Mortgage-Backed Securities are commonplace in today’s housing market woes. The securities are often blamed as one of the causes of the housing market crash, and thus the crash of the economy. However, the Residential Mortgage Backed Securities Fraud Working Group (“RMBS Fraud Working Group”) seeks to hold the major financial institutions accountable for the problems they have caused.
All investments represent an opportunity for the owner of the investment to make a profit on the risk taken in funding the investment–the Risk-Return Tradeoff. For example, a mortgagor/lender takes on the risk that the mortgagee/homeowner might default on his or her loan. In theory, the mortgagor takes on this risk because the mortgagor anticipates the revenue received from interest on all of its loans–on average–will be more than the costs incurred from the occasional homeowners who default. Assuming these mortgage loans were made prudently, the mortgages have value–they can be bought and sold because the income stream will provide revenue over the life of the loan.
Entities purchase these mortgage loans and pool them together to form Mortgage-Backed Securities, as a more marketable way to get investors. As such, it is easier to get someone to invest their money in a security instrument that is made up of many mortgage loans, rather than single mortgage loans–because the risk and reward of investing is made more stable by including many investments into one.
The key to prudent investing is knowledge of the risk–so that you are able to determine whether the reward will be worthwhile. The problem with the Mortgage Backed Securities is that major financial institutions have misrepresented the risk associated with the investments. This turns a great idea into a terrible idea.
Early this month, the New York Attorney General Eric Schneiderman, filed suit against JPMorgan Chase (formerly known as Bear Sterns & Co.) and EMC Mortgage LLC for misleading investors as to the riskiness of the Mortgage Backed Securities. Bear Sterns was obligated to evaluate the riskiness of the mortgage loans, continue to monitor the loans, and report to the investors. However, Bear Sterns allegedly failed to properly evaluate these loans, and securitized billions of dollars of mortgage loans that were likely to default. Investors are alleged to have suffered losses of about $22.5 billion so far, and about 43% of the $30 billion in unpaid principle is at risk of going unpaid.
Schneiderman’s suit is intended to be the first suit of many filed by the RMBS Fraud Working Group, which was created by President Obama to uncover and punish the misconduct that lead to the financial crisis. The New York Times provides a more comprehensive account of the suit.
Parker and DuFresne