After a few quiet months in the world of mortgage crisis litigation, we have seen a flurry of activity over the last six weeks that should put to rest speculation that mortgage derivative lawsuits are winding down. To recap these developments, I bring you The Subprime Shakeout’s Top Five Reasons that MBS Lawsuits Are Just Beginning:
Number 5: Statistical Sampling Gains Widespread Acceptance in MBS Cases. I have reported previously on Judge Bransten’s decision in New York state court in the case of MBIA v. Countrywide/BofA to allow MBIA to use statistical sampling and extrapolation to prove its claims for breach of reps and warranties. I also noted how, in subsequent litigation, Allstate cited those holdings in its complaint as a shortcut to proving widespread breaches in its MBS investments.
Now, United States District Court Judge Paul A. Crotty in the Southern District of New York has lent a new level of credibility to this line of reasoning, becoming the first federal judge to hold that a plaintiff could use statistical sampling to prove a generalized claim for breach, rather than being limited by the “sole remedy” language of the PSA to a loan-by-loan approach (opinion available here). Though the analysis applied by Judge Crotty in Syncora v. EMC rested on the unique rights of Syncora as a bond insurer, and thus may not be entirely applicable to private investors seeking to employ the same remedy, judges in investor lawsuits may find the opinion’s common-sense approach to the complexities of MBS litigation persuasive.
In particular, Judge Crotty was highly skeptical that the loan-by-loan repurchase protocol was intended to be applied to situations where widespread breaches of reps and warranties were alleged. This discussion, found in footnote 4 of the opinion, is worth reading in its entirety:
The repurchase protocol is a low-powered sanction for bad mortgages that slip through the cracks. It is a narrow remedy (“onesies and twosies”) that is appropriate for individualized breaches and designed to facilitate an ongoing information exchange among the parties. This is not what is alleged here. Here, Syncora alleges massive misleading and disruption of any meaningful change by distorting the truth. The futility of applying an individualized remedy to allegedly widespread misrepresentations is evident in the fact that, of the 1,300 loans actually submitted under the repurchase protocol, EMC has remedied only 20. This .015% [sic] success rate does not bode well for the efficiency of employing the repurchase protocol for a generalized claim of breach. Accordingly, EMC cannot reasonably expect the Court to examine each of the 9,871 transactions to determine whether there has been a breach, with the sole remedy of putting them back one by one. This transaction was put together in days and months. It is now in its second year of litigation.
You heard that right: of the 1,300 loans that Syncora has tried to put back to EMC to date under the repurchase protocol, EMC has agreed to repurchase only 20. Again, given the evidence emerging about the conduct of that lender, I shouldn’t be surprised that it is ignoring its contractual repurchase obligations entirely. Yet, somehow, this intransigence still makes my head spin.
Crotty’s language echoes the comments of Judge Bransten during the hearing on MBIA’s statistical sampling motion – that it is simply impractical to think that any court could adjudicate thousands of individual loans – but goes further, finding that the purpose of the repurchase protocol being to address “onesies” and “twosies.” I believe that other jurists will find this analysis persuasive, thereby encouraging other MBS plaintiffs to come forward with claims of widespread breach, as the pathway to judgment will be significantly shorter and cheaper if sampling can be used.
Number 4: Bank of America Settles Repurchase Claims with AGO for $1.6 billion. On April 15, bond insurer Assured Guaranty, Ltd. (AGO) announced that it had reached a settlement with Bank of America, including Countrywide Financial and its subsidiaries, to resolve rep and warranty issues on 29 MBS deals that AGO had insured on a primary basis. The settlement included $1.1 bn of cash up front and, according to Bank of America, up to another $500 million through a reinsurance agreement with BofA. AGO is projecting its losses from first lien Countrywide deals to be $490 million and losses from its second lien deals with Countrywide to top out at $2.4 billion. If BofA’s estimates of the value of this deal are correct, it could mean the bank is covering over 55% of AGO’s projected losses.
Though some would argue that the amount of this settlement was small compared to the number of breaches of reps and warranties that AGO was finding across all of its loan pools (88% of second liens and 93% of first liens according to AGO’s 2010 10-K), I see this as an out-and-out win for insurers and investors facing MBS losses. This is the first time that a major bank has settled for any sizeable amount with a private party over rep and warranty liability, and it undermines the banks’ party line–repeated ad nauseum–that these claims were nothing more than sophisticated parties seeking to pass their losses onto somebody else.
Indeed, as commentators have begun to recognize, this settlement gives credence to the notion that monolines and private investors stand to recover a significant portion of their losses related to MBS from the banks that originated or packaged the loans into securities. The accord may also embolden other plaintiffs to come forward with claims of their own, as it appears that BofA is making a concerted push to put its legacy issues from Countrywide’s portfolio behind it.
