Is Foreclosure Settlement Déjà Vu All Over Again?

Posted on February 9, 2012 by igradman

Today, the Attorneys General of 49 states (with Oklahoma being the lone holdout) announced a record $26 billion settlement with the nation’s five largest servicers over false and fraudulent foreclosure practices like robosigning.  That big number looks great on paper, but I’ve seen far to much during my time covering MBS developments to trust in optics alone.

As expected, when I dig into the details of this settlement, I realize that only $5 billion of the total consists of cash payments, while another $17-20 billion consists of principal write-downs and other aid to homeowners at risk of default. What this means is that, once again, regulators have allowed banks to shift penalties based on their improper servicing practices onto the bondholders that actually own the loans.  As Yogi Berra famously said, “it’s like déjà vu all over again,” only this time, the regulators should known better.

To understand why, let’s flash back to 2008, the last time we saw a massive, multi-state settlement sponsored by the AGs.  Back then, the target was Countrywide, and the lender was being sued from all sides by AGs over predatory lending practices.  The proposed solution back then, as it has been in every regulatory effort to solve the housing crisis to date, was widespread loan modifications (this is why you’ll notice that the cover of Way Too Big to Fail features Uncle Sam futilely swinging a hammer labeled “Loan Mods” at the problems that keep popping up in a game of Mortgage Crisis Whack-a-Mole).

With great fanfare, the AGs announced in October 2008 that they had reached an $8.6 billion settlement with Countrywide, in which Countrywide would modify 400,000 loans.  What I soon realized was that this would not be a cash payment of $8.6 billion — instead, most of that figure consisted of, you guessed it, principal writedowns and other loan modification “credits.”  The only problem was that 88% of the mortgages that Countrywide had agreed to modify were no longer owned by Countrywide, meaning that the bulk of the costs of this settlement would be born by others.

The settlement resulted in a lawsuit by Greenwich Financial Services on behalf of unnamed bondholders that essentially said, “hey, we actually have contracts with Countrywide that say they can’t modify loans willy-nilly and take money our of our pockets without compensating us.”  The lawsuit put Greenwich CEO Bill Frey in a position to be a spokesperson for aggrieved bondholders, thrusting him into the spotlight and the crosshairs of controversy.  The banks’ response was to begin a massive lobbying effort that led to the passage of the Servicer Safe Harbor in 2009 – a provision that in its original form said that banks could ignore its contracts with investors in the interests of public policy.  Only the Senate’s fears that such a law would run afoul of the Takings Clause of the 5th Amendment (I wrote a feature-length article on this issue), and a last-minute lobbying effort by bondholders, led to the provision being severely watered-down before it passed in its final form.

The question I asked at the time, along with several other astute commentators in the media, was whether the AGs had purposefully bailed out the banks by allowing them to pass costs onto investors, or whether they had been played by a more sophisticated counterparty.  I guessed that it was the latter – the AGs simply didn’t understand that most of these loans were in securitizations, and that the banks that had originated them and still serviced them, didn’t actually own them any longer.

But, what’s their excuse now?  Enough has been written about this issue in the 4 years since the last settlement, and enough trips have been taken to Washington and state capitols by bondholder advocates, that our elected officials should be reasonably knowledgeable about mortgage securitization and the transfer of ownership that took place.   They should understand that the bank that services a mortgage, and has the power to reduce the principal balance or otherwise modify the mortgage, may not actually own it or bear the cost of this modification.  And yet, we see the same strategy being implemented today to solve the housing crisis that was being attempted back in 2008 – yell at the banks about poor practices while bailing them out with a back-door loss shifting strategy, give the money to underwater homeowners in the form of loan mods, and ignore the fact that our pension funds, college endowments and life insurance investments are being looted in the process (note that homeowners haven’t even received the benefit of many of these bargains, as servicers have been reluctant to actually go through with loan mods due to uncertainty regarding their contractual rights to do so).

This doesn’t even get into the other 800 lb gorilla lurking in the corner of room — the $400 billion of second lien loans held by the biggest four servicers on their books.  These loans are being kept at close to par on banks balance sheets despite being worth a fraction of that because they sit behind underwater first liens in  priority.  Though the terms of this settlement are still emerging, I would be dollars to donuts that 2nd liens are being handled as they’ve always been by regulators — they’ll be modified in pari passu or “on equal footing” with first liens, which essentially disregards their contractual standing as subordinate to first liens (that is, seconds should be wiped out if a first lien modification becomes necessary).

To someone who has been writing for four years about the dire consequences of this type of loss shifting and contract trampling — including a loss of confidence in the financial markets and the rule of law that will discourage desperately-needed private capital from returning to the mortgage market — it’s incredibly disappointing that this message has apparently fallen on deaf ears. If this crisis is to be resolved, it must be resolved in a way that honors contracts and restores investor confidence, or the housing market will never recover.

The one silver lining in this otherwise grey cloud of an announcement is the fact that the settlement does not release any claims that regulators or private parties may have surrounding the origination or securitization of mortgage loans.  Thus, there remains some hope that by aggressively pursuing remedial action against the banks for the way in which they created and sold mortgage backed securities in the first place, regulators (the Mortgage Fraud Task Force, for example) could create a resolution framework that would disincentivize future fraud and irresponsible lending while sending a clear message to bondholders, insurers and homeowners that contracts and the rule of law still mean something in this country.

Based on what I’ve seen thus far, I’m not holding my breath.  Returning to the always-appropriate Yogi quotes, we may have “made too many wrong mistakes,” to dig ourselves out now.

