The lawsuit against J.P. Morgan for the alleged fraud and deceit by Bear Stearns (a company that J.P. Morgan acquired in 2008) highlights the breadth of the damage caused in connection with sales of Residential Mortgage-backed Securities (RMBS).  So far, investors have lost $22.5 billion in more than 100 subprime securities that Bear Stearns had issued in 2006 and 2007.  The lawsuit seeks injunctive relief, damages and payment of restitution to investors for “fraudulent and deceptive acts.” 

The complaint alleges two main types of wrongdoing.  First, that Bear Stearns represented to investors that it had conducted due diligence and would continue to monitor the investments, neither of which Bear Stearns in fact did.  Second, that Bear Stearns’ executives were made aware of problems with the securities but failed to correct its practices or disclose the information to investors.  Let’s examine the allegations of the complaint.

Preliminarily, and what is important to note, is that traditionally, mortgage loan originators held their mortgages through the term of the loan.  They thus had strong economic incentive to verify a borrower’s creditworthiness through strict compliance with underwriting guidelines and an accurate appraisal of the underlying property.  All of that changed when Wall Street created a new way to produce a product: securitization of mortgage loans.  By selling their loans to Wall Street firms, the originators bore no risk of non-payment.  RMBS were pools of residential mortgages deposited into trusts.  Investors purchased those trusts in order to receive a stream of income from the mortgages packaged in the RMBS.  Ultimately, mortgage borrowers could not repay those mortgages and defaulted on them in large numbers.  Instead of mortgage originators, or Wall Street firms, being left to bear the losses, investors were the ones left holding the bag.

The complaint alleges that Bear Stearns publicly filed documents and distributed marketing materials that led investors to believe that Bear Stearns “had carefully evaluated – and would continue to monitor” the quality of the loans in the RMBS.  Worse, the complaint alleges that Bear Stearns “systematically failed to fully evaluate the loans, largely ignored the defects that their limited review did uncover, and kept investors in the dark about both the inadequacy of their review procedures and the defects in the underlying loans.”  While Bear Stearns represented that it taken a variety of steps to ensure the quality of the loans in the RMBS, it failed, for example, to check that the loans were originated in accordance with the applicable underwriting guidelines – including that loans were extended only to borrowers who had demonstrated a willingness and an ability to repay them!

The complaint alleges that a conflict of interest apparently fueled the fraud and deceit.  Specifically, Bear Stearns could have conducted due diligence “to identify and eliminate the many defective loans that they purchased from originators.”  Instead, “and in order to preserve their relationships with loan originators”, they “routinely overlooked” defective loans and “ignored deficiencies.” 

The complaint alleges that Bear Stearns knew of the need to reform its review of the loans “but made no efforts to improve the process.”  The New York Attorney General cites an internal Bear Stearns document dated July, 2007.  In that document Bear Stearns acknowledges a “perfect storm” that resulted from having “wide guidelines” and having “abused the controls of them.”

            In terms of monitoring after the sale, the complaint alleges the great disconnect between what was represented to investors and what actually was done.  Whereas Bear Stearns promoted its quality control process, which would identify problematic loans and remove them from its RMBS, in reality, “the quality control department was so overwhelmed by the sheer number of defects in the underlying loans that it could not properly function.”  Not only did Bear Stearns fail to even correct the problem, it also failed to alert investors.  Worse still, the complaint alleges that Bear Stearns, again faced with a conflict of interest, “used the quality control process to secure monetary recoveries for themselves, which they failed to pass on to investors.” 

            As a result, “monumental losses” have been suffered in what the complaint calls “a systematic fraud on thousands of investors.”  Let’s hope that this complaint, and subsequent complaints against other Wall Street firms which the New York Attorney General states that it intends to file, will send a message to Wall Street!