The New York Attorney General sued JPMorgan Chase on Monday, alleging that Bear Stearns, the troubled investment bank it bought in 2008, "kept investors in the dark" about the quality of the mortgage-backed bonds it was selling as the market started to sour.
The lawsuit is the first legal action against a Wall Street bank to come from a joint federal and state task force announced by President Barack Obama during his State of the Union address in January. It alleges civil fraud violations, which means that potential penalties will be measured in dollars, not jail terms. Nevertheless, the JPMorgan Chase lawsuit qualifies as one of the more significant actions taken by a law enforcement agency to date against a Wall Street bank.
JPMorgan Chase acquired Bear Stearns in March 2008 in a deal brokered and supported by the federal government.
According to the lawsuit, filed in New York State Supreme Court, Bear promised a "robust and intensive" review process for selecting loans for sale to investors. But Bear didn't do that, according to the complaint. In order to continue the securitization machine -- the packaging and sale of home loans to investors -- the bank increasingly placed risky loans into the bonds, even as an outside contractor it had hired to evaluate those loans was warning the bank about their poor quality.
That vendor, Clayton Homes, sampled the quality of the loans Bear wanted to package and sell. At one point the vendor identified 17 percent of the loans in a bond as defective. Nevertheless, Bear put half of those loans in a mortgage-backed security.
"Defendants systematically failed to fully evaluate the loans, largely ignored the defects that their limited review did uncover, and kept investors in the dark about both the inadequacy of their review procedures and the defects in the underlying loans," the lawsuit says. "Furthermore, even when Defendants were made aware of these problems, they failed to reform their practices or to disclose material information to investors."
Largely as a result of these delinquencies and defaults, the lawsuit claims, the mortgage bonds have suffered tremendous losses. The current cumulative realized losses on over 100 subprime and Alt-A securitizations in the years 2006 and 2007 total approximately $22.5 billion, or approximately 26 percent of the original principal balance of approximately $87 billion, the lawsuit says.
The lawsuit is the first to describe systemwide misconduct at one of the banks. Other cases, such as the Securities and Exchange Commission's allegations against Goldman Sachs that led to an earlier $550 million settlement, focused on alleged fraud in the sale of one product.
The task force -- officially, the Residential Mortgage-Backed Securities Working Group -- was formed at the urging of New York Attorney General Eric Schneiderman, who was frustrated that more had not been done to hold accountable the Wall Street banks that packaged and sold the mortgage-backed bonds that imploded, nearly bringing down the U.S. economy.
Schneiderman co-leads the task force, along with Robert Khuzami, the enforcement director of the SEC; Lanny Breuer, the head of the criminal division at the Justice Department; Stuart Delery, the head of Justice's civil division; and John Walsh, the U.S. Attorney for the District of Colorado.
UPDATE 6:49 p.m. -- In a statement, a JPMorgan Chase spokeswoman said the bank was disappointed that Schneiderman "decided to pursue its civil action without ever offering us an opportunity to rebut the claims and without developing a full record - instead relying on recycled claims already made by private plaintiffs."
The bank will contest the allegations, the spokeswoman said.