HSBC is paying to settle claims by US prosecutors that relate to its packaging, securitisation, issuance, marketing and sale of residential mortgage-backed securities between 2005 and 2007.

During this period, federally-insured financial institutions and others suffered major losses from investing in such securities issued and underwritten by HSBC. The settlement's civil penalty is pursuant to the Financial Institutions Reform, Recovery and Enforcement Act 1989 (FIRREA).

Bob Troyer, the United States Attorney for the District of Colorado, said that HSBC “chose to use a due diligence process it knew from the start didn’t work. It chose to put lots of defective mortgages into its deals. When HSBC saw problems, it chose to rush those deals out the door. When deals went south, investors who trusted HSBC suffered.”

Prosecutors allege that HSBC broke FIRREA by misrepresenting to investors the quality of its securities and the 'due diligence' procedures it claimed that it would use to ensure that quality. HSBC disputes and does not admit the allegations.

Facts of the matter

As early as 2005, according to the prosecutors, an HSBC credit risk manager expressed concerns with the bank's 'due diligence' process, but the bank nevertheless praised that process to potential investors. It told investors that when it purchased pools of subprime loans, it would review at least 25% of the loans in the pool for credit and compliance. It told investors that it selected 20% of the loan pool as an “adverse sample” based on “a proprietary model, which will risk-rank the mortgage loans in the pool.” On some loan pools, however, HSBC’s residential mortgage-backed securities trading desk influenced the way in which the risk management group selected loans for the adverse portion of the sample, and as a result, the sample was not based on its model. HSBC also told investors that it selected another 5% of the loan pool as a “random sample” but in some instances, HSBC used a random sample that was less than 5% of the pool, or used a sample that was not random at all.

To review the loans HSBC did select for review, HSBC used 'due diligence' vendors and HSBC saw the results of the vendors’ reviews of the loans before the deals were issued. Between January 2006 and June 2007, the main vendor said that 7,400 loans had low grades — more than one out of every four loans it reviewed. When HSBC employees saw loans with low grades, they sometimes waived those loans through or recategorised the grades to make things look better. One HSBC trader said of a mortgage-backed security that HSBC was about to issue: “it will suck.”

FIRREA

In 2013, Andrew Schilling of Reuters explained the utility of FIRREA to US prosecutors: "Counsel need to know that FIRREA, enacted in 1989 in response to the savings and Loan crisis, is a federal law that authorises the Justice Department to sue for civil penalties when a person or entity has violated any one of fourteen enumerated criminal statutes [to do with] bank fraud, false statements, mail fraud, wire fraud and other offences involving or affecting federally insured financial institutions. The statute authorizes civil monetary penalties of up to the amount of the gain or loss resulting from the fraud.

"In recent years, the Department of Justice has been bringing more and more civil penalty lawsuits under FIRREA. In fact, the department has filed more FIRREA lawsuits in the last three years than it did in the prior two decades combined. These lawsuits are typically built upon information obtained by the government pursuant to FIRREA subpoenas."

The DoJ has used the statute to extract eye-watering sums from giant banking corporations. In April this year it used it to induce Barclays to pay $2 billion in respect of the marketing and sale of residential mortgage-backed securities between 2005 and 2007. In January last year it used it to make Deutsche Bank pay $7.2 billion for misleading investors in its sale of residential mortgage-backed securities. In 2014 it used it to force Bank of America to pay $16.65 billion for financial fraud leading up to and during the financial crisis – the largest civil settlement with a single entity in American history. Almost $10 billion was paid to settle federal and state civil claims by various entities related to residential mortgage-backed securities, collateralised debt obligations and other types of fraud.