Motion to Exclude Frey Testimony from Article 77 Raises Eyebrows, Questions About Role of BlackRock and PIMCO

The backyard brawl between the AIG-led objecting investors on one hand and Bank of New York Mellon (BNYM) and the investors supporting BofA’s $8.5 billion settlement on the other is about to get even messier.  As I last wrote on May 29, before the merits hearing on the Article 77 settlement began in New York Supreme Court, that AIG had subpoenaed the records and testimony of Bill Frey, a bondholder advocate that had been hired to develop evidence against Countrywide.  We had heard very little about that testimony until this past Friday, September 20, when BNYM and the supporting investors filed this motion to prohibit Frey from testifying.

The essence of the 2-page motion is that Frey’s testimony was both irrelevant protected from disclosure by an NDA.  But both of these arguments may be subject to attack.

BNYM and the institutional investors that support the deal, including BlackRock and PIMCO (the “Institutional Investors”), argue that the only topic at issue in the Article 77 proceeding is whether the Trustee’s conduct in reaching and submitting this settlement was reasonable.  Since the Trustee never hired Frey or considered any of his work, nothing Frey would say could have any bearing on whether the Trustee’s actions were reasonable.

However, Frey’s testimony may reveal that the settlement was actually the product of a non-arms-length transaction, something that the Trustee should have investigated before swallowing the deal and its assumptions whole.  And I believe that this is why the Institutional Investors are afraid of what Frey will say on the stand.

As has long been rumored, and as Debtwire has previously reported, Frey had developed, on behalf of Tal Franklin’s much larger group of investors (a group that originally included BlackRock and PIMCO), a study of whether servicing practices by Countrywide had complied with its servicing obligations.  This study found that, in nearly every deal examined, Countywide had violated its servicing obligations in its treatment of first liens for which it or BofA held the associated second lien (i.e. self-dealing).  Multiple sources have told me that this study was actually verified by Fannie Mae, which confirmed that the methodology and results were accurate.

However, when it came time to submit this information to BNYM and demand that it take action, which would have created an Event of Default and heightened duties for BNYM, the Institutional Investors pulled out, submarining Franklin’s effort.  Instead, the Institutional Investors, led by attorney Kathy Patrick, opted to ignore this hard evidence, stay on friendly terms with BofA and BNYM, and negotiate the sweetheart deal (8 cents on the dollar of potential claims) that’s now at issue in the Article 77 proceeding.

When reached by telephone, Frey told me that he had “no comment” regarding the legal proceedings.  Frey’s attorney, Bob Knuts, and the attorneys for the objectors and the Institutional Investors did not return calls for comment.

While we don’t know exactly what Frey’s testimony would entail, or what his records would reveal, we can only imagine what juicy details would emerge regarding the way this deal came together.  From the lone internal email communication that has been released to the public thus far, we’ve already learned plenty.

Here is a copy of that email from Kathy Patrick to her group of Institutional Investors, informing them that participation in attorney Tal Franklin’s more aggressive effort to declare an Event of Default in a letter to the Trustee “is not in your interests.” [Note that this email was originally published by Reuters in connection with this story - the link remains but the content is now subscription-only, so I have posted it on Scribd.]  Patrick goes on to tell her group that “it would be a terrible shame to waste the traction we have gained with BONY by sending them a default letter at this critical stage.”

Patrick then notes that she believes that sending conflicting instructions to the Trustee would cause it to freeze in place and do nothing.  Tellingly, she concludes with the line, “[w]e don’t want to be forced to go to war with [BONY] if there is an opportunity to achieve victory by different means.”

The email initially came to light during the time that U.S. District Court Judge William Pauley had the case before him, and was considering whether to remand the proceeding back to state court.  Though Patrick was arguing before Judge Pauley that her clients were the only game in town and any amount they got was pure gravy, read this email and tell me you’re not left with the distinct impression that there was another, more serious game in town, and that her clients, instead of playing in the big leagues, opted to play patty-cake with the Trustee.

In short, Frey’s testimony and records could show that Kathy Patrick’s clients, like BlackRock and PIMCO, had purposefully ignored strong evidence at their disposal, and had negotiated a settlement that was better for BlackRock and PIMCO than it was for the pensioners and savers whose money they managed.  In other words, they never really intended to litigate these claims or push BofA for the best deal possible – instead, they may have had business reasons (including liquidity needs supplied by BofA and overlapping ownership with BofA) for wanting to keep BofA happy while looking like they were pursuing remedies.  Why else would the Institutional Investors provide a limited conflict waiver to BNYM attorney Mayer Brown, so that the Trustee’s counsel could only negotiate a settlement, and would not be permitted to litigate?

This raises perhaps the most important question to emerge from this trial – did these Institutional Investors breach their fiduciary duties to their own investors by agreeing to this deal?  This is a question that every union pension fund and college endowment that runs money through these institutions should be asking, whether or not this deal gets approved.  If these money managers gave away valuable claims for pennies on the dollar based on conflicts of interest, they should have to face the music.

Meanwhile, if Trustee had signs that the deal wasn’t truly arms-length, it shows that the Trustee may not have acted reasonably in accepting the deal.  Instead, it should have asked more questions about the process and how the numbers were reached, and certainly should have invited other stakeholders to participate in the conversations, before seeking the Court’s approval for the settlement, and pre-committing itself to use its “best efforts” to see that the deal was approved, no matter what evidence emerged.

At its heart, our legal system is adversarial in nature, and requires both sides to be pulling as hard as they can for the best result possible, so that the factfinder can find the middle ground.  If nobody was actually acting in an adversarial manner during the settlement negotiations, and if the settlement is then given a presumption of reasonableness in the Article 77 proceeding, it distorts this adversarial process.

As I wrote about recently, this proceeding is odd in that party that stands to lose the most (BofA) isn’t even a party to the proceeding, and the party pulling for the deal to be approved (BNYM) has no stake in the outcome, other than preserving the indemnity provided to it by BofA.  Thus, it makes for an awkward and distorted platform from which to render justice of any sort.  At the very least, Judge Kapnick would have to look more closely at the deal and the Trustee’s actions if it becomes clear that the deal was the product of conflicted self-dealing.

[As an aside, this also raises questions about Fannie Mae's involvement and the reasonableness of its conduct.  If it's true that Fannie had verified data that showed that Countrywide had engaged in widespread servicing defaults, why didn't it (or the FHFA as conservator) pursue claims based on that data to recover funds for taxpayers?  Why would Fannie only be willing to go forward if BlackRock and PIMCO had joined?  Sure, there's a strength in numbers argument, but Fannie's holdings (as revealed through the FHFA lawsuit against Countywide) were sizeable enough for it to pursue significant claims on its own.  Did it lack the political cover to move forward with putback and breach of contract claims, and if so, was that a proper consideration when leaving taxpayer money on the table?]

In short, there are many reasons to think that Frey’s testimony would be relevant to Justice Kapnick’s evaluation of the merits of this Article 77 proceeding.  There is also grounds to believe that the NDA signed by Frey only covered certain aspects of his work, and only a limited time period.  One source, who asked not to be identified, told me that much of Frey’s work and communications with investors took place before any NDA was in place.

All of this raises interesting questions about where this proceeding is heading and what Justice Kapnick will do.  She has stated on the record that she wants objectors to wrap up their case by this Wednesday.  However, she’s also indicated that she may set aside time in Novermber for closing arguments.

This motion throws a wrench in the Justice’s original time frame for wrapping up the hearing.  She must first review briefing and hear oral argument on whether Frey’s testimony should come in.  Then, if she rules that it can, the parties will have to review any documents he intends to produce, and will likely have a fight over which of his communications and other documents are protected or subject to privilege.  Evaluating all of this will take time, and Kapnick is unlikely to exclude potentially relevant evidence based simply on an arbitrary deadline.  Doing so would provide AIG and the other objectors with ample grounds for appeal.

Call me an idealist, but I believe in the American system of justice and the rule of law.  But the system only works if the aggrieved parties actually present their claims.

Here, few can dispute that the aggrieved parties are the pensioners, retirees and savers of the world who were duped into buying mortgage backed securities that didn’t live up to their promises – not even close.  The problem is that there are too many layers of imperfect principal-agent relationships between the aggrieved parties and the responsible parties, to achieve widespread justice.

The savers invest in various BlackRock or PIMCO fixed income funds, for example.  Most of these savers have no idea what those funds actually bought or currently hold.  BlackRock and PIMCO then have a fiduciary duty to manage those funds to get the best returns possible for their investors.  But if things go horribly wrong, they often lack the incentives to stick their necks out and file lawsuits.  Instead, they opt to stay with the pack, preserve their business relationships, and not rock the boat.

Even when certain bold investors decide to press their claims, they must go through passive Trustees, who want to do everything in their power to avoid getting sued, and conflicted servicers, who act to protect their own portfolios rather than acting in the best interests of bondholders.  Only if those bondholders can compel the Trustee and the servicer to act in their interests can they then take advantage of the justice system and the rule of law to see their contracts enforced against the Countrywides, EMCs and GreenPoints of the world.

As you can see, there are many steps along the way in which the incentives to press these claims can be distorted, and the agents do not always act in the best interests of their principals.  This Article 77 proceeding is the product of several of these distortions.  And while it’s not obvious at first to the untrained eye, which only sees that investors managed to squeeze $8.5 billion out of BofA, the more accustomed one gets to the way this deal came together, the more evident it becomes that the process was far from legitimate.

Should Bill Frey’s testimony be allowed in, as I think it should, it will help Justice Kapnick come around to that view, making it incrementally more likely that she’ll reject the deal.  But whether or not the deal goes through, it’s beginning to look more and more obvious that many of the proponents of the deal (and not just BofA) should wind up having to defend themselves in court when all is said and done against claims of breach of fiduciary duty, negligence, and breach of contract.  Should enough aggrieved parties be willing to press such claims, I’d be willing to bet that some form of justice will ultimately prevail.

