JP Morgan Sold Investors MBS Covered By "SACK OF SHIT" Loans... Then Shorted All Those With Exposure: A Goldman-AIG Redux

Today's mortgage fraud stunner comes from Bloomberg's Jody Shenn who reports on the ongoing lawsuit between Ambac and former Bear Stearns mortgage unit EMC, now part of JP Morgan. In what can only be classified as fraud-cum-double dipping-cum-AIG/Goldman, "JPMorgan Chase & Co. demanded that a lender repurchase bad mortgages even as it resisted calls to buy back the loans from bonds created by Bear Stearns. “That would be pretty bad” if true, said Joshua Rosner, an analyst at New York-based research firm Graham Fisher & Co. He said such allegations show why “investors and consumers have a right to be distrustful of the banks’ statements." The bottom line is that JPM, which has so far been able to escape largely unscathed from the fraudclosure scandal, is about to take front and center. The reason: the very first line of the just released Exhibit 1 to the Ambac lawsuit: "In mid-2006, Bear Stearns induced investors to purchase, and Ambac as a financial guarantor to insure, securities that were backed by a pool of mortgage loans that - in the words of the Bear Stearns deal manager - was a "SACK OF SHIT." But the stunner, and nothing short of a full-blown scandal if proven true, is that Bear Stearns (aka JPM) after funneling misrepresented loans with Ambac's insurance, "implemented a trading strategy to profit from Ambac’s potential demise by “shorting” banks with large exposure to Ambac-insured securities." This needs its own congressional hearing right now, followed by a few wristslaps. After all such wholesale fraud can never possibly be prosecuted in the world's most advanced country.

(photo credit William Banzai)

More from the lawsuit:

Within the walls of its sparkling new office tower, Bear Stearns executives knew this derogatory and distasteful characterization aptly described the transaction. Indeed, Bear Stearns had deliberately and secretly altered its policies and neglected its controls to increase the volume of mortgage loans available for its "securitizations" made in patent disregard for the borrowers' ability to repay these loans. After the market collapse exposed its scheme to sell defective loans to investors through these transactions, Bear Stearns implemented an across-the-board strategy to disregard its contractual promises to disclose and repurchase defective loans. In what amounts to flagrant accounting fraud, Bear Stearns' improper strategy was designed to avoid and has avoided recognition of its vast off-balance sheet exposure relating to its contractualfollowing the taxpayer-financed acquisition by JP Morgan repurchase obligations - thereby enabling its senior executives to reap tens of millions of dollars in compensation." Surely in non-banana republics heads would roll. What happens, however, when the heads are the same ones that rule said banana republic?

Maybe it is time to increase JPM's very modest $1.5 billion in litigation reserves?

 EMC’s lawyers on Jan. 14 argued against letting Ambac file the proposed amended complaint. EMC has also asked Katz to reconsider his ruling.

JPMorgan last quarter set aside $1.5 billion in litigation reserves to cover costs related to buying back faulty mortgages. Chief Executive Officer Jamie Dimon said it will take years to resolve the disputes and to determine the ultimate cost to his bank.

It’s going to be a long ugly mess, but it won’t be life- threatening to JPMorgan,” he told analysts on a Jan. 14 conference call.

The bank also ignored the findings of mortgage-review firm Clayton Holdings LLC in abandoning mortgage repurchases that Bear Stearns had been considering in early 2008 stemming from a pool of 596 of loans in bonds guaranteed by Ambac, according to the insurer’s amended complaint.

Clayton found that 56 percent of the loans involved “material” breaches of Bear Stearns’s contractual promises, according to the filing, which cited a copy of a November 2007 document from the review firm to the company.

Some beg to differ with Dimon's assessment of the situation:

Proof that the bank ignored a third-party review is “major, that’s hugely newsworthy,” said Isaac Gradman, a San Francisco-based consultant and formerly a lawyer at Howard Rice Nemerovski Canady Falk & Rabkin.

And the stunner: this is nothing short of the AIG-Goldman parasitic relationship (from the amended Ambac vs EMC filing presented below):

Knowing that its fraudulent and breaching conduct was resulting and would result in grave harm to Ambac, Bear Stearns then implemented a trading strategy to profit from Ambac’s potential demise by “shorting” banks with large exposure to Ambac-insured securities.  (The “shorts” were bets the banks’ shares or holdings would decrease in value as Ambac incurred additional harm.)  In late 2007, Bear Stearns Senior Managing Director Jeffrey Verschleiser boasted that “[a]t the end of October, while presenting to the risk committee on our business I told them that a few financial guarantors were vulnerable to potential write downs in the CDO and MBS market and we should be short a multiple of 10 of the shorts I had put on ... In less than three weeks we made approximately $55 million on just these two trades.”

