How One "Sack Of Shit" Mortgage-Backed Security Came To Define The Financial Crisis

The history of SACO 2006-8, as told through court documents dating back more than six years, provides a view into how the mortgage-backed security industry was built up and spectacularly collapsed. For JPMorgan, it has become the mortgage-backed security from hell.

Last week, JPMorgan Chase's costly legal troubles took another step toward completion when trustees for 311 mortgage-backed securities sold by the bank or inherited through acquisitions prior to the financial crisis agreed to a $4.5 billion settlement. Another 14 got an extension to still consider the deal, while five trusts wholly rejected the settlement, leaving open the option for them to continue litigation against the bank. SACO 2006-8, created and marketed by Bear Stearns two years prior to its government-supported acquisition by JPMorgan in 2008, was one of the trusts that rejected the deal.

The detailed history of this one trust's creation and sale, as told through court documents dating back to a lawsuit filed by the bond insurer Ambac six years ago, provides a view into how the mortgage-backed security industry was built up and spectacularly collapsed. And it may be one of the very few chances that the investors who bought these securities — and the insurance companies that guaranteed them — can find out what actually happened.

More importantly, it may be the only chance left for the public to get a granular view of what actually happened in the run-up to the financial crisis.

The best way to understand the importance of SACO 2006-8 to both the inner workings of the mortgage-backed securities industry and JPMorgan is to start in the present and travel back to the past.

A large chunk of JPMorgan's more than $20 billion legal tab last year over the bank and its affiliates' practices in marketing and selling mortgage-backed securities before the financial crisis is owed to two settlements: one with the Department of Justice for $13 billion and the previously mentioned $4.5 billion deal. (The latter deal still requires approval by a judge, and if granted will finally remove the bulk of financial crisis-era legal liabilities from the bank.) The combined $17.5 billion cost of those two settlements, reached less than a week apart, nearly matched JPMorgan's net income of $17.9 billion last year.

The settlement included a statement of facts that JPMorgan agreed to — not a guilty plea — describing generally how its employees (and those of Bear Stearns and Washington Mutual) marketed mortgage-backed securities to investors even though some of the loans didn't comply with the loan underwriters' own guidelines for selling and securitizing them. The civil penalty of $2 billion only applied to what JPMorgan did before the crisis, not Bear Stearns or Washington Mutual, and released the bank from civil liability for claims arising from the securities included in the settlement.

"Without a doubt, the conduct uncovered in this investigation helped sow the seeds of the mortgage meltdown," Attorney General Eric Holder said when announcing the deal between the Justice Department, several states, and other regulatory agencies and JPMorgan, which ranks as the country's largest bank by assets.

JPMorgan's chairman and Chief Executive Officer Jamie Dimon described 2013 in a letter to investors as "the best of times [and] the worst of times," and said that the bank came through "scarred but strengthened — steadfast in our commitment to do the best we can."

Many of the same mortgage-backed securities covered by the Justice Department deal were also among those included in the $4.5 billion trustee settlement, SACO 2006-8 being one of them.

"We believe the acceptance by the Trustees of the overwhelming majority of the 330 trusts is a significant step toward finalizing the settlement," a JPMorgan spokesman said in a statement earlier this month. The spokesman declined further comment for this story.

SACO 2006-8 was one of many mortgage-backed securities pumped out by Bear Stearns during the housing and credit boom. Made up of almost 5,300 home equity lines of credit from California, Virginia, Florida, and Illinois acquired by a Bear subsidiary called EMC, the trust had a principal balance of $356 million. Its most senior notes, the "Class A Notes" that would get paid off first by the stream of home equity payments, got the highest possible ratings from Moody's and Standard & Poor's, and were buoyed by an insurance policy from the AAA-rated Wisconsin-based bond insurer Ambac that guaranteed payments on the senior debt.

Almost a third of the home equity lines came from American Home Mortgage Corporation, which would declare bankruptcy less than a year later — not coincidentally, the same year home equity origination would peak. By March 2008, Bear Stearns would be acquired by JPMorgan after its stock plummeted as clients and investors got nervous about its mortgage-backed securities holdings. Two years and a few months later, in November 2010, Ambac would file for bankruptcy.