Posted in AIG, allocation of loss, appeals, Bank of New York, banks, bench trials, BlackRock, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, demand letter, Event of Default, Fannie Mae, FHFA, fiduciary duties, global settlement, incentives, Investor Syndicate, investors, Judge Barbara Kapnick, Judge William Pauley, Judicial Opinions, Kathy Patrick, lawsuits, liabilities, litigation, MBS, negligence and recklessness, PIMCO, private label MBS, putbacks, remand, rep and warranty, repurchase, responsibility, RMBS, servicers, Trustees, William Frey | Leave a comment

Objectors’ Siren Song Enchants During Article 77 Proceeding

We are 20 days into the monumental bench trial over Bank of America’s proposed $8.5 billion settlement of Countrywide MBS claims, and with the proceedings now taking a break until September 9, we have a chance to sit back and evaluate what we’ve seen thus far.  When I do, I can honestly say that I’ve never seen a plaintiff take such a pounding during the presentation of its own case.  But, of course, this Article 77 proceeding is no ordinary case, and Bank of New York Mellon (BNYM) is no ordinary plaintiff.

As Trustee of all 530 Countrywide MBS Trusts at issue, and by virtue of having brought this odd proceeding before Justice Barbara Kapnick in New York Supreme Court, BNYM’s role is to ask the Court to bless Bank of America’s (BofA) settlement and the conduct of the Trustee as reasonable and beyond reproach.  The odd thing is that BofA – the party with the most at stake – isn’t even a party to this proceeding.  Instead, BNYM – which derives no economic benefit from the settlement dollars themselves – is serving as BofA’s foil – arguing for the settlement to be approved, while absorbing any attacks levied by the opponents to the settlement.

Even stranger, it has now become clear that the Trustee pre-committed itself to advocating for the approval of the settlement, regardless of what evidence or arguments the settlement’s opponents might present.  Much like the famous story from Homer’s The Odyssey in which Odysseus ties himself to the mast of his ship to avoid being persuaded off course by the enchanting sirens, BNYM has agreed to tie its own hands and bind itself to BofA’s chosen course for resolving Countrywide’s potentially massive mortgage liabilities.  The key question that Justice Kapnick and observers must ask is: was this an appropriate action for BNYM to have taken in this situation?

To see why this is so critical, let’s examine an exchange between counsel for BNYM, BofA, and the settlement objectors outside of the courtroom prior to this month’s proceedings (h/t Manal Mehta).  During trial on June 14, 2013, Justice Kapnick requested that the parties consider agreeing to mediation as a method of resolving the objectors’ complaints.  Following this request, two of the most prominent members of the objector Steering Committee – AIG and three of the Federal Home Loan Banks – sent a letter to counsel for BNYM confirming that the Steering Committee believed that mediation was appropriate and requesting that BNYM as Trustee “commence settlement negotiations immediately.”  It based this request, not on any direction by the objecting holders, but based on the Trustee’s “fiduciary duty of loyalty, which mandates that the Trustee act in the best interests of all certificateholders and avoid conflicts of interest.”

In response, Matt Ingber, counsel for BNYM, sent a letter to the Steering Committee and counsel for BofA, which attached the Steering Committee’s request for mediation.  Therein, he noted that “of course, a mediation cannot proceed without the participation of Bank of America and Countrywide.  Accordingly, please let us know the position of Bank of America and Countrywide on the request for mediation.”  This suggested that the Trustee was potentially open to negotiating with the objectors, but wasn’t going to take action without getting the approval of the bank behind the curtain.

Not wanting to keep anyone in suspense, BofA shot back with a response that was as clear as it was pithy.  Elaine Golin, BofA’s counsel from Wachtell Lipton, wrote, “Bank of America and Countrywide will not participate in the mediation that Objectors have proposed and will not otherwise engage in any renegotiation of the Settlement.  The Settlement Agreement reflects the result of lengthy, hard and arms-length negotiation.  It does not permit any of the economic terms to be renegotiated.”

BofA might have stopped there.  BNYM had already stated that the mediation could not proceed without BofA, so BofA’s refusal to participate should have ended the matter.  But, just in case anyone was in doubt about who was running this show, BofA decided to throw its weight around and smack the Trustee back into place.  Golin wrote to BNYM, “[w]e remind you of the Trustee’s obligations under Paragraph 2(a) of the Settlement Agreement to use its ‘reasonable best efforts to obtain Final Court Approval’ and under Paragraph 30 to use its ‘reasonable best efforts and cooperate in good faith to fully effectuate the intent, terms, and conditions of th[e] Settlement Agreement and the Settlement.’”  In other words, if you want us to continue to indemnify you and cover your expenses, don’t even think about questioning or renegotiating any aspect of this settlement.

Now, here’s the problem for BNYM.  It has an obligation to act in the best interests of the Certificateholders in each of the 530 Trusts at issue.  Yet, it negotiated a settlement that released the claims of all Certificateholders, without consulting the majority of those holders.

BNYM’s argument is that it independently evaluated the settlement and concluded that it was sound.  It has maintained throughout this Article 77 proceeding that it was perfectly reasonable for the Trustee not to consult with any Certificateholders outside of the 22 institutional investors who supported the deal.  Instead, it has argued that the Article 77 proceeding itself was Certificateholders’ opportunity to say their piece and speak out against the settlement.

Yet, this argument rings hollow when juxtaposed with the “best efforts clause.”  In fact, the Trustee has acted consistently with the “best efforts clause” by opposing the objectors’ requests for expanded discovery at every turn.  If this proceeding was the full and fair vetting of the settlement that the Trustee held it out to be, why wouldn’t it want all relevant facts to come to light, such as the actual breach rate in the loan pools at issue?  Wouldn’t this allow all Certificateholders to make a fully-informed decision about whether to support the settlement?

More importantly, what good is this opportunity for the objectors to speak out against the settlement if the Trustee isn’t listening?  Or, more appropriately in the context of the Odyssean metaphor, the Trustee may be listening to the objectors’ siren song, but it can’t change course because it’s tied to the mast of BofA’s settlement vessel.  If the Trustee has an obligation to act in Certificateholders’ best interests, why shouldn’t it be allowed to revisit the settlement if new evidence emerges?  And why should the Trustee work to prevent relevant evidence from seeing the light of day?

The counterargument is that the objectors have their opportunity to present their case to Justice Kapnick, and it’s ultimately the Court that will make the decision.  But, it’s becoming increasingly apparent that the Justice will make this determination based not on the absolute dollar amount of the settlement, but on whether the Trustee’s conduct in negotiating and accepting the settlement was reasonable.

Thus far, objectors’ counsel, led by Dan Reilly, Larry Pozner and Mike Rollin of Reilly Pozner and Beth Kaswan of Scott & Scott, have seized on this conflict to inflict significant damage during cross examination of the Trustee.  They have repeatedly pointed out the internal conflicts that imperiled BNYM as it helped to piece together one of the largest settlements in history between BofA and 22 investors willing to make a deal.  In one of the most compelling moments, during the hearing on July 16, the objectors forced BNYM’s counsel to admit that even if he had learned of facts or law that undermined the settlement, he was contractually prohibited from informing the Court of this (unless it involved intentional wrongdoing by BofA) due to the “best efforts” and related clauses of the settlement agreement.  This seems starkly at odds with the Trustee’s duties under the governing trust agreements.

Indeed, as Trustee of the 530 Countrywide MBS Trusts, BNYM had an obligation to remain loyal to the Certificateholders in those Trusts and avoid conflicts in carrying out that duty.  However, as I’ve often pointed out and the objectors have argued, the realities were that BNYM wanted to keep BofA happy, as BofA supplied it with over 60% of its MBS Trustee business and promised to indemnify it from any liability if the settlement went through.  So, instead of wanting to push for the best deal possible, it simply wanted to see this sweetheart deal get done.

Of course, BofA didn’t trust that these nebulous economic interests would keep BNYM in line.  So it forced the Trustee to swear off objectivity, and agree to use its “best efforts” to get BofA’s settlement approved.  This means that BNYM, the party ostensibly advocating for the settlement, really doesn’t have a dog in this fight, other than a fear that BofA will get really angry and yank their business and/or their indemnity.

The objectors’ arguments about BNYM’s strange conduct and awkward position seem to have finally caught the ear of Justice Kapnick.  She ruled just before trial that objectors had made out a colorable claim of self-dealing and conflicted conduct by BNYM, sufficient to overcome the attorney-client privilege and allow the objectors to obtain emails that traveled between BNYM and its counsel during settlement negotiations.  Armed with these documents, the objectors subjected BNYM’s counsel, Jason Kravitt of Mayer Brown, to withering cross examination during six straight days of testimony at trial that would have worn down even the most grizzled expert witness.  And Kravitt is not a grizzled expert witness – he’s far more accustomed to being the one in the board room or on the other side of the witness stand.  [For a great blow-by-blow of the various lines of questioning, the best resource (aside from the transcripts themselves) is Mark Palmer’s daily coverage of the trial at the BTIG Blog.  Palmer reported that when Kravitt learned he was going to be called back to the stand for a sixth day, he dropped his head into his hands for about ten seconds).

As I look at this trial from a 30,000-foot perspective, I’m struck by how appropriate the Odyssean metaphor really is for this strange position that BNYM finds itself in.  By agreeing to the “best efforts clause,” BNYM has agreed to do everything in its power to support the settlement and see it get approved, regardless of what this trial may unearth about the reasonableness of the deal.  For those who slept through their Classics or Mythology classes in school, a brief refresher: Odysseus was the captain of his ship, and yet asked his crew to tie him to the mast when they sailed past the beautiful sirens, so that he would not be persuaded by their alluring call and plunge his ship into the rocks like so many had before him.  His crew was ordered to place wax in their ears so that they could not hear the call of the sirens or the entreaties of their captain.  But Odysseus had no wax in his ears, so he could still hear the sirens' song; he just had no power to do anything about it.

It's the classic allegory of pre-commitment - binding yourself ahead of time to what you know is the right course because you don't think you'll have the strength to choose that path in the moment.  It's like the friend who gives you cash before you walk into a casino and tells you not to give it to him, no matter how much he protests.  [Never agree to this, by the way.  You'll find yourself out in the parking lot two hours later as your friend yells at you to give him his money back.]

Only here, BNYM, as the plaintiff and the “captain” of the Article 77 ship, has a fiduciary obligation to act in the best interests of all bondholders, which include those they’re treating as the sirens –  the objectors.  And it’s not so clear that BofA’s path is the right one for the Certificateholders as a whole.

