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Adkins v. Stanley

United States District Court, S.D. New York

May 14, 2015

BEVERLY ADKINS, CHARMAINE WILLIAMS, REBECCA PETTWAY, RUBBIE McCOY, WILLIAM YOUNG, on behalf of themselves and all others similarly situated, and MICHIGAN LEGAL SERVICES, Plaintiffs,


VALERIE CAPRONI, District Judge.

This is one of many cases arising out of the collapse of the housing market. This one comes with a twist: homeowners in Detroit who received subprime loans seek to hold a single investment bank responsible under the Fair Housing Act ("FHA") for discriminating against African-American borrowers, based on their claim that African-Americans were more likely than similarly-situated white borrowers to receive so-called "Combined-Risk loans." Plaintiffs allege that Morgan Stanley[1] so infected the market for residential mortgages - and for mortgages written by the New Century Mortgage Company, a now-defunct loan originator, in particular - that it bears responsibility for the disparate impact of New Century's lending practices. Although Plaintiffs advance creative theories, their class action lawsuit founders on the requirements of Federal Rule of Civil Procedure 23.

Plaintiffs seek to certify a class of "[a]ll African-American individuals who, between 2004 and 2007, resided in the Detroit[2] area... and received Combined-Risk Loans from New Century." Compl. ¶ 229. Plaintiffs define "Combined-Risk loans"[3] as loans that are "high-cost" as defined by the Home Mortgage Disclosure Act ("HMDA"), 12 U.S.C. § 2801 et seq., [4] and contain two or more of eight risk factors that, they allege, increase the risk of default. Compl. ¶ 34. Defendants oppose class certification, arguing that individual questions will predominate over questions common to the class.

The Court concludes that this class action lawsuit is an inappropriate vehicle to rectify the wrong that Plaintiffs allege Morgan Stanley perpetrated. The subprime mortgage crisis undoubtedly damaged our economy and may have - as Plaintiffs contend - exacerbated preexisting racial disparities in socioeconomic status. While the Court is not unsympathetic to Plaintiffs' claims, the harmfulness of the terms that Plaintiffs claim that Morgan Stanley caused New Century to include in loans and the role that Morgan Stanley played in causing the terms of specific Plaintiffs' loans differ considerably within the proposed class; accordingly, Plaintiffs' proposed class is unworkable.[5] Plaintiffs' motion for class certification is therefore DENIED. Defendants' motion to preclude some opinions in Plaintiffs' experts' reports is DISMISSED as moot.


I. The Parties

A. Plaintiffs

Beverly Adkins, Charmaine Williams, Rebecca Pettway, Rubbie McCoy, and William Young are African-Americans who purchased or refinanced homes with loans written by New Century, a non-party entity. For example, using an independent broker, Adkins refinanced her and her husband's home via a 30-year, adjustable rate loan with a substantial prepayment penalty and a 90 percent loan-to-value ratio ("LTV") (based on an inflated appraisal). Compl. ¶ 129-34; see also Sugnet Decl. Ex. 74, Dkt. 129; Reardon Decl. Ex. 28, Dkt. 169; Adkins Dep. at 63-65.[7] When New Century attempted to sell Adkins' loan to Morgan Stanley, Morgan Stanley "kicked [the loan] out" of the bundle of loans it would buy - meaning that its due diligence efforts flagged the loan and rejected it as undesirable. Gilly Decl. ¶ 10 & Ex. E, Dkt. 175. New Century ultimately sold the Adkins's loan to Credit Suisse First Boston. Expert Report of Timothy J. Riddiough, Ph.D. ("Riddiough"), Dkt. 206, ¶ 124. The other individual named plaintiffs have similar stories. Michigan Legal Services, the final plaintiff, alleges that it has been serving low-income communities in Michigan - primarily African-American residents of Detroit - by engaging "in impact-oriented litigation, legislative and administrative advocacy, and client community education." Compl. ¶¶ 205-20.

B. New Century

New Century, a California-based lender, originated approximately 250, 000 subprime mortgage loans per year during the period from 2004 through 2006 (although the number of loans it originated dropped precipitously in the months before its 2007 bankruptcy). Riddiough ¶ 31, FINANCIAL CRISIS INQUIRY COMM'N, FINANCIAL CRISIS INQUIRY REPORT (Jan. 2011) ("FCIC") 71. Plaintiffs allege that New Century was "the second largest originator of subprime residential loans (in terms of loan amounts) each year from 2003 to 2006." Expert Op. of Ian Ayres in Support of Class Certification ("Ayres") ¶ 21.

