FHFA Sues UBS to Recover GSE Mortgage Losses

UBS Americas Inc., several of its subsidiaries, and four former executive officers were sued Wednesday morning in U.S. District court for the Southern District of New York.  The Federal Housing Finance Agency (FHFA) brought suit charging violations of securities laws in the sale of private label residential mortgage-backed securities (MBS) to government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae.  FHFA sued as conservator of the GSEs and seeks a jury trial in an attempt to recover losses and damages on behalf of the GSEs that occurred as a result of their investment in the UBS securities.

In addition to UBS America the defendants are UBS Real Estate Securities, Inc; UBS Securities, LLC; Mortgage Asset Securitization Transactions, Inc., and former UBS employees David Martin, Per Dyrvick, Hugh Corcoran, and Peter Slagowitz.

The lawsuit seeks specifically to recover damages from the GSEs investment in 16 separate pools of MBS sold by UBS between 2005 and 2007.  FHFA is claiming that the GSE's had a total investment of $4.5 billion in the securities sold by UBS.

The suit alleges that the underwriters of the underlying mortgages systematically disregarded their respective underwriting guidelines in order to increase production and profits and that the Defendants failed to conduct adequate due diligence on the mortgage loan files and mortgaged properties prior to or during the securitization process.  A number of banks and mortgage companies originated the loans in question including Fremont Mortgage, Wells Fargo Bank, Countrywide Home Loans, IndyMac, and Provident Funding Associates.

A forensic review of a sample of 966 randomly selected loans from two of the pools at issue found that approximately 78 percent were not underwritten in conformance with guidelines. The underwriting guidelines that were violated were those designed to assess the likelihood that loans would be repaid.  The forensic review revealed the following types of breaches:

1. Failure to test the reasonableness of the borrowers' stated income relative to their line of work, leading to material misrepresentation of income.  The forensic review found multiple instances in which income appeared unreasonable yet there was no indication the originator attempted to confirm that income.
2. Failure to investigate multiple submissions from the same borrower of applications showing increasing stated incomes.  In each instance the stated income on the original application did not meet underwriting guidelines, but subsequent applications at higher income levels did.  Forensic review confirmed that the later applications misrepresented that income and that underwriters did not investigate the discrepancies.
3. Failure to confirm the intended owner occupancy of the property despite indications that the property was intended as an investment.  In some cases the loans were underwritten as owner-occupied properties even though the borrower stated they intended the property to be as second home or investment.  Additionally, the Prospectus Supplements materially understated the proportions of the loans that were not owner occupied.
4. Failure to properly calculate the borrower's outstanding debt, resulting in a debt-to-income (DTI) ratio that exceeded underwriting guidelines.  When properly calculated, 32 percent of the 996 loans in the random sample for forensic review contained DTI ratios that exceeded applicable guidelines.
5. Failure to investigate credit report information that indicated potential misrepresentation of borrower debt.  The forensic review revealed numerous instances where multiple credit inquiries on borrower credit reports should have put underwriters on notice for potential misrepresentations of debt obligations, but underwriters did not investigate

FHFA alleges that while securitization Prospectus Supplements state that there may be compensating factors to warrant exceptions to applicable underwriting guidelines, none of the 966 loan files reviewed evidenced compensating factors that would support such exceptions.  "A 78 percent breach rate, in any event, could not possibly be explained by the proper allocation of any such exemptions."

In addition to the forensic review, a review of loan level data was conducted to evaluate the accuracy of information provided in the Prospectus Supplements.  At least 1000 loans were sampled in each securitization and a review confirmed that much of the information contained in the Supplements regarding owner occupancy and loan-to-value was materially false.  

The suit contains a table (see page 91 of 102) showing the ratings by various agencies (S&P, Fitch, Moody's) at the time of issuance and the ratings as of May 3, 2011.  Without exception every Tranche had a rating of at least Aaa at issuance.  Most are currently rated CCC or even D.

FHFA is asking for an award against all Defendants for all damages sustained as a result of their wrongdoing in an amount to include rescission and recovery of the consideration paid for the GSE Certificates with interest; the GSEs' monetary losses including lost principal and interest payments' attorneys' fees and costs, pre-judgment interest and other relief as deemed proper by the Court.

Acting FHFA Director Edward J. DeMarco said of the suit, "FHFA is taking this action consistent with our responsibilities as conservator of each Enterprise. From the issuance of 64 subpoenas last year to the filing of this lawsuit and further actions to come, we continue to seek redress for the losses suffered by the Enterprises."