act, the SEC offered a definition in the rules that it promulgated under those statutes. According to SEC regulations, "[t]he term control (including the terms controlling, controlled by and under common control with) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." 17 C.F.R. § 230.405 (Securities Act); id. § 240.12b-2 (Exchange Act).
The Second Circuit has adopted the SEC's definition and has held that "control" under Section 15 is "the power to direct or cause the direction of the management
Numerous considerations bear on whether a defendant exercised "control" for purposes of Section 15, and the inquiry is necessarily context and fact dependent (as is the inquiry into Section 15's affirmative defense). See Howard v. Everex Sys., Inc., 228 F.3d 1057, 1065 (9th Cir.2000) (Exchange Act Section 20(a)). A review of relevant caselaw and other authority on Section 15 control person liability reveals certain principles that guide the analysis. Those principles include the nature of the controlled entity, the status of the alleged controlling entity, and the actions taken by the controlling entity on behalf of the controlled entity. These principles must be viewed in the broader context of the purposes of the securities laws, discussed above.
The nature of the controlled entity matters, because if it turns out that the controlled entity was incapable of taking, or unlikely to take, actions on its own, it becomes more likely that others, who controlled the entity, took actions on its behalf. As the Second Circuit has explained, "Section 15 had its genesis in the concern that directors would attempt to evade liability under the registration provisions by utilizing `dummy' directors to act in their stead." Mgmt. Dynamics, 515 F.2d at 812 (citing S.Rep. No. 73-47, at 5; H.R.Rep. No. 73-152, at 27 (1933) (Conf.Rep.)). The Circuit has not held that a finding of a "dummy director" or "shell corporation," standing alone, demonstrates that some other entity or individual is exercising control, but the Circuit has suggested that such a finding is relevant to the inquiry.
In Lehman, the plaintiffs argued that they had adequately alleged control simply by stating that one of the defendants was a dummy corporation with the sole purpose of securitizing transactions. 650 F.3d at 187. Were dummy or shell status completely irrelevant to the control person inquiry, the Second Circuit would likely have said as much. Instead, the Circuit noted that the complaint did not, in fact, allege that the corporation was a dummy, and did not, in fact, plead facts suggesting that the corporation "was a shell company created to avoid liability for securities law violations." Id. at 187-88. By negative implication, had facts supporting a shell or dummy finding been adequately pled (and ultimately proved), that would have borne on the control person analysis.
The status of the putative controlling entity is also relevant. Certain types of entities, or entities that stand in certain relationships to the controlled entity, are especially likely to exert the hallmarks of control. For example, Section 15 itself provides that being a "stock owner[]" is probative. 15 U.S.C. § 77o(a). Being a parent corporation over a subsidiary, and having common officers, directors, personnel, and office space or other shared resources, are also relevant indicia of control. See, e.g., Waterford Inv. Servs., Inc. v. Bosco, 682 F.3d 348, 356 (4th Cir.2012) (noting relevance of these factors to inquiry of control under FINRA Rule 12100(r), which court analogized to control person inquiry under federal securities law); In re Mut. Funds Inv. Litig., 566 F.3d 111, 131 (4th Cir.2009) rev'd on other grounds sub nom. Janus Capital Grp., Inc. v. First Derivative Traders, 564 U.S. 135, 131 S.Ct. 2296, 180 L.Ed.2d 166 (2011) (Exchange
The status of the putative controlling entity is important not only if that entity is a business, but also if it is a natural person, such as a director, officer, or employee of a company found to be primarily liable. Officer or director status alone does not constitute control, but it is relevant to the inquiry. Howard, 228 F.3d at 1065 ("[A]lthough the directors' status as such was insufficient for a finding of control, their day-to-day oversight of company operations and involvement in the financial statements at issue" were relevant considerations.).
In this regard, the number and nature of positions held are pertinent. See, e.g., Adams v. Kinder-Morgan, Inc., 340 F.3d 1083, 1108 (10th Cir.2003), as amended on denial of reh'g (Aug. 29, 2003) (Exchange Act). Thus, the distinction between inside and outside directors can be important to the control person analysis, since an inside director has at least two positions from which to exercise control. The potential for the distinction between inside and outside directors to be relevant for purposes of control person liability mirrors the importance played by that distinction elsewhere in the regulatory scheme. See, e.g., 15 U.S.C. § 78u-4(f)(2), (10)(C)(ii).
Again, the SEC's definition of control, adopted by the Second Circuit, focuses on power over "the management and policies" of the controlled person. Lehman, 650 F.3d at 185; 17 C.F.R. § 230.405. Because the status of the putative controlling person, standing alone, may not suffice, it is useful to look as well at the actions that that person took or had the duty to take on behalf of the controlled entity. For instance, in a different RMBS case where, like here, control person liability was alleged against the sponsors of the securities, the district court found that control had been sufficiently pled:
Capital Ventures Int'l v. J.P. Morgan Mortg. Acquisition Corp., No. 12cv10085 (RWZ), 2013 WL 535320, at *9-10 (D.Mass. Feb. 13, 2013) (citation omitted) (materially similar Massachusetts state statute).
Of particular importance when the putative controlling person is a natural person is whether he or she acted on the controlled entity's behalf by rendering his or her signature on documents issued by the entity. See Howard, 228 F.3d at 1065-66 ("[One's] participation in the day-to-day management of [the controlled entity] and his review and signature of the financial statements" was relevant to control inquiry.). Demonstrating the holistic nature of the control person inquiry, in which one's status and the actions that one takes cannot be viewed in isolation, one's director or officer status and one's responsibility for signing financial disclosures can be linked, further reinforcing the degree of responsibility that one has for the financial actions of the firm.
In re WorldCom, Inc. Sec. Litig., 294 F.Supp.2d 392, 420 (S.D.N.Y.2003) (quoting Integration of Sec. Act Disclosure Sys., Securities Act Release No. AS-279, 20 SEC Docket 1308 (Sept. 25, 1980)).
