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occurs post loan origination when mortgage servicers use false statements and book-keeping entries, fabricated assignments, forged signatures and utter counterfeit intangible Notes to take a homeowner's property and equity.
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Fair Game

Testing Investors’ Faith in State Street
New York Times - January 6, 2008

FORCED over the last five months to face icky truths about the credit crisis, investors seem to believe we are near the end of a disturbing interlude. How else to explain the 8.2 percent rally last Thursday in shares of the State Street Corporation after it said it would seek fresh capital and add $618 million in reserves to cover lawsuits over subprime mortgage investments it made for some clients?

Normally, the disclosures by State Street, custodian of $15.1 trillion in investor assets and manager of $2 trillion for clients, would not qualify as good news. Raising capital means diluting existing shareholders, after all. And most of the financial institutions that have had to seek capital recently have given their new investors hefty discounts.

It’s also not a positive sign that State Street is adding the reserves to settle lawsuits contending that it breached its fiduciary duties to clients for whom it bought subprime securities. Only last October, it said it would defend itself vigorously against one such lawsuit that the Prudential Retirement Insurance and Annuity Company filed against it in Federal District Court in Manhattan. Prudential contended that it lost $80 million after State Street Global Advisors and State Street Bank and Trust* engaged in “deceptive, imprudent and incompetent” investing in two nominally conservative bond funds.

State Street said last week that it had changed its stance on such lawsuits to put the issue behind it. The stock hit a new 52-week high of $85.37 on the news. While it fell on Friday, closing at $81.82, it was up 1.4 percent on the week.

Stock market investors are ever the optimists. The question is whether or not their enthusiasm is justified.

To be sure, State Street’s primary business — administering customers’ trades and keeping custody of their assets — makes it less likely to be hurt by debt market troubles than, say, financial institutions that underwrite these securities. And State Street managers’ upbeat report on 2007 results in their conference call on Thursday certainly gave investors and analysts a good deal to be sanguine about.

Nevertheless, now seems a peculiar time for shareholders to suspend their disbelief about the full impact the continuing credit crisis might have on financial services stocks, even models of New England rectitude like State Street. After all, how many initial estimates of losses from big financial institutions in recent months were later shown to have been too modest?

And does it make sense to retain a blinkered faith in financiers’ abilities to corral risk — as if it weren’t the unwieldy and surprising beast it often turns out to be?

Designing convoluted securities out of simple mortgage loans, Wall Street’s wizards thought they had managed to offload all their risks to others. But the rocket scientists forgot this: for all their magic and ingenuity, structured finance products do not eliminate reputation risk. Many of these tarnished securities are boomeranging, either in lawsuits aimed at companies that sold or recommended them or in the repatriation of assets from off-balance-sheet entities.

Still, investors seem inordinately sure of the solidity of four off-balance-sheet entities that issue commercial paper and are backed by State Street. With assets of $29 billion and names like the Clipper Receivables Company and Galleon Capital, these conduits are similar in design to the vehicles Citigroup and other financial institutions have had to bring back onto their balance sheets when the assets in them deteriorated.

Just one week ago, Zions Bancorporation, a financial holding company based in Salt Lake City, disclosed that it was buying $840 million of securities held by Lockhart Funding, an affiliated asset-backed commercial paper issuer. That bailout resulted in a $33 million loss for Zions because it had to pay higher-than-market prices for the securities.

Edward J. Resch, State Street’s chief financial officer, said in the conference call that the company was confident in the administration of its conduits and that it did not believe it had to consolidate them onto its balance sheet.

Asked for more details about this view, a spokeswoman said Friday that State Street’s conduits differed from troubled counterparts at other institutions because State Street vigorously vetted the high-quality, consumer-oriented assets in them. The conduits have performed well since they were created over a decade ago, the spokeswoman said, and have passed the test of time.

All the assets in these entities are now rated investment grade. But downgrades in the types of assets they hold — vast amounts of mortgage-backed securities as well as student loans and credit card receivables — have been rising in recent months as rating agencies acknowledged that previous loss projections were far too rosy. If downgrades hit securities in the State Street conduits, losses would almost certainly result and the company would likely absorb them if the conduit could not.

When State Street created these entities, it also agreed to provide them with credit enhancement. If a problem emerged in an asset, State Street could be forced to buy the troubled loan or security at a price higher than current market levels.

Last September, State Street told investors that if it had to bring its conduits’ assets back onto its balance sheet, it would have recorded an after-tax loss of $215 million in the third quarter. The company’s net income in the period was $358 million.

State Street says it is confident that its conduit assets will remain off its balance sheet. It may be right: no assets have returned to the company since it formed the conduits.

But the current period is far worse than any seen since the big State Street conduits were formed in 1992 and 1994. Furthermore, the estimated loss of $215 million includes a valuation of the assets in the conduits that is not entirely based on market pricing. For $3.4 billion of the assets, more than 10 percent of the total, State Street used book value as an approximation of fair value. That may not reflect market reality.

Investors alert to the lessons of the last few months have certainly gotten wise. One lesson is especially notable: If you sold it (or sold commercial paper against it) and it breaks, you own it. And it is my bet that the costs of that little truth have not yet been tallied.

*Note: StateStreetBank and Trust Co, Trustee for Holders of Bear Stearns Mortgage Securities Inc. Mortgage Pass-Through Certificates, Series 1993-12 v. Harley Lord, et al., 851 So.2d 790 (Fla. 4th DCA 2003). The Court held that StateStreet could not maintain a cause of action to enforce a missing promissory note or to foreclose on the related mortgage in the absence of proof that it or its assignor ever held possession of the promissory note. Section 673.3091, Florida Statutes (2002).

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