This is a Securities and Exchange Commission enforcement action for fraudulent misrepresentations and omissions about a mortgage company’s financial condition, margin call activity, and liquidity by the mortgage company’s executives.
The company, which obtained financing through “repo” agreements that subjected it to margin calls if the value of certain of its securities fell below certain thresholds, received more than $300 million in margin calls that severely drained its liquidity. It was late in meeting the margin calls from at least three lenders and had received a reservation of rights letter from one of these lenders confirming that it was in violation of its lending agreement and could be declared in default at any time.
The extent of the company’s liquidity crisis and exposure to default and cross-default notices would have (1) undermined the company’s imminent plans to raise additional cash and thereby alleviate its liquidity crisis and (2) led the company’s outside auditor to question its conclusion that over $400 million in market value losses associated with its adjustable-rate-mortgage (ARM) securities were temporary and therefore did not need to be recognized in the company’s income statement. In an effort to avoid these consequences, the executives allegedly failed to disclose to the company auditor and the investing public that it had violated its lending agreements, received a reservation of rights letter, and was required to sell certain portions of its securitized ARM loans to meet margin calls, the government alleges. Misrepresentations were made through the company’s annual report, financial statements and in statements to the auditor, according to the complaint. A number of experts that specialize in crisis management and securities were sought to opine on this issue.
Question(s) For Expert Witness
- 1. Did the mortgage company have a reasonable belief that it could satisfy its margin calls?
- 2. Should the company have responded to rumors of a hedge fund collapse?
Expert Witness Response
The judgment of the mortgage company’s management that the company would be able to continue satisfying margin calls after the filing of its 2007 Form 10-K was reasonable. My opinion is based on several factors, including the following:
• The use of repo financing as an investment strategy is appropriate and commonplace.
• Beginning in August 2007, the company began implementing a strategy to manage the risks of leverage by consolidating its repo borrowing relationships, obtaining long-term financing through securitizations, and raising additional capital.
• A reasonable repo lender would have viewed the company’s de-leveraging strategy and proven ability to access capital as sources of strength and as positive factors in assessing whether to work with it on the satisfaction of a margin call.
• The company’s repo collateral was of high credit quality and was not internally leveraged, and a reasonable repo lender would have viewed that collateral as a positive factor in assessing whether to work with the company on the satisfaction of a margin call.
• Given the nature and dynamics of repo lending relationships, repo lenders and borrowers have strong incentives to work cooperatively with respect to margin calls, and reasonably expect such cooperation from each other.
The information in the market about the rumored collapse of an unnamed European hedge fund on February 27, 2008 did not provide sufficient specific information to the company’s management or to a reasonable repo lender to expect a significant impact on the value of the company’s assets financed through repo. My opinion is based on several factors, including the following:
• Market rumors are unsubstantiated reports of a potential event that market participants do not typically rely on to make business decisions. During the financial crisis in 2007-2008, rumors in the markets were frequent, and many were unreliable and untrue.
• The information conveyed to company management about the supposedly impending collapse of a European hedge fund was a market rumor without any confirmed specific details.
• The rumored holdings of the hedge fund were readily distinguishable from the company’s repo holdings. In fact, as reported after the 2007 Form 10-K filing, the hedge fund’s actual MBS holdings were significantly different from the company’s repo assets.
The expert is a consultant on business disputes and corporate and regulatory investigations.