Signature requirements were expanded yet again when Congress enacted the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), Pub.L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 15 and 18 U.S.C.), "[t]o safeguard investors in public companies and restore trust in the financial markets." Lawson v. FMR LLC, ___ U.S. ___, 134 S.Ct. 1158, 1161, 188 L.Ed.2d 158 (2014) (citation omitted); see also In re Herald, 730 F.3d 112, 117 (2d Cir.2013) (noting that Congress passed Sarbanes-Oxley "to increase transparency and stability in the securities markets." (citation omitted)). "The Sarbanes-Oxley Act is a major piece of legislation... designed to improve the quality of and transparency in financial reporting.... [It] requires CEOs and CFOs to certify their companies' financial reports...." Cohen v. Viray, 622 F.3d 188, 195 (2d Cir.2010) (citation omitted).
Specifically, Section 302 of Sarbanes-Oxley, requires principal executive and financial officers to certify each annual and quarterly report. See 15 U.S.C. § 7241(a).
Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 1003 (9th Cir.2009), as amended (Feb. 10, 2009) (citation omitted). "It [is] reasonable to expect that corporate officers stand behind the company's public disclosure and be subject to sanction
The importance that attaches to certifications of quarterly and annual financial reports similarly applies to the certification of Registration Statements and their amendments. After all, Section 11 of the Securities Act imposes liability on "every person who signed the registration statement," if the Registration Statement contains a materially misleading statement or omission. 15 U.S.C. § 77k(a). This broad imposition of liability underscores the significance that inheres in placing one's name on a document filed with the SEC for the purpose of providing information to investors or would-be investors. As the Second Circuit has explained:
Barnes v. Osofsky, 373 F.2d 269, 272 (2d Cir.1967) (citation omitted).
As expressed in the language of Section 15 reproduced above, the provision includes an affirmative defense if the defendant can show that "the controlling person had no knowledge of or reasonable ground to believe in the existence of the facts by reason of which the liability of the controlled person is alleged to exist." 15 U.S.C. § 77o(a). NHA, NCCI, and the Individual Defendants assert this affirmative defense.
The statutory language of this defense echoes Section 11's defense of reliance on expertised portions of a Registration Statement, which, like the Section 15 defense, turns on whether a defendant has "reasonable ground to believe" that statements are true. Because "it is a normal rule of statutory construction that identical words used in different parts of the same act are intended to have the same meaning," Taniguchi v. Kan Pac. Saipan, Ltd., ___ U.S. ___, 132 S.Ct. 1997, 2004-05, 182 L.Ed.2d 903 (2012) (citation omitted), the meaning of "reasonableness" under Section 15 can be informed by Section 11's mandate that "the standard of reasonableness shall be that required of a prudent man in the management of his own property," 15 U.S.C. § 77k(c).
A prudent man does not assume a totally passive, willfully blind role in the management of his own property. Thus, although the "unless" clause of Section 15 — "unless the controlling person had no knowledge of or reasonable ground to believe in the existence of the facts" — could be read to condone a see-no-evil, hear-no-evil approach, that clause must be read in the broader context of the federal securities laws, which promote the opposite values: supervision, due diligence, and accountability. Indeed, the Tenth Circuit has explicitly rejected the see-no-evil, hear-no-evil approach. As that court explained in S.F.-Okla. Petroleum Exploration Corp. v. Carstan Oil Co.:
765 F.2d 962, 964-65 (10th Cir.1985).
Similarly, the Seventh Circuit, in ruling that "control does not depend on the qualifications of the control people ... [but i]nstead ... refers to their authority," noted that "[i]f the rule were otherwise, corporate officers and directors could escape control liability by remaining as ignorant as possible — surely not the result that Congress intended." Donohoe v. Consol. Operating & Prod. Corp., 982 F.2d 1130, 1138 (7th Cir.1992) (emphasis added).
This Opinion likewise rejects the see-no-evil, hear-no-evil approach. The determination of whether someone lacks a reasonable ground to believe in the existence of the facts creating liability must be context-and fact-dependent. Some of the same factors that bear on the control inquiry bear on this inquiry as well, including most notably the status of the controlling person and the actions the controlling person took, or had the responsibility to take, on behalf of the controlled person. The very same considerations that cause one's status as a corporate director or officer charged with signing Offering Documents to support a finding of control, may undermine a finding of a lack of a reasonable ground to believe in the existence of certain underlying facts when those facts relate to the accuracy of statements in Offering Documents. In short, while the statute offers a defense to one who lacks reasonable grounds to believe in the existence of the underlying facts, if discharging one's responsibilities as a signatory of public documents would furnish such grounds, one will be hard pressed to make out the defense. After all, as described above, the securities laws and the surrounding regulatory framework impute a certain degree of knowledge and responsibility to those who certify an offering's information to the public.
Before evaluating the statuses and actions taken by the purported controlling entities — NHA, NCCI, and the Individual Defendants — it is useful to note something about the nature of two of the controlled entities, NAAC and NHELI. These two special purpose vehicles were, in effect, shells, with no employees or assets aside from what they held for purposes of Nomura's RMBS business. Their sole function was to serve as depositors for securitizations, including the seven at issue.
NHA controlled — that is to say, enjoyed the power to direct or cause the direction of the management and policies of — all three primary violators: Nomura Securities, NAAC, and NHELI. NHA's ownership of Nomura Securities, NAAC, and NHELI;
Moreover, NHA created NAAC and NHELI for the purpose of issuing RMBS Certificates. Because NHA could decide which loans NCCI could purchase and could deny NCCI permission to buy any loans, NHA had the ability to control and even halt NAAC's and NHELI's issuance of securitizations. Indeed, all the varied ways in which NHA oversaw, set policy for, and provided support to the other Nomura entities are detailed above and need not be reproduced here.
Similarly, NCCI controlled all three primary violators. The overlap of officers, directors, and personnel has been noted: Notably, the CEOs of NAAC and NHELI, Graham and LaRocca, were also officers of NCCI.
NCCI also controlled the three primary violators by directing their RMBS business activities. NCCI's disclosed position as sponsor manifested a responsibility for the content of the Prospectus Supplements. NCCI was responsible for conducting diligence on the loans before purchase, decided which loans to purchase and securitize, and held the loans on its books before depositing them with NAAC or NHELI. In other words, NCCI could prevent the primary violators from issuing RMBS by refusing to purchase loans for securitization, or, having bought loans, refusing to deposit them.
