by Josh Rosner - March 13th, 2013, 8:00am
Josh Rosner (@JoshRosner) is co-author of the New York Times Bestseller “Reckless
Endangerment” and Managing Director at independent research
consultancy Graham Fisher & Co. He advises regulators, policy-makers
and institutional investors on banking and financial services (a more
complete bio appears at the end of this column).
This is part 2 of 5; Yesterday evening, we published the Introduction. We will be releasing a different part each evening and morning
culminating in the release of Rosner’s complete report on Friday morning. On that date, the Senate
Permanent Subcommittee on Investigations will release their final report on JPM’s CIO Group (aka the London Whale).
~~~
We will address under-appreciated but material fundamental issues in a
forthcoming report. Consistent with the purpose of this report we felt
it important to consider outstanding internal control, headline and
other extraordinary items that could materially
impact JPM’s profitability and potentially highlight further breakdowns
in controls.
Washington Mutual: a Story of Opacity and Impunity
Perhaps no other example illustrates JPMorgan’s scorched-earth
legal approach better than the disputes over the estate of Washington
Mutual (WaMu), which the firm acquired from the FDIC in
September 2008. JPMorgan portrays its purchase
of WaMu during the depths of the financial crisis as a patriotic act
performed by a well-run bank. Its public statements and regulatory
filings tell a different tale.
In August 2009, Deutsche Bank, as trustee for about $92 billion of
notional WaMu securitizations, filed suit against the FDIC demanding the
repurchase of billions of dollars of mortgages that they argued
violated representations and warranties in the pooling
agreement. The FDIC moved to dismiss the complaint, arguing that
JPMorgan had assumed the liabilities in the WaMu purchase. Consequently,
Deutsche Bank amended its complaint to add JPMorgan
[i].
JPMorgan is protected by a broad gag order that has sealed away, from
public view, any internal communications on Washington Mutual. We have
had to rely on public information and information provided as a result
of freedom of information requests.
After several years of agreeing with the FDIC’s position and
acknowledging that it acquired the mortgage liabilities of Washington
Mutual[ii],
JPMorgan appears to have changed its mind when it realized the enormity the industry’s mortgage putback risks
[iii]. JPMorgan is now boldly demanding
indemnification from the FDIC Insurance Fund.
JPMorgan, which in the aftermath of the financial crisis, accepted more
than $391 billion of government emergency program support
[iv], is
seeking
to shift losses on over $190 billion of
Washington Mutual-related mortgage securities onto the FDIC – claiming
that for a mere $1.9 billion it bought nearly all of the positive value
of WaMu and was able to stick the public with essentially all of the
ongoing losses. If the firm fails in
these efforts it
could be stuck with settlement costs on claims of
between $3 and $5 billion. Unfortunately, a continued lack of clarity
about the firm’s reserves coupled with recent plaintiff-friendly court
rulings that may increase putback settlement costs
make it difficult to assess whether JPMorgan is adequately reserved.
Since it began to deny its obligation, JPMorgan has repeatedly tried
getting the FDIC to agree that it has approval to settle and then send
the FDIC the bill. The arrogance, impunity and extent to which lengths
JPM’s lawyers go in attempts to saddle the FDIC
with its own losses are amazing.
In a strongly worded letter of
response to JPM’s repeated attempts to fool the FDIC into stating or
implying it accepted consent, the FDIC strongly states that it has not
consented to any actions or inactions by JPM and
that “insomuch as these assertions may have become boilerplate language
in correspondence from this firm, please consider this letter to be the
FDIC’s standing rebuttal” [v].
Still, recent press reports suggest that JPMorgan and
Deutsche Bank are engaged in settlement talks and that JPM’s strategy
may be to settle with the Deutsche Bank (Trustee) investors, indemnify
those investors and have them file a claim against
the FDIC for indemnification.
Even beyond losses on the $92 billion of original principal balance for
which Deutsche Bank is trustee, there are losses associated with another
$100 billion of WaMu mortgage securities over which either JPMorgan or
the FDIC will ultimately be required to settle.
