Attestation Update – A&A for CPAs

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Is that $13B settlement with JP Morgan justice or a travesty?

with 2 comments

If J.P. Morgan pays out $13 billion to settle claims over residential securities as expected, is it reasonable justice or is it unjust?

There is a divergence of opinion on that question. This post will explore both schools of thought.

Two main issues

First of the major sources of head scratching for me is the assertion that Fannie and Freddie were innocent victims.

On the contrary, they not only knew what they were getting, they also were asking for large volumes of subprime loans because of requirements imposed by Congress.

They knew they were getting subprime loans. There weren’t surprised by huge number of loans with no income verification and loan amounts at or above appraisal. In the acronym I’ve just learned, their portfolio was full of NINA and they knew it.

If they had full, informed knowledge of what they were buying, why is there liability to JPM for selling them what they knew they bought?

Second source of my head scratching is whether the FDIC should pick up the losses from the bad loans in a foreclosed bank.

The specific question is whether the FDIC should reimburse JPM for losses on the WaMu portfolio, which would include a large portion of this settlement. Here is a recap of that issue, from the Wall Street Journal, Troubles for J.P. Morgan in Its Effort to Settle:

Part of the dispute centers on dueling views of what J.P. Morgan purchased when it assumed the operations of Washington Mutual. The bank has said an agreement it signed with the FDIC to buy the assets for less than $2 billion gave it protection from any future liabilities related to the purchase.

The FDIC, which seized the thrift and auctioned off its banking assets, has said J.P. Morgan inherited any problems associated with Washington Mutual as part of the purchase.

At issue is how the various costs of poor-performing mortgage bonds issued by Washington Mutual will be handled by participants in the tentative pact.

J.P. Morgan has been trying to preserve its ability to pursue a receivership run by the FDIC for any Washington Mutual-related liabilities, said people close to the talks. J.P. Morgan estimates those liabilities at roughly $4 billion, those people said. That is more money than the receivership fund holds.

On to some comments from others.

“Little Orphan Fannie”

That’s the name the WSJ editorial board assigns to Fannie Mae because of their naive innocence in knowing what was in all those loans they bought.

In Little Orphan Fannie Mae, the WSJ says:

So the government-favored mortgage giants that did as much as anyone to foment the housing bubble and bust are now presented as victims.

The premise of the allegations settled on Friday is that while it may appear that Fan and Fred were recklessly gambling on the housing market for years before the crisis, they were duped by Morgan and other banks into buying risky mortgage-backed securities that they did not understand. This is the Little Orphan Fannie defense.

And

The evidence against Fan and Fred is so voluminous we could go on listing it for days, but the feds want everyone to forget all that as they try to whitewash Washington’s role in the panic. They present the duo as victims to extort $5 billion from Morgan, which never needed a bailout, to make up for the $188 billion taxpayer bailout that Fan and Fred required. 

Political persecution?

At the opposite end of the political and economic spectrum, we see the Washington Post editorial board weigh in with JPMorgan Chase’s political persecution.

The editorial wonders whether JPM qualifies as victim.

Does it? Well, yes and no.

For the Whale trade, probably no, according to the editorial. I’d add a few more allegations for which JPM fully deserves prosecutorial attention.

Read the editorial for their nuanced comments on this settlement. My summary of their points is this one goes too far.

Justice

A Washington Post Op-Ed by Katrina vanden Heuvel says JPMorgan settlement is justice, not a shakedown.

She provides a superb summary of the opposing argument for injustice:

The Post suggested that JPMorgan only made the same errors about housing prices that everyone else made. The government was charged with acting in bad faith, holding JPMorgan accountable for misdeeds committed by Bear Stearns and Washington Mutual before Dimon agreed to acquire them at the behest of the government. All in all, we’re supposed to see this deal as a miscarriage of justice.

Her response?

Give me a break.

She then provides a summary of the JPM “rap sheet”, which she could have extended.

There are fewer words in her op-ed than in the post I’m writing, so there isn’t much space to develop her position that this settlement is justice. In quite summarized terms, the ideas would include JPM only paying nickels on the dollar for poor quality loans they sold. Garbage is the word used twice.

Also, JPM got a bargain basement price for the Bear and WaMu purchases, which would include known and unknown liabilities. Presumably with more space, that concept would extent to explain the purchase price being a bargain even after the $5B settlement with Fannie and Freddie.

For accountants, that would essentially make the $5B a purchase price adjustment.

Also addressed, but not fully developed because of space, is the idea that JPM, along with lots of other bankers, was ripping off individuals during the financial crisis.

So, the summary? The settlement is justice.

Assumed liabilities

Matt Levine, writing at Bloomberg, says JPMorgan Still Isn’t Sure What It Bought in 2008.