Multiple factors also lead to the conclusion that the Individual Defendants controlled the primary violators in some combination or another.
The Individual Defendants seek to disclaim their responsibility for the accuracy of the statements made in the Prospectus Supplements issued pursuant to those Registration Statements, because they did not sign the Prospectus Supplements. But there is no one better positioned to be held accountable as a control person. With the exception of the third director of the depositors (Ito), the five Individual Defendants are the only signatories of the Registration Statements. If anyone is responsible for the accuracy of the statements made in the Prospectus Supplements issued pursuant to them, it is these five individuals. While the absence of their signatures from the Prospectus Supplements means that they will not be held strictly liable as primary violators, the presence of their signatures on the Registration Statements is highly pertinent to the inquiry of control person liability.
No defendant has carried the burden of proving, under Section 15, that he had no knowledge of, or reasonable ground to believe in, the existence of the facts by reason of which the primary violators are liable. Assuming defendants had no subjective knowledge of the material misrepresentations in the Offering Documents, they did not prove that they had no reasonable ground to believe that there were such misrepresentations.
NHA did not prove that it lacked a reasonable ground to believe in the existence of the material misrepresentations, both because Findlay designed Nomura's diligence process on NHA's behalf, and because, through the various channels described above, NHA continuously monitored the problems and risks in Nomura's RMBS business. Due to the flaws in the design of Nomura's diligence process and the red flags that even that flawed process raised, NHA failed to show that it had no reasonable grounds to believe that the Prospectus Supplements contained the misrepresentations at issue here. Similarly, NCCI did not prove that it lacked a reasonable ground to believe in the existence of the material misrepresentations, largely because, as sponsor, NCCI was intimately connected to every aspect of the securitization process, including the diligence.
The Individual Defendants similarly failed to make out the affirmative defense for control persons. Based on their roles and knowledge as described in earlier sections of this Opinion, Findlay, Graham, and LaRocca each failed to prove the lack of a reasonable ground to believe in the existence of the material misrepresentations, because it was revealed that they did, in fact, have reasonable grounds to know the nature of the work being done during the diligence process, the red flags it raised, and the flawed loans that were being securitized.
Gorin and McCarthy are not entitled to the affirmative defense, but, unlike Findlay, Graham, and LaRocca, not because of demonstrated familiarity with the faults of Nomura's diligence or the red flags it revealed. Quite the opposite. Gorin and McCarthy were familiar with next to nothing about Nomura's RMBS business; they took no steps to educate themselves about what was going on and did nothing to assure themselves of the truth of the statements in the Offering Documents. Any information they did have about the business of which they were a part was limited, inaccurate, or both. Their see-no-evil,
In fact, not just Gorin and McCarthy, but all the Individual Defendants, on some level, professed ignorance about the way in which Nomura's system was supposed to work, and in particular, about whose responsibility it was to ensure that the Prospectus Supplements made accurate representations. Their ignorance is unsurprising, as it appears that no one held that responsibility. But this cannot furnish the basis for the defense. If no one is in charge, those who should be do not get a pass. For instance, none of the Individual Defendants has presented an affirmative defense by showing that he had a reasonable basis to believe both that another qualified, trustworthy, and responsible person or entity was charged with ensuring the accuracy of those portions of the Prospectus Supplements that are at issue here, and that that person or entity had fulfilled that duty.
The Individual Defendants' approach to defending against the charges in this action is not entirely surprising. They effectively had two options, given the interplay between the element of control and the affirmative defense. They could have effectively conceded control but attempted to construct a strong defense by demonstrating the ways in which they, or those on whom they were entitled to rely, were actively engaged in ensuring the quality of Nomura's RMBS business and the accuracy of its Offering Documents-how, despite having discharged their director and officer responsibilities with care, they simply had no reasonable grounds to believe that the Offering Documents contained material misrepresentations. They did not take this tack. Instead, they attempted to fight Section 15 liability by downplaying their involvement in the business, and maintained that, because they were so absent, they had no grounds to believe in the existence of any underlying facts about the business, including the potential for material misrepresentations in the Offering Documents. But, as described, they cannot seek the protection of the affirmative defense if simply doing their job-in the way expected of a prudent man conducting his own affairs-would have provided the reasonable grounds to believe in the existence of the relevant facts.
The point is encapsulated in Findlay's claim that he did not read the UBS report before passing it along to others, with the expectation that a response would require authorization from his superiors. Either Findlay in this instance, and the other Individual Defendants more generally, were aware of information such as the UBS report, in which case they were affirmatively provided the reasonable grounds to believe that Nomura's Offering Documents contained material misrepresentations. Or Findlay actually did not read the report, as he testified, and the other Individual Defendants actually made no efforts to educate themselves about the processes in which they placed their trust.
But as officers and directors of the two depositors, whose business was exclusively devoted to the securitization of RMBS, and as the individuals invested with signatory authority over the Registration Statements for the Securitizations, they were obligated to act prudently in connection with each of the Prospectus Supplements filed by the depositors. They abdicated these roles and shirked this knowledge and responsibility by failing to satisfy themselves, outside of what each viewed as his narrowly circumscribed role, that the NAAC and NHELI Offering Documents were truthful and complied with the requirements of the law. Without any basis and without taking any steps to assure themselves, they blindly trusted that the rest of the Nomura
Section 12 provides a fixed formula for damages: The plaintiff is entitled "to recover the consideration paid for [the] security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security." 15 U.S.C. § 77l(a)(2) (emphasis added). The GSEs retain the Certificates they purchased from defendants, and thus their recovery is measured by the statutory formula. In the case of an RMBS, investors' original investment is repaid in regular increments. Accordingly, each month, the GSE was to be paid a return of principal on its Certificate and a coupon reflecting an interest payment.
To calculate damages, FHFA's expert deducted principal payments received by each GSE on a month-to-month basis to arrive at the amount of pre-judgment interest due on the consideration paid. The proceeds balance at the time of judgment plus the accumulated prejudgment interest make up the statute's "consideration paid" with "interest thereon." Finally, to arrive at a damages figure, the expert added all of the coupon interest payments received by the GSEs and subtracted that amount from the sum of the consideration paid and prejudgment interest. The parties do not dispute the amount of "income received" on the seven Certificates, nor is there substantial disagreement about the amount of "consideration paid." Prior to trial, defendants' request for a further reduction of damages based on a calculation of interest on interest was rejected. Riddiough Opinion, 2015 WL 640875, at *2-3.
