The Justice Department this week announced a $4.9 billion settlement with The Royal Bank of Scotland Group RBS) resolving federal civil claims that it misled investors in the underwriting and issuing of residential mortgage-backed securities (RMBS) between 2005 and 2008.
The penalty is the largest imposed by the Justice Department for financial crisis-era misconduct at a single entity under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, which authorizes the federal government to seek civil penalties against financial institutions that violate various predicate criminal offenses, including wire and mail fraud.
“Many Americans suffered lasting economic harm as a result of the 2008 financial crisis,” Acting Associate Attorney General Jesse Panuccio said in a statement. “This settlement holds RBS accountable for serious misconduct that contributed to that financial crisis, and it sends an important message that the Department of Justice will pursue financial institutions that illicitly harm the American economy and our consumers.”
“Despite assurances by RBS to its investors, RBS’s deals were backed by mortgage loans with a high risk of default,” said Andrew Lelling, U.S. attorney for the District of Massachusetts. “Our settlement makes clear that institutions like RBS cannot evade responsibility for the damage caused by their illicit conduct.”
The settlement details, using the phone calls and e-mails of RBS executives, how the bank routinely made misrepresentations to investors about significant risks it failed to disclose about its RMBS.
For example, RBS failed to disclose systemic problems with originators’ loan underwriting. Its due diligence reviews of loans backing its RMBS confirmed that loan originators had failed to follow their own underwriting procedures and that those procedures were ineffective at preventing risky loans from being made. As a result, the bank routinely found that borrowers for the loans in its RMBS did not have the ability to repay and that appraisals for the properties guaranteeing the loans had materially inflated the property values.
RBS never disclosed that these material risks both existed and increased the likelihood that loans in its RMBS would default.
RBS also, according to the Justice Department, changed due diligence findings without justification. The due diligence practices did not remove fraudulent and high-risk loans from its RMBS.
For example, when the bank’s due diligence vendors graded loans materially defective, RBS frequently directed the vendors to “waive” the defects without justification. One due diligence vendor, which tracked waivers by most major participants in the RMBS industry, concluded that RBS waived material defects 30 percent more frequently than the industry average.
The bank’s waiver of material defects routinely resulted in the securitization of loans with excessive risk. When it engaged in such waivers, RBS never included enhanced disclosures that would have alerted investors that loans with excessive risks were included in the RMBS.
RBS is also accused of providing investors with inaccurate loan data. Due diligence frequently found that loan data—which RBS passed on to investors, who then used the data to analyze the risks associated with its RMBS—were riddled with errors. Inaccuracies made the loans look less risky than they actually were.
RBS, however, did not require originators to correct the data errors. In one deal, where the bank identified over 600 data errors associated with 563 loans (including debt-to-income ratios understated by as much as 2700 percent), RBS failed to disclose these errors even to the originator; instead, it reassured the originator that they had not required originators to correct data errors in the past and did not anticipate doing so for that deal.
The Justice Department alleges that RBS securitized tens of thousands of loans that it determined or suspected were fraudulent or had material problems without disclosing the nature of the loans to investors. It earned hundreds of millions of dollars, while simultaneously ensuring that it received repayment of billions of dollars it had lent to originators to fund the faulty loans underlying the RMBS.
“RBS used RMBS to push the risk of the loans, and tens of billions of dollars in subsequent losses, onto unsuspecting investors across the world, including non-profits, retirement funds, and federally-insured financial institutions. As losses mounted, and after many mortgage lenders who originated those loans had gone out of business, RBS executives showed little regard for this misconduct and made light of it,” the settlement says.
The settlement was the result of a multi-year investigation. The Justice Department, however, points out that these are allegations only, which RBS disputes and does not admit, and there has been no trial, adjudication, or judicial finding.