Posted in allocation of loss, Attorneys General, bailout, banks, BofA, consitutionality, contract rights, costs of the crisis, Countrywide, education, foreclosure crisis, global settlement, Government bailout, Greenwich Financial Services, Helping Families Save Homes, homeowner relief, improper documentation, incentives, investigations, investors, irresponsible lending, junior liens, lenders, liabilities, loan modifications, lobbying, MBS, media coverage, moral hazard, mortgage market, predatory lending, press, private label MBS, probes, public perceptions, Regulators, RMBS, robo-signers, securitization, Servicer Safe Harbor, servicers, settlements, sophistication, subprime, Takings Clause, The Subprime Shakeout, Way Too Big to Fail, William Frey, workouts | 1 Comment

Federal Judge in Goldman Sachs MBS Suit Grants Class Action Status to All Bondholders in Trust

Posted on February 6, 2012 by igradman

This just in: the Hon. Harold Baer, Jr. of the Southern District of New York has certified a class of bondholders in Goldman Sachs MBS Trust 2006-S2 led by the Mississippi Public Employees Retirement Fund.  Included in the class are all bondholders in the Trust, not limited by the class of securities purchased.  With this decision, it’s official: the trend I’ve discussed previously of courts approving more permissive definitions of MBS classes has taken hold, and should allow far more coordination between adversely affected bondholders, and far greater securities law recoveries.  You can read the full decision here.

What’s really striking about this decision, and what confirms that the roots of a more permissive trend have taken hold, is that Judge Baer’s decision flies in the face of a earlier decision on MBS certification issued by… Judge Baer (discussed in development #3 in my prior article on RMBS Developments).  In this decision by Judge Baer in a case brought by the New Jersey Carpenters Vacation Fund, et al. against Residential Capital and Royal Bank of Scotland (hereinafter “Residential Capital”), Hizzoner held that class certification was not appropriate because investors varied in sophistication and knowledge (based in part on the timing of their purchases) to such an extent that individual questions predominated.

In his newest decision involving Goldman’s securities, Judge Baer seems to downplay these differences, noting that differences in knowledge and sophistication alone do not require that class cert be denied.  In fact, he explicitly mentions and distinguishes his earlier decision in Residential Capital, saying:

In [my prior holding in] Residential Capital I determined that common issues did not predominate where different putative class members had different levels of knowledge regarding underwriting guidelines and practices. While Residential Capital
refers to the sophistication of certain class members and their familiarity with the mortgage-backed securities market, 272 F.R.D. at 168, sophistication is not sufficient on its own to find that questions of individual investor knowledge predominate over common issues. See Rocco v. Nam Tai Elecs., Inc., 245 F.R.D. 131, 136 (S.D.N.Y. 2007), cited by DLJ, 2011 WL 3874821, at*8–9 n. 1.

Indeed, [my ruling in] Residential Capital rested on a finding of individual investor knowledge that was informed not only by the sophistication of class members and differences in the availability of information over time, but other, more specific, evidence as well. See, e.g., Residential Capital, 272 F.R.D. at 169 (finding that certain class members “were extensively involved in the structuring of the [offerings at issue], including in the review and selection of the loans that backed the certificates”). (Order Granting Class Certification in Public Employees Retirement System v. Goldman Sachs, et al. at 9)

Throughout the Goldman decision, Judge Baer returns to this notion that the specific evidence cited in Residential Capital, that certain investors had knowledge that the mortgages backing their investment may not have been as represented, was not present in Goldman Sachs.  Whether this turnabout is based on subsequent rulings that distinguish or contradict the Judge’s Residential Capital decision or whether Judge Baer sees the specific facts of the Rescap case as distinguishing that case in a meaningful way is difficult to know for sure.  What is patently clear, however, is that Judge Baer has significantly narrowed the circumstances in which class certification is not appropriate, and opened the door for far broader class actions against Wall St. MBS issuers.

Full Opinion: http://www.scribd.com/fullscreen/80703372?access_key=key-2b8hdr6hsk1t4h4z6xfr

Posted in bondholder actions, class actions, Goldman Sachs, investors, irresponsible lending, Judge Harold Baer, Judicial Opinions, lawsuits, lending guidelines, litigation, MBS, private label MBS, Residential Capital, RMBS, securities, securities laws, securitization, sellers and sponsors, sophistication, standing, underwriting guidelines, underwriting practices, Wall St. | Leave a comment

BlackRock Attorney to Face Stiffer Challenges to Next Set of MBS Settlements

Posted on January 31, 2012 by igradman

(Updated version, including new 6th paragraph on subsequent announcement of larger probe into Morgan Stanley bonds)

Having received copious kudos for engineering an $8.5 billion investor settlement with Bank of America over soured Countrywide residential mortgage backed securities (RMBS), “pitbull” lawyer Kathy Patrick, of the Houston-based firm, Gibbs & Bruns, has now trained her sights on the other big dogs in the world of pre-crisis MBS issuance.

Patrick’s most recently disclosed target is Wells Fargo, one of the Big Four Banks that up to now has stayed largely out of the RMBS litigation spotlight, as investors and insurers have gone after more notoriously irresponsible lenders such as Countrywide/BofA and EMC/JPMorgan.   But that all changed on January 5, 2012, when Gibbs & Bruns issued letters to RMBS Trustees US Bank and HSBC, stating that its clients held 25% of the voting rights (the critical threshold for legal standing) in 48 trusts that issued these securities and instructing them to open investigations into ineligible mortgages backing $19 billion of RMBS issued by Wells Fargo affiliates.

Recall that it was just such a letter that kicked off negotiations between Patrick’s bondholder clients, BofA-Countrywide and Bank of New York Mellon (BoNY) as Trustee.  Despite purposefully avoiding a more aggressive stance with the Trustee that may have involved declaring an event of default and triggering the Trustee’s fiduciary duties (as other bondholders were contemplating), the letter got the Trustee’s attention and was the precursor to the $8.5 billion proposed settlement that is currently being challenged in federal court.

A Pattern Emerges

The Wells Fargo letter comes on the heels of two other recent assaults by Patrick’s bondholder group.  On December 16, 2011, the group announced that it was going after JPMorgan.  In the announcement, Gibbs & Bruns said that it had issued instructions to BNY Mellon, US Bank, Wells Fargo, Citibank, and HSBC, as Trustees, to open investigations into ineligible mortgages in pools securing over $95 billion of MBS issued by various affiliates of JPM.  The most eye-popping number in this announcement was the law firm’s claim that its clients held 25% of voting rights in 243 JPMorgan trusts, even more than the 180 Countrywide trusts in which the group currently claims it has standing (now that it’s no longer counting Freddie Mac’s holdings).