At least one of the objectors, AIG, has stated publicly that it holds an interest in 97 of the 530 trusts at issue.  Should the Trustee be permitted to pre-commit itself to a settlement without speaking to investors like AIG, before all the facts have been examined, and before the settlement has been finalized?  What if instead of steering the Trustee into the rocks, these objectors are showing the Trustee how it can reach friendlier shores (Ithaca?) – that is, squeeze a whole lot more money out of BofA?  Wouldn’t the Trustee have a duty to pursue this path and see where it leads?

BNYM’s expert JH Langbein thought so, but after he said in deposition that the Trustee owed a fiduciary duty to bondholders to maximize their recoveries, BNYM pulled him from their witness list.  Now, we won’t hear from him personally at trial, though AIG’s counsel read his deposition testimony into the record.  Same goes for Brian Lin, the now infamous expert from RRMS, whose calculations form the primary basis for BNYM’s determination that the $8.5 billion settlement amount was reasonable.  Lin’s no longer on BNYM’s expert list, but you can be sure that the objectors will call him to the stand as one of their witnesses.

Even without these witnesses showing up to discuss or defend their analyses, the objectors have scored plenty of points and brought many compelling facts to light.  First, they established through Kravitt that the “best efforts clause” could be read to amend the Pooling and Servicing Agreements, the contracts governing the 530 Trusts.  Yet, the Trustee did not follow the protocol established in those documents for amending their terms, which generally require a super-majority of Certificateholder votes.  So, agreeing to this clause may have been an improper amendment of the Trustee’s duties.

Second, they got Kravitt to admit that his firm, Mayer Brown, had no authority to actually sue BofA if settlement negotiations fell through.  That’s because Mayer Brown had also represented BofA, and had only obtained a limited conflict waiver from BofA to negotiate the settlement, not to sue.  At least ten of the institutional investors supporting the deal also had prior relationships with Mayer Brown, and they had all executed similar conflict letters.  This completely undermines BNYM’s position that these were arms-length negotiations and that it took an aggressive approach toward BofA, including an implicit threat of litigation.  If this was true, wouldn’t BNYM have hired a counsel that could hold the sword of litigation over BofA’s head?

Third, the objectors established that BofA was paying BNYM’s legal expenses throughout much of the negotiations and the Article 77 proceeding.  Though Kravitt contended that this was perfectly normal, I have yet to engage in negotiations with a responsible party over RMBS liabilities in which the party we were threatening to sue agreed to pay my legal fees.  I’d like to ask for that at the outset of my next negotiation and see how that goes over.

Fourth, the objectors established that the settlement treats all 530 Trusts alike despite the fact that they have differing legal rights (most importantly, with respect to certain breaches being deemed material and adverse in certain Trusts).  BNYM had not disclosed this to the Court previously, but it has now come out during the trial.  This flies in the face of BNYM’s duty to act, not as the Trustee of all 530 Trusts at once, but as the independent Trustee of each of those Trusts, bound to make a separate determination for each as to what’s in the best interests of that Trust’s bondholders.

When this proceeding resumes on September 9, BNYM will present the last two of its witnesses.  With the bulk of its case now having been presented, you would expect the Trustee to have built up a sizeable lead, since the objectors have still not put on a single of its own witnesses or experts.  And yet, if the Trustee has any lead at all, it’s a small one, and it’s only by virtue of the high standard that objectors must meet to get the Court to reject the Trustee’s Petition (as discussed previously, the standard for approval is simply reasonableness, so the objectors must show the Trustee acted irrationally or arbitrarily for the Petition to be rejected).  Though I still feel it’s unlikely that Justice Kapnick will reject the settlement entirely, it’s beginning to look increasingly likely that she forces the parties back to the negotiating table.

You see, one can only deny the facts so long.  And no matter how much BofA hammers on BNYM that it must abide by the “best efforts” clause, at some point, Justice Kapnick herself may start to become persuaded by the objectors’ siren song, and begin to see this settlement for what it is: a sweetheart deal designed to protect BofA from far greater potential liabilities.  At that point, this trial may shift decidedly in favor of the objectors.  And rather than risk having the Court reject the whole thing, send everyone back to square one and erase the indemnity the Trustee covets so badly, BNYM may decide it’s obligated to mediate with the objectors and see what it would take to have them drop their objections.  Though this might send BofA’s $8.5 billion settlement crashing into the rocks, it would also be just what AIG and the other objectors have wanted from the start: to be heard by a Trustee with the incentive and the ability to heed their calls.

[I will be on vacation the remainder of this week, and will respond to any questions or comments as soon as I can upon my return - IMG]

Posted in AIG, Bank of New York, bench trials, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, damages, discovery, Federal Home Loan Banks, fiduciary duties, global settlement, incentives, investors, Judge Barbara Kapnick, Kathy Patrick, lawsuits, liabilities, litigation, loan files, MBS, pooling agreements, private label MBS, putbacks, re-underwriting, rep and warranty, RMBS, securities, settlements, successor liability, Trustees, waiver of rights to sue | 3 Comments

BREAKING NEWS: Article 77 Hearing Postponed, Bill Frey Subpoenaed by AIG

I wanted to publish a quick update to yesterday’s article breaking down the challenges BofA will face to its $8.5 billion mortgage rep and warranty settlement.  Sources have informed me that the May 30 Merits Hearing for this settlement proceeding has, in fact, been postponed, with new date yet to be determined (likely several months hence).  There has of yet been no formal announcement on this, other than word-of-mouth from the court clerk.  However, my guess is that it has something to do with the the Intervenors’ Notice of Appeal regarding Judge Kapnick’s decision to strike Intervenors’ demand for a jury trial (h/t Manal Mehta).

In other breaking news, Bill Frey has been subpoenaed by AIG. I can only speculate that he will be asked about the circumstances that led Kathy Patrick to split off from the Investor Syndicate and encourage her clients to take a less confrontational approach to Bank of New York Mellon (BNYM) and BofA.

It has long been rumored that Frey developed specific evidence for the Investor Syndicate, which had been verified by Fannie Mae, of thousands of loan defaults in hundreds of Countrywide trusts.  If true, this would severely undermine one of the Institutional Investors’ main arguments supporting the settlement: that they were the only group that was taking action against Countrywide and that they were serious about recouping their constituents’ losses.

Since many of Kathy Patrick’s group of institutional investors were previously part of Tal Franklin’s larger Investor Syndicate, why did they fail to cite any of the specific evidence of default, which they must have known existed, in their letter to BNYM?  Instead, Patrick circulated an email, that has since been brought to light in these settlement proceedings, encouraging her clients not to put BNYM in default as it would “set back significantly the progress we have made to get to get BONY to consider an alternative rep and warranty strategy.”  This alternative strategy became the sweetheart deal for BofA that BNYM is now asking the court to bless in the Article 77 proceeding.

Posted in appeals, BofA, Event of Default, global settlement, Investor Syndicate, Judge Barbara Kapnick, jury trials, Kathy Patrick, specificity, William Frey | Leave a comment

The Bell Tolls for BofA

Memorial Day Weekend is always cause for some reflection, but as we draw closer to the May 30, 2013 merits hearing on Bank of America’s (BofA) proposed $8.5 billion settlement of Countrywide mortgage liabilities, this last one seemed particularly appropriate for reflecting on the battles that have come to pass since Bank of New York Mellon (BNYM) first proposed the settlement on BofA’s behalf back in June 2011.  Though there has been some speculation that a recent win for settlement objectors would delay the merits hearing in BofA’s legacy mortgage D-Day, the lawyers on both sides must prepare as if they’re going to war on Thursday.

The odds have certainly been stacked against the investors who object to this settlement (the “Steering Committee”), as the accord is being presented for approval in New York’s commercial division under Article 77, an obscure vehicle designed to obtain rapid approval for trustees who are performing administrative actions for trusts.  Is BNYM’s decision to release  over $100 billion of mortgage backed securities (MBS) contract claims across 530 different Trusts in exchange for $8.5 billion a reasonable administrative action for trustee?  That’s for Judge Barbara Kapnick to decide.

But she need not make this decision in a vacuum.  Many guiding decisions have been handed down in the most prominent MBS cases over the last few months, and most of them point to flaws in the assumptions made by BNYM in deciding whether this was a good deal for the investors whose trusts it represents.

Earlier this month, MBIA announced that it had finally settled its long-running battle royale with Countrywide and BofA, resulting in a payment to MBIA of over $1.7 billion in cash plus various additional consideration, bringing the total settlement value to somewhere north of $2.7 billion.  This announcement was both vindicating and bittersweet for me; while I had long been predicting a settlement along these lines (see, e.g., here and much earlier, here), MBIA had achieved so many victories in the meantime that I was starting to look forward to seeing BofA get hammered at trial for refusing to acknowledge these liabilities.

And indeed, while BofA saved itself from near-certain disaster by preventing this case from proceeding to trial, it may have waited too long to avoid serious damage to BNYM’s $8.5 settlement of mortgage repurchase or “putback” claims, the centerpiece of its legacy mortgage strategy.

Today, I will looking back on recent events, including evaluating the read-through from the MBIA settlement, but I will also be looking forward to the upcoming merits hearing on the Article 77 proceeding and the challenges BofA and other banks will be facing in putting legacy mortgage issues behind them.  And the more I look at these recent developments, the more I can hear foreboding bells tolling for BofA and the largest issuers of MBS.

In fact, “For Whom the Bell Tolls,” in all of its embodiments, appears to be the perfect theme for this analysis. My younger readers will probably associate this reference with the heavy metal classic from Metallica, which opens with the ominous tolling of bells followed by the driving guitar riffs that suggest the end is coming soon. So I will begin there, as when I consider the predicament of the Big Four Banks, I can’t help but hear the final lines of this song, suggesting that the reality of legal liability cannot be denied forever:

Now they will see what will be
Blinded eyes to see
For whom the bell tolls
Time marches on

Where do Investors Stand?

