Bank Hapoalim has filed a massive $720 million suit against Bank of America, Merrill Lynch and Countrywide over its losses in the U.S. subprime crisis, alleging that the U.S. institutions misled and defrauded it.

Among Israel's financial institutions, Hapoalim suffered the worst losses in the subprime crisis due to its investments in mortgage-backed securities.

Open gallery view A branch of Bank Hapoalim. Credit: Tomer Appelbaum

Between 2005 and 2007, the bank, led by Shlomo Nehama and Zvi Ziv, snapped up mortgage-backed securities in an attempt to meet its goal of a 15% return on equity by 2007.

By the end of that year, the bank had invested $3.65 billion in such securities. But when the subprime crisis broke out in mid-2007, these securities collapsed as American homebuyers defaulted on their mortgages.

Only then did many investors realize that the securities were based on mortgages given to some of America's weakest borrowers, who found themselves unable to pay the moment their homes stopped appreciating in value.

In 2008, Hapoalim booked a NIS 3.9 billion loss due to its investments in instruments including credit-default swaps, mortgage-backed securities and structured investment vehicles - all complex, poorly understood instruments that nosedived during the crash. The losses were on assets Hapoalim bought from Bank of America, Merrill Lynch, Countrywide and other financial institutions. Hapoalim is considering filing suits against these other companies as well.

It filed its suit against Bank of America, the United States' second-largest bank, two weeks ago in Manhattan federal court.

U.S. gov't also filed suit

Hapoalim is in good company - dozens of investors and the U.S. government itself have filed suits against financial institutions that sold mortgage-backed securities.

The U.S. government filed its suit in September over $196 billion in mortgage-backed securities sold to national mortgage agencies Freddie Mac and Fannie Mae.

In its suit, Hapoalim says that between January 2006 and July 2007, it bought $721 million in assets issued by Bank of America, Merrill Lynch and Countrywide. Merrill and Countrywide were acquired by Bank of America during the crisis.

These institutions played a role in every stage and published misleading or incomplete information when selling the assets, Hapoalim alleges.

It alleges, for instance, that the institutions published misleading and incomplete information on the loan-to-value ratio of the mortgages underlying the assets - the percentage of a home's value borrowed.

Also, the institutions were aware that they were misleading the public when they issued these assets, alleges Hapoalim. Hapoalim was not aware of any of this, and sustained massive losses because it trusted the information it was given, it says.

Blindsided by the crisis

There is backing for this statement in Hapoalim's financial reports. In its 2007 report, filed in March 2008 - when the subprime crisis was in full swing - the bank said external consultant ADCO, which specialized in mortgage-backed securities, had told it that its mortgage-backed-security portfolio would sustain losses of no more than $20 million to $30 million.

ADCO estimated that the probability of losses above $30 million was only 20%, which it deemed low, Hapoalim said in the 2007 report. In an extreme scenario, the bank would lose $216 million - a scenario ADCO gave a probability of only 2%.

The bank noted in its 2007 report that in a very extreme scenario, it could lose up to $340 million on mortgage-backed securities.

Within two months, it turned out that those estimates had been very optimistic. In May 2008, Hapoalim sold its entire portfolio of mortgage-backed securities for $2.55 billion - a $879 million loss. The buyer was Pimco.

Hapoalim would not have sold had it not been forced to do so by Israel's banks commissioner at the time, Rony Hizkiyahu.

That year, Hapoalim also booked heavy losses on its investments in structured investment vehicles and credit-default swaps. The former caused it losses of $367 million, the latter lost it $418 million.

In total, the bank lost NIS 3.9 billion due to its investments in mortgage-backed securities, structured investment vehicles and credit-default swaps that year. Most of these investments had been made via the bank's branches in New York and London.

'We didn't really understand'

"Until the crisis broke out, we didn't really understand these investment vehicles," said a former senior banker at Hapoalim, echoing a common sentiment in the financial industry.

Further evidence of this can be seen in yet another statement in that 2007 annual report. "The credit quality of the portfolio is high - 99.8% of the mortgage-backed securities are ranked AAA," the bank wrote.

Hapoalim apparently was blindsided by the crisis - it continued buying mortgage-backed securities right until the crisis broke, according to its court papers. It made its final purchases on June 19, 2007, from Countrywide - a month before the crisis began.