The parties dispute two remaining issues regarding damages: the date of "tender," and the proper interest rate. The date of tender is the date of judgment, when the GSEs will tender their Certificates to defendants. Prejudgment interest will be calculated at the Certificates' coupon rate.
With its February 20, 2015 submission of the pretrial order and the direct testimony of its damages expert, FHFA argued for the first time that it constructively tendered its securities as of September 2, 2011, the date of the initial complaint, and that because under Section 12 consideration paid is recovered "upon the tender of such security," it is entitled to receive the recovery dictated by the statute's formula as of that date and to retain all payments received since that date. With this interpretation of the recovery formula, FHFA would be entitled to retain over $178 million in principal and interest payments received since this lawsuit was filed.
FHFA found support for its creative argument in caselaw recognizing the doctrine of "constructive tender." But that doctrine has been applied not to fix a date from which to calculate damages, but to clarify how a plaintiff might satisfy the prerequisite of "tender" some courts have required of Section 12 claimants. See Wigand v. Flo-Tek, Inc., 609 F.2d 1028, 1034-35 (2d Cir.1979). In that context, the constructive tender doctrine refers to the implicit offer to tender rather than the actual tender of securities. For instance,
Id. (emphasis added); see also Morin v. Trupin, 747 F.Supp. 1051, 1063 (S.D.N.Y. 1990) ("A requisite element of a Section 12[(a)] (2) claim is the plaintiffs' tender of the securities they purchased.... A complaint that does not plead at least an offer of tender is insufficient and subject to dismissal."); Anisfeld v. Cantor Fitzgerald & Co., 631 F.Supp. 1461, 1464 (S.D.N.Y. 1986) ("An essential condition of liability under Section 12[(a)] (2) of the Securities Act is that the plaintiff tender the securities he purchased, ... and an offer in the complaint to tender the securities is sufficient to satisfy the condition.").
In any event, it would be wholly inconsistent with Section 12's rescissionary aim to impose a date past which a plaintiff would be permitted to keep some kind of recovery bonus. In return for receiving the award dictated by the statute, the statutory formula requires FHFA to return the principal and interest payments it has received during the time that it has possessed the Certificates. While it is true, as FHFA argues, that "Congress shifted the risk of an intervening decline in the value of the security to defendants," Loftsgaarden, 478 U.S. at 659, 106 S.Ct. 3143, that risk does not include the risk that FHFA will receive a windfall in its recovery. That risk is the risk that defendants bear from any decline in the value of the Certificates since their sale to the GSEs. In allowing a rescissionary remedy, Section 12(a)(2) restores the parties to their positions as of the time the contract was made. See Post-Filing Payments Opinion, 68 F.Supp.3d at 497-98, 2014 WL 7232590, at *10.
The parties also dispute the appropriate interest rate to impose. They have advocated for a series of different rates, but both agree that one of those rates may be the coupon rate. FHFA has advocated for the IRS underpayment interest rate, although it also submitted damages estimates assuming the Certificates' coupon rate as well as a flat 3% interest rate. For their part, defendants advocated for the "risk-free" federal postjudgment rate, but concede that if a rate higher than the federal postjudgment rate is imposed, "the only appropriate one would be the coupon rate." The impact of these various interest rate formulations is as follows:
Risk-Free Rate Coupon Rate 3% Rate IRS Penalty Rate $562,825,709 $624,406,948 $693,635,028 $1,001,704,235
The most appropriate rate for Section 12(a)(2) damages is the coupon rate. That rate vindicates the GSEs' original expectations when purchasing the Certificates. The interests of "full[] compensation," "fairness," and remediation each militate in favor of the coupon rate. See Gierlinger, 160 F.3d at 873.
FHFA asserts that the appropriate rate is the IRS underpayment interest rate for
Similarly inappropriate is the "risk-free" federal postjudgment interest rate proposed by defendants. The federal postjudgment rate is defined by statute as "the 1-year constant maturity Treasury yield." 28 U.S.C. § 1961(a). While, as defendants point out, interest in some circumstances "should be measured by interest on short-term, risk-free obligations," an award of interest is first and foremost "intended to make the injured party whole." N.Y. Marine & Gen. Ins. Co. v. Tradeline (L.L.C.), 266 F.3d 112, 131 (2d Cir.2001). In this case, fully compensating FHFA for its reasonable expectations for recovery on AAA rated Certificates is necessary to achieve that end.
Pursuant to 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, defendants have pursued the statutory affirmative defense of negative loss causation. The statute provides:
15 U.S.C. § 77l(b) (emphasis added). In other words, the statute permits a defendant to reduce or eliminate altogether the obligation to pay damages for its violation of Section 12(a)(2). Section 12 places the burden on defendants to prove that something other than the subject of the misrepresentations or omissions was responsible for any decrease in value of the Certificates.
"Loss causation is the causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff ... [and] is related to the tort law concept of proximate cause." Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 157 (2d Cir.2007) (citation omitted) (Section 10(b) claim).
Section 12's loss causation defense
FHFA v. Nomura Holding Am., Inc. ("Ryan Opinion"), No. 11cv6201 (DLC), 2015 WL 629336, at *2 (S.D.N.Y. Feb. 13, 2015) (citation omitted).
Defendants contend that the entirety of any loss here is due to macroeconomic factors, all stemming from the collapse of housing prices, beginning in 2007. Recently, in a context in which the plaintiff bore the burden of affirmatively establishing loss causation, the Second Circuit remarked that, "[c]ertainly, when a plaintiff's loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that the plaintiff's loss was caused by the [misrepresentation] is lessened." Fin. Guar. Ins. Co. v. Putnam Advisory Co., LLC, 783 F.3d 395, 404 n. 2 (2d Cir.2015).