With MBIA’s multifaceted litigation against BofA now coming to a close, it’s clear to me that we are entering the most critical period yet in the war over who will bear the losses from the country’s pre-crisis credit binge.  The settlement between MBIA and BofA can only be read, as the markets did, as a win for MBIA and monoline insurers in similar positions.  But I also view it as validation for the position that commentators such as myself have been espousing for nearly five years now – that banks are on the hook for billions in bad loans based on faulty underwriting.  Yet, while bond insurers such as MBIA, AGO and Syncora have been overwhelmingly successful in their MBS litigation, and have now settled most of their outstanding disputes on favorable terms, investors have yet to obtain similar results.

As we’ve discussed at length on this blog, this difference stems from a variety of factors, including less robust contractual rights, standing issues, and lack of organization.  However, certain motivated investors have now banded together with like-minded investors to form critical mass, overcome standing issues by wrangling MBS Trustees into acting on their behalf, and compelled those Trustees to institute litigation.  These plaintiffs are now poised to follow the roadmap laid down by the monolines and recoup a significant portion of the Trust’s losses.  That is, of course, unless the largest banks pull off the equivalent of a legal Hail Mary

As my readers are well aware, I have viewed the Article 77 proceeding from the beginning as exactly that – a desperate and aggressive move by an institution with its back against the wall.  Further, as many observers still don’t seem to realize, this was not a typical arms-length settlement between adverse parties.  Instead, this was a sweetheart deal struck between BofA and a small number of conflicted institutions who desired to keep BofA happy and look like they were taking meaningful action, rather than squeezing all they could out of the nation’s former No. 1 bank.

Today, we find the settlement proceeding rapidly approaching an approval hearing before Judge Barbara Kapnick in New York State Court, scheduled for May 30. Battle lines have been drawn between the institutional investors that support the deal, BNYM as the trustee, and BofA/Countrywide on the one hand; and on the other hand the steering committee of institutional investors who oppose the deal, comprised primarily of AIG, Triaxx, and a three of the Federal Home Loan Banks  (up until recently, at least on paper, it included the attorneys general of New York and Delaware; however, these entities turned out to be paper tigers once they were allowed to intervene, saying little in court and doing less, making their exit from the Steering Committee less important than widely thought).

Central to the outcome of the case is the determination of whether BNYM’s decision to settle over $100 billion of potential liabilities for just $8.5 billion was reasonable.  Much is at stake for both sides, as Bank of America’s current loss reserves rest on the assumption that this deal will be approved, and other banks are beginning to use this settlement to estimate their own MBS liabilities.

As far as Hail Mary plays go, this play was drawn up rather well – file an action in a favorable court using a favorable, but obscure, legal vehicle with little precedent regarding its application; have the Trustee file the suit so it appears to be acting on behalf of all investors; and then cross your fingers and hope the judge doesn’t have the gall or the depth of understanding to reject one of the largest settlements (by gross dollar amount) in history.

The problem, of course, is that this is a sweetheart deal parading as an arms-length transaction, and its justifications are illusory.  And, like any illusion, the more you poke and prod and ask questions about it, the more shaky this deal begins to look.  True to form, a flurry of legal rulings and evidentiary developments in recent months has threatened to decimate this settlement.

Punches to the Gut

To supporters of the Article 77 settlement, each of the past few months’ developments must have felt like punches to the gut, continuing to undermine the foundation on which this settlement was built.  For these entities, I’m sure the merits hearing could not come fast enough.

Most prominent among the legal developments was the February 5, 2013 decision of Judge Jed Rakoff in the Southern District of New York in a case brought by monoline bond insurer Assured Guaranty against lesser-known MBS issuer Flagstar Bank. This was the first MBS repurchase case to go to trial, and after hearing weeks of testimony regarding alleged breaches of the underwriting guidelines, Rakoff awarded Assured more than $90 million, an amount sufficient to cover all of its claims payments to date.

In doing so, Rakoff ruled that that the bond insurer need not show that the underwriting defects actually caused the loans to go into default, but only that the defect increased the risk profile of the loan. Specifically, Rakoff held that, “it is irrelevant to the Court’s determination of material breach what Flagstar believes ultimately caused the loans to default, whether it is a life event or if the underwriting defects could be deemed ‘immaterial’ based on twelve months of payment. Risk of loss can be realized or not; it is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach.”  This holding effectively sounded the death knell for issuing banks’ best defense to mortgage rep and warranty claims.

Following this holding, on April 2, 2013, New York State’s First Department Appellate Division had occasion to consider the question of whether the putback standard turned on materiality or loss causation, when Judge Bransten’s partial summary judgment holdings from nearly a year ago in MBIA v. Countrywide were finally decided on appeal.  Though Bransten had punted on the question of loss causation for loan-level putbacks, the First Department made the unusual move of ruling that Bransten should have issued a judgment in favor of MBIA on this issue.  Citing Judge Rakoff’s holding in the Flagstar case with approval, the First Department held that MBIA,

is entitled to a finding that the loan need not be in default to trigger defendants’ obligation to repurchase it. There is simply nothing in the contractual language which limits defendants’ repurchase obligations in such a manner. The clause requires only that “the inaccuracy [underlying the repurchase request] materially and adversely affect[] the interest of” plaintiff. Thus, to the extent plaintiff can prove that a loan which continues to perform “materially and adversely affect[ed]” its interest, it is entitled to have defendants repurchase that loan.

If Rakoff’s decision in the Southern District of New York sounded the death knell for BofA’s best putback defense, the New York State Appellate decision put the final nail in the coffin.  This is because the majority of MBS deals from this period are governed by New York law, and a New York Appellate Court decision interpreting the language of those deals is binding precedent for virtually all of them.  Why is this particularly relevant to the Article 77 proceeding?  Because, as we will discuss later in this article, Bank of New York Mellon’s “expert” gave a 60% haircut to his calculation of a reasonable settlement value based on the availability of this defense.

Finally, on April 29, 2013, Judge Bransten handed down her long-awaited rulings on MBIA and Countrywide/BofA’s motions for summary judgment on the separate issues of primary liability for Countrywide and secondary or successor liability for BofA.  Though Bransten did not issue judgment for either side on either of these issues, she did issues several preliminary rulings that were nearly unanimously favorable to MBIA and other MBS plaintiffs.

Though I could devote an entire article to analysis of these decisions – the most detailed and well-informed yet on putback liability -  I will simply summarize for the purposes of this article the most important points of read-through for the Article 77 proceeding.  The biggest impact on the settlement proceeding arises out of Bransten’s holdings on successor liability.  MBIA had based its case for successor liability on two grounds: 1) that there had been a merger in fact though not in form (a.k.a. “de facto merger”) and 2) that BofA had voluntarily assumed Countrywide’s liabilities by holding itself out to the public as doing so.

If you’ll recall, one of the major justifications for the low settlement amount in the Article 77 proceeding was the fact that Countrywide had insufficient resources to pay a large settlement, and BNYM’s expert, Stanford Professor Robert Daines, had opined that a court was unlikely to hold that BofA was on the hook for Countrywide’s liabilities.  On de facto merger, Professor Daines had discounted the likelihood of such a holding based primarily on his findings that Delaware law would likely govern this question and that the “fair value” test would prevent a court from piercing the corporate veil.

On summary judgment in MBIA v. Countrywide, Bransten rejected both of these arguments.  First, she held that New York law governed the question of BofA’s successor liability for Countrywide.  As I’ve written in the past, this determination is hugely significant, as New York law is much more favorable to a finding of de facto merger than Delaware law.  While Delaware law requires a showing of bad faith and values form over substance in making this determination – resulting in Delaware almost never finding that a de factor merger took place – New York law does not require a showing of bad faith and looks at the substance of the transaction over its form.

Second, Bransten rejected BofA’s assertion that MBIA’s successor liability claim failed as a matter of law because BofA paid “fair value” for the assets of Countrywide.  Specifically, Bransten held that,

[w]hether fair value is paid for the assets required has no bearing on whether a New York court will look at a transaction or series of transactions and deem them “in substance a consolidation or merger of seller and purchaser.

Compare this with Professor Daines’ opinion that, “I think a successor liability case would be difficult to win if a court concluded that BAC paid a fair price in the Transactions,” (h/t Manal Mehta) and you see that, once again, BNYM’s settlement determination is on shaky ground.  In fact, based on these holdings and Bransten’s comments on the record throughout this case, I pegged the likelihood at 75% that Bransten would have found for MBIA on the question of successor liability if this case had gone to trial.

Note also that Bransten kept alive MBIA’s alternative successor liability claim against BofA based on the theory that BofA impliedly assumed the liabilities of Countrywide when it made public statements to that effect.  Professor Daines dismissed the value of such a claim based on the express disclaimers to successor liability that were included in the acquisition deal documents and on the fact that MBIA could not have relied on these public statements since it entered into the bond insurance agreements prior to these statements being made.

However, Bransten also rejected these arguments, finding that the express disclaimers did not preclude a finding that BofA impliedly assumed these liabilities at a later date and that subjective third party reliance is immaterial to the question of successor liability (this is why I’ve been saying that the case for successor liability does not differ or depend on who is bringing it).

Now, to be clear, this holding does not constitute binding precedent in New York State – other judges would have had the discretion to find differently.  However, as a well-respected judge that has been the closest to this issue and has been handling mortgage crisis cases since the outset, I believe that Bransten is highly influential in the New York commercial division, and her opinion would have been quite persuasive to other judges in her jurisdiction.  This means that BNYM’s assumption that BofA would not have successor liability for Countrywide was likely inappropriate, further undermining the diligence of its settlement determination.

On the issue of primary liability, Bransten’s summary judgment opinion was helpful to Article 77 objectors in several ways.  First, she adopted the First Department’s loss causation holding, discussed above, and extended it from the single trust that the Appellate Court had ruled upon to every trust in the lawsuit.

Second, she laid down plaintiff-friendly interpretations of several important reps and warranties, including the “no default” rep - that there would be no default of a material obligation with respect to any loan – which is found in many deals.  Rejecting arguments by Countrywide that the representation referred only a default in the payment of the loan, Bransten held that this provision related to any material obligation, including borrower misrepresentations.

