By Kenneth R. Harney
Saturday, November 29, 2008
In what appears to be the first legal action of its kind, an association of community-based organizations has filed a federal civil rights complaint against two of the three largest Wall Street ratings agencies, charging that their inflated ratings on subprime mortgage bonds disproportionately caused financial harm to African American and Latino home buyers.
The complaint, filed by the National Community Reinvestment Coalition, alleges that Moody's Investors Service and Fitch Ratings enriched themselves by assigning high ratings to bonds backed by mortgages "that were designed to fail" because of "unfair payment terms and insufficient borrower income levels."
The agencies "knew or should have known" that subprime loans disproportionately were marketed to minority consumers -- a process known as "reverse redlining" -- and that those borrowers would ultimately default and go into foreclosure at high rates, according to the complaint.
Fitch Managing Director David Weinfurter said the NCRC's filing "is fully without merit, and Fitch intends to defend itself vigorously." Moody's had no immediate comment.
The filing cites multiple studies that found that African Americans and Latinos received a disproportionate share of subprime loans during the housing boom years. A Federal Reserve study in 2006 estimated that 45 percent of mortgages extended to Latinos and 55 percent of loans to African Americans were subprime -- a rate "three to four times that of non-Hispanic whites."
Because the loans often came with terms that increased borrowers' probability of default -- upfront teaser rates followed by unaffordable payment adjustments, no required documentation of applicants' incomes or assets, hefty prepayment penalties -- African Americans with subprime mortgages are projected to lose $71 billion to $92 billion through foreclosures while Latinos are projected to lose $75 billion to $98 billion, according to one study cited in the complaint.
"Had subprime loans been distributed equitably," the complaint says, "losses for whites would be 44.5 percent higher and losses for people of color would be about 24 percent lower."
A third rating agency with heavy involvement in the subprime boom, Standard & Poor's, was not named in the complaint but has been "in discussions" with the NCRC, according to David Berenbaum, the group's executive vice president. If the discussions with S&P prove "unsatisfactory," he said, the company could be the subject of a separate action.
The NCRC filed its complaint with the Department of Housing and Urban Development's fair housing and equal opportunity unit. After a review, the department could either dismiss the allegations or refer the case to the Justice Department of the incoming Obama administration for litigation next year. If HUD fails to respond adequately, the NCRC may file a federal civil lawsuit, the group said.
The civil rights complaint is the latest in a series of lawsuits, regulatory investigations and congressional criticism of the rating agencies' roles and conduct during the mortgage-bond heyday years of 2003-05. In dollar terms, subprime and so-called "Alt-A" no-documentation loans accounted for 32 percent of all mortgage originations in 2005. Their share had been only 10 percent just two years before. Almost all of those high-risk loans were sold to Wall Street firms for inclusion in complex bond structures that were resold -- often in bits and pieces -- to pension funds and financial institutions.
The rating agencies have traditionally been Wall Street's gatekeepers, evaluating the risks involved in the collateral that backs bonds. Their assignment of investment-grade ratings to securities based on high-risk mortgages -- and their subsequent mass lowering of those ratings as default losses piled up -- has earned them scorching criticism from investors, regulators and Congress.
Much of the criticism has focused on the fact that the agencies are paid lucrative fees for their ratings by bond issuers themselves -- not investors -- thereby creating potential conflicts of interest. The agencies also competed with each other to rate subprime loan securitizations, creating additional pressure to provide the most favorable ratings.
The Securities and Exchange Commission investigated the agencies earlier this year and found "serious shortcomings" at Moody's, Fitch and S&P, including lack of oversight of conflicts of interest. Investigators also turned up evidence that agency personnel apparently knew that some of the mortgage pools they were rating were potentially toxic.
In one instant-message exchange, an analyst reportedly called a deal "ridiculous. . . . We should not be rating it." A colleague responded: "We rate every deal. It could be structured by cows and we would rate it."
Critics such as Berenbaum argue that without Wall Street's mass securitizations of high-risk mortgages -- with stamps of approval from the ratings agencies -- far fewer subprime loans would have been made and far fewer minority homebuyers would have ended up in foreclosure.
Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.