One of the reasons, of course, that is cited as a cause of the credit crunch of 2007 is the fact that banks did not know how much toxic debt in the form of collateralised debt obligations (CDOs), or shares in sub-prime mortgages in other words, other banks were holding. As a result all the banks stopped lending to each other and the ones that didn’t have ready capital of their own became insolvent. Four years later there is no such mystery over where the sub-prime poison and other bad debts ended up but, fortunately for those who run the banks if not for their shareholders, governments stepped in to prevent all except Lehman Bros. from going to the wall.
Two institutions that were especially badly damaged by becoming party to sub-prime lending were Fannie Mae and Freddie Mac. They were hurriedly and expensively rescued by the US government in the form of the Federal Housing Finance Agency (FHFA). The FHFA not unreasonably has taken a long hard look at the CDOs that Fannie Mae and Freddie Mac bought in the years running up to the credit crunch to see who was responsible for the appalling losses that they sustained. The answer, it seems, is that these bundles of mortgage were deliberately or wilfully mis-sold and the FHFA is suing the banks that sold them in order to get its money back.
Taking the suit against Barclays as an example it looks on the face of it as though FHFA has a very good case. The complaint alleges that when its ‘securitizations’ were issued, Barclays either did know or should have known that the registrations and prospectus supplements were substantially untrue. It looks at statistics which would have been available at the time to see if the figures that were quoted for levels of owner-occupancy and loan-to-value ratios were accurate. Not surprisingly, given subsequent events, it finds that they weren’t: they were miles out. More damningly the FHFA repeats in its complaint evidence that was produced in government investigations and court cases that have taken place since the crisis. So, for instance, the Supreme Judicial Court of Massachusetts found that Fremont, a mortgage originator for Barclays, “made no effort to determine whether borrowers could ‘make the scheduled payments under the terms of the loan,’” and that “Fremont knew or should have known that [its lending practices and loan terms] would operate in concert essentially to guarantee that the borrower would be unable to pay and default would follow.” Given the amount of testimony that the court had seen of appalling malpractice at the mortgage originators these conclusions seem inevitable.
This skeleton has been out of the closet for some time now and it is highly likely that FHFA will arrive at some sort of very expensive settlement with the banks. Why shouldn’t any other wounded party that bought CDOs follow the FHFA example and suing for its money back and, if they did, where would that all end?