Number 3: AIG Jumps into the Fray. The sleeping giant has finally awoken. Monolithic insurance company AIG, whose investments in the mortgage market forced Uncle Sam to swoop in to its rescue, has finally started taking legal action against some of the banks that induced it to insure mortgage products designed to fail and engaged in other underhanded conduct with respect to these investments. Last Thursday, April 28, AIG sued two little-known CDO managers, saying they had conspired with affiliates to inflate the prices of these CDOs and create windfall profits and management fees for themselves.
As I’ve discussed before, AIG was forced to release its claims against the issuers of the mortgage securities it had insured through Credit Default Swaps and other derivatives when it accepted bailout money from the New York Fed. However, AIG did not waive its claims as to the managers of those deals or as to the $40 billion of MBS that AIG purchased outright. According to several people familiar with this matter, AIG is planning to bring additional lawsuits regarding those investments. The insurer has hired Quinn Emmanuel, which also represents MBIA and several other bond insurers in MBS litigation, so it certainly looks like AIG is taking these issues seriously.
Notably, AIG’s first lawsuit draws on allegations made by the SEC last year when it accused the same money managers of securities fraud. This creates a nice segue into the next item…
Number 2: Duetsche Bank and MortgageIT Sued by U.S. Department of Justice for Reckless Lending Practices. Nothing engenders more private follow-on litigation than when the government steps in and decides to sue somebody for fraud or negligence. Similarly, the DOJ’s 48-page complaint against Deutsche Bank and its subsidiary, MortgageIT (available here), should give would-be plaintiffs substantial fodder upon which to base civil lawsuits against Deutsche for any harms stemming from MBS investments.
The DOJ’s suit accuses Deutsche of several violations of the federal False Claims Act, (carrying the potential for treble damages), as well as common law negligence and gross negligence based upon years of reckless lending. Notably, though the complaint opens with the statements that, “This is a civil mortgage fraud lawsuit brought by the United States against Deutsche Bank and MortgageIT…[which] repeatedly lied to be included in a Government program to select mortgages for insurance by the Government,” it stops short of actually accusing the lenders of civil fraud.
Perhaps the DOJ, based on the heightened pleading standard for civil fraud, is awaiting the acquisition of better evidence through discovery before bringing any fraud claims (as Ambac recently did), or maybe it doesn’t feel it has a strong enough case to prove all of the elements of common law fraud (including knowledge of falsity, intent to deceive, and detrimental reliance). Regardless, the allegations in the complaint suggest a strong basis for fraud, and the inclusion of such a claim would only add fuel to the fires of prospective plaintiffs.
Furthermore, Bloomberg reports that this may be only the beginning of U.S. suits against Deutsche and other lenders. They note that the FHA and HUD are investigating existing loans for other potential claims to refer to the DOJ, and quote one commentator as saying that the Government may have filed this lawsuit as a “test case” before bringing more suit. These cases, in turn, will beget many times that number of additional civil cases.
Number 1: Levin Report Referred to the SEC and DOJ for Potential Criminal Charges. Okay, remember when I just said that nothing brings about more private litigation than government lawsuits? Well, I should rephrase that. Nothing brings about more private litigation than government lawsuits, except for criminal charges. Of course, as was illustrated most glaringly by Matt Taibbi in the article, “Why Isn’t Wall Street in Jail?” in Rolling Stone Magazine, not a single criminal indictment has been lodged, let alone any convictions obtained, against Wall Street bankers in the wake of the mortgage crisis that destroyed more than 40% of the world’s wealth.
However, it appears that this is about to change. First, Eric Holder testified before the House Judiciary Committee that more suits and prosecutions may follow the Deutsche Bank action discussed above. In particular, Holder stated that, “we are in the process of looking at a whole variety of these matters, and it is possible that criminal prosecutions will result.” Not exactly a guarantee, but it’s a start.
Then, just yesterday, the Levin report issued by the U.S. Senate, which finds that Goldman Sachs misled its clients about mortgage derivatives, was formally referred to the DOJ and SEC. This puts the issue at the “top of the list” for the agencies and increases the likelihood that criminal actions will be brought. Not only could charges be brought against Goldman and its executives for its actions leading up to the mortgage crisis, but additional charges of perjury could be levied against the executives that testified before Congress, as much of their testimony ran directly contrary to the ultimate findings of the Commission.
Though many were hopeful that all of the buzz surrounding the potential MBS litigation wave would fade with time, these five key developments over the last month or so send a strong signal that we haven’t seen the last of these lawsuits. In fact, they’re likely just beginning.
[Many thanks to Manal Mehta from Branch Hill Capital for passing along several of the articles referenced in this post.
This updated post corrects some of the numbers with respect to the AGO/BofA settlement in the first and second paragraph of Reason Number 4 - IMG.]