The Acquisition
In early 2008, JPMorgan began to do due diligence on Washington Mutual
with an eye to acquiring the troubled but still solvent firm, but
because of the potential for big losses at WaMu, JPMorgan CEO Jamie
Dimon chose not to move forward with an acquisition
[vi].
Three months later, WaMu was bankrupt. As the FDIC began to plan for the
closing and sale of WaMu, it offered bidders five possible transaction
structures
[vii], each with different levels of
acquired liabilities.
On September 23 and 24, 2008, the FDIC negotiated over JPMorgan’s
bid, which was for the acquisition of all of WaMu’s assets and
liabilities except for the preferred stock, subordinated debt and senior
debt of the bank[viii].
The deal structure that JPMorgan chose also required that the winning bid come at the least cost to the FDIC.
During the talks, JPMorgan sent an e-mail
[ix] to the FDIC expressing concerns and seeking clarity about the “liabilities assumed by the assuming bank”
[x]
and expressed concern over the broadness of the provision
[xi]. In a Q&A document released during the initial invitation to bid process,
the FDIC made it clear that the obligations
associated with mortgage securitizations would pass to the buyer[xii],
their position did not change and JPMorgan did not receive the desired
changes to the standard indemnification to protect itself against the
liabilities associated with Washington Mutual’s mortgage
securitizations. It couldn’t have been clearer that JPMorgan understood
the liabilities it was accepting.
The FDIC did make limited changes to the standard bidding form,
indemnifying the bank for up to $500 million for damages brought by
Washington Mutual or third parties.
[xiii] The agency also
agreed to provide JPMorgan indemnification against mortgage-borrower (but not investor) claims
[xiv], a frequent cause for concern in the fall of 2008.
On September 25, 2008, the FDIC announced that JPMorgan acquired
the banking operations of Washington Mutual at no cost to the FDIC’s
insurance fund [xv].
In an SEC filing that evening, JPMorgan said it “acquired all
deposits, assets and certain liabilities of Washington Mutual’s banking
operations from the Federal Deposit Insurance Corporation (FDIC),
effective immediately. Excluded from the transaction
are the senior unsecured debt, subordinated debt, and preferred stock of
Washington Mutual’s banks. JPMorgan Chase will not be acquiring any
assets or liabilities of the banks’ parent holding company (WM) or the
holding company’s non-bank subsidiaries. As part
of this transaction, JPMorgan Chase will make a payment of approximately
$1.9 billion to the FDIC”[xvi].
Clearly, the FDIC and JPMorgan both intended and believed that all
liabilities not specifically excluded were transferred. Had the FDIC
believed otherwise it would have considered its potential exposures to
retained liabilities in its announcement and, if there
were other bidders, in its decision to award Washington Mutual to
JPMorgan. After all, the FDIC has a statutory obligation to approve the
least costly resolution.
Acknowledgment of WaMu Liabilities
When JPMorgan announced its earnings for the fourth quarter of 2008,
Dimon proudly claimed that JPMorgan was “doing its part” to help stabilize the financial markets and hasten recovery. We assumed risk and expended resources to assimilate
Bear Stearns and Washington Mutual.”[xvii]
The comments make for a great patriotic sound-bite but deserve further
scrutiny in light of the bank’s subsequent claim that it never acquired
WaMu’s mortgage liabilities. After all, since the bank bought WaMu’s
assets at book value and wrote the loan book down by $31 billion,
it is hard to understand what risk it took if it didn’t acquire the liabilities relating to Washington Mutual’s securitization
activities.
In a Jan. 9, 2009, SEC filing, Freddie Mac disclosed that “JPMorgan
Chase will assume Washington Mutual’s recourse obligations to repurchase
any of such mortgages that were sold to Freddie Mac with recourse.
With
respect to mortgages that Washington Mutual
sold to Freddie Mac without recourse, JPMorgan Chase has agreed to make a
one-time payment to Freddie Mac with respect to obligations of
Washington Mutual to repurchase any of such mortgages that are
inconsistent with certain representations and warranties
made at the time of sale[xviii].”
This filing, like several filings made by JPMorgan, demonstrate that
the firm had recognized its obligations to repurchase WaMu-related
mortgages sold to the GSEs[xix].