And more unbelievable disclosures from the Ambac filing. We apologize for the length, but this will be the story of the next few weeks:

As discovery of Bear Stearns’ files and depositions of its employees have revealed, Bear Stearns secretly adopted certain practices and policies, and abandoned others, to (i.) increase its transaction volume by quickly securitizing defective loans before they defaulted, (ii). Conceal from Ambac and others the defective loans so it could keep churning out securitizations, (iii.) obtain a double-recovery on the defective loans it securitized, (iv.) disregard its obligations to repurchase defective loans, and (v). profit on Ambac’s harm.”

“...Bear Stearns utilized due diligence firms to re-undewrite loans for its securitizations that it knew were not screening out loans that were defective and likely to default.  As Bear, Stearns & Co. Managing Director Jeffrey Verschleiser stated in no uncertain terms to fellow Senior Managing Director Michael Nirenberg in March 2006, “[we] are wasting way too much money on Bad Due Diligence.”  Almost exactly one year later nothing had changed, and in March 2007, Verschleiser reiterated with respect to the same due diligence firm that “[we] are just burning money on hiring them.” Despite this recognition, Bear Stearns did not change firms or enhance the diligence protocols.  Thus, as one of its due diligence consultants frankly admitted, “[a]bout 75 percent of the time, loans that should have been rejected were still put into the pool and sold.” 

“Moreover, even while criticizing its due diligence firms for failing to adequately detect defective loans, Bear Stearns routinely overrode their conclusions that loans should not be purchased for securitizations, and went ahead and purchased and securitized those loans (up to 65% of the time in the third quarter of 2006 according to one firm’s report).  Bear Stearns ignored the proposals made by the head of its due diligence department in May 2005 to track the override decisions, and instead took the opposite tack, adopting an internal policy that directed its due diligence managers to delete the communications with its due diligence firms leading to its final loan purchase decisions, thereby eliminating the audit trail.”  Source: Deposition

“Bear Stearns disregarded loan quality to appease its trading desk’s ever-increasing demand for loans to securitize.  In fact, Bear, Stearns & Co. Senior Managing Director Mary Haggerty issued a directive in early 2005 to reduce the due diligence “in order to make us more competitive on bids with larger sub-prime sellers.” Source: Emails

“In full recognition that its due diligence protocols did not screen out defective loans and were merely a façade maintained for marketing purposes, Bear Stearns’ trading desk needed to quickly transfer the toxic loans from its inventory and into securitizations befor the loans defaulted.  So as early as 2005, Bear Stearns quietly revised its protocols to allow it to securitize loans before the expiration fo the thirty- to ninety-day period following the acquisitions of the loans by EMC, referred to as the “early payment default” or “EPD” period.  Bear Stearns previously held loans in inventory during the EPD period because, as Bear Stearns’ Managing Director Baron Silverstein recently acknowledged, loans that miss a payment shortly after the loan origination (i.e., within the EPD period) raise “red flags” that the loans never should have been issued in the first instance.  The revised policy enhanced Bear Stearns’ earnings by increasing the volume of loans it sold into the securitizatoins – but materially increased the riskiness of loans sold to the securitizations.  Nonetheless, as its executives uniformly conceded, Bear Stearns never once disclosed the changes in its due diligence and securization policies to investors...”

“And it gets worse.  Not satisfied with the increased fees from the securitizations, Bear Stearns executed a scheme to double its recovery on the defective loans.  Thus, when the defective loans it purchased and then sold into securitizations stopped performing during the EPD period, Bear Stearns confidentiality (i) made claims against the suppliers from which it purchased the loans (i.e., the “originators” of these loans) for the amount due on the loans, (ii) settled the claims at deep discounts, (iii) pocketed the recoveries and (iv) left the defective loans in the securitizations.  Bear Stearns did not tell the securitization participates that it made and settled claims against the suppliers.  Nor did it review the loans for breaches of EMC’s representations and warranties in response to the “red flags” raised by the EPDs.  Bear Stearns thus profited doubly on defective loans it sold into securitizations.  Indeed, the increase in loan volume from the securitization of defective loans proved to substantial, and the recovered secured on those defective loans proved so lucrative that, by the end of 2005, the Bear Stearns’ trading desk mandated ahat all loans were to be securitized before the EPD period expired.”

“The secret settlement of the claims on the securitized loans was a win-win for Bear Stearn and its suppliers, but a loss for the securitizations.  It was a win for the suppliers in that they settled in confidence all claims with respect to the defective loans at a fraction fo the full amount that would have been due had the loans been repurchased from the securitization.  Conversely, if they did not comply with Bear Stearn’s repurchase demands, Bear Stearns cut off the financing it extended for the origination of additional defective loans.  The secret settlement was a win for Bear Stearns, which (i) reinforced its relations with the suppliers that it depended on to provide the precious fodder for future securitizations by settling at the discounted amount, and (ii) pocketed the recovery from the suppliers. It was a loss to the securitization participants, which were not notified of the defective loans in the securitizations and did not receive the benefit from the repurchase of defective loans from the securitizations.” Source: Email traffic, which includes the co-head of fixed income

“By mid-2006, Bear Stearns’ repurchase claims agains the suppliers of the loans had risen to alarming levels, prompting warnings from its external auditors and counsel.  In a report dated August 31, 2006, the audit firm PriceWaterhouseCoopers advised Bear Stearns that its failure to promptly evaluate whether the defaulting loans breached EMC’s representations and warranties to the securization particpants was contrary to “common industry practices, the expectation of investors and ... the provisions in the [deal documents].”  Shortly thereafter, Bear Stearns’ internal counsel advised Bear Stearns’ management that it was breaching its contractual oblications by failing to contribute to the securitizations the proceeds it recovered pertaining to the loans in the securitizations.  Bear Stearns did not disclose to Ambac either of the findings.”

