By Carrie Johnson
updated 12:47 a.m. CT, Thurs., Dec. 27, 2007
The nation's largest banks are losing billions of dollars from the mortgage debacle. But will pain from bad housing bets be compounded by government investigations?
As credit woes sparked by the troubled housing market threaten the broader economy, investigators are trying to determine whether Wall Street investment banks bundled risky loans with good ones without properly disclosing such risk to investors.
Law enforcement officials including those at the Justice Department, the Securities and Exchange Commission and the New York attorney general's office are scrutinizing whether banks and mortgage lenders helped fuel the crisis by misleading investors about dicey housing assets and then covered up losses when the markets turned sour. Government subpoenas are flying, investor lawsuits are mounting, and in the nastiest cases, businesses are pointing the finger of blame at one another.
The tangled system of bank regulation and the challenge of proving that executives intended to break the law when they unloaded bum assets could pose significant hurdles for investigators, current and former government officials say. Many of the assets that tumbled were explicitly marketed as involving borrowers with troubled credit histories, alerting investors that they were high-risk bets.
This complexity means investigators are searching for e-mails or witnesses to show that companies knew about the problems and failed to disclose them. Defense lawyers say that without such witnesses or documents, proving cases will be difficult.
"Just because you have a business reversal doesn't mean there's a basis for a government investigation," said Robert J. Giuffra Jr., a New York securities defense lawyer. "The kinds of things we're talking about here turn on valuation judgments and market forces. This is not the stuff of a securities fraud case."
Focus on small-scale housing swindles
The FBI and criminal prosecutors have focused on small-scale, localized housing swindles that involve phony paperwork and inflated valuations of a single home or group of nearby properties. Last week, the U.S. attorney in Miami filed charges against what he called a fraud ring of more than 30 brokers, sellers and appraisers who allegedly agreed to buy and sell homes at inflated prices. In California, also last week, a former broker pleaded guilty to accepting payoffs for approving questionable loans with phony paperwork.
The legal jeopardy of the market's biggest actors, however, remains unclear even as scrutiny of their activities has intensified.
The SEC, which is responsible for policing the stock market, is probing whether Merrill Lynch and a handful of other large investment banks and brokerages properly disclosed losses and financial problems in the weeks before Merrill's chief executive retired under pressure in October. Merrill's estimated losses ballooned from nearly $5 billion to almost $8 billion in just three weeks earlier this year, and stock analysts have asked how the problems could have gotten so far out of line without the knowledge of Merrill's top managers. A Merrill Lynch spokesman said the company is cooperating with the SEC probe.
Meanwhile, the U.S. attorney in Brooklyn is looking into last summer's precipitous collapse of two Bear Stearns investment funds, as well as whether former fund managers may have taken advantage of early warnings to transfer millions of dollars of their own money out of the deteriorating accounts and into more stable investments.
Bear Stearns has also been sued by authorities in Massachusetts and by Barclays Bank, which slapped it with a civil fraud lawsuit last week for allegedly misrepresenting the health of a hedge fund and reassuring Barclays investors that all was well in the months before the fund's June collapse.
Bear Sterns called the lawsuit "unjustified and without merit" in a statement. In a defense likely to be echoed by other financial institutions under scrutiny, Bear Stearns said its clients were sophisticated and made their own assessments after fully digesting the risks and rewards of such an investment without anticipating "what, in hindsight, turned out to be a historically difficult market."
The SEC has opened more than two dozen investigations into how companies are valuing their mortgage investments, whether businesses downplayed losses and whether executives may have sold stock when they secretly knew that problems had emerged. Regulators underscored their concern this month by sending a letter to banks and insurance companies that, in essence, reminded them to be honest with investors about looming financial troubles .
Banks as victims?
Lawyers who have analyzed scandals involving savings and loans, stock option awards and arcane accounting issues say that businesses can shield themselves by arguing they relied on advice from accountants and lawyers. In some cases, the banks can claim they were victims of the same bad judgments that are hurting ordinary investors.
"This is one of those situations, kind of like the Internet bubble, where everybody and his brother guessed wrong," said Jonathan Dickey, whose firm defends companies, including Freddie Mac, against government investigations and investor lawsuits. "There are going to be very strong and powerful defenses that most of these firms are going to have."
Armed with far-reaching state laws that prohibit deceptive business conduct, New York Attorney General Andrew M. Cuomo may have the lowest legal bar to proceed against financial institutions for their role in packaging suspect mortgage loans and selling them. Through a spokesman, Cuomo, who has issued subpoenas to Merrill and Deutsche Bank, among others, declined to comment on the progress of his investigation. Deutsche Bank did not return calls.
Lawyers who have worked with Cuomo, a former Housing and Urban Development secretary, in probes involving the student loan industry suggested that he might be more interested in reaching quick settlements in which companies promise to change their behavior rather than waging a costly, time-consuming court fight. Cuomo's ambitions may be fenced in, in part, by an appeals court ruling this month that limits his authority to pursue lending violations by national banks.
That means a patchwork of regulators including the SEC and the Office of Thrift Supervision, which oversees savings and loans, are taking the lead in looking at activities of Washington Mutual, whose home-lending and appraisal practices have come to Cuomo's attention. Washington Mutual said it is taking the government inquiries seriously and will cooperate with authorities.
Another open question, current and former regulators said, is how the U.S. Supreme Court will rule in a major securities lawsuit that could determine whether investors can sue third parties for their role in financial frauds. Industry groups are seeking to limit shareholders' power in such cases, which could bar the courthouse door to plaintiffs suing credit-rating agencies, investment banks and accountants and law firms that may have helped clients disguise housing-related losses. A ruling is expected by summer.