If, as JPMorgan now contends, these repurchase obligations were the
rightful liabilities of the FDIC, then one must ask how the
firm could legally have settled them on behalf of the FDIC. In fact,
section 12.2(f) of the Purchase Agreement specifically protects the FDIC
from paying for liabilities it did not assume by requiring that it
consent to any settlement that would result in an
indemnification obligation.
Further supporting the argument that JPMorgan acquired the WaMu
liabilities are SEC filings and presentations to shareholders by
JPMorgan. In connection with 2010 earnings, the bank warned that
“we
and certain of our subsidiaries, as
well as entities acquired by us as part of the Bear Stearns, Washington
Mutual and other transactions, have made such representations and
warranties in connection with the sale and securitization of loans
(whether with or without recourse… Our obligations with
respect to these representations and warranties are generally
outstanding for the life of the loan, and relate to, among other things,
compliance with laws and regulations; underwriting standards; the
accuracy of information in the loan documents and loan file;
and the characteristics and enforceability of the loan…. if a loan that
does not comply with such representations and warranties is sold, we may
be obligated to repurchase the loan and bear any associated loss
directly, or we may be obligated to indemnify the
purchaser against any such loss. Accordingly, such repurchase and/or
indemnity obligations …acquired by us as part of the Bear Stearns,
Washington Mutual and other transactions…could materially and adversely
impact our results of operations and financial condition.”
The essence was repeated in other filings as well
[xx].
In November 2011, Judge Denise Cote
[xxi]of
the Southern District of New York found that “JPMorgan does not
directly contest the Amended Complaint’s detailed allegations that it
has assumed
WaMu Bank’s liabilities with respect to the securitizations at issue
here. Indeed, as the plaintiff points out,
JPMorgan itself has
publicly referenced its liability for ‘repurchase and/or indemnity
obligations arising in connection with sale and securitization
of loans’ by, among others, WaMu. The FDIC has likewise opined that
‘the liabilities and obligations’ arising from WaMu’s sale of
mortgage-backed securities ‘were assumed in their entirety by JPMC
[(JPMorgan Chase)] under the P&A Agreement, thereby extinguishing
any potential liability by FDIC Receiver.’ Thus, for the purposes of
this motion, there is no dispute that JPMorgan is a proper defendant
with respect to FHFA’s WaMu- related claims.” Did this finding cause JPMorgan to increase its litigation reserves?
We do not know because their disclosures are inadequate.
Lack of Clarity on Reserving Policy
On the first quarter of 2010 earnings call, JPMorgan’s Michael Cavanagh noted that the bank had put up representation and warranty reserves for WaMu exposures related to both GSEs but acknowledged that the reserves were difficult to
decipher, were in several pockets and he then informed investors that JPM would not give any more meaningful guidance or detail[xxii].
In a November 2010 presentation at a Bancanalysts
Association of Boston Conference, a JPMorgan senior executive provided details of the Company’s “Private Label Repurchase Risk Exposure” broken out by Chase, Bear and WaMu and by product type. Nowhere in this presentation did the firm disavow
the liabilities or suggest that they were the liabilities of the FDIC[xxiii].
In January 2010, recognizing that JPMorgan’s disclosures were inadequate for investors’ ability to analyze its risks, the
SEC sent a letter to Michael Cavanagh directing the bank to provide greater detail[xxiv]
of their repurchase obligations. Again, rather than
providing investors with the class-leading transparency JPMorgan often
claims, the bank responded to the letter, in redacted form[xxv],
requesting confidential treatment of certain portions of their response.
While,
in the past the bank repeatedly acknowledged its acquisition
of WaMu repurchase liabilities and initially included those in
discussions of repurchase reserves, it appears those policies have not
been consistent over time. Where earlier WaMu-related
repurchase liabilities appear to have resulted in increased repurchase
reserves it seems that once JPMorgan decided to assert that the WaMu
repurchase liabilities as the FDIC’s obligation, the comparability of
their already weak disclosures became even less
analyzable.