But, in a telling observation that resonates with the record created here, the Circuit went on to "observe that there may be circumstances under which a marketwide economic collapse is itself caused by the conduct alleged to have caused a plaintiff's loss, although the link between any particular defendant's alleged misconduct and the downturn may be difficult to establish." Id. Again, this statement was made in a context in which an element of the plaintiff's claim would require the plaintiff to affirmatively establish that link. Here, by contrast, defendants bear the burden of proving that something other than that which was concealed by the misrepresentations in the Prospectus Supplements caused the loss in value of the Certificates.
In making its observation about the linkage between a defendant's misconduct and a market-wide phenomenon, the Court of Appeals cited the Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (2011), better known as the Financial Crisis Inquiry Report ("Report"), published by the U.S. Financial Crisis Inquiry Commission.
Report at 225 (emphasis added).
Defendants have failed to carry their burden of proving their affirmative defense of negative loss causation. Notably, they have not quantified the loss that they say is due to macroeconomic factors. They seek to offset the entirety of any judgment awarded to FHFA and offer no means to set off only a portion of any award. As already described, shoddy origination practices contributed to the housing bubble, and were among the factors that contributed to the economic collapse that followed when that bubble burst. Defendants do not dispute this. They do not deny that there is a link between the securitization frenzy associated with those shoddy practices and the very macroeconomic factors that they say caused the losses to the Certificates. This lack of contest, standing alone, dooms defendants' loss causation defense, which, again, requires them to affirmatively prove that something other than the alleged defects caused the losses.
Rather than fighting the existence of the link, defendants present a series of other arguments, each of which is addressed here. They argue that four decisions from the Second Circuit Court of Appeals support their defense; the recession was not within the zone of risk of the misrepresentations and omissions in the Offering Documents; these seven Securitizations played a miniscule role in the creation of the housing bubble; the Government played a role in the creation of the bubble; FHFA has already admitted in court filings and elsewhere that the collapse of housing prices led to the decline in securities' prices; and excluded evidence would have supported the defense.
Defendants cite four decisions by the Court of Appeals for the Second Circuit in support of the argument that market-wide phenomena, such as the housing and financial crises, "can be" intervening causes sufficient to break the proximate causal chain.
In Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir.2005), in the context of an Exchange Act Section 10(b) claim, where loss causation is an element of the plaintiff's prima facie case, the complaint failed to plead loss causation because it included "no allegation that the market reacted negatively to a corrective disclosure" by the defendants. Id. at 175. In Castellano v. Young & Rubicam, Inc., 257 F.3d 171, 188-89 (2d Cir.2001), there was no argument
Finally, in First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 765 (2d Cir.1994), a bank that made loans through mortgage brokers brought a civil RICO claim against one such broker, alleging that the broker misrepresented the value of properties pledged as collateral to induce the bank to make loans. Affirming dismissal of the RICO complaint for failure to plead loss causation, the court reasoned:
Id. at 772 (emphasis added). The court went on to qualify its ruling by warning that it "d[id] not mean to suggest that in all cases a fraud plaintiff will be unable to plead proximate cause when the claim follows a market collapse." Id. Again, unlike the instant case, there is no indication that the plaintiff in First Nationwide Bank attempted to connect the real estate market crash of the '90s to widespread misconduct of the kind in which its defendant was alleged to have engaged.
In their March 9 filing, defendants argue that the housing market and economic recession that they say led to the losses in value of the Certificates were not within the "zone of risk" concealed by the misrepresentations, and thus represent a break in the causal chain, giving rise to a loss causation defense. This argument conceives of "zone of risk" under the loss causation doctrine too narrowly. Narrowly construed, what caused the losses on the Certificates was default and delinquency by borrowers on the mortgages backing the relevant SLGs. The relevant question, of course, is what caused these instances of default and delinquency. It is in response to this question that the interrelatedness of the underlying undisclosed collateral defects and the macroeconomic factors urged by defendants comes into stark relief.
Defendants argue that their role in the market generally, and with respect to these deals individually, was too small to have contributed in a serious way to the liquidity that fueled the housing bubble. These seven deals, valued at roughly $2.45 billion, represented less than 0.1% of the roughly $3 trillion in PLS issued in the period 2005 to 2007.
Such an approach will not be credited. On defendants' view, each PLS depositor, sponsor, or underwriter in the RMBS market may well have contributed to the
Defendants bemoan the fact that FHFA's expert Barth would not quantify the precise extent to which the loans at issue in the seven Securitizations contributed to the oversupply of credit in the housing market. But this turns the burden on its head. For FHFA's purposes of rebutting a showing of loss causation, it is enough to call into question whether defendants have succeeded in putting forth a cause of loss independent of the material misrepresentations. Affirmative quantification would be required on defendants' part, to prove the amount, if any, of the losses attributable to such independent factors. Notably, and indicative of defendants' shortfall in this case, their expert Vandell admitted that he had not undertaken any effort to evaluate how much additional credit went to borrowers as a result of the origination of defective loans, or to apportion the loss to the value of the Certificates to different causes.
Defendants argue that Government regulations and policies, such as those pursued by the GSEs, also contributed to the macroeconomic factors that defendants say caused the losses. The implication, presumably, is that FHFA as a governmental agency and the Government Sponsored Entities on whose behalf it acts should not seek to recover for losses that may have been caused in part by the Government. As has been recounted tirelessly in this litigation, the identity of the plaintiff is wholly irrelevant to the legal issues that were tried here. Defendants were not restricted from offering evidence of the growth of liquidity in the housing market. But what is at stake is the amount of growth overall; not the particular amounts attributable to any one actor. For present purposes, the question is whether defendants persuasively proved that something other than that which was misrepresented in the Offering Documents caused the alleged losses. Defendants did not.
Defendants used trial testimony from three witnesses who worked at the GSEs, GSE statements made in SEC filings and elsewhere, and court filings on behalf of the GSEs in support their loss causation defense. According to defendants, since the GSEs and FHFA have admitted repeatedly that the collapse in housing prices caused the GSEs to incur losses, they have essentially conceded the loss causation defense offered at this trial.
In particular, defendants contend that the statements by GSE agents in prior lawsuits definitively establish FHFA's position on the issue of losses sustained by these seven Certificates. In other words, defendants argue that, under the doctrine of judicial estoppel, FHFA may not make a different argument to rebut defendants' loss causation defense here.