Finally, Bransten held that Countrywide could not use “blanket rebuttals” to dispute loan-level breaches found by MBIA, but instead had to go loan-by-loan and provided specific bases for rebutting each breach identified.  This finding took BofA’s loan-by-loan argument and turned it on its head, placing the burden on the bank to come up with specific reasons to rebut every breach.  Further, while BofA had also argued that MBS plaintiffs were only entitled to a loan-by-loan remedy, Bransten ultimately held on summary judgment (just as Judge Crotty had in the Southern District of New York in Syncora v. EMC) that MBIA would be entitled to other forms of monetary relief besides loan-by-loan repurchase.

In addition, Bransten’s opinions on summary judgment were not the only source of ammunition for MBS plaintiffs.  In reading Countrywide’s opposition to MBIA’s summary judgment motion on primary liability, it occurred to me that one of their arguments could be used effectively against them in the Article 77 proceeding.  As to MBIA, Countrywide argued that the monoline could not prove its fraud claim because it had the opportunity to conduct loan-level due diligence before entering into the deals but declined.  This meant that MBIA could not have “justifiably relied” on Countrywide’s misrepresentations.  Countrywide even went so far as to argue that no reasonable bond insurer should have entered into an MBS deal without conducing loan level due diligence to understand the types of loans and risks at issue.  Bransten ultimately rejected this argument, as it was not clear that MBIA even had access to loan files to conduct such a review.

However, in the Article 77 proceeding, the Trustee and BofA have been arguing since the beginning that no loan level due diligence was necessary for the Trustee to determine whether and at what price to settle over $100 billion worth of potential claims!  There, the settlement proponents argued that it was unnecessary and would have been too costly for the Trustee to actually look at loans in these pools to find out how many breaches were present.  But, in this case, the Trustee had full access to loan files and even the Institutional Investors that support the current deal were offering to show the Trustee loan-level data on similar pools.

This will not be lost on the Steering Committee of objectors, who has pointed out the hypocrisy in BofA’s position on this issue in the past.  I would imagine that the Steering Committee will seize on this latest both-sides-of-its-mouth argument by Countrywide to show that it was entirely unreasonable for the Trustee to accept BofA’s representations of its breach rate with respect to Freddie and Fannie conforming loans (a whole different ballgame) in lieu of loan-level review of the actual non-prime loans in these deals.

No Man is An Island

This brings up another appropriate reference to “For Whom the Bell Tolls,” this time to the original 1624 poem by John Donne that is credited with originating the phrase. In the poem of the same name (also known as “No Man is an Island”), Donne wrote:

No man is an island
Entire of itself
Each is a piece of the continent
A part of the main


Therefore, send not to know
For whom the bell tolls
It tolls for thee

These words summarize for me both the state of BofA’s settlement with BNYM and the state of the other large MBS issuers and originators watching from the sidelines. As to the former, BofA’s settlement is not an island, self-contained and removed from important legal developments in other MBS cases.

As to the latter, no bank is an island, and the mere fact that BofA has been the earliest target of mortgage litigation due to its acquisition of Countrywide does not mean that plaintiffs will not turn their sights on the other large banks next. In fact, the same group of institutional investors that initiated the BNYM settlement, still represented by Kathy Patrick, has also initiated negotiations and/or legal notices with respect to Morgan Stanley, Wells Fargo and JP Morgan Chase.

Let’s address the former first. BNYM has now admitted in the Article 77 settlement proceedings that it reached the $8.5 billion number based entirely on the work of one expert, Brian Lin, of the relatively unknown firm, RRMS Advisors. Lin is a former Merrill Lynch trader with no disclosed experience in evaluating MBS settlements and no disclosed clients other than BNYM. He reached his number based on a number of questionable assumptions that resulted in “haircuts” applied to the original loss estimates for the 530 trusts.

One of these assumptions was that only 30 percent of loans that were between 60 and 179 days delinquent would eventually default (the actual percentage is closer to 90 percent). Another assumption, as mentioned above, was that it was reasonable to forego reviewing individual loans from the Countrywide MBS for defects in favor of borrowing data from BofA’s experience with Freddie Mac and Fannie Mae on higher-quality conforming loans. Finally, the analysis relied on the aforementioned “loss causation” haircut – the assumption that BofA would not be compelled to repurchase 60 percent of the loans that contained defects because the identified breaches could not be tied to the reason the borrower stopped paying the mortgage.

In a March 13 filing in the Article 77 proceeding, the Steering Committee of investors who oppose the deal submitted the expert report of Dr. Charles Cowan.  Cowan marched through Lin’s expert report methodically and scientifically, dismantling several of the assumptions on which it relied. Notably, he argues that Lin had better evidence at his disposal than the Freddie and Fannie repurchase experience, and could have used that to estimate the pool’s breach rate rather than swallowing whole the non-analogous number provided by BofA itself. He also discussed why Lin had not used proper estimates of default and loss severity rates, and why Lin’s 60 percent “success rate” haircut was entirely improper.

Using what he represented as a “scientifically valid approach to the use of the limited information provided to Mr. Lin,” Dr. Cowan concluded that “the estimated average total repurchase liability is $56.34 billion” rather than the $8.5 billion that was at the low end of Lin’s range of reasonableness and which figure the Trustee eventually accepted.  Dr. Cowan also noted that this was not his view on the actual repurchase liability, but only the logical conclusion that Mr. Lin should have reached had he pursued “a scientifically sound approach to the task.”

While I found Dr. Cowan’s analysis compelling, I don’t think the outcome of the Article 77 proceeding will come down to a battle of the experts and whose number was more accurate or appropriate.  Instead, it will turn on an analysis of the process - that is, did the BNYM undertake a reasonable approach to determining whether to settle and at what price.  Dr. Cowan’s report does an excellent job of addressing this aspect, as well, pointing out the fact that Mr. Lin ignored better data at his disposal.

But the subsequent legal decisions we’ve discussed above will likely be most influential in showing that many of the legal assumptions and others underpinning the settlement were unreasonable when made. As noted above, the loss causation defense has been rejected by every court that considered it, showing it never had legs in the first place.  Even BofA’s own attorneys in the MBIA case, O’Melveny & Meyers, published a client alert back on July 27, 2012 (before Rakoff or the First Department had issued their opinions) warning that banks that issued MBS may have to increase reserves due to the failure of the losss causation defense. This defense, which has been repeated by every major MBS defendant in the fallout from the mortgage crisis, is simply not supported by the governing trust agreements themselves.

Bank of America has itself acknowledged the importance of this defense, stating in its 2010 third quarter 10-Q that, “if courts, in the context of claims brought by private-label securitization trustees, were to disagree with our interpretation that the underlying agreements require a claimant to prove that the representations and warranties breach was the cause of the loss, it could significantly impact the estimated range of possible loss.” BofA has also stated that its reserves may have to increase if courts reject its argument that statistical sampling should not be allowed in these types of cases, and that plaintiffs should have to prove their claims on a loan-by-loan basis. Both of these arguments have now been rejected in every MBS case to have reached that determination.

Still, even more influential to Judge Kapnick’s decision may be the allegations that the Trustee was conflicted when it made its determination.  The Steering Committee has argued this from the beginning, and this argument has now been supported by the expert opinion of Georgetown Law Professor Adam Levitin, who pointed out how much of BNYM’s custodial business is based on keeping BofA happy, and how the structure of MBS transactions does not provide Trustees with the incentives to act on behalf of investors.

Just last week in the Article 77 proceeding (h/t Manal Mehta), Judge Kapnick held that the Steering Committee had alleged a colorable claim of conflict of interest on the part based on, “1) the event of default and the Trustee’s related decision to enter into a forebearance agreement; 2) the Trustee’s decision not to provide notice to the certificateholders at any point before settlement was reached; and 3) the broad release of claims BNYM sought for itself at any point before settlement was reached.”  (J. Kapnick, May 20, 2013 Order at p. 16.)

Based on this, Judge Kapnick forced BNYM to turn over attorney-client communications on those three subjects.  It is unclear whether this additional discovery will force the postponement of the May 30 hearing date, but at the very least it provides an indication that Kapnick is questioning BNYM’s good faith and independence, and provides the Steering Committee with a pathway to evidence that could potentially prove a breach of fiduciary duty by the Trustee.

I further expect the Steering Committee to pull out all the stops in the merits hearing, examining how Kathy Patrick’s efforts came about in the first place, and questioning whether she was really the only game in town, as she claimed.  As I’ve written about at length in the past, there is plenty of documentation showing that this was not the case, and that Patrick steered her investor clients away from the more aggressive and effective strategy of Tal Franklin’s Investor Syndicate.

I consult on developments in RMBS litigation on a regular basis, and while most of my clients are interested in a detailed analysis of timing, inflection points and influential precedent, they always ask for a bottom line estimate of the odds that the case will go one way or another.  As a reward for making it through this lengthy post, I’d love to give my readers the same on the Article 77 proceeding.  But while I’ve made strong predictions in the past (see here on MBIA), I’m simply not as confident in doing so when it comes to the Article 77 settlement hearing.

Yes, many of the assumptions on which the settlement were based were unreasonable, even at the time they were made.  Yes, the process the Trustee followed likely ran afoul of due process, as they consulted with a small group of interested investors and failed to give Certificateholders notice and an opportunity to respond until the deal was done.  And yes, BNYM was operating under several conflicts of interest.  But all of this serves, in my mind, only to even the scales, which were decidedly tilted in BofA’s favor at the outset.  This inherent advantage to BofA was based on 1) the deference provided under Article 77 to the Trustee’s decision; 2) the fact that Judge Kapnick is not as proactive or assertive a judge as say a Jed Rakoff, William Pauley or Eileen Bransten (see her reluctance to delve into the details of MBIA’s transformation in BofA’s Article 78 proceeding); and 3) the fact that the Trustee of all 530 trusts and a large group of investors support the deal, while only a small group of investors have spoken out against the deal.

Add to this the fact that there is virtually no precedent for a proceeding like this, and I’m left feeling like the outcome of this proceeding is pretty close to a coin flip.  I probably give a slight edge to BNYM-Bofa (say 55% likelihood of approval), but this is down from the 65-75% likelihood of success that I would have given it after the case returned to state court and before all of the aforementioned legal developments were handed down in related cases.  Still, this is a far greater probability of the settlement being rejected than I feel like most observers are giving the deal.

For Whom Does the Bell Toll?

