Deutsche Bank Wins in Stare-Down With Department of Justice Over Mortgage-Backed Securities Liability; Credit Suisse Also Settles While Barclays Holds Out

As we’d pointed out in the context of the Security and Exchange Commission’s settlements of private equity regulatory violations, it’s widely recognized that senior members of the agency are in a rush to wrap up outstanding matters before the Trump regime starts. Anyone who has worked on a negotiation knows that if someone is in a rush, they lose a ton of negotiating leverage.

The resolution of the Deutsche Bank case is instructive. Oddly, US authorities had apparently leaked that they were seeking a settlement of $14 billion, at a point in time much earlier than they had typically let their ask be known. Historically, these media smoke signals took place after there had been some interaction between the target and the Feds. The early news stories might have been a slip up, or they might have signaled an intent to be bloody-minded. Or perhaps they were to show how far apart the German bank’s bid of $2 to $3 billion was from the DoJ’s $14 billion offer, and get harmed US borrowers and media allies to make a stink, allowing the US authorities to say the the public recognized that Deutsche was a bad actor and thus showing much leniency was not politically feasible.

Deutsche’s wee problem was that this was a lot of money, particularly given that the world was finally waking up to the fact that it was a garbage barge. At around the time this story broke, its market cap was down to $18 billion. It had litigation reserves of only €5.5 billion in litigation reserves, which was then equivalent to a bit over $6 billion.

We had thought the Department of Justice had a strong hand, and that Deutsche was not likely to get a huge concession on the headline amount, particularly since the way US officials finessed these settlements in the past was to have a large headline figure, but a much smaller hard dollar fine. The rest was made up phony-baloney undertakings, which rewarded banks for activities they were going to pursue regardless, were values at vastly in excess of what they cost the bank, or even better, had them impose costs on third parties (as in get credit for writing down mortgages in mortgage securitizations, when the cost of doing the mod was vastly below the reduction imposed on investors. And that’s before you get to the fact that banks would cherry pick and focus on modifying first mortgages held by investors to make their own home equity lines of credit to the same borrowers, which were due to be written off, have some economic value). But we had also noted that Deutshe wasn’t a large mortgage servicer, so it would have less ability to engage in this sort of non-cash optics.

Given that Deutsche had been patient zero of subprime CDOs and had worked closely with the major subprime shorts, it seemed plausible that the DoJ could make a strong case. The flip side was the German government would not allow Deutsche to be hit so hard that it would start looking wounded. We thought one finesse would be to let the negotiations drag out beyond the German elections….meaning October 2017.

But Christmas came early for the German bank in the form of the Trump win. While Trump might view a foreign bank as a cheap target for burnishing his law-enforcement credentials (all the US banks have settled on these issues), it’s now clear that the incoming Administration intends to roll out the red carpet for financiers.

The result is Deutsche got off easy. It is only having to pay $3.1 billion in cash (and some of these settlements have been deductible for tax purposes) and another $4.1 billion in promised “consumer relief” as in “stuff maybe we’ll do in the future.” Even with an official (but toothless) monitor for the National Mortgage Settlement of 2012, many of those terms were violated, in addition to banks falling short of their targets. And the bottom line was very little of the “consumer relief” actually went to harmed borrowers.

This settlement allows each side to declare victory (one of the big objectives), since Deutsche paid more than many observers expected but still well less than the Department of Justice’s too-well-broadcast target. But the fact that Deutsche still has plenty left in its litigation reserve even after deducting the full cash portion says it did very well.

From the Wall Street Journal:

The combined $7.2 billion agreement is higher than many investors and analysts expected. But investors are likely to see as positive that the proportion making up the cash penalty—which has an immediate financial impact—is less than half the total..

The settlement came together quickly in the latter part of this week following intense negotiations between lawyers representing the bank and the government, a person familiar with the matter said. Going into the week, the two sides still had significant differences to overcome, people close to the discussions said.

The German bank said it would take a roughly $1.17 billion pretax charge this quarter as a result of the $3.1 billion penalty. The additional consumer relief has less immediate and less solid consequences, because it is to be paid out over at least five years, the bank said in a statement late Thursday night.

The impact of the $4.1 billion consumer relief could fluctuate over time. The bank said that portion of the settlement isn’t expected to have a material impact on its 2016 financial results.

In a breaking story, Credit Suisse, which was also negotiating a mortgage liability settlement, just announced its deal. Again from the Journal:

Credit Suisse Group AG said Friday it has settled a U.S. probe into the Swiss bank’s selling of mortgage-backed securities before the financial crisis for about $5.3 billion.

Zurich-based Credit Suisse, one of several European banks that have been working toward a settlement on the mortgage-backed securities issue, said its deal includes a penalty from the Justice Department of $2.48 billion, and consumer-relief payments of about $2.8 billion, to be paid over five years.

As a result, the bank said it would take a $2 billion charge to its results in the current quarter.

Note that the cash portion of this deal is higher and Credit Suisse is also recognizing much more of the total cost in this quarter than Deutsche did.