The testimony offered by trial witnesses employed by the GSEs and the GSEs' own documents and filings have been described earlier in the Opinion. None of that evidence contradicts the position taken by FHFA here in its analysis of defendants' loss causation defense. Similarly, statements made in the four prior lawsuits on which defendants rely do not judicially estop FHFA from asserting at this trial that the industry-wide practices in which defendants engaged, and the subject matter of the misrepresentations and omissions in the Offering Documents, contributed to any loss in value of the Certificates.
In the four prior lawsuits on which defendants rely, the GSEs were defending against allegations that their stock prices — a reflection of the GSEs' performance overall (including both their PLS and Single-Family businesses) — had fallen because of the GSEs' own misrepresentations or mismanagement. In mounting their defense, the GSEs sensibly pointed to a systemic economic collapse to argue that the plaintiffs had failed to adequately plead loss causation (as was their burden).
First, in Ohio Pub. Emps. Ret. Sys. v. Fed. Home Loan Mortg. Corp., No. 08cv160 (BYP), 2014 WL 5516374 (N.D.Ohio), the plaintiff alleged that Freddie Mac and its officers misrepresented the amount of subprime loans that the GSE purchased. 2014 WL 5516374, at *2. In moving to dismiss, Freddie Mac argued that the plaintiffs could not show loss causation because, among other reasons, they "ignor[ed] the single worst financial crisis since the Great Depression" and thus "fail[ed] to allege any facts to exclude the most obvious explanation for Freddie Mac's stock decline — the impact of a dramatic, unprecedented financial markets collapse." Freddie Mac's motion was granted on loss causation grounds — not because the plaintiff failed to account for the market collapse, but because under controlling Sixth Circuit precedent it failed to plead that Freddie Mac made a corrective disclosure or revealed a truth behind any alleged misrepresentation. Id. at *9.
Second, in In re Fed. Home Loan Mortg. Corp. Derivative Litig., prior to initiating derivative suits, the plaintiffs made demands on Freddie Mac's board, which appointed a special litigation committee to investigate. The case was stayed after the court found that the plaintiffs lacked standing, see 643 F.Supp.2d 790,
Third, in Kuriakose v. Fed. Home Loan Mortg. Corp., No. 08cv7281 (JFK), 2011 WL 1158028 (S.D.N.Y.), the plaintiff brought a securities fraud action against Freddie Mac and its officers, asserting that they had materially misrepresented Freddie Mac's exposure to non-prime mortgage products, the sufficiency of its capital, and the strength of its due diligence and quality control mechanisms. 2011 WL 1158028, at *4 (S.D.N.Y. Mar. 30, 2011). In moving to dismiss, Freddie Mac pointed to macroeconomic factors and argued that "[f]ailing to predict the timing and magnitude of a historically unprecedented drop in housing prices and the recent financial crisis is not fraud." The district court dismissed all claims. In dismissing the claims concerning its exposure to loss and capitalization, the court found that the complaint failed to plead a false or misleading statement, or to present facts giving rise to a strong inference of scienter. Id. at *11-13. In dismissing the plaintiffs' allegations that Freddie Mac misrepresented the strength of its underwriting standards and internal controls, the court found that the plaintiffs failed to plead that any disclosure of concealed information by Freddie Mac concerning its internal controls supported a theory of loss causation. Id. at *13. It further found that, given that "the price of Freddie Mac's stock was clearly linked to the `marketwide phenomenon' of the housing price collapse, there [was] a decreased probability that Plaintiffs' losses were caused by fraud." Id. In summarily affirming the subsequent dismissal of a second amended complaint, the Second Circuit explained that the plaintiff had failed to allege any decline in the price of the GSE's stock that was related to a corrective disclosure regarding the alleged misrepresentations. Cent. States, Se. & Sw. Areas Pension Fund v. Fed. Home Loan Mortg. Corp., 543 Fed.Appx. 72, 74 (2d Cir.2013).
Finally, in In re Fannie Mae 2008 Sec. Litig., (about which, as noted earlier, Mudd was questioned during this trial), in moving to dismiss, Fannie Mae argued that the plaintiffs could not show loss causation because "in the historically tumultuous market of late 2007 through 2008, there were a multitude of factors affecting the price of Fannie Mae's securities — most of which were global and market-wide factors not specifically relating to Fannie Mae." The court dismissed all but the plaintiffs' claims related to risk management and internal controls for failure to adequately plead material misrepresentation. In relation to the remaining claims, it held that, "[a]lthough it may be likely that a significant portion, if not all, of Plaintiffs' losses were actually the result of the housing market downturn and not these alleged misstatements," the plaintiffs had still pled a theory of loss causation adequate to survive a motion to dismiss. 742 F.Supp.2d 382, 414 (S.D.N.Y.2010).
Here, FHFA is not judicially estopped from presenting its evidence and arguments against defendants' loss causation defense. In this case, FHFA seeks to hold specific parties responsible, under strict liability securities law, for their roles in making misrepresentations in Offering Documents for seven specific Certificates. Arguing that a systemic collapse in housing prices caused a decline in the GSEs' stock price does not conflict with, let alone
There is no dispute that there is a strong correlation between the collapse of housing prices and losses incurred by the GSEs, whose entire existence is devoted to the housing market. The question presented by the loss causation defense in this case, however, when asserted in connection with FHFA's Securities Act claims, is a different one. The question is whether defendants have shown that the macroeconomic events that contributed to a loss in value of the Certificates were unrelated to defective loans whose quality was misrepresented in the Offering Documents. The various statements by the GSEs and FHFA (in prior lawsuits, public filings, and elsewhere) to which defendants point do not assist them in answering that question.
The losses the GSEs suffered on these seven Certificates certainly coincided with a catastrophic market event. The misrepresentations FHFA has shown were made in defendants' Offering Documents have not been persuasively separated from that event. An event cannot be "intervening" if defendants' misrepresentations, and the underlying facts they concealed, were part and parcel of it.