This brings me to a final comment about the impact of this proceeding on the rest of the RMBS landscape.  As discussed, Bank of America has made it abundantly clear in its earning statements that its loss reserves on its private label putback liabilities are predicated on the success of the BNYM settlement, and that if final court approval is not obtained, the bank’s representations and warranties provisions could prove insufficient. Given the aforementioned developments in the last few months and other losses for BofA in its epic battle against MBIA (including losing its Article 78 challenge to MBIA’s 2009 transformation), it appears that BofA will be making its stand on a settlement with numerous cracks in its foundation.

Should it lose, it may finally have to face the music and recognize that the bulk of Countrywide’s non-prime mortgage loans met no semblance of their stated underwriting guidelines. But, no bank is an island, and the other major issuers will soon have to face the same reality. As I have seen during my representation of investors and mortgage insurers, irresponsible lending was not confined to Countrywide, it was endemic.

As the battle over approval of the $8.5 billion settlement unfolds over the next few weeks, I’m reminded of yet another reference to “For Whom the Bell Tolls,” this one to the final chapter of Ernest Hemingway’s famous book:

Today is only one day in all the days that will ever be. But what will happen in all the other days that ever come can depend on what you do today…All of war is that way.

The world’s largest banks take notice: BofA is in a particularly bad position because of its ill-conceived of Countrywide, but it is not on an island by itself.  What happens this week and in the weeks to come in the Article 77 proceeding will affect the other major players in the non-prime mortgage securitization game from 2005 to 2007.  Either the deal goes through and becomes a template for how to extract oneself from this mess, or it gets rejected and signals that far more pain is coming down the pike.  Either way, do not ask for whom BofA’s bell tolls, it tolls for thee.

Posted in Adam Levitin, AIG, allocation of loss, Alt-A, appeals, Attorneys General, bad faith, Bank of New York, banks, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, damages, Federal Home Loan Banks, Flagstar, global catastrophe defense, global settlement, incentives, Investor Syndicate, investors, irresponsible lending, Judge Barbara Kapnick, Judge Eileen Bransten, Judge Jed Rakoff, Judge Paul Crotty, Judge William Pauley, Judicial Opinions, Kathy Patrick, lawsuits, liabilities, litigation, loan files, loss causation, MBIA, MBS, monoline actions, O'Melveny & Myers, private label MBS, procedural hurdles, putbacks, rep and warranty, repurchase, RMBS, securitization, sellers and sponsors, sole remedy, standing, statistical sampling, successor liability, summary judgment, Trustees, vicarious liability | 3 Comments

Mortgage Lit Roundup: Five Signs That Plaintiffs Are Winning the RMBS War

A lot can happen in a few months.  I’ve largely taken a break from blogging over the last quarter, as the demands of becoming a new father and joining a new law firm (see “Legal Practice” link in the header) have kept my plate plenty full.  But of course the world of mortgage litigation takes no breaks, and in fact things have been heating up in a big way over the last few months in the lawsuits over soured mortgage backed securities.

While the mainstream media has seemed to tire a bit of this story over the last year, in part as a result of the lack of headline-grabbing criminal prosecutions or dramatic case resolutions, it is just now starting to return to the topic in a big way.  Notably, the New York Times made waves with a story last week about the toll this litigation is taking on banks’ balance sheets – something folks like Manal Mehta and yours truly have been talking about and predicting for years.

Nevertheless, I can’t help but agree that we’re reaching a critical point of reckoning in the arc of post-crisis litigation – the inflection point at which banks can stall no longer and must either acknowledge the true cost of their and their affiliates’ irresponsible lending or risk trials and adverse judgments.  Importantly, we are beginning to see clear victors emerge in the litigation battles that had been raging in board rooms and court rooms over the last four years.  This, in turn has forced banks to launch flank attacks at some of their most ardent litigation counterparties.  In the face of these efforts, I’ve compiled my top five signs that this war of attrition is tilting in favor of RMBS plaintiffs.

Sign No. 5: Walnut Place (Baupost) Back from the Dead

This past summer, I started hearing rumblings that investors were packing it in, cashing in their chips and giving up on RMBS litigation.  The poster child for this theory was The Baupost Group hedge fund, also known by its litigation alias Walnut Place, which had been among the most vocal objectors to the $8.5 billion global settlement between Bank of New York and Bank of America over Countrywide RMBS.  After suffering the disheartening dismissal of its claims against BofA at the hands of Judge Kapnick, and the confirmation of that dismissal by the New York appellate court, Walnut Place withdrew its objections to the global settlement and soon began offloading its positions in Countrywide bonds.

However, it turns out that rumors of the fund’s demise in the world of RMBS litigation were greatly exaggerated.  On September 4, the Law Debenture Trust Co. of New York, as trustee for a Bear Stearns RMBS trust, filed an amended complaint against Bear Stearns lending unit EMC (now owned by JP Morgan), demanding that it buy back more than 1,000 loans that allegedly breached one or more reps and warranties.  A status report filed prior to the filing of the Amended Complaint (available here courtesy of Reuters) identified the Ashford Square Entities, wholly owned subsidiaries of Baupost, as the owners of 50.4% of the Trust and the representative of the certificateholders who are directing the trustee.

What’s interesting about this filing (redline version available here), is that it’s direct evidence of a development I’ve predicted for some time – that discovery obtained by the monolines in their more advanced litigation against the banks would embolden bondholders and provide them with a treasure trove of ammunition to use in their own lawsuits.  Indeed, Baupost’s Amended Complaint now includes allegations of a fraudulent “double-dipping” scheme at EMC/Bear Stearns/JPMorgan that first appeared in a lawsuit by Ambac against EMC back in January 2011 (these allegations have now popped up elsewhere, as we will see later in this post).

This is the first bondholder suit of which I’m aware to include these charges, as the Amended Complaint notes that discovery obtained in other suits against EMC shows a pattern of denying investor repurchases while seeking compensation from third party originators for the very same defects.  On top of that, the Amended Complaint contains the detailed results of an extensive file review of the loans at issue, revealing that well over 80% of the loans in the Trust were found to materially breach reps and warranties, and laying out some of most egregious underwriting errors.   Though BofA has born the brunt of mortgage litigation attacks over the past couple of years, JP Morgan is beginning to hear the drum beat of an RMBS army advancing in its direction.

Sign No. 4: Regulators (Finally) Jump Into the Fray

It has certainly been a long time coming, but it appears that regulators are finally starting to take discernible steps towards bringing accountability to at least some of those who contributed to the mortgage crisis.

As most are aware, New York Attorney General Eric Schneiderman filed a lawsuit against JP Morgan on October 1 that was premised on the same double dipping conduct by Bear Stearns and EMC that was the subject of Ambac’s Amended Complaint in January 2011.  The lawsuit was touted in a DOJ press release as “the first legal action from the RMBS Working Group.” It accused JP Morgan of two claims under New York law: securities fraud under Article 23-A of the Martin Act (the General Business Law) and persistent fraud or illegality under Section 63(12) of the Executive Law.

Schneiderman also announced that he hoped this case would be a “template for future actions” against other players in the securitization market, sending a signal that this would be the first of several lawsuits on this topic.  On November 20, Schneiderman made good on this promise, suing Credit Suisse over similar charges related to a fraudulent double dipping scheme.  The similarity of these two lawsuits is striking – and I’m not sure if this is more a result of Schneiderman using the JP Morgan action as a literal template (he has been accused of using a cut-and-paste style of lawyering) or the fact that the big banks tend to engage in the same exact types of fraud at the same times (but if you listen to the bank defenses in the LIBOR cases, “rogue traders” came up with all of the same brilliantly fraudulent schemes independently and without any collusion of any sort, and certainly without the knowledge or participation of upper management).

Most commentators who have written about these filings have been largely critical, and I have my own gripes, so I’ll get those out of the way first.  Primarily, I’m disappointed by the fact that the allegations in the complaints (here are links to the complaints against JP Morgan and Credit Suisse, so you can view them for yourself) are essentially carbon copies of those leveled by Ambac and other bond insurers against EMC and JP Morgan, and those leveled against Credit Suisse by MBIA, respectively, allegations that were first made nearly two years ago.  I would have thought that with all of the subpoena and investigative powers that the RMBS Working Group purportedly had at its fingertips, it would have had something to add to the evidence that private plaintiffs had already obtained through ordinary discovery.

If they weren’t going to add anything of their own, then why did it take the Working Group two years to file its first complaint?  Waiting until a month before the election likely had political benefits, but the running of the statute of limitations has cost the AG the ability to go after conduct occurring prior to 2006.

Moreover, I’m disappointed that these are entirely civil complaints, meaning that more than four years after the onset of this crisis, we still have seen no criminal charges brought against players who contributed to the mortgage meltdown.  As I have said repeatedly, only criminal charges against firms or individuals would truly deter this sort of complex financial fraud and prevent firms from simply “pricing in” civil penalties into the cost of doing business.  The complaint does not even bring any civil claims against individuals, even further guaranteeing that no decisionmakers will feel any real pain from this suit.

Finally, the suits appear to have been brought entirely under the auspices of the NYAG’s office, featuring only claims under New York law and taking advantage of none of the federal powers to which Schneiderman was reported to have access.  If Schneiderman really wanted to demonstrate the power and support that his Working Group carried, he likely would have preferred to list the DOJ as a co-plaintiff.

All complaining aside, however, I have to say that I was gratified to see that these complaints were filed at all.  After months of seeing little activity from the RMBS Working Group, we finally have something to point to as a sign that regulators really do give a hoot about the massive fraud that was and continues to be perpetrated against institutional investors, insurance funds and taxpayers in connection with mortgage bonds.  Rather than focusing on a symptom of the bigger problem, such as the both-sides-of-the-deal type allegations that the SEC brought against JP Morgan, Goldman, Citigroup and others for selling their clients collateralized debt obligations (securitizations of other securitized assets) as they became aware of the collapsing house of cards, this lawsuit focuses on the heart of the problem – the sale and securitization of knowingly defective loans on which the subprime securities were built.

This is an important development because it gives credence to all the private lawsuits surrounding this conduct, showing that third party regulators consider the banks’ conduct to have been illegal and worthy of their attention.  This provides private litigants with the political cover to continue their existing legal battles and bring new actions, while also promising to uncover additional evidence to aid in those pursuits.