By contrast, Barclays has decided to roll the dice and defy the Department of Justice, which obligingly filed suit today. The last time the British bank crossed swords with regulators, the result was the ouster of its chairman, CEO, and president. Mind you, this is not a battle in its home market with its primary regulator, but a mere fight over money. Barclays may hope that Trump will call the dogs off, but with a suit in motion, he’d have to spend political capital to intervene, and there is no strong reason to think that this fight would merit intervention.

The press stories indicate that the reason the Barclays talks fell apart was that the British bank had a strong opinion regarding what it should pay based on the total dollar amount of toxic securities other banks had sold versus the size of the settlements it paid. However, the Department of Justice appears to think that Barclays should pay a higher relative fine because its conduct was egregious even by subprime industry standards. From the Financial Times:

Federal prosecutors have sued Barclays and two of its executives over allegedly fraudulent mortgage-backed securities the bank issued as the US housing bubble was at its peak.

The suit claims the bank “securitised billions of dollars of loans it knew had material defects” and financed lenders that it knew were issuing mortgages to customers who would be unable to repay them, prosecutors charged. The loans in question defaulted “at exceptionally high rates early in the life of the deals”….

Barclays has calculated that investors in the residential mortgage-backed securities it issued suffered half the losses of investors in similar products issued by Goldman Sachs and less than a third of those of Citigroup.

While some US banks bet against the RMBS products they sold and kept little if any exposure to them, Barclays told the DoJ that it held the equity tranches of most mortgage securities it issued and so lost money alongside other investors when they went bad…

The US government is charging the defendants with violations of the Financial Institutions Reform, Recovery, and Enforcement Act, via mail fraud, wire fraud, bank fraud and other misconduct.

The two Barclays executives named in the suit are Paul Menefee, its head banker on subprime residential mortgage-backed securities, and John Carroll, the bank’s head trader for subprime loan acquisitions…

The DoJ said the bank had falsely assured investors it had conducted adequate due diligence on the loans underlying its subprime securities and had excluded “unacceptable” loans. “In reality, Barclays’ due diligence on the subject deals was a sham,” prosecutors wrote.

Even investors in triple A-rated securities, which carry the same rating as US Treasuries, suffered steep losses…

According to the complaint filed in federal court on Thursday, the bank misled investors and rating agencies about its loan selection criteria. In some cases, the lawsuit says, the bank found that more than half of the loans it reviewed contained defects, yet officials assured investors they were sound.

Companies that reviewed the loans for Barclays informed the bank that many did not meet underwriting guidelines or legal standards. “These vendors described some of these securitised loans as ‘craptacular’, others as ‘scariest collateral’, and others as having the ‘distinct aroma of default’,” the lawsuit says.

Mr Menefee, the Barclays executive in charge of due diligence on the subprime deals, is quoted as calling one loan pool “about as bad as it can be” and saying of a Wells Fargo pool that “we have to eat their sh*t loans”.

Mr Carroll, Barclays’ head subprime trader, allegedly told Mr Menefee to leave one group of 40 delinquent loans in a securitisation pool to save the bank $1m, even though it would make investor losses more likely.

Barclays ordered its vendors to change the grades they assigned on thousands of loans “for no legitimate reason”, the lawsuit says. “Even when loans were already delinquent or in default by the time a deal closed, it did not seem to matter to Barclays.”

Barclays prioritised its relationships with loan originators over protecting the investors who bought its mortgage-backed securities, the lawsuit alleges. As the housing bubble popped, the bank in some cases abandoned due diligence entirely.

In 2007, the DoJ alleges, Barclays executives decided that checking the quality of loans originated by New Century was a waste of time since any defective ones could not be forced back on to the cash-strapped issuer. The bank took that decision even as Mr Menefee and Mr Carroll agreed that the loans “look(ed) like sh*t”, the suit says.

“Defendants repeatedly misled investors and kept to themselves critical information about the loans in the deals, knowingly putting those investors at risk of harm,” the lawsuit says.

Yves here. Notice that the Barclays argument about losses on the equity tranches is misleading. The equity tranche was so attractive that in the years running up to the crisis, originators would sell them off in securities called “NIM bonds” for “net interest margin” bonds. These bonds appealed to hedge funds since the equity investment would typically be paid off at a nice profit in 18 months or so. Why? The NIM bonds benefitted both from overcollateralization (which offered greater protection against loss despite the apparent junior status) and “excess spread” meaning a premium interest rate. The mortgages at issue were sold between 2005 and 2007. So the DoJ should have a hard look at the older deals, since Barclays may have come out whole on its equity investment in them. And the equity tranche was also not that large, typically a mere 1% par value of the securitization.

But the real reason the DoJ may be willing to play hardball is that the documents it has uncovered so far show that the Barclays executives were fully aware of what they were up to. Damning e-mails make for easy cases. By contrast, even though Barclays thinks it should be fined on the same formula as Goldman, Goldman staffers are schooled to be very conscious of liability to the firm as well as to believe the PR about serving customer interest. Thus saying bad things about deals even verbally will typically result in a dressing-down by partners, and in e-mails, even more so. So even though Barclays may be correct that it ought to be treated no worse than Goldman, the New York bank left a document trial that said that just about no one internally thought the firm was up to no good. By contrast, at Barclays, it appears that it will not be hard to convince a judge that the bank’s execs knew full well that they were screwing investors and didn’t care.