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From Securities Regulation Daily, March 19, 2013

Fraud in Securitized Mortgage Offerings Sufficiently Pleaded Against Countrywide

By Matthew Garza, J.D.

The Federal Housing Finance Agency, conservator of government-sponsored enterprises Fannie Mae and Freddie Mac, has sufficiently pleaded securities fraud claims against Countrywide Financial Corporation for losses suffered by the GSEs when they invested in residential mortgage-backed securities (RMBS) offered by Countrywide from 2005 to 2008 (Federal Housing Finance Agency v. Countrywide Financial Corporation, March 15, 2013, Pfaelzer, M.).

The Federal Housing Finance Agency (FHFA) was created by the Housing and Economic Recovery Act of 2008 in response to the losses suffered by the GSEs when housing prices dropped precipitously beginning in 2007. FHFA filed suit against various issuers of mortgage-backed securities in February 2012, and this litigation against Countrywide was transferred to the federal district court in Los Angeles.

Securitized mortgages. FHFA said the GSEs purchased approximately $26.6 billion in residential mortgage-backed securities from Countrywide between August 30, 2005, and January 23, 2008. The loans were acquired and securitized by Countrywide entities and registered through shelf registration statements that allowed Countrywide to issue certificates at a later date, after a prospectus statement and prospectus supplements (offering documents) were issued explaining the structure of the investment. The holder of one of these securities was entitled to a portion of the cash flow from a pool of underlying mortgages sold in tranches, with riskier "junior" tranches carrying higher interest payments but lower credit ratings, and "senior" tranches offering lower interest payments but higher credit ratings.

Claims. FHFA sued Countrywide under Securities Act Section 11 alleging that the offering documents for the securities contained false statements and also sued underwriters under Section 12(a)(2) of the Securities Act. The underwriters included Countrywide Securities Corporation, Banc of America, Citigroup, Deutsche Bank, RBS Securities, and UBS Securities. FHFA asserted violations of Virginia state and Washington, D.C., blue sky laws, controlling person claims under Securities Act Section 15, and negligent misrepresentation claims under New York law.

Misrepresentations in the offering. The court initially found that the complaint adequately pleaded three out of four types of alleged misrepresentations in the offering documents: (1) misrepresentations of loan-to-value (LTV) ratios, a measure of the default risk of a mortgage loan; (2) deviation from listed underwriting guidelines; and (3) false credit ratings. A fourth type of misrepresentation alleged, regarding data about owner residence in the homes, was dismissed.

Loan-to-value ratios. The RMBS offering documents stated that none of the loans from the supporting pools had a LTV ratio over 100 percent and that 81.69 percent of the loans had LTV ratios at or below 80 percent. FHFA tested the accuracy of these ratios through the use of an automated valuation model recognized as an industry standard and found both of these statements were untrue. The model showed 26.25 percent of the reviewed sample had LTV ratios above 100 percent and 42.14 percent of the loans had ratios below 80 percent. "In other words, the Complaint alleges that the appraisals relayed in the Offering Documents systematically inflated the reported value of the properties, which deflated the LTV ratios," the court said.

False underwriting guidelines. FHFA sufficiently alleged that Countrywide misrepresented its compliance with the underwriting guidelines specified in the offering documents. Specifically, the court said Countrywide used a "matching strategy" to create the most aggressive guidelines in the origination market, making "excessive and wholesale use of ‘exceptions' to its normal underwriting standards." The only criterion for approving a loan, according to the complaint, was whether it could be securitized and sold in the secondary market, despite the fact that the offering documents listed more stringent standards. The court rejected Countrywide's defense that the statements were true or immaterial, or that the complaint failed to connect the allegedly false underwriting standards to specific loans. The matching strategy was an expansion of the underwriting standards that abandoned the listed guidelines, according to the court, and while this in itself did not support a fraud claim, failing to disclose it to investors constituted a viable misstatement.

False credit ratings. Countrywide inflated the credit ratings of each tranche to the credit agencies, according to the complaint, because they used incorrect data about the underlying collateral. The court said that because FHFA alleged Countryside misstated the credit ratings as a result of acquiring false information, the claim was adequately pleaded. The court said FHFA's allegations with regard to false owner-occupancy data in the offering documents were not adequately pleaded, finding that the offering documents did not include misstatements, but merely "accurately repeated information about occupancy provided by borrowers." Countrywide disclosed that this data was based on self-disclosure by the borrowers.

The court went on to hold that the FHFA complaint alleged justifiable reliance on the offering documents, that Countrywide knew the offering documents contained misrepresentations, and that the securities lost value as a result of the misrepresentations.

Dismissed claims. Negligent misrepresentation and aiding and abetting were not properly alleged, the court held. Also dismissed were the Washington, D.C., blue sky claims as well as the Securities Act Section 11 claims against individual defendants. With regard to individual liability for the misstatements in the offering documents, the court found that the misstatements were contained in prospectus supplements, and the registration statement signed by the individual defendants was essentially blank on its effective date, so the individual defendants could not be liable under Section 11.

The case is No. 2:11-ML-02265-MRP.

Attorneys: Brian Charles Devine (Goodwin Procter, LLP) and David Martin Halbreich (Reed Smith, LLP) for Countrywide Financial Corp.

Companies: Countrywide Financial Corp.; Fannie Mae; Freddie Mac; Banc of America Securities LLC; Citigroup Global Markets, Inc.; Deutsche Bank Securities; RBS Securities; UBS Securities, LLC.

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