New Mortgage Suits
In the past few months, a new round of mortgage-related suits were filed
against the firm. investors, regulators, prosecutors, and insurers have
filed a new round of claims against the bank related to billions of
dollars’ worth of securities backed by residential
mortgages.
On February 5, 2013, in the matter of Assured Guaranty v. Flagstar
[xxvi],
U.S. Southern District Court Judge Jed Rakoff appears to have created
precedent by handing down a decision to allow
staistical analysis provided by Assured’s independent auditor, rather
than loan-by-loan analysis, to be a basis for findings of breaches to
PSAs and Reps and Warranties in pooled mortgage loans. The auditor found
that 606 of the sample of 800 loans across the
trusts were found to have material breaches. While the ruling will
likely be appealed,
the reality is that it significantly heightens
the risks to JPM and other defendants in putback litigations. It may
also lead JPM to determine that they need to increase
reserves.
In November 2012, CIFG Assurance sued JPM over more than $100 million of
losses it sustained in CDOs. U.S. Bank, as Trustee, also filed suit
[xxvii],
claiming breaches of certain terms and conditions
of the Pooling and Servicing Agreements (defining the parties’
obligations to each other) of an RMBS with $698 million of original
principal balances suffered losses of $358 million. In a sample of the
loans that defaulted, the plaintiffs claim that 74% had
one or more breaches. Mortgage insurer Syncora Guarantee also filed suit
[xxviii]
claiming that, as a result of misrepresentations on almost 85% of the
loans involved in the deal, Syncora has
had to pay more than $94 million in claims to investors on losses of
more than $111 million. The National Credit Union Administration Board
filed suit against JPM on WaMu-related losses on almost 50 RMBS deals.
In the filing, the NCUA demonstrates the massive
difference between the expected losses and the actual losses in these
deals
[xxix]. This follows an NCUA suit filed against JPM relating to $3.6 billion of “faulty” securities related to JPM’s
Bear Stearns acquisition.
In October 2012, the New York Attorney General, Eric Schneiderman, filed
suit against JPM related to alleged misrepresentations in RMBS
securities offerings, which are claimed to have resulted in $22.5
billion losses of the $87 billion in original principal
value
[xxx].
On February 4, 2013, related to a suit filed against JPMorgan by Dexia,
Dexia released hundred of e-mails and employee interview transcripts
suggesting that JPM received independent underwriter reports showing
that between 8% and 20% of the loans sampled for
inclusion in pools did not meet underwriting guidelines. Rather than
disclose these defects to investors, JPM overrode the independent
determinations to create a “final, sanitized version.”
[xxxi]
[ii] http://files.shareholder.com/downloads/ONE/2289737617x0xS950123-10-102689/19617/filing.pdf
J P MORGAN CHASE & CO, “FORM 10-Q (Quarterly Report).” Last modified
2010.
http://files.shareholder.com/downloads/ONE/2289737617x0xS950123-10-102689/19617/filing.pdf.
“From 2005 to 2008, Washington Mutual sold approximately $150 billion
of loans to the GSEs
subject to certain representations and warranties. Subsequent to the
Firm’s acquisition of certain assets and liabilities of Washington
Mutual from the FDIC in September 2008, the Firm resolved and/or limited
certain current and future repurchase demands for
loans sold to the GSEs by Washington Mutual, although it remains the
Firm’s position that such obligations remain with the FDIC receivership.
Nevertheless, certain payments have been made with respect to certain
of the then current and future repurchase demands,
and the Firm will continue to evaluate and pay certain future repurchase
demands related to individual loans. In addition to the payments
already made, the Firm has a remaining repurchase liability of
approximately $250 million as of September 30, 2010, relating
to unresolved and future demands on the Washington Mutual portfolio.
After consideration of this repurchase liability, the Firm believes that
the remaining GSE repurchase exposure related to the Washington Mutual
portfolio presents minimal future risk to the
Firm’s financial results.”
[v]
Federal Deposit Insurance Corporation, “Identification Claims Letter.”
Last modified 2012.
http://www.scribd.com/doc/127203581/Fdic-Letter-to-Jpm-05-011-2012.
