The President’s Residential Mortgage-Backed Securities Working Group, announced earlier this year in the State of the Union speech, brought its first case. The action is against Bear, Stearns & Co., Inc., which has been acquired by JPMorgan Chase. It was brought by the New York Attorney General who serves as the co-chair of the joint federal – state working group. People of the State of NY v. J.P.Morgan Securities LLC. (S.Ct. N.Y. Filed Oct. 1, 2012).

The complaint focuses on the sale of mortgage backed securities or RMBS by Bear Stearns as the market crisis unfolded. The securities were pools of mortgages deposited into trusts. Shares were sold to investors who were to receive a stream of income from the packaged mortgages. Bear Stearns sold billions of dollars of RMBS.

Critical to the entire securitization process was the quality of the mortgages put in the pool. Sales representations thus focused on the careful selection process for the loans included. Bear Stearns told investors about its due diligence process and quality control guidelines. They were assured that there were procedures in place to ensure that the loans which had been pooled had only been extended to those who had a demonstrated willingness and ability to repay.

Investors were also told that Bear Stearns operated a quality control department. That department was supposed to detect red flags and resolve difficulties. When necessary there were procedures to resolve a difficulty.

Contrary to these representations, the complaint alleges that Bear Stearns ignored its own procedures and was overwhelmed by the number of securitizations. The firm systematically failed to properly conduct due diligence during the securitization process and often overlooked defects. The quality control department could not handle the large number of issues. Even when Bear Stearns’ executives became aware of difficulties they were not resolved. The firm had an incentive not to raise issues, according to the complaint, since it needed to maintain business relationships with those from whom it acquired the mortgages. Thus even when the firm entered into settlements they tended to favor the originator at the expense of investors.

Investors were never informed about the firm’s failures. They were not told about Bear Stearns’ routine failure to properly conduct due diligence. They were not told about its failure to follow up on red flags or that the quality control department was overwhelmed. Nor were they told that quality control procedures were used to secure monetary recoveries for Bear Stearns which were not passed on to investors.

As of August 2012 Bear Stearns had MSRB outstanding with a principle balance of $87 billion. At that point about 26% of the 103 subprime and Alt.A securitizations that Bear Stearns sponsored and underwritten in 2006 and 2007 were suffering losses. Those losses total $22.5 billion.

Another $30 billion in implied principal on the mortgages remain in the trusts today. About 43% of those loans are 90 days delinquent, in foreclosure, in bankruptcy or are considered to be bank owned real estate. Accordingly, investors are likely to suffer further losses.

The complaint alleges violations of General Business law Article 23-A, securities fraud and Executive Law Section 63(12), persistent fraud or illegality. It seeks an injunction, an accounting of all fees and revenues received, disgorgement, damages caused, restitution, and costs and attorneys’ fees.

The Residential Mortgage Backed Securities Working Group is one of eight working groups within the President’s Financial Fraud Enforcement Task Force. The group includes the NY AG, the Justice Department, the Securities and Exchange Commission, Housing and Urban Development and the Federal housing Finance Agency Inspector. At the press conference announcing this case, it was indicated that more suits will be brought.