On the issue of JPM paying for WaMu’s behavior, he says:

Some people think that this is unfair to JPMorgan, since it wasn’t selling the bad mortgages,* WaMu was. Why should JPMorgan pay for the sins of WaMu?

Well, because it bought WaMu, is the reasonable answer. When you buy a company you assume its liabilities. 

He read the Purchase and Assumption Agreement, including the paragraph that JPM is leaning on to assert that the FDIC should pick up the tab for WaMu’s portion of the settlement.

After reading the PAA, he disagrees. It is so obvious  to him that words used in the article to describe the JPM position include “bonkers” twice, “nuts”, and “blazingly nuts.”

If you have read this far in my post, you will really want to read the third footnote where he quotes and then explains different positions on the PPA. It is a superb explanation but is far too long to quote.

Not assumed liabilities

Francesco Guerrera, writing at the Wall Street Journal says J.P. Morgan Settlement Puts U.S. in Tight Spot.

He reads the PPA and comes to no conclusion. One key comment is short enough to quote:

The really bad news: After reading the WaMu purchase agreement and speaking to the two sides, it is apparent that there is no clear-cut answer on whether J.P. Morgan inherited these mortgage liabilities. The document does contain a detailed description of what’s not in the purchase (see page 25 for those scoring this at home), but there is no specific mention of mortgage bonds.

The killer paragraphs, according to the J.P. Morgan side, are those stating that the buyer is not responsible for “claims based on any action or inaction” or “any malfeasance, misfeasance or nonfeasance” by directors, officers or employees of WaMu. In J.P. Morgan’s interpretation, this includes selling mortgage securities.

How will this turn out?

The guess from my simple brain sitting in my little corner of the accounting world is JPM will settle with the Justice Department, write a check with many zeros in the amount, and then move on with making tons of money. It will also take a tax writeoff for the deductible portions and recover from the FDIC whatever it can.

The rest of us will have lots of time to trumpet the justice or bemoan the injustice. For this settlement I’ll likely continue on the injustice side. Hey, I’ll be in good company with the Post and Journal.

Written by Jim Ulvog

October 31, 2013, 10:23 am at 10:23 am

Posted in Other stuff

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2 Responses

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  1. Jim, in my mind, calling these subprime loans is an extreme mischaracterization of the junk that JPM is paying for today. Subprime loans go through normal (albeit looser) underwriting processes and have realistic underlying collateral appraisals, unlike the fraudulent loans in question, which were pooled and securitized as CMOs, CDOs, etc.). The loan pools in question were funded largely based on waiving and ignoring normal underwriting requirements for even the lowest quality/highest risk subprime loan products.

    During 2005-2007, millions of mortgage loans were made where the lenders knew, because of their reckless lending practices, that the loans would not be repaid. I’ve seen confirmatory documents from multiple loan originators. Because of inflated appraisals and generous cash-out funding, the amounts loaned were generally excessive even for non-subprime borrowers, whereas these borrowers, for the most part, could never qualify for legitimate subprime loans. The lenders/syndicators knew the borrowers lacked sufficient (or any!) income to support the loans and also knew that the value of the loan collateral was grossly inflated. Many loan pools had default rates of >50% to >90%, sometimes within 24 months, depending on the specifics of the junky loan products.

    As evidence, noted bank criminologist William K. Black points to widescale rejections of appraisals by lenders that did not support the loan amounts requested. Lenders routinely fired appraisers (and underwriters) who applied ordinary professional standards to their work. No responsible lender would pressure appraisers to inflate appraisals and underwriters to waive underwriting standards, but this was SOP at the time.

    http://econintersect.com/wordpress/?p=39423

    http://www.creditwritedowns.com/2013/07/housing-appraisers-warnings-fraud-crisis.html

    The fraud and the reason JPM and others are paying now is that these loans were accompanied by false reps and warranties saying normal subprime underwriting standards HAD been applied and that the collateral supported the loan amounts. These reps and warranties are required for securitization and repackaging of loans, and they were demonstrably false. You could argue, perhaps, that the buyers of the loan products are responsible for poor due diligence, or for relying on reps and warranties that were quickly shown to be suspect, but please don’t make it seem that there was a legitimate basis for the lenders/syndicators to say that met the underwriting standards they claimed, or had any realistic basis to believe that the loans would be repaid according to their terms.

    Keith Mautner

    October 31, 2013, 12:42 pm at 12:42 pm

  2. Hi Keith:

    Superb comment. You apparently have some good first-hand knowledge of the fiasco. Thanks for taking the time to make a very persuasive comment.

    Jim

    Jim Ulvog

    October 31, 2013, 13:13 pm at 1:13 pm


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