Among the many battles left to fight for the big banks who committed fraud up and down the mortgage market concerns a series of lawsuits against monoline insurance companies, which provided mortgage bond insurance (and paid out billions in claims) during the housing bubble. Like other investors, bond insurers have sued firms which contributed to the issuance of mortgage backed securities, arguing that the loans in the mortgage pools did not meet proper underwriting standards.

One of the major trials comes from Assured Guaranty, against an underwriter known as Flagstar, which they claim improperly allowed loans in mortgage pools that were sure to default. This trial is significant because Assured was granted a sample of the loan files to determine the quality of the underwriting. The judge in the case should be familiar to FDL News readers: Jed Rakoff, who has waged a lonely battle against the SEC’s secret settlement deals.

Rakoff pulled one of the loan files at random and found a truly incredible circumstance:

Rakoff was fixated on one of the loans underlying the Flagstar mortgage-backed securities that Assured insured, in which the borrower — a Detroit police officer — claimed to be the president of a mortgage brokerage. The judge was so disturbed by the loan-level details that emerged Monday that he twice mused whether to refer the matter to prosecutors in Michigan [...]

According to a transcript of Monday’s proceeding, when Assured’s lead counsel, Jacob Buchdahl of Susman Godfrey, stood up to defend the methodology of his underwriting expert, Rakoff brought up the suspect loan file, which he had selected at random for review last week when Assured’s expert was testifying. At the time, the judge noticed that the loan applicant claimed to be both a Detroit cop and the president of a financial services company, which smacked of fraud to Rakoff.

Buchdahl told him Monday morning that there was even more to the story: The cop claimed to be the president of the very same company that issued the mortgage. (Flagstar subsequently acquired the loan for securitization.) Buchdahl’s implication, which Rakoff immediately detected, was that the cop and the loan officer who authorized his mortgage had conspired to misrepresent the police officer’s qualifications.

“Wow,” Rakoff said. “The statute of limitations hasn’t run. I wonder whether there is a good fraud case here against both the interviewer and the interviewee.”

Flagstar tried bravely to defend the case of the cop/president of mortgage company. One underwriting manager actually suggested that the cop could have also been President. Rakoff replied “You think that a Detroit police officer would also be the president of a substantial financial (firm), Regional Financial Group… That that was sort of his sideline, he came home at 7:00 and as soon as he had dinner, he turned his attention to being the president of a major financial group?” Flagstar backed down.

This is just a random loan file out of 15,000 in the pool (Assured Guaranty presented about 20 loan files in the trial, which they were allowed to sample). And Flagstar plans to argue that it’s impossible to extrapolate from the random sample; it doesn’t tell us enough about the quality of the underwriting as a whole. In other words, the extremely fraudulent nature of the individual file could IMPROVE the case for Flagstar, because it’s such an outlier and proves the subjectivity of the whole enterprise, which cannot be prosecuted. “We are supposed to rely upon this approach as though it is valid across 16,000 loan files and be thinking about paying over $100 million based upon this testimony, when it boils down to nothing more than an unarticulated principle of I-know-it-when-I-see-it,” said Flagstar’s chief counsel.

This is fairly ridiculous, as if you cannot make rules based on bad or fraudulent underwriting. But the ruling matters because bond insurers want to use random sampling to prove their cases about faulty underwriting, and this would increase exposure on the issuers of mortgage backed securities. Other bond insurers have been granted samples, but Rakoff will be the first judge to use them on which to base his ruling. So plenty of banks will look to this ruling.