As noted above, two of the categories of evidence listed in defendants' April 1 Offer of Proof are testimony from Niculescu and Cook, and evidence concerning Housing Goals and the GSEs' selection of loans in the Securitizations. Defendants contend that this evidence would have been probative with respect to the loss causation defense.
FHFA moved in limine to preclude defendants from using GSE employee witnesses to provide their opinions regarding the issue of loss causation. In response, as the Offer of Proof recounts, the Court outlined before trial the evidentiary showing that a party would need to make for the admission of lay opinion testimony. See GSE Loss Causation Opinion, 2015 WL 685159, at *4; Order of March 4, 2015, ECF Doc. No. 1358. And at the final pretrial conference, the Court explained that what was critical to the receipt of lay opinion testimony was a showing that the employee had a responsibility for developing an opinion regarding the cause of any loss, and not whether the employee was the person who did the research necessary to inform that opinion.
The Offer of Proof lists the subjects concerning loss causation on which defendants were unsuccessful in questioning Niculescu and Cook because the Court sustained FHFA's objections.
On December 18, 2014, the Court excluded evidence pertaining to the Housing Goals put in place for the GSEs by federal statute and regulations promulgated by the Department of Housing and Urban Development. Housing Goals Opinion, at *3-4 (S.D.N.Y. Dec. 18, 2014). The Court rejected defendants' contention that Housing Goals are important to the loss causation defense, explaining:
Id. at *3.
Defendants' Offer of Proof maintains that absent this ruling, they would have offered evidence that the GSEs' losses were caused by their desire to invest in PLS to meet the agencies' Housing Goals.
For all of the reasons given above, defendants ultimately failed to disentangle, as was their burden on the affirmative defense, what they say caused the losses from the very subjects of the material misrepresentations at issue. Defendants set for themselves the challenging task of proving the counterintuitive proposition that more shoddy origination did not produce worse performing loans. It is unsurprising that they failed to carry that burden.
With respect to four of the seven Securitizations, FHFA has brought suit under the Blue Sky laws of Virginia and the District of Columbia, Va.Code Ann. § 13.1-522(A)(ii); D.C.Code § 31-5606.05(a)(1)(B), (c).
The Virginia and D.C. Blue Sky laws were modeled on the Uniform Securities Act of 1956, which was in turn modeled on the Securities Act of 1933. FHFA v. HSBC N. Am. Holdings Inc., 988 F.Supp.2d 363, 370 (S.D.N.Y.2013). Therefore, it is not surprising that the two Blue Sky laws have similar language, and that courts look to federal law to interpret the similar terms.
The Virginia Blue Sky law provides, in pertinent part, that
Va.Code Ann. § 13.1-522(A)(ii). The Virginia Blue Sky law has been described as "substantially identical" to the Securities Act. Dunn v. Borta, 369 F.3d 421, 428 (4th Cir.2004). For that reason, "Virginia courts will look to interpretations of the federal securities laws when called upon to construe the Virginia Securities Act." Id. at 428 n. 17 (citation omitted); Andrews v. Browne, 276 Va. 141, 662 S.E.2d 58, 62 (2008).
The D.C. Blue Sky law provides:
D.C.Code § 31-5606.05(a)(1)(B), (b)(1)(A). Like the Virginia Blue Sky law, the D.C. Blue Sky law is generally interpreted in
The relevant provisions of the Virginia and D.C. Blue Sky laws are essentially the same as those of Section 12(a)(2), and the same duty to prove falsity and materiality is imposed on FHFA. Dunn, 369 F.3d at 428, 433; Hite, 429 F.Supp.2d at 114. Accordingly, here it will suffice to note the ways in which the legal standards applicable to the Blue Sky claims differ from those applicable to the Securities Act claims.
The Virginia and District of Columbia Blue Sky laws both adopt Section 12(a)(2)'s measure of damages. Va.Code Ann. § 13.1-522(A); D.C.Code § 31-5606.05(b)(1)(A). "The formulae differ only in the applicable interest rate." Riddiough Opinion, 2015 WL 640875, at *1. Additionally, while Section 12(a)(2) does not expressly provide for recovery of costs and reasonable attorneys' fees, the Blue Sky laws do. Va.Code Ann. § 13.1-522(A); D.C.Code § 31-5606.05(b)(1)(A).
Under the Virginia Blue Sky law, a six-percent interest rate is set by statute. Va.Code Ann. § 13.1-522(A) ("together with interest thereon at the annual rate of six percent"). Similarly, under the D.C. Blue Sky law, the interest rate is the "rate used in the Superior Court of the District of Columbia," D.C.Code § 31-5606.05(b)(1), which is also six percent, id. § 28-3302(a) ("The rate of interest in the District upon ... things in action in the absence of expressed contract, is 6% per annum.").
"[N]either Virginia's nor the District of Columbia's Blue Sky law provides a loss causation defense to the claims at issue." Ryan Opinion, 2015 WL 629336, at *2.
FHFA asserts control person liability not only under Section 15 of the Securities Act, but also under a largely analogous provision of the D.C. Blue Sky law
D.C.Code § 31-5606.05(c). The notable difference is that the D.C. Blue Sky law renders liable (subject to a reasonable care affirmative defense) officers and directors of the person liable without regard to whether they possessed control.
Under the Virginia and D.C. Blue Sky laws, FHFA bears the burden of demonstrating that the sales of the Certificates occurred in Virginia and D.C., respectively. Freddie Mac is headquartered in McLean, Virginia, and Fannie Mae is headquartered in Washington, D.C.
The Uniform Securities Act, substantially adopted by both jurisdictions, by its own terms applies "to persons who sell
The D.C. Blue Sky statute itself provides that it "shall apply to a person who sells, or offers to sell, when an offer to sell is made in the District or an offer to purchase is made and accepted in the District." D.C.Code § 31-5608.01(a). Again, like the Uniform Act, the D.C. statute provides that "an offer to sell or to purchase is made in the District, whether or not either person is present in the District, if the offer originates in the District, or is directed by the offeror to a destination in the District and received where it is directed." Id. § 31-5608.01(c).
Given the substantial similarity between both Blue Sky laws and the relevant provisions of Section 12, the proof of falsity and materiality described above with respect to Section 12 suffices to prove falsity and materiality under the Blue Sky laws. Defendants have not argued to the contrary.
