Wells Fargo ordered to pay $2.09B to settle allegations of misrepresentation of Loan quality

Ten years after the financial crisis which was largely contributed by the faulty mortgage system, Wells Fargo agreed to go on record to pay $2.09 Billion to settle a U.S. Probe into its creation and sale of loan that contributed to the horror. The settlement comes as a fine to settle claims that Wells Faro misled investors about the quality of the subprime mortgage loans that it had initiated and sold between years 2005 and 2007.

The long awaited penalty was announced on Wednesday and was in line with what some of the analysts had predicted and to some degree, smaller than the sanctions borne by some bank’s competitors. Wells Fargo originated and sold Mortgage loans that contained incorrect income information, warranting a civil penalty. Between years 2005 and 2007, Wells Fargo was the second largest originator of the residential mortgages. It pushed hard into the sub-prime loans by encouraging underwriters to be more aggressive according to a settlement agreement signed by Wells Fargo.

Probe into the bank’s dealing proved that indeed the bank had a “substantial” number of loans which contained misrepresentations or materially inaccurate information and still, the bank greenlighted the loans through the process.

“Abuses in the mortgage-backed securities industry led to a financial crisis that devastated millions of Americans,” said Acting U.S. Attorney for the Northern District of California, Alex G. Tse. “Today’s agreement holds Wells Fargo responsible for originating and selling tens of thousands of loans that were packaged into securities and subsequently defaulted. Our office is steadfast in pursuing those who engage in wrongful conduct that hurts the public.”

The settlement by the DOJ holds Wells Fargo accountable for the actions leading to the financial crisis. “It sends a strong message that the Department is committed to protecting the nation’s economy and financial markets against fraud.”  Said Acting Associate Attorney General Jesse Panuccio.

Basically, the rule or the civil penalty by the DOJ was in fact under the Financial Institution Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and according to DOJ, Investors including Federally Insured financial institutions suffered a blow in losses from investing in residential mortgage-backed securities (RMBS) which contained loans originated by Wells Fargo. The probe jeers on debts in which the borrowers were allowed to declare their income without substantial proof.

FIRREA authorizes the federal government to seek civil penalties against institutions that violate the code of ethics and allows for predicate criminal offenses including wire and mail fraud. United States alleged that in 2005, Wells Fargo initiated a program to double its production of the subprime and the Alt-A loans (loans where the borrower simply states their incomes without providing any further supporting income documentation)

In its evaluation part, Wells Fargo subjected a sample of the loans to “4506-T testing.” This is a government document signed by the borrower during the loans approval process and allows the lender to obtain the borrower’s tax transcripts from the Internal Revenue Service (IRS). Basically 4506-T testing involves a comparison of the tax transcripts of the borrower with the income stated on the loan application. Wells Fargo initiated this testing on two of its programs.

Disturbing revelations

Probe into the matter revealed that more than 70% of the loans that Well Fargo sampled had an unacceptable variance. The average variance was approximately 65%. After Wells Fargo received the results, the bank conducted a further internal testing. The additional testing was designed to determine if the plausible explanations existed for the unacceptable variance of over 20%. This further revealed that nearly half of the stated income loans that Wells Fargo tested had both an unacceptable variance and the absence of the plausible explanation for the variance.

Despite having the knowledge about this misrepresentation, Wells Fargo failed to disclose this information and instead, the bank reported false information about the debt-to-income ratios in connection with the loan it sold. Furthermore, Wells Fargo also allegedly prefigured its fraud controls by failing to disclose discrepancies in its income which the controls had identified.

The United State further alleged that Wells Fargo took a huge step to cloister itself from the risk of its stated income loans. This it did by screening out many of these loans from its own loan portfolio held for investment and by limiting the liability to the third parties for accuracy of the stated income loans. Wells Fargo allegedly sold at least 73, 539 stated income loans which were included in the RMBS in 2005-2007. Nearly half of the loans have so far defaulted resulting in billions of dollars in loses to the investors.