New Financial Crimes Unit to Police Banks for Faulty Mortgages

The Justice Department is set to create a special unit to investigate abusive lending and packaging of risky mortgages, as part of President Obama's 2012 agenda.

(January 30, 2012) — A new Financial Crimes Unit, announced by President Barack Obama during last week’s State of the Union address, could jeopardize regulations among five of the largest banks in the United States over mortgage fraud and wrongful foreclosures.

In a statement released Friday, the Department of Justice asserted: “Beginning with its first full meeting…the Working Group will streamline and strengthen current and future efforts to identify, investigate, and prosecute instances of wrongdoing in the packaging, selling, and valuing of residential mortgage-backed securities. I am confident that this new effort will improve our ability to ensure justice for victims; help restore faith in our financial markets and institutions; and allow us to answer the call that President Obama issued earlier this week, in his State of the Union address.”

The unit will police major financial crimes, and will focus on both the origination and securitization (or packaging) of mortgage loans, according to Justice Department officials. The working group will be co-chaired by New York Attorney General Eric Schneiderman along with senior officials at the Department of Justice and Securities and Exchange Commission.

The unit is currently comprised of 15 attorneys and 10 investigators, including FBI agents. When fully staffed, it will employ about 55 people. “I am asking my Attorney General to create a special unit of federal prosecutors and leading state attorneys general to expand our investigations into the abusive lending and packaging of risky mortgages that led to the housing crisis. This new unit will hold accountable those who broke the law, speed assistance to homeowners, and help turn the page on an era of recklessness that hurt so many Americans,” the President said.

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In response to Obama’s speech, New York’s Comptroller Tom DiNapoli said: “A great wrong was done to the millions of Americans who were victimized by the reckless behavior of certain financial institutions. As President Obama pointed out last night, we are still feeling the effects of the mortgage crisis in New York and across this nation.”

In November, SEC Chairwoman Mary Schapiro asked Congress to heighten the penalties it can impose out for violations of financial laws. The SEC exerted pressure on JP Morgan, announcing in June that the bank would pay $153 million to settle charges of allegedly selling $1.1 billion in mortgage-backed securities that were designed to fail. The US regulator asserted that as the housing market crumbled in March and April 2007, JP Morgan executives urged the marketing of Squared CDO 2007-1, a synthetic CDO linked to a collection of residential mortgages, without informing investors that a hedge fund — Magnetar Capital — helped select the assets in the CDO portfolio and had a short position in more than half of those assets. Consequently, the hedge fund was positioned to benefit if the CDO assets it was selecting for the portfolio defaulted. “J.P Morgan marketed highly-complex CDO investments to investors with promises that the mortgage assets underlying the CDO would be selected by an independent manager looking out for investor interests,” Robert Khuzami, the SEC’s director of the division of enforcement, said in a statement. “What JP Morgan failed to tell investors was that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection. With today’s settlement, harmed investors receive a full return of the losses they suffered.”

Institutional investors have been active players in going after banks for allegedly misleading them about the quality of mortgage-based securities. In early January, Credit Suisse Group AG was sued by the $324 billion Dutch pension giant Stichting Pensioenfonds ABP. ABP has been aggressive in targeting banks over mortgage-backed securities it purchased during the financial crisis. In early December, the Netherlands-based pension fund sued JPMorgan Chase & Co. According to the lawsuit, filed in New York State Supreme Court in Manhattan, the Dutch fund purchased the pools of home loans based on false and misleading statements. The lawsuit noted that the mortgage loans backing the securities were taken out by borrowers “who were much less creditworthy than had been represented.”

The Endowment Effect: A Mind-trap Among Investors

The cognitive tendency among investors to get caught up in the endowment effect -- a mental roadblock that can cause investors to hold onto something too long -- applies to shares, bonds, and funds in a portfolio, a newly released report by Morningstar concludes.

(January 27, 2012) — Investors must scrutinize both what they own and what they don’t in order to overcome the endowment effect – one of the first cognitive biases to violate standard economic theory — according to a newly published article by Morningstar.

The article — titled “Investors Behaving Badly: Endowment Effect” — explains that the cognitive tendency to ‘love what you own’ applies to the shares, bonds, and funds in a portfolio. In other words, the article asserts that investors often overvalue what they already own.

“We’re trying to raise awareness about the type of research in the behavioral economics field,” the article’s author Lee Davidson, an ETF analyst with Morningstar, told aiCIO, adding that the aim of studying the field is to raise investor awareness, highlighting the tendance among investors to hold onto losing investments longer than they should.

The danger then, among investors, is that they fail to evaluate securities on a level playing field, failing to focus on the question that actually matters: How will my investments perform in the future?

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“We naturally exhibit a tendency to be lenient on evaluating the performance of what we own. If the market says our stock is worth £10, we naturally think its worth more even before we perform any analysis whatsoever. Not surprisingly, this cognitive bias does us a disservice,” the report states.

The report continues: “For every type of investor, therefore, it is important to be cognizant of the endowment effect and judge the various products impartially as best as possible, especially when you already own one or more of them.”

The report by Morningstar follows another critical report published in May. According to Andrew Ang, professor of business, finance and economics at Columbia University, endowments around the country need to do a better job at figuring out how to allocate money among liquid and illiquid assets.

“For Harvard, the main problem during the financial crisis was that about 1/3 of the university operating revenues came from the endowment. In 2008, that endowment, like every university portfolio, had large losses,” Ang told aiCIO following the release of his research report, explaining that the four ways to fill the hole is to cut expenses, liquidate the portfolio, issue debt, or increase donations.

Ang’s paper draws attention to the central question — which he describes as a philosophical one — among endowment heads: How should you be allocating your money when you have liquid and illiquid assets in your portfolio? “Harvard’s endowment fell and they couldn’t meet their cash requirement because they tied up a majority of their portfolio in investments that were illiquid. They couldn’t sell at short notice or raise cash when required,” Ang says.

According to Ang, most endowments completely ignore illiquidity risk on asset allocation, largely due to the increasing percentage they have devoted to alternatives, most of which are illiquid. The increased allocation to alternatives, Ang believes, is due to institutional investors aiming to emulate the investing approaches of Harvard and Yale’s endowments. “Endowments largely achieved high returns till 2008, but if you chase returns without taking into account illiquidity, that risk really bites.”