Prior to that, on October 18, 2011, Gibbs & Bruns sent a letter to Morgan Stanley, saying that its clients held 25% of the voting rights in 17 MBS deals issued by the investment bank, and that it had found a large amount of servicing violations and false or fraudulent information that had been published in connection with the offering of those securities.  The letter, which has not been released to the public, only became public knowledge after Morgan Stanley disclosed it in its 2011 Q3 10-Q report.  The original face value of the 17 MBS deals was reported to be over $6 billion.

Subsequently, on January 31, 2012, Gibbs & Bruns issued a formal announcement regarding Morgan Stanley, in which the law firm stated that it had instructed RMBS trustees US Bank, Deutsche Bank and Wells Fargo to open investigations into ineligible mortgage securing $25 billion of Morgan Stanley-issued RMBS.  In that announcement, the firm claimed to have standing in 69 different Trusts.  It’s unclear why the numbers disclosed by Morgan Stanley in their earlier 10-Q are only a quarter of the size of the holdings announced by Gibbs & Bruns, but perhaps the firm has been able to attract a number of new clients in the last few months.

Shotgun Approach

By the numbers, the Wells Fargo deals represent the smallest original principal amount of RMBS out of the four issuers that Patrick has confronted thus far.  But what makes that effort particularly interesting is that it illustrates that Patrick’s group, which currently contains at least 22 major institutional investors, is not exactly taking a surgical approach to selecting the deals it wants trustees to investigate.

For example, several of the WFB deals contained in Gibbs & Bruns’ press release are experiencing delinquency rates of less than 1% and minimal cumulative losses. One analyst has also pointed out that some of the deals Patrick has identified in the past contain few actionable reps and warranties and extremely high procedural hurdles (such as voting rights thresholds of 50% just to petition the trustee).

What this indicates is that Patrick is not examining individual deals and hand picking the ones on which she is most likely to recover significant returns for her clients through putback litigation or other legal claims.  Instead, she’s identifying every trust in which her clients have standing, in the hopes of giving her the broadest platform from which to negotiate a global putback settlement for each targeted lender – a settlement, by the way, that will bind every investor in these deals, not just Patrick’s own clients.

But don’t just take my word for it.  Listen to Patrick herself, quoted in her firm’s press release on the Wells Fargo letters:

Our clients continue to seek a comprehensive solution to the problems of ineligible mortgages in RMBS pools and deficient servicing of those loans.  Today’s action is another step toward achieving that goal.

Or take Patrick’s quote in this Forbes article from October 2011:

This group did not come together just to deal with Bank of America. They came together because they wanted a comprehensive industrywide strategy and an industrywide solution… They started with Bank of America because they thought they could achieve a template that they could extend to other institutions.

These quotes may not seem remarkable until you delve into choice of language and the objections raised in the past to to Patrick’s efforts, including allegations regarding conflicts of interest and the secretive manner in which she negotiated the settlement.  What Patrick is not saying is that she wants a comprehensive solution for just her 22+ institutional clients; she’s saying that she wants a comprehensive solution for the entire industry. Recall that the big banks (who should be Patrick’s biggest opponents) have been saying much the same thing since the early days of this litigation – that they want a comprehensive, industrywide solution – and their support for efforts such as the proposed 50-state robosigning settlement have backed that up.

This only gives more credence to the fears of many of the bondholders outside of Patrick’s group: that she’s actually working to achieve sweetheart deals for the banks that would allow her institutional clients to maintain their cozy relationships with the financial firms while allowing the conflicted investors, Trustees and issuers to put these issues behind them.  But while it may be clear that Patrick is trying to architect a comprehensive settlement of all putback liabilities for the major banks along the lines of her groundbreaking settlement with BofA, what’s also clear is that this time around, her opponents will be better prepared to thwart her efforts.

A Mobilized Opposition

In the world of MBS litigation, bondholders and bond insurers have thus far gravitated toward a select few attorneys who have made their names by diligently pursuing investor interests.  This short list includes Philippe Selendy, whose firm, Quinn Emanuel, represents a number of bond insurers, including MBIA, and bondholders like the FHFA; David Grais, who represents many of the FHLBs, the distressed debt fund Baupost Group (aka Walnut Place), and TM1, to name a few; Talcott Franklin, who created the Investor Clearinghouse and represents Knights of Columbus in its lawsuit against Bank of New York Mellon; and Bernstein Litowitz, which represented the class that settled with Merrill Lynch for $315 million and currently represents Allstate and a number of European funds in recent suits.

But none of these attorneys has been the source of more controversy, more media adulation or more rampant speculation than Patrick.  The adulation stems in part from the fact that Patrick represents some of the biggest names in the world of MBS investors, such as BlackRock, PIMCO and the New York Fed, and the fact that Patrick’s firm stands to make $85 million in fees if the proposed $8.5 billion settlement between BoNY and BofA gets court approval.

Yet, Patrick has also been the source of significant controversy, primarily because of the manner in which Patrick steered her bondholder clients – many of whom have significant conflicts of interest with the issuer banks – away from more aggressive approaches to putback litigation. While I have been skeptical of the strategy behind Patrick’s efforts since she sent her first letter to BofA in September 2010 (as she failed to include any of the powerful supporting evidence she had at her disposal), recent revelations have only reinforced that belief.

Specifically, at a hearing before Judge Pauley over whether to keep the proposed $8.5 bn settlement in federal court, it emerged that Patrick had submarined efforts by the Investor Clearinghouse by urging her clients to avoid taking the more aggressive stance that was being advocated by Franklin.  This revelation came after lawyers for Gibbs & Bruns had argued that they were the only group of bondholders doing anything about MBS losses.