But SACO 2006-8 continued to live. It would be quickly downgraded and, by the end of 2010, it had already experienced some $141 million worth of losses and had 41% of its loans go delinquent or charged off entirely.

A lawsuit filed in 2008 by Ambac, unsealed in 2011, included an email from a Bears Stearns manager to a trader describing the loans that would make up SACO 2006-8 as a "SACK OF SHIT" and, alternately, a "shit breather."

"I hope you're making a lot of money off of this trade," the manager also wrote to a trader. When asked to explain himself in a deposition, the manager said that "shit breather" was a "term of endearment."

SACO 2006-8 was hardly the only Bear Stearns mortgage deal that Ambac and others have said was put together by hiding the low quality of the underlying mortgages from investors and insurers. Ambac's complaint alleges that Bear "knew and actively concealed that it was building a house of cards."

Ambac further said in its complaint that less than 25% of the loans Bear Stearns had acquired from American Home Mortgage were current and 60% had been delinquent for a month. Of those loans, 1,600 ended up in SACO 2006-8. The four transactions covered in the first Ambac suit (it has also filed a second suit against JPMorgan) had $1.2 billion in losses by 2011 and lead to Ambac paying out $641 million on their insurance coverage to bondholders.

JPMorgan, which inherited the suit from Bear, responded in court documents that Ambac was a financially sophisticated company that actively sought Bear's business and had access to the underlying loan data used in constructing the securities.

Selling mortgages based on home equity lines of credit were a relatively new but quickly growing portion of Bear's mortgage securities business. Ambac's complaint says that Bear's EMC subsidiary in 2005 had 9,300 home equity lines worth $509 million, but by the end of 2006 those figures had grown to some 18,000 loans worth $1.2 billion. Moreover, the home equity business was just one portion of Bear's mortgage machine. From 2003 to 2007, EMC would purchase and then package for investors over 345,000 loans worth some $69 billion.

As Ambac's lawsuit was winding its way through the courts, SACO 2006-8 emerged again, this time in a lawsuit brought by New York Attorney General Eric Schneiderman.

As co-chairman of the Residential Mortgage-Backed Securities Working Group, a group of law enforcement officials convened by the Obama administration to investigate mortgage fraud before the financial crisis, Schneiderman said Bear Stearns sold mortgage-backed securities featuring "material misrepresentations and flagrant omissions."

Bear's representations as to the quality of the loans "were false, misleading, and designed to conceal fundamental flaws and defects in the defendants' due diligence systems," Schneiderman said.

The complaint said "thousands of investors" were harmed by "systemic fraud" and that losses on more than 100 mortgage-backed securities it identified from 2006 and 2007 were $22.5 billion on an original balance of $87 billion. One of those securities was SACO 2006-8.

For its part, JPMorgan said that Schneiderman's suit was based on "recycled claims already made by private plaintiffs." To be sure, one of the lawyers in Schneiderman's office, Karla Sanchez, was one of Ambac's lawyers during her time at Patterson Belknap Webb & Tyler. But a source told the Wall Street Journal at the time that Sanchez did not work on the case.

JPMorgan settled the Schneiderman case as part of its $13 billion deal with the Justice Department, with the state of New York receiving $613 million of that amount.

"We've won a major victory today in the fight to hold those who caused the financial crisis accountable," Schneiderman said at the time of the settlement.

SACO would come up again in a suit filed by the credit union regulator against JPMorgan in New York federal court in September 2013. The National Credit Union Administration, which liquidated several credit unions that had purchased JPMorgan and Bear Stearns mortgage-backed securities, sued the bank, along with several others, alleging that the securities purchased by the now-failed credit unions had been sold dishonestly.

Credit unions, which have several tax exemptions compared to normal banks, are only allowed to invest in putatively safe securities, which then included SACO 2006-8. One of the failed credit unions, Southwest Corporate Federal Credit Union purchased $15 million worth of certificates issued by SACO 2006-8 in September 2006. Like Ambac, Southwest was aggressively going after riskier and less traditional mortgage securities. An NCUA inspector general report found that Southwest's staff " implemented an aggressive investment strategy ... that allowed for a significant concentration of investments directly in privately-issued residential mortgage backed securities."