[vi]http://wmish.com/joshua_hochbergs_joke/epic_fail/4366/JPM_EX00004075.PDF
Morgan Chase and Company,
“Letter: (Fw: Meeting with Emilio Botin).” Last modified 2008.
http://wmish.com/joshua_hochbergs_joke/epic_fail/4366/JPM_EX00004075.PDF.
(See: “Asked why did JP Morgan not buy Wamu and instead TPG injected
the capital Jamie replied he thinks the potential
losses are higher than TPG estimating plus their losses are limited to
their initial equity investment unlike for JPMorgan or any other USA
bank which has to mark to market and assign/inject additional capital
accordingly”)
[viii]
Insert link to p. 31 of Deutsche Bank Response to FDIC and JPM Motions
(See: “Under this transaction, the Purchase and Assumption (Whole Bank),
the Potential Acquirer whose Bid
is accepted by the Corporation assumes the Assumed Deposits of the Bank
and all other liabilities but
specifically excluding the preferred stock, non-asset related defensive
litigation, subordinated debt and senior debt, and purchases all of the
assets
of the Bank, excluding those assets identified as excluded assets in the
Legal Documents and subject to the provisions thereof.”)
[ix] p. 31 of Deutsche Bank Response
.
[xi] See
p. 32
Deutsche Bank Response (See: ” Let’s say there is a contract between
the thrift and the Parent and that is included in the Books and Records
(not something like
“accrued for on the books of the Failed Bank,” which probably would fix
the problem) of the thrift at the time of closing.
Any liability
under that contract is then arguably a liability reflected in the Books
and Records. Therefore one would most likely
conclude that liabilities under that contract are assumed under 2.1.
. . . In a normal P&A between commercial parties this is not
something a buyer would ever assume and it really doesn’t make sense
(nor frankly is it fair) here.”)
[xii]
Deutsche response p. 33 (See: “9. Are the off-balance sheet credit card
portfolio and mortgage securitizations included in the transaction? Do
you expect the acquirer to assume
the servicing obligations? If there are pricing issues associated with
the contracts (e.g., the pricing is disadvantageous to the assuming
institution), can we take advantage of the FDIC’s repudiation powers to
effect a repricing?
Answer:
The bank’s interests and obligations associated with the off-balance sheet credit card portfolio
and mortgage securitizations pass to the acquirer. Only contracts and obligations remaining in the receivership are subject to repudiation
powers.”)
[xiv] Ibid.
(See: “any liability associated with borrower claims for payment of or
liability to any borrower for monetary relief, or that provide for any
other form of relief to
any borrower . . . related in any way to any loan or commitment to lend
made by the Failed Bank prior to failure, or to any loan made by a third
party in connection with a loan which is or was held by the Failed
Bank, or otherwise arising in connection with
the Failed Bank’s lending or loan purchase activities”)
[xx] http://www.sec.gov/Archives/edgar/data/19617/000119312509249391/d424b7.htm (See:P. JP Morgan
Chase and Company, “PRELIMINARY PROSPECTUS SUPPLEMENT (October 16, 2007).” Last modified 2007.
http://www.sec.gov/Archives/edgar/data/19617/000119312509249391/d424b7.htm
. (See: p. S -7 “We and certain of our subsidiaries, as well as
entities acquired by us as part of the Bear Stearns, Washington Mutual
and other transactions, have made such representations and warranties in
connection with the sale and securitization of loans
(whether with or without recourse), and we will continue to do so as
part of our normal Consumer Lending business. Our obligations with
respect to these representations and warranties are generally
outstanding for the life of the loan, and relate to, among
other things, compliance with laws and regulations; underwriting
standards; the accuracy of information in the loan documents and loan
file; and the characteristics and enforceability of the loan.