In addition, conflicts of interest identified between Bank of New York and Bank of America (such as the fact that BofA provides BoNY with over 60% of its trustee business and the fact that BofA has agreed to indemnify BoNY from all liability stemming from its conduct as Trustee of Countrywide trusts) have drawn the ire of bondholders and New York Attorney General Eric Schneiderman, who sought leave to file a counterclaim under the Martin Act against BoNY in court proceedings surrounding the proposed settlement.  In short, these developments have caused many bondholders, commentators and regulators to view this settlement as a sweetheart deal concocted by funds that want to maintain a cozy relationship with the big banks while satisfying their fiduciary obligation to do something about the massive losses they’ve suffered in their MBS portfolios.

Thus, it would be no exaggeration to say that Patrick and her bondholder group have been the single greatest galvanizing force for bondholders, motivating a diverse and largely passive group of institutions to band together, hire counsel, and begin taking steps to enforce their legal claims against the banks that sold them atrociously performing private label RMBS. For this reason, Patrick will likely face a stiffer challenge the next time she works with a trustee to seek judicial approval for a proposed global settlement.

Challenges to Next Set of MBS Settlements

As I see it, Patrick faces three major challenges to accomplishing her goal of piecing together global settlements with the remaining MBS issuers.  First, most of these issuers did not use the same Trustee on all their deals, as Countrywide did with BoNY.  This will make it significantly harder to coordinate a global settlement, as Patrick’s group does not have standing in the majority of any particular issuer’s trusts and needs the cooperation of a friendly Trustee to impose the settlement on the remainder of the bondholders.  For banks like JPMorgan, who used at least five separate Trustees (all with varying interests and motivations), getting all Trustees to buy into any settlement could be a logistical nightmare.

Second, the world has changed since Patrick’s BofA settlement was first proposed in New York State Court. Since then, bondholders have organized and mobilized in opposition, with over 40 bondholder groups having now retained counsel and filed petitions to intervene in the proposed settlement proceedings.  These bondholders have also had success in forcing the settlement outside of the favorable posture in which Patrick, BoNY and BofA sought to adjudicate it – in state court, under the deferential standards of Article 77.  Opposition bondholder groups, led by Walnut Place, LLC, have successfully removed the case to Federal Court, where (pending success on appeal) it will presumably be treated more like a class action, meaning it will be subject to an entire fairness standard, more robust discovery, and bondholder rights to opt out.

Finally, opposition bondholders are now on guard against another settlement negotiated in secret.  There was a significant amount of controversy in the BofA settlement surrounding whether David Grais was denied the right to participate in negotiations.  This time around, opposition bondholders are not likely to let another deal get to court without making some serious noise and creating a record showing that they tried to participate in negotiations but were stonewalled.

Meanwhile, Patrick’s group will probably start down the path of negotiating with issuing banks, who themselves will be armed with the benefit of hindsight after watching how the BofA settlement has fared in court.  While these banks likely won’t have the luxury of seeing how that first settlement is ultimately resolved, rest assured that they will learn from the pitfalls suffered by their competitor thus far and dream up new strategies to allow them to put these legacy mortgage issues behind them.  The upcoming battle, involving some of the best legal minds in the country, promises to be a chess game for the ages.

Thank you to India Autry for her meaningful contributions to this story.

Posted in Allstate, appeals, Attorneys General, Bank of New York, banks, BlackRock, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, emc, Event of Default, Federal Home Loan Banks, FHFA, global settlement, hedge funds, Investor Syndicate, investors, JPMorgan, jurisdiction, Kathy Patrick, lawsuits, lenders, liabilities, litigation, MBIA, MBS, Morgan Stanley, Philippe Selendy, press, private label MBS, putbacks, quinn emanuel, Regulators, remand, removability, rep and warranty, repurchase, RMBS, securities, securitization, settlements, standing, toxic assets, Wall St., Wells Fargo | Leave a comment

Way Too Big to Fail Goes to Washington (Book Tour Day 3)

Posted on January 23, 2012 by igradman

After a hiatus over the holidays, I return with Part IV of this five-part series on my experiences during a recent book tour to promote the release of Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System.  Use the following links to read Parts I, II, and III.

Way Too Big to Fail, by Bill Frey, ed. by Isaac Gradman

I again woke before dawn on the third day of our East Coast tour to promote the release of Way Too Big to Fail (WTBTF).  Over the last two days, author Bill Frey and I had met with numerous individuals in finance, academia and the media, but today would be different.  That’s because today we would be flying directly into the mouth of the beast—Washington D.C.—to meet with some of our nation’s elected officials.

The cover of WTBTF (see left or visit the book’s Facebook page for more detail) depicts a cartoon of Uncle Sam playing a game of Mortgage Crisis Strategy Whack-A-Mole, futilely swinging the hammer of “Loan Mods” at the various mortgage problems that pop up, while the “U.S. Economy” leg of the game’s table cracks and money flows out of the back of the machine into a bag labeled “Banker’s Bonuses.”  Suffice it to say that WTBTF’s cover does not paint the most complimentary picture of Washington’s efforts to solve the mortgage crisis, so it would be interesting to see what the folks at Capitol Hill would say when we handed them a copy.

Our flight into D.C. arrived around 8:30 AM and we jumped on the Metro to get to our first meeting of the day: with Georgetown Law Professor Adam Levitin.  Levitin was one of the few academics who consistently had been willing to speak the truth regarding the depth of the banks’ problems stemming from their subprime origination and securitization activities.

In one particularly memorable instance, Levitin was hired by Citigroup as a guest speaker and asked to give his assessment of problems associated with improper foreclosures, robosigning and broken chain of title.  The resulting report, entitled “Foreclosures Gone Wild,” was released by Citigroup despite being, in Citi’s own words, “one of the bleaker portraits of these matters and their ultimate resolution.”  It then summarized Levitin’s findings as follows:

[i]t appears that in many instances during the mortgage securitization process over the past few years, the paperwork was not properly transferred. If the paperwork was not transferred in the legally required manner, it raises  questions  not  only  about  who  owns  the  mortgages  in  question  but  also about  the  validity  and  tax  exempt  status  of  the  trusts  in  which  the  mortgages reside.