New Century was an "especially aggressive" independent mortgage company that ranked among the leaders in subprime loan originations. FCIC 89. Historically loan originators "avoided making unsound loans because they would be stuck with them in their loan portfolios." Id. at 7. But like other originators, by the mid-2000s New Century regularly made subprime loans based on questionable underwriting and then sold those loans to investment banks and other secondary market purchasers, including Morgan Stanley, which securitized them. Licata Dep. at 47, Lindsay Dep. at 93. Like many loan originators, New Century relied on three "channels" to originate loans - the retail, correspondent, and broker channels. Riddiough ¶ 32.[8] The vast majority of New Century's loans were originated through the broker channel, which "originated loans through a network of independent mortgage brokers." Id. In 2005, the broker channel accounted for approximately 71 percent of New Century's loans. Id. ¶ 33; see also Ayres ¶¶ 39-40.

Brokers who originated loans were truly "independent, " meaning that after they had written a loan with particular terms, they could shop the loan around to find an originator willing to fund it. See Reardon Decl. Ex. 9, McKay Dep. at 99. Brokers could determine whether a loan would likely meet New Century's guidelines by entering data regarding the borrower and the loan into a computer program known as "FastQual, " which would apply "automated underwriting rules" set by New Century. Id. at 51; see also id. at 131 ("It was really designed to make sure that the underwriting guidelines were being applied consistently."). When brokers had a loan with terms that were not available on FastQual - for example, when they wanted to qualify a borrower for a loan with an 85 percent LTV but FastQual only provided options up to 80 percent - they could seek an exception from a New Century account executive. Id. at 128-29. While brokers and internal account managers (who generated direct loans) could be "aggressive" with respect to underwriting guidelines, an underwriter from New Century approved every loan that New Century originated, id. at 123-24; the New Century underwriter's review ranged from ensuring that the documentation matched the data input into the FastQual system, id. at 124, to determining whether a particular loan was worth the risk associated with its terms, id. at 129. Defendants allege that approximately 10 to 25 percent of New Century loans received some sort of an exception to New Century's underwriting guidelines. Tr. at 60.[9]

In order to originate a loan - through any channel - New Century had to be able to fund the loan. Like most originators, New Century relied on "short-term lines of credit, or warehouse lines, ' from commercial or investment banks." FCIC 68; see Reardon Decl. Ex. 1 (identifying the banks that provided warehouse loans to New Century, including Bank of America, Barclays Bank, Bear Stearns, Citigroup, Credit Suisse First Boston, Deutsche Bank, Morgan Stanley, and UBS).[10] The terms of its warehouse loans permitted New Century to make a loan and assign it to the credit facility, which would then free assets on the facility for New Century's use. After New Century had sold the loan (either through a whole loan sale or a securitization), it would be removed from the ledger of the warehouse line against which it had been assigned. Tr. at 113-14. The parties appear to dispute the extent to which New Century depended on Morgan Stanley's warehouse line in particular, but in general New Century relied on the existence of warehouse facilities to fund most of the loans that it originated. Cf. Riddiough ¶¶ 40-41, Expert Op. of Patricia A. McCoy in Support of Class Certification ("McCoy") 22.

C. Morgan Stanley

Morgan Stanley, like many other large investment banks, was heavily involved in the securitization and sale of residential mortgage-backed securities ("RMBSs"), both as an investor and as a seller.[11] Morgan Stanley was one of a number of banks that had extensive dealings with New Century, as a lender, underwriter of the New Century securitizations, and as purchaser of New Century's loans.

The parties sharply dispute the relative significance to New Century's lending practices of Morgan Stanley as compared to the other banks. Plaintiffs' expert, Patricia McCoy, asserted that Morgan Stanley exerted "singular influence" over New Century. McCoy 22. Defendants' expert, Timothy Riddiough, disagreed, noting that Professor McCoy did not supply a standard against which to evaluate the claim of "singular influence, " Riddiough ¶¶ 55-56, and that even she conceded that other banks were the "cause" or "principal cause" of some of the so-called Combined-Risk loans that New Century made during the class period, id. ¶ 56 (citing Reardon Decl. Ex. 17, McCoy Dep. at 50, 100-05).

The relationship between Morgan Stanley and New Century was indisputably close, although it is not clear how it compares to New Century's relationships with similar banks. Morgan Stanley officials wrote at the time that "[w]hile they don't keep specific metrics, we are clearly [New Century's] largest and most important counterparty." Sugnet Decl. Ex. 7. Other Morgan Stanley-authored materials described Morgan Stanley's goal "to continue its relationship with New Century in 2005 by maintaining its status as the #1 whole loan purchaser, #1 warehouse lender, and #1 underwriter on a market share basis." Sugnet Decl. Ex. 2 at MS00834840; see also Ex. 3 at MS02685210 ("New Century has approached Morgan Stanley because we are their number one relationship and they would like to keep us their number one relationship.").