Finally, this action encourages other regulators to jump on the RMBS litigation bandwagon or risk looking like wallflowers while more active agencies gain positive publicity and potential returns for their constituents.  We’ve already seen some evidence of that last point.  On October 9, the Manhattan U.S. Attorney, in conjunction with HUD, sued Wells Fargo Corp. over allegations of falsely certifying mortgages that were federally insured.  This comes on the heels of similar suits against CitiMortgage, Flagstar, Deutsche Bank, and Allied Home Mortgage.

While not an entirely novel type of suit, the tone of the fraud allegations against Wells Fargo and the fact that they extend to Wells’ alleged fraudulent cover-up when faced with subpoena, suggest an increasingly aggressive campaign by the DOJ.  This was later confirmed when U.S. Attorney Preet Bharaha, on behalf of the DOJ, filed a civil fraud complaint against Countrywide and BofA on October 24, seeking over $1 billion in damages for systematically deceiving the GSEs about the loans it was selling to them, and then refusing to honor contractual obligations to repurchase defective loans.  This is by far the most aggressive legal action taken by the DOJ to date with respect to improper origination practices.

In addition, regulators responsible for conserving the assets of failed institutions have become more active in recent months.  On August 10, the FDIC sued a dozen banks over misrepresentations in the offerings of $388 million in securities sold to the failed Colonial Bank.  Apart from attorney’s fees and court expenses, this lawsuit seeks $189 million in damages.  On August 21, the FDIC sued Goldman Sachs, JP Morgan, BofA, Deutsche Bank and Ally Financial’s Residential Funding Securities LLC in three separate lawsuits in Texas over misrepresentations in the offerings of $5.4 billion of securities sold to the failed Guaranty Bank.  These three suits seek over $2 billion in damages.

The National Credit Union Administration (“NCUA”), a federal regulator that supervises and insures the nation’s credit unions, was forced to step in as conservator for five credit unions that failed in 2009-10 due in large part to their massive RMBS holdings.  Having been saddled with approximately $50 billion in battered RMBS from these institutions, the NCUA proceeded to take aggressive legal action with respect to certain issuers of private label RMBS, beginning with lawsuits against Royal Bank of Scotland, Goldman Sachs, and J.P. Morgan in June, July and August 2011, respectively.  Several more suits followed over the next year.

The NCUA later became the first regulator to recover losses on behalf of failed banking institutions when it settled three such suits – against Citigroup, Deutsche Bank and HSBC – to the tune of $170 million.  Since September 2012, the agency has now filed three additional lawsuits on behalf of now-defunct credit unions, including a suit against Credit Suisse surrounding alleged misrepresentations in the sale of $715 million worth of RMBS, a suit against Barclays over the sale of $555 million in RMBS, and a suit against UBS over the sale of $1.1 billion in RMBS.  At last count, the NCUA had nine lawsuits pending against various issuers of RMBS securities on behalf of failed federal credit that collectively paid $8.45 billion for the bonds.

If regulators acting on behalf of failed institutions feel compelled to bring actions to recover losses associated with MBS, you would think we’d see more such lawsuits from private institutions.  But, alas, agent-principal conflicts and political considerations prevent more investors from becoming active litigants.  Still, the recent actions by regulators show that the private investors who have sued are making headway, and they’re now gaining political cover and additional ammunition that can only help their efforts.

Sign No. 3 – Smoke Meet Gun

Establishing a claim of civil fraud requires knowing misrepresentation, made with the intent to mislead, on which the intended target reasonably relies to its detriment.  As I have been quick to point out, without smoking gun evidence that shows knowledge of falsity and intent to mislead, it is incredibly hard to prove civil fraud in a court of law.  Though the double dipping charges discussed above certainly suggest bad faith on the part of the banks, they don’t necessarily fall squarely into this tight definition of fraud.  With the latest lawsuit by MBIA, however, I think plaintiffs have found the smoke for their guns.

On September 14, MBIA sued JP Morgan (as successor to Bear Stearns) over conduct that, if proven, can only be described as blatant fraud.  MBIA accuses Bear of duping the bond insurer to provide financial guaranty insurance for a GMAC securitization by showing it a doctored due diligence report that concealed the true rate of defects in the deal’s loans.

I have heard whispers about this type of conduct for years, but no evidence had ever emerged publically to back it up.  It was common industry practice for issuers to provide potential insurers with a supposedly independent due diligence report provided by a third party, like Clayton or Bohan.  This report, evaluating the conformance of a sample of loans to the governing laws, contracts and underwriting guidelines, was supposed to provide the insurer with an accurate picture of the risk of the underlying loan pool, allowing it to gain comfort with accepting and pricing the risk.

However, as MBIA now alleges, it ultimately learned that the report it was shown by the issuer had been “scrubbed” or doctored, and the adverse findings had been deleted from the report before it was turned over to the insurer.  How did MBIA find this out?  It got the original due diligence report from Mortgage Data Management Corporation.  By comparing the findings in both, MBIA was able to discover that 50 columns of adverse findings in the spreadsheet had simply been removed by Bear Stearns to make the loans appear far rosier.  If this isn’t evidence of blatant civil (and criminal) fraud, I don’t know what is.  Prosecutors looking to make a name for themselves, take notice (and if you’re looking for individuals to prosecute, how about the person who went into the document to delete the adverse findings, as well as the manager that instructed this person to do so?).

The important takeaway from this case is that it further erodes the “global catastrophe” defense that banks have been hiding behind for years – that they had no knowledge of how the market would turn, and that it was this unforeseen catastrophe of housing price collapse, unemployment and credit crunches that caused these deals to fail, not anything they could have controlled.  This evidence of scrubbing shows that banks were well aware of how poor these loans were underwritten (and thus how likely they were to fail), and shouldn’t be able to have that conduct whitewashed by the crisis that followed.  Though the mantra of Wall St. may have been to make sure some other patsy was holding the bag when the music stopped, the law allows these transactions to be reversed in certain situations.  And when that unsuspecting third party can show that someone went into a spreadsheet, erased problematic findings of an independent due diligence provider, and then passed the report of as authentic, that third party has as good a chance as any of winning in court.

Sign No. 2 – We Finally Have a Trial

As I mentioned above, the mainstream press seemed to grow tired of RMBS litigation news of the last year due to the slow pace of these lawsuits.  More than four years after their filing, many were still winding their way through discovery and motions for summary judgment, and no trials or dramatic resolutions were available to report.  That all changed this fall, when bond insurer Assured Guaranty went to trial against Flagstar seeking $116 million in a case over soured RMBS in the Southern District of New York.

Presiding over the trial was Judge Jed Rakoff, who should be familiar to readers of the Subprime Shakeout for his outspoken opinions and willingness to challenge both regulators and the big banks over their handling of the mortgage backed securities problem.  And if Rakoff’s reputation didn’t make Flagstar nervous heading into a bench trial, the opinion Hizzoner issued just before trial certainly should have.  Though he had denied Flagstar’s motion for summary judgment back in February, he issued his explanation for this ruling in September, and it was a godsend for RMBS plaintiffs.

I’ve written extensively about the banks’ most important and oft-repeated defense — that there were intervening causes that were responsible for the damages investors and insurers suffered, and those plaintiffs must prove that their losses were directly caused by poor underwriting.  Every judge to have reviewed this issue has ruled that this was not the case — plaintiffs must only show that poor underwriting increased their risk, not that it led directly to default.

However, these opinions had been limited to the bond insurance context.  Though Rakoff’s was similar, and he explicitly noted that he agreed with Judge Crotty’s analysis from Syncora v. EMC, the logic of Rakoff’s opinion could much more readily extend to investor putbacks. Rakoff’s primary holding, similar to prior holdings on this topic, was that Assured “must only show that the breaches materially increased its risk of loss. Put another way, the causation that must here be shown is that the alleged breaches caused plaintiff to incur an increased risk of loss.”  But in support of this holding, Rakoff noted that:

the Transaction Documents do not mention “cause,” “loss” or “default” with respect to the defendants’ repurchase obligations. If the sophisticated parties had intended that the plaintiff be required to show direct loss causation, they could have included that in the
contract, but they did not do so, and the Court will not include that language now “under the guise of interpreting the writing.” (Rakoff Summary Judgment Opinion at 11-12 (citations omitted))

By focusing on the language in the pooling and servicing agreements – the same language to which investors will look to assert their own repurchase claims – rather than solely on the “interests” of the party asserting the claim, Rakoff has given bondholders a large hook on which to hang their hats when they reach this stage of their lawsuits (which are about two years behind bond insurer suits).  More immediately, Rakoff has given Flagstar and Assured an indication that he’s not buying the bank’s defenses.

This indication was only further confirmed by the trial itself, which was simply fascinating (at least to me).  Because this was a bench trial, meaning that the case was not tried before a jury and Judge Rakoff was the sole factfinder, Rakoff had broad latitude to insert himself into the trial proceedings, and he took advantage.  Repeatedly throughout the trial, Rakoff interrupted counsel presentations or questioning of witnesses to ask his own questions and point out inconsistencies he found in the loan documents.

One example, discussed at length by commentators, including Alison Frankel here, was when Rakoff questioned Flagstar’s underwriting manager regarding a borrower who listed himself as both a Detroit police officer and the president of a mortgage broker.  Rakoff expressed extreme skepticism about whether it was plausible that this individual held both jobs, and whether he should have received a loan at all.

Though Rakoff had chosen this loan at random from a pool of 20 loans being reviewed at trial, in my experience, it was more an example that proved the rule than an anomaly.  What I found when I began coordinating reviews of subprime and Alt-A loans for clients at the outset of the Mortgage Crisis was that the overwhelming majority had no business being made, and you couldn’t throw a dart at these loan files without finding a red flag.  It was based on this experience that I concluded that investors had hundreds of billions of dollars worth of valid putback claims on their hands, if only they had the intestinal fortitude to pursue them.