Not surprisingly, this report and it’s conclusions made waves instantly among commentators and analysts, prompting me to write that someone at Citi was likely on the Budweiser Hot Seat for having hired Levitin to be the featured guest in the first place.  Citigroup’s legal team ultimately pulled the report from the Internet, stating that it was simply standard practice to “investigate any misuse of Citi’s intellectual property,” but the damage had been done.  Interestingly, the report can still be found here and here.

I had first started talking to Levitin in early 2011 when he linked to some of my articles on Credit Slips.  Later, I asked him to read an advanced copy of Way Too Big to Fail and offer us his thoughts.  Despite his busy schedule, he had made the time to do so, and reported back that he thought the book was great.  He ultimately provided extensive feedback, both positive and constructive, as well as a blurb, which now appears on the back cover (you can read Levitin’s blurb, along with other testimonials, here).  Frey, Levitin and I had since had several productive conversations, and everyone seemed to benefit from the ongoing exchange of ideas.

I was excited to finally meet in person the man who had been willing to tell the banks what he thought, not what they wanted to hear.  I sat down in Levitin’s office at Georgetown Law Center and took a quick look around.  The décor did little to suggest that Levitin was anything other than the typical law professor.  His bookshelves were lined with legal texts and memorabilia from some of the most famous legal cases (he even had a framed certificate of original shares in Erie Railroad from the famous choice of law case Erie Railroad v. Tompkins).

Yet, Levitin was not the typical law professor, consumed solely with esoteric questions about subtle distinctions in legal interpretation or trends in Supreme Court precedent.  Levitin had a decidedly macro perspective that evinced a much deeper interest and understanding in global finance and politics than most of his peers.  And, importantly, he was not afraid to share his views on this diverse array of topics in both published papers and on the Credit Slips blog.

Today, Levitin was focused on trying to understand why Bank of America had moved its derivatives into a depository, and what this revealed about its deeper problems.  In particular, he was focused on the gap between BofA’s then-book value of about $220 billion and its then-market cap of about $70 bn.  This, he felt, could only be explained by the market’s perception that BofA had bogus assets and/or unrecognized liabilities.  But in that case, why had the bank made such a large investment in the bonds of troubled European sovereigns (the so-called PIIGS)?

Frey had a response: the banks will use these positions to hold the PIIGS, and the U.S. Treasury, hostage.  “Remember that scene in Blazing Saddles,” Frey said, “where the Sherriff comes to town and is about to be lynched because he’s black?  So he holds a gun to his own head and says, ‘Don’t make a move or the black guy gets shot!’?”  [This was the first I knew that Frey was a Mel Brooks fan.]  “That’s essentially what the banks are doing.  They’ll go to Geithner and say, ‘Now that we hold these bonds, you better bail out the PIIGS or they’ll take us down with them and you’ll have a much bigger problem on your hands.’”

This was a point that Frey had also made in WTBTF – that it was dangerous for a country to let a bank or any other entity exist without capital but with implied government backing.  Such a state of affairs could lead to reckless “double-or-nothing” type bets that, while rational for the bank, would be grossly detrimental to the country and the taxpayer in the long run.

Levitin was intrigued.  A week later, he published this article on Credit Slips entitled, “Is Bank of America Gambling on Resurrection (or Is BoA Holding the US Hostage)?  Therein, he explored further the possibility of the banks using European debt to hold the U.S. over a barrel.

That day in his office, we also spoke about Way Too Big to Fail, and Levitin offered some suggestions of other people in the industry who might benefit from reading the book or have valuable feedback.  He reiterated that he thought WTBTF was a valuable resource and that the folks in Washington should take notice, though there was no guarantee they would.  “Everyone else seems to want to stick it to the banks these days and see someone go to jail,” Levitin said.  “When will Washington get that?”

We were determined to find out.  We said goodbye to Levitin, as he was heading out to teach a first year class on contract law, and we headed to Capitol Hill.  We had a full slate of meetings planned that day with the staffs of a half dozen congressmen.  Frey had done this sort of thing before, but it was my first time, and I was apprehensive about what I might encounter.  Exactly how far behind the curve were our elected officials?

Our first meeting did little to reassure me.  We met with the “housing policy expert” on the staff of a senator who will remain nameless.  The staffer was a spitting image of Frey’s description in WTBTF of most staffers he had met while lobbying against the Servicer Safe Harbor:

[f]or those unfamiliar with the lobbying process, as I was at the time, it turns out that one rarely gets to meet with any elected officials.  Instead, each official is usually represented by a young adult with a freshly minted law degree who, while ostensibly well intentioned, is a self-described “policy wonk” with little experience in the subject matter. (WTBTF at xxxvi)

After handing the staffer a copy of our book, our first order of business was to understand how much the staffer already knew so we could decide where to start.  “You can rebuild securitization privately through reforming the standard PSA,” Frey began, “but it can be done faster and more uniformly by having the government enact certain measures that get the ball rolling in the right direction.”

“What’s a PSA?” the staffer responded.  This came as a bit of a surprise, as a housing policy expert probably should have been familiar with a Pooling and Servicing Agreement, the central contract governing a mortgage securitization.  It was then that Frey and I realized the enormity of the task that lay ahead – educating our nation’s decision-makers and their staffs about the complexities of housing finance that stood in the way of housing market recovery.

But of course, the reason that we had published WTBTF in the first place was to provide an educational tool to those who wished to improve this very system.  This necessarily involved teaching those without a background in structured finance about the history and legal underpinnings of securitization, its inherent conflicts of interest, and the steps that should be taken if it was to be rebuilt so that it survived.

Patiently, we spent the next hour explaining some of these concepts to the staffer.  At the end of this meeting, we felt fairly confident that the staffer knew far more about mortgage backed securities than he or she had going in, but we still knew we had barely scraped the surface.  This was certainly going to be no easy task, but it was one that we were excited about finally undertaking in earnest.

