In the wide-ranging litigation against banks that sold mortgage-backed securities to two government-sponsored enterprises, Fannie Mae and Freddie Mac, Judge Cote issued a decision Monday largely denying a motion to dismiss brought by certain of the banks. The plaintiff Federal Housing Finance Agency (or “FHFA,” as conservator for Fannie Mae and Freddie Mac) claims that the banks’ offering documents falsely described the strength of the loans and the underwriting process. As evidence of fraud, FHFA pointed out that the ratings agencies substantially downgraded the securities after the banks sold them. The banks argued that this was simply “fraud by hindsight,” especially because of the intervening financial crisis. Judge Cote rejected that argument:
The defendants are correct that the downgrade of an investment once thought to be riskless to near-junk status could reflect a variety of factors, including mistakes on the part of the ratings agencies and larger economic forces. But such a downgrade could also reflect a realization on the part of the market that the assets underlying the securities at issue “were not as advertised.” UBS I, 858 F. Supp. 2d at 321. FHFA’s allegation that the credit-rating downgrades are, at least in part, evidence of defects in the securitization process finds further support in the remarkably high percentages of loans in all of the Supporting Loan Groups that are delinquent, defaulted or foreclosed upon. The Agency’s reliance on this information is not, as the defendants allege, an effort to argue “fraud by hindsight;” rather the Amended Complaint suggests that these market events are telltale signs of defects that were present in the securitizations all along, albeit unbeknownst to the purchasing public. FHFA may be wrong, of course; a jury will decide. But the claim is not an implausible one, particularly given the Amended Complaint’s allegations that lax underwriting practices and, in some instances, purposeful manipulation of borrowers’ credit profiles were widespread among some of the defendants’ own origination arms and among third-party mortgage originators who are known to have contributed significant numbers of loans to these securitizations.
(H/T: Alison Frankel)