The Subprime Mortgage Crisis on Trial

    The financial crisis has led to only a few civil and criminal cases against executives, and even those focused on peripheral issues: Goldman Sachs’s peddling of a credit derivative obligation and the communications of two former Bear Stearns hedge fund managers.

    But the Securities and Exchange Commission’s securities fraud action against Angelo R. Mozilo, former chief executive of Countrywide Financial, promises to feature the aggressive mortgage practices of what was then the nation’s largest mortgage lender.

    Mr. Mozilo and two co-defendants, Countrywide’s former president and chief financial officer, have asked the United States District Court in Los Angeles to dismiss the case, and the judge will hear arguments on Monday to decide whether the S.E.C. has gathered enough evidence to show that investors were misled about the company. Should the court grant the motion, it will be a major setback for the commission in its efforts to police Wall Street’s disclosure practices.

    Bank of America acquired Countrywide in July 2008 as the company teetered on the brink of collapse when the market for mortgage-backed securities dried up. If lax underwriting standards that led to the granting of highly risky mortgages to borrowers with questionable finances constituted securities fraud, then this might well be an open-and-shut case.

    That’s not what the law prohibits, however, and the S.E.C. will have show that Mr. Mozilo misled investors by promoting the strength of the company’s mortgage underwriting standards while he was aware that increasingly lax lending was pushing Countrywide toward financial disaster.

    The S.E.C. argues in a brief filed with the court that there was a “disclosure sleight of hand” when Countrywide presented itself to investors as making high-quality loans when in fact it was increasingly allowing exceptions to underwriting procedures, leading to a significant deterioration in the quality of its mortgages. Of course, Mr. Mozilo was not dealing with individual borrowers, with one significant exception, but the S.E.C. claims that he and the other defendants pushed Countrywide into making riskier mortgages while assuring investors that it followed high standards.

    As the Associated Press reported, the S.E.C. points to special treatment of borrowers personally favored by Mr. Mozilo, known as the “Friends of Angelo” program. This included loans to members of Congress and their staffs, which have also become the focus of investigations on Capitol Hill.

    The total amount of the Friends-of-Angelo loans was minuscule for a company that issued more than $400 billion in mortgages annually in its last three years of existence. It was not the size of the loans that matters, however, but Mr. Mozilo’s personal involvement that the S.E.C. will use as evidence of his willingness to cut corners and ignore Countrywide’s underwriting procedures. Proving his “bad character” will be as much a part of the case as showing how the company made increasingly risky mortgages.

    The S.E.C. also accused Mr. Mozilo of insider trading for selling blocks of Countrywide stock in late 2006 and early 2007 that gave him gross profits of more than $140 million while not revealing the deterioration in the company’s mortgage operation. Like the Friends of Angelo program, the insider trading allegation tries to paint Mr. Mozilo as being both greedy and duplicitous, willing to sell out the company while promoting its virtues. With those dollar figures thrown around in court, it will not be easy for Mr. Mozilo to overcome the bias against very wealthy defendants whose timing appears to be propitious.

    The defendants attack the S.E.C.’s disclosure case in their brief by pointing out that Countrywide sold virtually all the mortgages it originated, so investors would not have cared about changes in the company’s underwriting procedures so long as it continued to make loans. The problems Countrywide faced were a result of the freezing of the mortgage market in 2007, which cut off funding for the company’s mortgage operation, and were attributable to outside economic forces that had nothing to do with its underwriting standards.

    The defendants argue that Countrywide made extensive disclosure about its mortgage process and operating model, so that all the S.E.C. can show is that the statements to investors were at worst mere puffery – a bit inflated, but not fraudulent.

    Determining whether a misstatement made by a public company constitutes securities fraud depends on whether a reasonable investor would consider the information “material.” The Supreme Court explained in TSC v. Northway that information is material if it “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

    What the court has never explained is: Who is this hypothetical “reasonable investor?” The views of the S.E.C. and Mr. Mozilo and his co-defendants reflect the basic divide in the investing world between short-term and long-term investors, and the materiality standard says nothing about whose viewpoint should be applied.

    The S.E.C. focuses on how Countrywide’s underwriting procedures deteriorated over time as it responded to market pressures by offering increasingly risky loans, like the “pay option ARMs” that involved numerous instances of misrepresentations by borrowers. As the loans became more problematic, Countrywide edged closer to collapse as problems developed in the financial markets.

    This is very much the long view of the company’s prospects, and the S.E.C. essentially argues that the greater risks in Countrywide’s mortgage operation should have been disclosed to investors. In effect, the company should have revealed that the light at the end of the tunnel may well have been a fast-approaching freight train.

    The defendants’ approach to materiality focuses much more on the immediate risks to Countrywide from its mortgage program, which involved selling all of its loans as quickly as possible to finance new lending. Any changes in its underwriting standards would be irrelevant to investors so long as the company could sell it loans in the secondary market, which was the case until the liquidity crisis hit the mortgage market in 2007.

    This is a narrower view of Countrywide’s operation that focuses on whether it could meet its immediate funding needs, so consideration of underwriting standards would be largely irrelevant. To the extent investors were concerned about the potential implications for its business, the information was provided for them to make their own assessment.

    The materiality standard does not address which viewpoint should apply, and so this is likely to be an issue that the jury will have to decide. If there is a dispute about a factual issue, then the court will deny the motion and let the case proceed to trial. I think that standard makes it much less likely the judge will grant summary judgment in favor of the defendants and dismiss the S.E.C.’s case because it is so difficult to determine what a reasonable investor would consider important short of a full-scale trial.

    The trial is scheduled to begin on Oct. 19, assuming the case is not dismissed. Look for the S.E.C. to try to make Mr. Mozilo the face of the mortgage crisis that led to the financial meltdown in 2008 to show that he misled investors in his company. Whether that proves securities fraud remains to be seen.

    – Peter J. Henning

    Published on 02/09/2010 12:34:16