A loan that does not comply with such representations and warranties may
take longer to sell, or may be unsaleable or saleable only at a
significant discount. More importantly, if a loan that does not comply
with such representations and warranties is sold,
we may be obligated to repurchase the loan and bear any associated loss
directly, or we may be obligated to indemnify the purchaser against any
such loss. Accordingly, such repurchase and/or indemnity obligations
arising in connection with the sale and securitization
of loans (whether with or without recourse) by us and certain of our
subsidiaries, as well as entities acquired by us as part of the Bear
Stearns, Washington Mutual and other transactions, could materially
increase our costs and lower our profitability, and
could materially and adversely impact our results of operations and
financial condition.”) and
http://files.shareholder.com/downloads/ONE/847571171x0x415409/c88f9007-6b75-4d7c-abf6-846b90dbc9e3/BAAB_Presentation_Draft_11-03-10_FINAL_PRINT.pdf(JP
Morgan Chase and Company, “BANCAN LYSTS ASSOCIATION OF BOSTON CONFERENCE.” Last modified 2010.
http://files.shareholder.com/downloads/ONE/847571171x0x415409/c88f9007-6b75-4d7c-abf6-846b90dbc9e3/BAAB_Presentation_Draft_11-03-10_FINAL_PRINT.pdf
.
(See: P24-26 “Private label Repurchase risk exposure.”)
[xxii] http://seekingalpha.com/article/198755-jp-morgan-chase-amp-co-q1-2010-earnings-call-transcript?part=single
Seeking Alpha, “JP Morgan Chase & Co. Q1 2010 Earnings Call
Transcript.” Last modified 2010.
http://seekingalpha.com/article/198755-jp-morgan-chase-amp-co-q1-2010-earnings-call-transcript?page=1.
(See: “Let me make this simple. In the investment bank, retail
and corporate we have put up rep and warranty reserves and litigation
reserves for GSEs and all other mortgages including private securities.
We have tried to do it diligently. Some of those numbers ran through the
investment bank this quarter. We have broken
out the numbers in retail and we have put the numbers in corporate. A
lot of the numbers in corporate relate to WaMu. We are not going to give
any other information. We think we properly accrued for reps and
warranties whether they come through on the rep and
warranty line or the litigation line.
There are legitimate claims
that some of these mortgages were [properly] done. It is going to be
done mortgage by mortgage. Other than that we think we have done a
pretty good job recognizing the problem early.”)
[xxiv] http://www.scribd.com/doc/33507476/SEC-Letter-to-JPM-Re-More-Disclosure-on-Buybacks-Jun-17-2010
Security and Exchange Commission, “SEC Letter to JPM, Re More Disclosure on Buybacks.” Last modified 2010.
http://www.scribd.com/doc/33507476/SEC-Letter-to-JPM-Re-More-Disclosure-on-Buybacks-Jun-17-2010.
(See: The specific methodology employed to estimate the allowance
related to various representations and warranties, including any
differences that may result depending on the type of counterparty to the
contract; Discuss the level of allowances established
related to these repurchase requests and how and where they are
classified in the financial statements; Discuss the level and type of
repurchase requests you are receiving, and any trends that have been
identified, including your success rates in avoiding settling
the claim; Discuss your methods of settling the claims under the
agreements. Specifically, tell us whether you repurchase the loans
outright from the counterparty or just make a settlement payment to
them. If the former, discuss any effects or trends on your
nonperforming loan statistics. If the latter, discuss any trends in
terms of the average settlement amount by loan type; and Discuss the
typical length of time of your repurchase obligation and any trends you
are seeing by loan vintage”)
[xxv] http://www.sec.gov/Archives/edgar/data/19617/000095012310020146/filename1.htm Rauchenberger,
Louis.
JPMorgan Chase & Co., “Mr. Amit Pande, Accounting Branch Chief
Division of Corporation Finance United States Securities and Exchange
Commission Letter.” Last modified 2010.
http://www.sec.gov/Archives/edgar/data/19617/000095012310020146/filename1.htm.
The Firm informed the SEC that:
Their potential rep and warranties violations generally surface and are
resolved within approximately 24 – 36 months of the loan’s origination
date.
After the Firm’s acquisition of certain residential loan assets and
liabilities of Washington Mutual Bank from the FDIC in September 2008,
the Firm reached agreements with the Agencies to limit the Agencies’
repurchase demands with respect to certain Washington
Mutual Bank loan repurchase liabilities.
As of December 31, 2009, the Firm’s allowance related to breaches of
reps and warranties (the “Allowance”) was $1.7 billion. [Redacted]