Only the Securitization's direct seller, RBS, is liable under Virginia's Blue Sky law. Under the D.C. Blue Sky law, Nomura Securities and NAAC are liable as direct sellers. Under the D.C. Blue Sky law, Findlay, Graham, Gorin, and McCarthy are liable as control persons due to their positions as officers and directors of NAAC,
FHFA is awarded damages under the Blue Sky laws in accordance with the damages calculation described above, with the exception that the interest rate applied is the statutorily prescribed 6% interest rate. As of March 31, 2015, those damages are $522,942,248. As double recovery is not permitted, to the extent it seeks Blue Sky damages on a Securitization, FHFA may not also recover on its Section 12 claims for that Securitization.
Defendants offer a single defense unique to the Blue Sky laws. They contend that FHFA did not carry its burden of proving that the sales or offers of sale were directed to persons within Virginia or the District of Columbia. After all, say defendants, that an employee was generally based at a particular location does not mean that the person was necessarily at that location at the time he or she received or sent an email.
Freddie Mac has its principal place of business in McLean, Virginia. This is where Freddie Mac's PLS traders worked between 2005 and 2007, including Hackney and Aneiro, who worked on the three Securitizations.
RBS and Nomura sent offering materials and collateral information regarding each of the three Securitizations to Freddie Mac employees using their Freddie Mac email addresses, to a designated Freddie Mac email address for the receipt of documents,
Fannie Mae has its principal place of business in Washington, D.C., which is where Fannie Mae's PLS traders worked when Fannie Mae purchased the NAA 2005-AR6 Certificate in 2005. Nomura sent offering materials and collateral information for this Securitization to Fannie Mae PLS traders at their work email addresses. Nomura Securities sent its confirmation for the Certificate's purchase to Fannie Mae's physical address in Washington, D.C.
Defendants have offered no affirmative evidence that the offers to sell were not made in and/or accepted in Virginia and D.C. RBS has pointed to the fact that one Freddie Mac trader communicated an agreement to purchase a Certificate from his Blackberry. The implication, apparently, is that the trader must have been using his Blackberry because he was not in the office on that day. It hardly follows from use of a Blackberry that the user is out of the office. Moreover, the Blackberry message was for a Certificate other than the three Freddie Mac Certificates on which FHFA is proceeding under the Blue Sky laws. Finally, defendants point to no evidence that any Freddie Mac traders lived anywhere other than the State of Virginia.
Defendants argued that an adverse inference should be drawn against FHFA because it did not bring the traders or other GSE witnesses to New York to testify to the traders' locations at the time they made the decisions to purchase the Certificates. No adverse inference is appropriate. There is sufficient evidence to find that both the offers to sell and the decisions to buy were made in the relevant jurisdiction, and evidence of either one would be sufficient.
Defendants made a last-minute argument that applying the Blue Sky laws here
For over a century it has been established that state Blue Sky laws do not violate the Dormant Commerce Clause because they "only regulate[] transactions occurring within the regulating States." Edgar v. MITE Corp., 457 U.S. 624, 641, 102 S.Ct. 2629, 73 L.Ed.2d 269 (1982) (citing Hall v. Geiger-Jones Co., 242 U.S. 539, 557-58, 37 S.Ct. 217, 61 L.Ed. 480 (1917)). Indeed, Congress has recognized the validity of intrastate securities laws through a provision in the Securities Exchange Act "designed to save state blue-sky laws from pre-emption." Edgar, 457 U.S. at 641, 102 S.Ct. 2629 (citation omitted).
Defendants acknowledge this line of precedent, but argue that it was overturned sub silentio by Morrison v. Nat'l Austl. Bank Ltd., 561 U.S. 247, 130 S.Ct. 2869, 177 L.Ed.2d 535 (2010), and Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60 (2d Cir.2012), which they claim "set[] forth a new, federal definition of where a transaction occurs." Morrison and Absolute Activist are the "principal case authority in this Circuit governing the application of § 10(b) and Rule 10b-5 to claims involving extraterritorial conduct." Parkcentral Global Hub Ltd. v. Porsche Auto. Holdings SE, 763 F.3d 198, 209 (2d Cir.2014) (emphasis added). The Blue Sky claims do not involve extraterritorial conduct, and a legal standard for cases that do involve such conduct will not be applied.
Judgment will issue on the following claims, against the following defendants, as to the following Securitizations:
D.C.Code D.C.Code Va.Code Ann.
§ 31-5606.05 § 31-5606.0 § 13.1-522
Securitization Section 12(a)(2) Section 15 (a)(1)(B) 5(c) (A)(ii)
NAA 2005-AR6 NAAC, Nomura NHA, NCCI, NAAC, Nomura NHA, NCCI,
Securities Individual Securities Findlay, Gorin,
Defendants Graham,
McCarthy
NHELI 2006-FM1 NHELI, Nomura NHA, NCCI,
Securities Individual
Defendants
NHELI 2006-HE3 NHELI, RBS NHA, NCCI,
Individual
Defendants
NHELI 2006-FM2 NHELI, RBS NHA, NCCI, RBS
Individual
Defendants
NHELI 2007-1 NHELI, RBS NHA, NCCI, RBS
Individual
Defendants
NHELI 2007-2 NHELI, RBS NHA, NCCI, RBS
Individual
Defendants
NHELI 2007-3 NHELI NHA, NCCI,
Individual
Defendants
Eighty-two years ago, in the midst of the Great Depression, Congress passed the Securities Act in the hope that "full disclosure of material information," Hochfelder,
An order will issue for FHFA to submit a proposed judgment with updated damages figures calculated under the formulae applied in this Opinion. A schedule will also be set for submissions concerning attorneys' fees.
SO ORDERED.
In keeping with their strategy throughout the trial, defendants sought to prevent the Court from evaluating the evidence on a loan-by-loan basis. As already mentioned, the organization of Hedden's testimony did not readily lend itself to such an evaluation, and defendants objected (successfully) when FHFA propounded a table that listed by loan number all 184 non-credible appraisals and displayed how the CAM scores would change if Hedden's criticisms were adopted. In short, the excluded table performed the analysis that the Court independently undertook.