The parties dispute the significance of these self-congratulatory documents, but regardless of whether other banks enjoyed similar relationships with New Century, the record makes clear that at least some Morgan Stanley officials believed that their preferences had a significant impact on New Century's practices. Morgan Stanley officials described New Century as "extremely open to our advice and involvement in all elements of their operation, " Sugnet Decl. Ex. 9, and internal Morgan Stanley documents asserted that "Morgan Stanley is involved in almost every strategic decision that New Century makes in securitized products" and described in detail the bank's "mutually beneficial" relationship with New Century, Sugnet Decl. Ex. 11 at 6. The synergistic relationship between Morgan Stanley and New Century included the placement of Morgan Stanley due diligence staff onsite at New Century. Sugnet Decl. Ex. 13 at 387-99; Ex. 14 at 23-24. Contemporaneous Morgan Stanley documents demonstrated some employees' understanding that New Century "incorporated many of Morgan Stanley's best practices into [its] origination practices, " apparently "[b]ecause Morgan Stanley is such a large purchaser of loans from New Century." Sugnet Decl. Ex. 12 at 4.

New Century was receptive to the advice of "investors" writ large, see, e.g., Sugnet Decl. Ex. 28 at MJM-001152, and was under pressure from the market "to make sales and fund loans, " id. at MJM-001156. New Century had regular meetings "with Wall Street... to obtain their feedback: what kind of products they wanted, what things New Century was doing that they did or did not like[, ] etc." Id. at MJM-001158; see also id. at MJM-001161 (New Century officials would "go to Wall Street and match their products and their loan pools with Wall Street's expectations. They would not make any changes internally without making sure [they] complied with what Wall Street wanted."). The role of Morgan Stanley in particular, as opposed to investor demand in general, is a hotly-contested area not suitable for resolution at this stage of the case.

II. Residential Mortgage-Backed Securities and Subprime Loans


By 2015, most readers are surely familiar with the acronym "RMBS" for "residential mortgage-backed security."

RMBS[s] are "a type of asset-backed security - that is, a security whose value is derived from a specified pool of underlying assets. Typically, an entity (such as a bank) will buy up a large number of mortgages from other banks, assemble those mortgages into pools, securitize the pools ( i.e., split them into shares that can be sold off), and then sell them, usually as bonds, to banks or other investors."

City of Pontiac Policemen's & Firemen's Ret. Sys. v. UBS AG, 752 F.3d 173, 177 n.7 (2d Cir. 2014) (quoting Litwin v. Blackstone Grp., L.P., 634 F.3d 706, 710 n.3 (2d Cir. 2011)).

RMBSs can be aggregated into [collateralized debt obligations ("CDOs")] which are sold in "tranches" based on priority of entitlement to the cash flow. Each tranche of a given RMBS is exposed to the same pool of mortgages, but lower tranches sustain losses before higher tranches in the event that mortgages in the pool default or do not meet payment deadlines. CDOs are similarly divided into higher and lower tranches.

Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 97 n.2 (2d Cir. 2015).

During the so-called "housing bubble, " Wall Street banks exhibited a "quenchless appetite for high-priced, [risky] loans for use in residential mortgage-backed securitization." McCoy 17; see also Riddiough ¶ 14 ("[T]he aggregate value of non-Agency residential mortgage loan securitizations increased from $50 million in 1995 to $1.2 billion in 2005."). Loan originators - the entities that made mortgage loans to homeowners - sold residential mortgage loans to investment banks (such as Morgan Stanley); the investment banks in turn bundled the loans into RMBSs that were sold on the secondary market. McCoy 17-18.

Plaintiffs claim that "Wall Street's insatiable demand for high-priced loans caused lenders to cut corners to qualify borrowers however they could." Id. at 19 (citing Clifford V. Rossi, Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future 36 (Research Institute for Housing America 2010)). Regardless of whether the originators "cut corners, " the demand for RMBSs, among other factors, "led to a significant expansion in the U.S. mortgage market generally, and the subprime mortgage loan market specifically." Riddiough ¶ 26. Plaintiffs postulate that satisfying the appetite for RMBSs "required expanding mortgage lending to borrowers who could not repay." McCoy 19; see also id. at 24 ("During the housing bubble, investors including Morgan Stanley also pressed [loan originators] to deliver increasingly higher volumes of subprime loans.").[12]

At least in part to accommodate prospective homeowners who could less clearly afford the homes that they wished to buy, loan originators increased the number of offerings with terms designed to lower the initial cost of a home; these offerings typically offset their lower initial cost by passing the risk of increases in interest rates onto the homeowners. Id. at 24-25. Although they would not make loans to people whom the originators knew to be unable to repay, loan originators "evaluated [people's] ability to repay based solely on the initial payment, without regard to subsequent payment shock, " "used stated-income and other types of reduced documentation underwriting to mask weak income or assets, " "relied on inflated appraisals as a way to artificially inflate loan-to-value ratios, " "stretch[ed] [their] underwriting guidelines, ... approv[ed] exceptions to [their] underwriting guidelines and... approv[ed] loans that did not make sense.'" Id. at 25; see also Reardon Decl. Ex. 3, Shane M. Sherlund, The Past, Present, and Future of Subprime Mortgages 2 (Fin. & Econ. Discussion Series Divs. of Research & Stats. and Monetary Affairs, Fed. Reserve Bd., Washington, D.C., Working Paper No. 2008-63, Nov. 2008) ("Sherlund").