I also had experience presenting these sorts of underwriting defects to mediators during attempts to settle mortgage putback cases on behalf of mortgage insurance clients.  These mediators were often retired judges with no experience evaluating mortgage backed securities or underwriting guidelines, but all had expertise in evaluating contracts.  It was thus relatively simple to educate them about the meaning of representations and warranties in the trust agreements, and all came away agreeing that, were they to have to make a ruling, they would agree that the overwhelming majority of our adverse findings constituted material rep and warranty breaches.  It does not surprise me that Rakoff, a seasoned and well-respected jurist, would have little trouble finding blatant underwriting defects in the subject loan files.

Even more striking was the straightforward manner in which Rakoff cut through the continued efforts of Flagstar to frame the claims in a backward-looking, results-oriented manner based on the borrower’s payment or employment history post-origination.   Manal Mehta of Sunesis Capital highlights the following three passages as directly debunking the banks’ logic for their minimal private label putback reserves:

THE COURT:  I don’t understand the relevance of what the witness just said at all.  At the time the borrower applies to the bank for the loan, there is no way of knowing whether he’s going to be paying for the next three years or not, so you have to assess the risk as it stands at the moment of application, true?


THE COURT:  The information that was available at the time was that, in fact, it appeared that he had substantially misrepresented his income, and his income was less, considerably less than he had represented, yes?


THE COURT:  But I am still missing the point.  It is true, of course, that someone who may have made all sorts of misrepresentations on their loan application may still wind up paying the mortgage for a while.  They may have hit the lottery or they may have a relative who helped them out or a hundred other possibilities.  But the relevant thing is, in assessing risk, is the risk at the time the loan was approved, yes?

From my perspective, Rakoff has nailed it.  The reps and warranties made by originators and issuers were made as of the date the securitization trust closed and the securities were sold to investors.  The question is whether a reasonable underwriter using an objective methodology should have found that the borrower was likely to repay the mortgage.  Whether the borrower ultimately paid is immaterial – underwriting is all about trying to control the risk at the outset.  In other words, even a blind underwriter can sometimes find a bone (a risky borrower who actually does repay the mortgage), but that doesn’t mean it was acceptable for him or her to ignore underwriting guidelines just to push more loans through to closing.

Insurance companies, like investors, had a right to rely on the loan origination process that was represented in the contracts and offering documents.  The abandonment of that process, in and of itself, entitles these aggrieved parties to recover, regardless of whether borrowers made one payment or 60.

Thus, it seems likely that Rakoff is going to come back with a sledge hammer of a ruling against Flagstar on the merits of Assured’s putback claims.  And though he did not rule directly on this issue, based on the way the trial proceeded with a focus on a small pool of 20 loans, it appears that Rakoff will allow summary evidence to be presented as a proxy for the remaining 15,000 loans in the pool (a.k.a. sampling).  If he does, this will  be the biggest nail yet in the coffin of the banks’ loan-by-loan defense.

Sign No. 1 – BofA Resorts to Flank Attacks

Readers of this blog know that one of the cases I’ve been covering in the most depth, and the one that will likely have the biggest impact on handicapping legacy RMBS exposure, is MBIA v. Countrywide, BofA.  As one of the earliest-filed RMBS cases, and featuring two of the strongest legal teams on either side in an all-out bet-the-company litigation, this case has generated important rulings in every major facet of securitization case law.

Now in its fourth year of litigation, the case has finally reached the last pleading hurdle before trial, and each side has presented two motions for summary judgment – one on Countrywide’s liability for fraud and breach of contract, and one on Bank of America’s liability as a successor-in-interest to Countrywide.  Hearings on these motions began last week, with MBIA’s attorney, Philippe Selendy, from the New York office of Quinn Emanuel Urquhart & Sullivan, raising eyebrows by announcing in court that at least $12.7 billion in Countrywide loans were materially defective.

I could write an entire article about the arguments raised in these motions, and how they’re likely to play out, but I will leave that for another day.  The long and short of it is that neither side is likely to knock out the other side’s case in summary judgment, and while the issues may be narrowed significantly by Judge Bransten, we are going to see a trial in this case if it doesn’t settle first.

Apparently sensing this, BofA has begun leaning even more heavily on a strategy of flank attacks against MBIA, turning the dispute between the parties into a conflagration of all-out corporate warfare.  This, to me, is the most important takeaway from the latest developments in this case – the indication from BofA that it doesn’t believe it can win on the papers or knock out MBIA’s legal claims head on.

We’ve already seen some of this in the battle between the parties.  BofA has emerged as the leader in a consortium of banks that sued MBIA and the New York Insurance Department in separate cases over MBIA’s transformation, hoping to unwind that transaction and push the parent to the brink of insolvency.  Though we’re approaching six months and counting since the conclusion of the merits hearing in the first transformation case (the Article 78 proceeding before Judge Kapnick), my initial assessment still holds: that BofA is unlikely to obtain a victory at this stage, as the judge is obligated to give broad deference to the Insurance Commissioner’s decision to approve MBIA’s transformation.

But this has not stopped the nation’s former number one bank from trying to squeeze the monoline six ways from Sunday.  The latest skirmish began when MBIA announced that it was seeking to change the terms governing almost $900 million of bonds, to eliminate cross-default provisions that would allow bondholders to immediately demand payment from the parent company if MBIA Insurance was seized by regulators.  In layman’s terms, MBIA was seeking to shore up the parent by isolating the insurance company and preventing the troubled subsidiary from dragging the parent down with it.  Of course, if you believe MBIA, the insurance company is only in trouble because BofA refuses to buy back the defective loans that it duped MBIA into insuring.

Of course, BofA wasn’t about to let MBIA get away with this.  So, BofA came back with a tender off of its own – seeking to buy $329 million worth of MBIA bonds to block the insurer’s efforts.  BofA justified the move by saying that if the insurer succeeded with its consent solicitation, “the risk of MBIA Insurance Corporation being placed in rehabilitation or liquidation will increase, which would jeopardize all policyholder claims, including Bank of America’s.”

MBIA’s request to bondholders was accompanied by an offer to pay $10 per $1,000 of notes to those who consented.  Meanwhile, in its counter offer, BofA offered to pay bondholders as much as a 22 percentage point premium on bonds governed by one of two indentures MBIA was trying to amend.  MBIA’s stock went on a roller coaster that week, as theses various developments played out.

Ultimately, MBIA announced that it was successful in its consent solicitation but that didn’t stop BofA from purchasing $136 million worth of MBIA bonds, anyway.  Christian Herzeca posted a couple of great articles on his blog (available here and here) regarding the strategy (or lack thereof) behind this move by the banking giant.

Herzeca’s takeaway was that BofA was gearing up to settle with MBIA, and was gathering assets that they could wrap up into an eventual settlement to cloud the bottom line dollar amount (a la the Syncora Settlement).  I tended to think that BofA was gearing up for the opposite – a long, drawn out battle to the death, in which they were gathering any tools they could use to put pressure on MBIA to cave cheaply.

Well, we didn’t need to linger in suspense for long.  This past Friday, BofA sued MBIA yet again, claiming that the insurer had tortiously interfered with BofA’s tender offer to buy MBIA bonds.  Yes, that’s right – BofA tried to block MBIA’s consent solicitation, and when that failed, it sued MBIA for tortiously interfering with BofA’s attempted tender offer.  It goes without saying that there is no love lost between these companies, but their escalating battle is starting to take on a certain Through the Looking Glass kind of flavor.

What I read from these shenanigans is that MBIA is trying to buy some time to see its putback litigation against BofA through to completion.  It realizes that every day that goes by without obtaining any of the recoveries it booked from this litigation makes the insurance subsidiary’s balance sheet look that much weaker, and thus at greater risk of intervention from regulators.  BofA also knows this, which is why the bank’s primary strategy is to drag out these recoveries as long as possible, hoping that liquidity pressure and/or pressure from regulators will force MBIA to settle otherwise ironclad claims at pennies on the dollar. And since this case is such a widely-watched bellwether, a cheap settlement here sets the ceiling for the torrent of other putback litigation BofA is beating back.

By amending the cross-default provisions in its bonds, MBIA is basically saying, we’re not afraid to go down with this ship.  We are betting the company (at least the insurance subsidiary) on this putback litigation, and we will litigate as long as we have to in order to get the recoveries we deserve.  BofA apparently felt this move was dangerous enough that it was willing to launch it’s own tender offer, and then file a lawsuit when they lost, in an attempt to undo the amendment MBIA achieved. This, in turn, means that MBIA has exposed BofA’s litigation strategy for what it is, and has come up with an effective plan of attack.

When all is said and done, watching these elaborate corporate machinations play out is somewhat gratifying, because it confirms a hypothesis I formed over four years ago when I first began covering this litigation: that these insurer and investor putback claims were so strong, and based on such powerful and extensive evidence of irresponsible lending in the pre-crisis loan files, that the banks had no viable defense.  Nor could the banks acknowledge the liability because the magnitude of the potential payouts could reveal the banks to be insolvent.  Therefore, the only logical response was for the banks to try to drag out the recoveries as long as they could (the “loan-by-loan” strategy), and to try to earn their way out of this problem.  Nothing I have seen in four years since has persuaded me otherwise; instead, this flurry of collateral attacks by Bank of America has only convinced me that my assessment was spot on.

One of the main purposes of the rule of law and the civil justice system is to redistribute losses in a socially expedient manner.  It’s just too bad that the wheels of justice grind so slowly that aggrieved parties can run the risk of going bankrupt before they can recover what they’re owed.


I don’t mean to paint an overly rosy picture of RMBS litigation and imply that there have been no adverse decisions for RMBS plaintiffs.  Certainly, we’ve seen a few oddball decisions that have limited recoveries where financial guaranty insurers continued to accept premiums after realizing there were breaches in the pools, or limiting putback recoveries to loans that had not yet been charged off, but as I will explain in future posts, these non-binding decisions are largely idiosyncratic and difficult to justify in any logical manner.  For that reason, they are unlikely to be seen as persuasive by the other judges who are wrestling with these cases.  Instead, the overwhelming majority will go the way that Bransten, Pauley, Crotty, and Rakoff have gone thus far, and conclude that even in Wonderland, the banks can’t escape the inevitable conclusion that they’re on the hook for the shoddy mortgages they sold.

Hat tips to Manal Mehta, Deontos, Alison Frankel and Sari Krieger for keeping me up-to-date on many of these developments.

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