It turns out that most of the staffers we met that day were more knowledgeable about mortgage issues than the staffer from our first meeting, but there were still plenty of gaps in their knowledge that we felt we could fill in.  A common refrain we heard was that most congressmen had one staffer who was his or her “housing policy expert” and one staffer who was their “finance expert,” but that “housing finance” fell somewhere in between.  This was more than a little disconcerting, considering that this market was as large as $11 trillion at its peak and should hardly have been considered a niche expertise, let alone something that fell through the cracks.

Later in the day, we had the pleasure of meeting with a few staffers who understood many of the issues plaguing housing finance and the importance of rebuilding this market.  It was refreshing to speak at last to folks in Washington who were on the same page about the need for reform in this area, and who could speak intelligently about the challenges they faced in trying to do so.  While I won’t disclose their names, as I don’t want to suggest a partisan bent to this plainly bipartisan issue, I will say that this understanding of the issues is reflected in the public statements and legislation that has been authored by their offices.

It made me realize that behind every reasonably-coherent statement by an elected official on a matter of housing finance is a wise staffer or two that actually gets it.  After handing out copies of WTBTF to more than a dozen such staffers today, I’m hoping that we can at least add a few more individuals’ names to those ranks in the coming months.

Follow @WTBTF on Twitter for real time updates on the book and its impact.

Posted in Adam Levitin, bailout, balance sheets, banks, BofA, book tour, chain of title, Citigroup, conflicts of interest, Congress, foreclosure crisis, Government bailout, improper documentation, legislation, lobbying, MBS, mortgage market, negligence and recklessness, pooling agreements, regulation, Regulators, RMBS, robo-signers, Senate staffers, Servicer Safe Harbor, Timothy Geithner, too big to fail, Treasury, Way Too Big to Fail, William Frey | Leave a comment

MBIA Celebrates Bransten Decision on Loss Causation; Bondholders Still Looking for Guidance

Posted on January 9, 2012 by igradman

As loyal readers will recall, I laid it on the line a few weeks back and predicted that MBIA would win its loss causation argument against Countrywide/BofA, making the nation’s largest bank wish it had settled this bellwether piece of New York litigation. Well, I was right… to a point.

MBIA and other bond insurers with MBS exposure were certainly smiling after MBIA won the majority of its claims in Tuesday’s opinion on summary judgment (the “Order”). In particular, MBIA succeeded in convincing Judge Bransten that it did not have to tie specific claims payments to particular misrepresentations in order to prove its claims of fraud and breach of contract and recover the insurance proceeds it has paid on defective loans.  “We are very pleased by today’s ruling,” MBIA Chief Executive Jay Brown said. “The ruling provides us with a straightforward path to recovery of our losses.”

However, the Judge stopped short of providing the complete relief that MBIA was seeking – to bar Countrywide’s defenses regarding intervening causes entirely. The Judge also kicked the can down the road on providing MBS plaintiffs with their first piece authority as to whether the materiality standard for mortgage putbacks required a showing that the breach in question caused the loan to go into default. Unfortunately, her Honor punted on this last (and arguably most important and far-reaching) issue, leaving bondholders without guidance on the strength of repurchase claims.

As per my MO, I will break down Bransten’s recent Order in a bit of detail. This time, I’ll include my real-time reactions from last Tuesday as I read each section of analysis in the Order.

Section 1 – Summary of Arguments on Fraud and Breach of Warranty

In this first section, Judge Bransten reiterates MBIA’s argument that in order to succeed on its claim for insurance fraud, it need only prove that the application for insurance contained a material misrepresentation that, had MBIA known the true facts, would have led it to change the terms or provision of insurance coverage.  Bransten also notes that MBIA makes a similar argument on loss causation with respect to its claims for breach of warranty in its insurance agreements: it must only prove that the breach of warranty materially increased the insurer’s risk.  Bransten then recites the counterargument from Countrywide: that MBIA must instead establish that the claims payments it made were caused directly by Countrywide’s misrepresentations or breaches of reps and warranties, and not by some intervening cause (e.g., the economic downturn, the housing market crash, or the price of tea in China).

At this point, it strikes me again how strained an interpretation of causation Countrywide/BofA is trying to sell the court.  They’re essentially saying, “we can lie all we want to induce you to insure our bonds, and our lies might actually succeed in inducing you to insure our bonds when you wouldn’t have otherwise.  But, if you can’t prove that our lies led directly to your payment of a claim, tough luck.”  I’m as confident as ever that Bransten will side with MBIA.

Section 2A – Causation

Bransten next identifies the “base issue before this court… when causation occurs in claims for insurance fraud and breach of representations and warranties.”   In reaching this issue, she must first address Countrywide’s argument that the First Department (New York’s Court of Appeals) had already held that MBIA must prove that Countrywide’s alleged wrongdoing caused MBIA’s losses.  Bransten has little trouble disposing of this argument, holding:

the court disagrees with Countrywide’s characterization of this court’s holding and the Appellate Division’s June 30, 2011 decision with regard to causation.  The Appellate Division decision did not hold, as Countrywide argues, that this court must determine which of MBIA’s losses were caused by countrywide’s alleged wrongdoing and which were caused by the “Mortgage Market Meltdown.”  Rather, in the section that Countrywide quotes, the First Department rejected Countrywide’s contention that MBIA’s fraud claim must be dismissed for failure to plead a causal link between Countrywide’s alleged misrepresentations and MBIA’s alleged damages. (Opinion at 9-10 (citations omitted))

You may recall from my article analyzing these pleadings that I didn’t see how the First Department’s decision lent any support to Countrywide’s global catastrophe defense.  Apparently, Bransten sees it the same way as she goes on to determine that no decision exists that must be treated as “the law of the case.”  So far, so good.

Bransten next turns to MBIA’s arguments that its claims under New York law are informed and influenced by New York Insurance Law Sections 3105 and 3106.  First, she holds that MBIA’s insurance law claims are valid in this action for damages and that Countrywide is the proper defendant for the misrepresentations alleged by MBIA.  The court then finds that MBIA’s common law claims are indeed informed by New York common law and Insurance law Sections 3105 and 3106.