B. "Combined-Risk" Loans

The Plaintiffs seek to certify a class of borrowers who received what they describe as "Combined-Risk" loans. They further define these loans as:

loans that meet the definition of high-cost loan under [the] HMDA and also contain two or more of the following high-risk terms: (a) the loan was issued based upon the "stated income, " rather than the verified income, of the borrower; (b) the debtto-income ratio exceeds 55%; (c) the loan-to-value ratio is at least 90%; (d) the loan has an adjustable interest rate; (e) the loan has "interest only" payment features; (f) the loan has negative loan amortization features; (g) the loan has "balloon" payment features; and/or (h) the loan imposes prepayment penalties.

Compl. ¶ 34. Each of the potential components of a Combined-Risk loan bears some explanation.

1. High-Cost Loans

During the relevant time period, the HMDA defined "high-cost loans" as loans whose annual percentage rate was at least 3 percentage points (for loans secured by a first lien on a dwelling) or 5 percentage points (for loans secured by a subordinate lien on a dwelling) higher than the yield on Treasury securities having comparable maturity periods. Home Mortgage Disclosure, 67 Fed. Reg. 43218, 43223 (June 27, 2002) (amending 12 C.F.R. § 203.4(a)).[13] Essentially, the "high-cost" component of a "combined-risk loan" means that the interest rate on the loan is substantially higher than the market interest rate on loans made to well-qualified borrowers.

In isolation, high "interest rates increase the risk of default and foreclosure because they raise the borrowers' monthly payments, putting added strain on often tight family budgets." McCoy 8. While borrowers who were deemed poor risks qualified only for very high interest rates, a substantial portion of homebuyers who obtained subprime loans were actually eligible for prime rates but were steered to more expensive subprime loans. Id. at 8 n.15 (collecting sources identifying the percentage of subprime borrowers who qualified for prime loans at somewhere between 10 and 55 percent). The value to lenders of high interest rate loans is obvious - controlling for other factors (such as the risk that the borrower would default), the higher the interest rate, the higher the return for risking the same capital.

2. Stated-Income Loans

"Stated-income" loans were "known to the knowing as liars' loans' because in a statedincome loan the lender accepts the borrower's statement of his income without trying to verify it." United States v. Phillips, 731 F.3d 649, 651 (7th Cir. 2013) ( en banc ); see also Black's Law Dictionary 1079 (10th ed. 2014). Requiring little or no documentation to support a borrower's claimed income "opens the mortgage window to large numbers of borrowers who would not qualify ordinarily." McCoy 10 (quoting Michael LaCour-Little and Jing Yang, Taking the Lie out of Liar Loans: The Effect of Reduced Documentation on the Performance and Pricing of Alt-A and Subprime Mortgages 26 (working paper, Annual AREUEA Conference Paper, 2010)). Not requiring a borrower to supply documentation verifying his or her income has no effect on the risk of default if the borrower is truthful, but the practice permits borrowers who exaggerate or lie about their income to obtain mortgages that exceed their means (and for which they might otherwise be ineligible). Accordingly, Plaintiffs contend that "low-documentation loans substantially raised default rates during the housing bubble." Id. (collecting sources); but see Reardon Decl. Ex. 5, Morgan J. Rose, Predatory Lending Practices and Subprime Foreclosures: Distinguishing Impacts by Loan Category, 60 J. ECON. & BUS. 13, 28 (2008) ("Low- or nodocumentation for refinances is generally associated with significantly greater probabilities of foreclosure. In contrast, low- or no-documentation is associated with lesser probabilities of foreclosure for purchase [Fixed Rate Mortgages (FRMs')], and has no significant effects for purchase [Adjustable Rate Mortgages (ARMs')]").

Unlike high interest rates, which have an intuitive appeal to the lenders and to the secondary market, stated income loans lack any features that recommend them to lenders or the secondary market, and the risks associated with such loans make them generally less desirable than a fully documented loan. See Sherlund 16. Accordingly, some investment banks sought to minimize the percentage of no- or low-documentation loans that could be included in a pool of loans being purchased. Riddiough ¶ 97. Still, "the share of ...

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