By July 2007, it had almost four times as much in home equity loan securities, like SACO 2006-8, as it did in capital. The bank would then be placed into conservatorship in September 2010. In the suit three years later, the NCUA alleged that the securities purchased by Southwest and another failed credit union were sold to the credit unions with either false offering documents or ones that omitted the true condition of the underlying loans. Southwest had particularly gorged on securities underwritten by Bear Stearns, buying up some $290 million worth of asset-backed securities from and Bear and its eventual rescuer, JPMorgan. The bonds quickly soured.

According to the NCUA lawsuit, within a month of the purchase of the SACO 2006-8 certificates, just over 2% of the underlying loans were delinquent, 5.5% in six months, and, one year after it was issued, 10% of the loans were delinquent. With the delinquencies, came losses. While there are expected losses in any asset-backed security, the hits suffered by SACO 2006-8 quickly exceeded the projected shortfalls.

Within a year, the losses in the loan pool that was turned into certificate payments were $11.5 million, compared to $17,601 as expected by the ratings agencies. Moody's first downgraded the Class A notes in June 2008, after having put them "on watch" in January. Some 97 classes of certificates issued by difference iterations of the SACO 2006-8 trust were downgraded in May 2008. The SACO 2006-8 certificates finally fell below investment grade the next year, with S&P taking the plunge in August 2009, some four months after Moody's.

The NCUA case, like the one brought by Schneiderman, was settled as part of JPMorgan's $13 billion deal with the Justice Department. But while that settlement eliminated the bank's civil liability for SACO 2006-8, one interested party remained firmly uncompensated: the investors.

More specifically, the investors in the five trusts who rejected the $4.5 billion deal and could still continue litigation against JPMorgan.

Daniel Fishel, an expert retained to evaluate the deal, advised the trustees not to accept the proposed settlement for 16 of the 330 mortgage-backed securities covered under the lawsuit, one of which was SACO 2006-8.

Fishel said in a report that the proposed $4.5 billion offer was lower than other settlements and cited findings from another law firm, Quinn Emanuel, arguing that it would only pay 6 to 8 cents on the dollar back to investors. Two attorneys at Gibbs & Bruns, the Houston law firm that negotiated the trustee settlement, did not respond to requests to comment on the non-accepting trusts.

"We are pleased that the Trustees have accepted the settlement for so many trusts," Gibbs & Bruns attorney Robert Madden told Reuters when the deal was reached.

Fishel's analysis found that the proposed payout would cover a paltry 7% of the lifetime losses of the trusts, and their future lifetime losses would total a staggering $10.5 billion. His report added that losses on the loans that could be repurchased are "significantly more" than what the settlement would payout and that over 40% of the certificate holders oppose the settlement. Fishel estimated that SACO 2006-8 trustees would receive a $14 million payout even though it had suffered losses of $186 million.

Isaac Gradman, a lawyer at Perry, Johnson, Anderson, Miller & Moskowitz who specializes in mortgage put-back litigation, said that the analysis used in the expert reports for most of the trusts were based on what government-sponsored enterprises Fannie Mae and Freddie Mac were able to get back on securities they had purchased.

"The reality is that the deals where third parties have done some work to expose the breach rates and the losses are the deals that are most likely to get a recommendation of a reject and the ultimate rejection by the trust, but this doesn't mean the other deals are any less defective," Gradman said. "It's far harder for the trustee to take the deal on those trusts because there's already publicly available data about how bad the pool is."

SACO 2006-8 is precisely one of those securities — because of its long history of litigation, far more details about its composition have been uncovered than perhaps any other mortgage-backed security that helped precipitate the financial crisis, decimating the values of investors' assets, bankrupting insurers, and dragging down the banks that still held them on their balance sheets. And while it was just one of thousands of such securities to sour following the housing collapse, its sordid history perfectly underscores what a "sack of shit" banks were selling leading up to the financial crisis.