This is a critical win for MBIA and the first sign that MBIA might score a complete victory on its motion.  Remember that the familiar understanding of materiality in the insurance context under New York common law and Insurance Law is that a misrepresentation that would have affected the insurer’s willingness to insure the risk or the terms on which it would have insured the risk constitutes a material misrepresentation.  The fact that the court will be using these sources to determine causation and materiality bodes extremely well for MBIA.

Sure enough, in the following paragraph of the Order, the court finds that, “no basis in law exists to mandate that MBIA establish a direct causal link between the misrepresentations allegedly made by Countrywide and claims made under the policy.” (Order at 14)  Instead, Bransten holds that to recover for fraud or breach of warranty, MBIA must prove only that Countrywide’s misrepresentations were material to MBIA’s decisions to issue the insurance policies, and that materiality means that Countrywide’s statements,

induced MBIA to take action which MBIA might otherwise not have taken, or would have taken in a different manner… MBIA must prove for its fraud claim that it issued the Insurance Policies on representations made in the policies’ applications, and that it would not have done so or would have issued the policies on different terms had the alleged misrepresentations not been made.  Similarly, MBIA must prove for its breach of warranty claim that Countrywide’s alleged misrepresentations materially increased MBIA’s risk of loss. ” (Id. at 14-15)

At this point, the court’s analysis has squared precisely with my own, and I am as confident as ever that the court will strike a decisive blow to Countrywide’s loss causation argument across the board.  If common law claims for fraud and breach of insurance contract reps and warranties only require a showing of a material misrepresentation, then why should putbacks require anything more, especially when the contract language is “materially adverse impact” on the insurer’s interest in the mortgage loans?

Section 2B – Rescissory Damages

Before handing down what I’m certain will be a sparkling affirmation of MBIA’s argument on putbacks, Bransten first deals Countrywide another crucial setback.  As part of its Partial Summary Judgment Motion, MBIA had sought a declaration that it could recover its alleged economic injury through rescissory damages.  Countrywide had countered that to recover under New York Insurance Law, MBIA could seek only to rescind or avoid the policies, which would be both unfair to the bondholders and barred by the provisions of MBIA’s financial guaranty policy.

Here, though there was little governing case law in New York regarding the application of rescissory damages in lieu of actual rescission, Bransten shows a surprising openness to the idea that rescissory damages may be awarded as the economic equivalent to rescisison where rescission is not practical.  After finding that rescission would indeed be impractical in this case, even though it may ultimately be warranted, Bransten finds that “rescissory damages are appropriate in this instance under persuasive case law and this court’s power to award relief.” (Order at 17-18)

To support this finding, which has MBIA and the other monolines smiling because it will provide them with the most direct and complete pathway to recovery, the court is forced to rely on cases from such diverse sources as the Delaware Chancery Court, the U.S. District Court for the Southern District of New York, and the U.S. District Court for the District of Arizona. The fact that the court is willing to broadly interpret the law and the scope of its powers in this regard, and to apply substance over form in fashioning an equitable remedy for the insurer, bodes well for MBIA’s chances on the rest of this motion.  Bransten seems to be going out of her way to ensure that MBIA has an avenue for recovering its losses.

At the end of this section called “Causation,” Bransten sums up her findings: MBIA may prove fraud or breach of warranty based upon a misrepresentation by Countrywide that induced action resulting in damages, and rescissory damages may make MBIA whole for any wrongdoing which it is able to prove.  She then writes: “However, the court does not find that this disposes of Countrywide’s fourteenth and fifteenth affirmative defenses.  The burden of proof remains upon MBIA to prove all elements of its causes of action.”

Recall that Countrywide’s 14th Affirmative Defense is that Defendants were not the proximate cause of MBIA’s losses.  Countrywide’s 15th Defense is that there were superceding or intervening causes which were the actual cause of MBIA’s losses, “including but not limited to macroeconomic and mortgage industry events.”  Based on Bransten’s other findings in her Order, that MBIA must still show proximate causation connecting the misrepresentations that induced it to issue the insurance policies and its losses, it makes sense that she would leave these defenses intact.  She certainly could have been more proactive here and barred any defenses suggesting that proximate causation must connect a policy payment and a misrepresentation, or any defenses pertaining to intervening causes that occurred after MBIA insured the policies, but I can understand that Bransten would want to stick to addressing MBIA’s particular request to bar the defenses entirely, and not go too far afield.  I still have little inkling that all is not rosy in Loss Causation Land.

Section 3 – MBIA’s Claims for Breach of the Repurchase Obligation

Finally, the moment I have been waiting for.  I have been saying for years that insurers’ and bondholders’ putback claims were relatively strong because the standard was “materially adverse impact” rather than “proximately causes loss.”  Since this is the first post-crisis MBS case to reach this question, it’s the first real guidance we’ll have on a critical and far-reaching issue in MBS litigation.

Yet, if I was hoping that Bransten would come right out of the box with an answer, I was sorely disappointed.  Instead, the court takes the next five pages to lay out in excruciating detail each side’s arguments on this issue.  Her Honor had summed up the parties’ arguments in the prior sections with a few sentences or a paragraph at the most.  The fact that Bransten is now going into this much detail in recapping the same arguments we’ve read in the pleadings and heard at oral argument sets off alarm bells in my head: the court is setting up a genuine dispute of material fact.

You see, summary judgment is only appropriate if there is no genuine dispute of material fact; that is, looking only at the facts agreed upon by both parties, it is apparent to the court that judgment must issue for one side or the other.   Contractual disputes are usually particularly well-suited for summary judgment because the parties agree that the contracts are the contracts, and the court is thus left to interpret the contracts and the parties’ intent based on the plain language of their written agreements.

Summary judgment seems especially appropriate here in MBIA v. Countrywide, as we have heard little about any oral agreements or other facts outside of the four corners of the contracts that might inform their interpretation.  Thus, I would have expected Bransten at this point to be running through her analysis of the contractual language on putbacks, not the parties’ arguments.  The fact that she’s instead spending pages rehashing the parties’ interpretations feels distinctly like a football team running a draw play on 3rd and 14 – they’re playing it safe and preparing to punt.