“By January 2007, the Bear Stearns internal audit department reported in 2006 it had resoled “$1.7 billion of claims, an increase of over 227% from the previous year,” and that “$2.5 billion in claims were filed, reflecting an increase of 78% from the prior year.”  The “majority” of the claims pertained to loans with EPDs...”

“...the Bear Stearns analyst working on the deal more accurately described the deal in internal correspondence as a “going out of business sale.”  Another called it a “DOG”.”

“By late 2007, Ambac began observing initial sings of performance deterioration in the Transactions, and requested from Bear Stearns the loan files for 695 non-performing loans, which were drawn from each of the SACO Transactions.  Ambac reviewed the loan files for compliance with EMC’s representaitons and warranties and discovered widespread breaches of representation and warranties in almost 80% of the loans examined, with an aggregate principal balance of approximately $40.8 million across all the Transactions.  Ambac provided EMC with its findings and asked EMC to comply with its contractual obligations to cure or repurchase the non-compliant loans.  In disregard of its contractual obligations, EMC refused and continues to refuse to do so, even though Bear Stearns itself had identified widespread breaches in the very same loans sample.” 

Indeed, unbeknownst to Ambac until the discovery in this case, Bear Stearns engaged a consultant to preemptively review the same loan files Ambac requested in late 2007.  After an iterative review process between Bear Stearns and its consluting firm to whittle down the breach rate, they still concluded that 56% of the loans were defective.  In breach of its clear contractual obligations, Bear Stearns did not advise Ambac of its conclusions or provide Ambac or any other securitization participant with “prompt notice” of the breaches identified as was required to do so.  Bear Stearns instead adopted a strategy to reject as a matter of course Ambac and other insurers’ repurchase demands, regardless of Bear Stearns’ own findings.”

“Knowing that its fraudulent and breaching conduct was resulting and would result in grave harm to Ambac, Bear Stearns then implemented a trading strategy to profit from Ambac’s potential demise by “shorting” banks with large exposure to Ambac-insured securities.  (The “shorts” were bets the banks’ shares or holdings would decrease in value as Ambac incurred additional harm.)  In late 2007, Bear Stearns Senior Managing Director Jeffrey Verschleiser boasted that “[a]t the end of October, while presenting to the risk committee on our business I told them that a few financial guarantors were vulnerable to potential write downs in the CDO and MBS market and we should be short a multiple of 10 of the shorts I had put on ... In less than three weeks we made approximately $55 million on just these two trades.”  Bolstered by this success, Bear Stearns carried this trading strategy into 2008.  On February 17, 2008, a Bear Stearns trader told colleagues and Defendant Verschleiser, “I am positive fgic is done and ambac is not far behind.” The next day, in the same emal chain, the trader again wrote to Defendant Verschleiser to clarify which banks had large exposures to Ambac, asking “who else has big fgic or abk [Ambac] exposures besides sog gen?”  As it was “shorting” the banks holding Ambac insured securities, Bear Stearns continued to conceal the defects it discovered and deny Ambac’s requests repurchase demands relating to collateral that back the securities in the Transaction.”

“Bear Stearns’ derogatory characterization of the loan pools it securitized is consistent with Ambac’s on-going analyses of the loans in the Transactions.  After conducting the initial review noted above, Ambac reviewed a random sample of 1482 loans, with an aggregate principal balance of approximately $88.2 million, selected across all four Transactions.  The results of that review are remarkable.  Of these 1,482 loans, 1,351, or over 91%, breached one or more of the representations and warranties that EMC had made to Ambac.  As of June 2010, Ambac’s loan-level review consisted of 6,309 loans, of which it identified 5,724 loans across the Transactions that breached one or more of EMC’s representations and warranties.  Bear Stearns (now JP Morgan) – acting with authority to perform EMC’s obligations under Transactions – has to date “agreed” to repurchase only 52 loans, or less than 1%, of those breaching loans, but has in fact not repurchased a single one.”

In a nutshell: JPM committed fraud through misrepresentation, then wilfully and maliciously traded against the entities it had sold misrepresented securities to, and lastly, when even all this failed to rescue the failed bank, it was rescued, courtesy of the US taxpayers. Only in America will this lead to absolutely no jail time whatsoever.