Sure enough, at the bottom of the fifth page of recap, Bransten finally reaches her conclusion.  Noting that “MBIA has posited a strong argument,” she nonetheless finds that “summary judgment is not here appropriate.” (Order at 23)  Her reasons?  MBIA only cites contract language from one of the 15 MBS Trusts, and though it states that a similar repurchase remedy exists across all 15 trusts, it hasn’t sufficiently laid out the contract language for those 15 trusts in its Rule 19-a statement of material facts.  Then, as if it was an afterthought, Bransten throws in an extra sentence about how the words “interest” and “aggregate” in the contracts are subject to varying interpretations.

Suddenly, Bransten has gone from flexible rulings, bending to give MBIA a pathway to recovery, to strict rulings that rely on technicalities for support.  Yes, technically, the particular facts upon which a party wants the court to rely must be laid out in its statement of facts.  But, must MBIA go through and lay out the relevant contract language from multiple sections of every one of 15 trusts?  Isn’t it sufficient for MBIA to provide a sample and to state that this is representative of the other contracts – a fact that can be verified from the record?

Keep in mind, this is the same judge that approved statistical sampling to present loan-level evidence because the court did not want to spend the time going through every one of the 300,000+ loans at issue.  Wasn’t it reasonable for MBIA to assume that this judge would not want to see 15 separate factual statements for each trust?  Moreover, if Bransten had wanted to rule on this issue, she certainly could have had her clerk go through the pertinent sections of the various Trust Agreements (which are presumably part of the record) and determine whether there was any relevant difference in their language.

Similarly, relying on the fact that there are “varying interpretations” regarding the word “interest” without making any value judgment about the strength of those interpretations falls short of the judicial diligence I expected.  There will always be varying interpretations of any contract in litigation.  It is entirely within the court’s province to decide which one most closely effectuates the intent of the parties.  This is especially true when Bransten has just called MBIA’s argument “strong.”  Heck, she just walked through the case law providing that insurers are entitled to know the nature of the risks they’re assuming.  How difficult would it have been to find that an insurer’s interest in the loans is the same as its interest in the policies – the riskiness of the asset it was insuring?  All told, this portion of the Order feels distinctly like a cop-out – the judge guided us 3/4 of the way across a rickety rope bridge, and had everything she needed to get us to the other side, but for some reason stopped short and told us “good luck!”

Loss Causation Fallout

Of course this decision, and the mirror-image decision Bransten issued in the case of Syncora v. Countrywide, et al., do provide the monolines with fodder that they can use in their ongoing MBS cases.  But applying this decision to bondholder cases will be more of a stretch.  Shortly after reading the opinion, I tweeted, “J. Bransten goes 3/4 of way toward giving MBIA & Syncora complete wins v. BofA on MSJ but stops short of applying same reasoning to putbacks.”  Soon, a response came from Scott Walker (@scottleewalker), a litigator in the Structured Finance group at Lowenstein Sandler: “@isaacgradman — I had the exact same thought. Have been waiting for some guidance in that area. Oh well.”

All of which raises the immediate question: why did Bransten stop short?  I have a theory, but obviously this is just speculation on my part.  By way of the first 3/4 of the Order, Bransten provided MBIA with a shorter, cheaper and more complete pathway to recovery than putbacks by allowing it to seek rescissory damages.  Now, instead of having to go loan-by-loan (at least through a sample of some 6,000+ loans), and being able to recover only those losses on loans it can prove were defective, MBIA can just prove that it was induced to issue the policies by a misrepresentation and thereby recover all of its losses.

Maybe Bransten hopes that MBIA be happy with that decision (they were), not appeal her on putbacks (still an open question) and opt to go down the fraud and breach of insurance contract paths exclusively, saving Bransten one huge headache of a trial.  Or at least she hopes that by providing MBIA this weapon in its arsenal, it will make BofA more likely to settle.

Bransten also made several comments on the record during oral argument on this motion recognizing the unique attention this case was attracting and the impact it would have.  She stated,

It is a very full courtroom so we’re going to have a few things that we have to talk about before I even address my attorneys here today. In the first place, I have my other attorneys sitting the jury box, am I right? Okay. Usually I wouldn’t permit any standing room. However, I understand that this has a major impact on lots of people and some people didn’t get here quick enough to get a seat, so if there is an empty seat anywhere I want it filled and we can squeeze as much as we can, that’s number one.

Number two, the strict rule that I will enforce is I do not want anyone to speak during any of our arguments. We have to be absolutely silent. For those of you standing, the only thing I can say is if you get uncomfortable or you want to speak or you have anything to say, just go outside and do it. I think from now on, this is it. I think we have reached maximum capacity, so that will be it. Anybody who is here, if we take a break and come back, no new people, because I really do think that we’re maxed out. (Transcript, Oral Argument on MBIA’s Motion for Partial Summary Judgment at 3:2-22 (emphasis added))

These comments certainly don’t give me the impression that Bransten presides over cases with this much national interest very often.  With this decision, Bransten avoids the spotlight on appeal and possibly avoids having to try this dog of a case.  Let’s be clear: as an analyst following these issues, I find this case fascinating and important, but to a state court judge, a case dealing with hundreds of thousands of loans and 15 complex mortgage securitizations that has taken 3 years just to get this far is probably beginning to look distinctly dog-like.

So maybe she was hesitant to stick her neck out, risk getting overturned on appeal, and at the very least have her opinion bandied about in every MBS case in the country.  I get it, but part of me was hoping that Bransten would be inspired by the judicial courage shown recently but Jed Rakoff and put to rest an issue that IMHO was plenty ripe for determination.

Posted in appeals, banks, BofA, bondholder actions, broader credit crisis, causes of the crisis, contract rights, damages, investors, Judge Jed Rakoff, Judicial Opinions, lawsuits, liabilities, litigation, loss causation, MBIA, MBS, misrespresentation, monoline actions, monolines, pooling agreements, private label MBS, putbacks, rep and warranty, repurchase, rescission, RMBS, securitization, statistical sampling, The Subprime Shakeout | 1 Comment