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As more details emerge about Bank of America’s proposed $8.5 billion settlement with Kathy Patrick’s bondholder group and Bank of New York Mellon (“BoNY”) as Trustee, the deal looks even worse for Countrywide RMBS investors. Now, it is apparent that BofA is trying to settle all past and future repurchase and servicing claims with respect to all 530 Countrywide trusts, whether the involved bondholder group has standing in those trusts or not. What’s even more apparent is that my original assessment of this effort was correct: the investors supporting this deal had conflicts of interest that prevented them from pursuing an aggressive settlement.
Here’s a quick summary of the key facts about this settlement, from what we know. This information has been gleaned from the press release posted on the website of Kathy Patrick’s firm, Gibbs & Bruns, the press release issued by BofA, the Bank of New York settlement agreement, the separate settlement agreement with the 22 participating investors, and the investor call held by BofA this morning:
- Settlement covers all 530 Countrywide trusts, that is, RMBS trusts issued by Countrywide itself;
- Prominent investors involved include BlackRock, PIMCO, New York Life, New York Fed, Goldman Sachs Asset Management, Prudential, Western Asset Management, MetLife, TIAA-CREF and the Federal Home Loan Bank of Atlanta (Freddie Mac is listed as a client of Kathy Patrick, but not as one of the 22 supporting investors);
- Combined original unpaid principal balances of trusts at issue was $424 billion;
- Current unpaid principal balances of trusts at issue is $221 billion;
- $47 billion from these trusts has already gone into default;
- Another $59 billion is severely delinquent;
- $203 billion has been paid off;
- The settlements release all rep and warranty (i.e., putback) claims for Countrywide RMBS bondholders, as well as all past and future servicing claims (so long as BofA services according to newly agreed-upon standards) and any chain of title claims;
- The settlement proceeds of $8.5 billion will flow through the trust waterfalls to all investors, and be allocated to the trusts pro rata based on BoNY’s assessment of which have suffered the greatest losses; and
- Because the settlement deals with potential claims under New York state law, a New York state court will have to approve the settlement.
It is important to note that there are several potential liabilities that are not covered by this settlement. BofA stated in its investor call this morning that the settlement covers half of its private label exposure. The other half includes things like:
- Fraud and securities law claims with respect to Countrywide-issued RMBS;
- All potential claims as to loans that Countrywide sold to third parties, which third parties then securitized them; and
- All potential claims as to loans sold by other BofA entities (e.g., Merrill Lynch).
Thus, servicing and foreclosure documentation problems (i.e., the 50 State AG efforts) are still on the table. The settlement also does not cover new repurchase claims submitted by Fannie Mae, which unlike Freddie Mac, did not release all future putback claims as part of its settlement with BofA at the beginning of this year. As part of its announcement of this settlement, BofA stated that it will have to up its repurchase reserve for GSE claims because of the soft housing market and because GSE “behavior has changed,” as well as up its reserves for private label rep and warranty issues from an estimate of up to $10 bn at the end of 2010 and an estimate of up to $14 bn at the end of 1Q11, to an estimate of at least $19 billion for 2Q11. Whether that number will continue to climb upwards depends, in large part, on whether the investors sitting on the sidelines step out of the shadows.
All of this leads me to the main point of this article: investors must — and, in my opinion, will — challenge this settlement as not in the interests of the majority of bondholders. BoNY, which has filed the settlement petition in New York state court and will be advocating for its approval, has no financial interest in recovering additional money for investors. In fact, it has a far greater economic incentive to keep BofA happy, as BofA has the potential to hire the bank for many more trustee gigs and other financial services roles in the future. Further, BoNY has proven since the onset of the mortgage crisis to be one of the least cooperative trustees for investors, throwing up roadblock after roadblock to its having to work with investors to resolve putback issues. This is likely why BofNY has so readily thrown its weight behind this settlement, which will allow it to end the back and forth with investors over all of its Countrywide deals (as far as I know, BofNY is the trustee on all Countrywide-issued RMBS deals).
Thus, outside investors cannot rely on the trustee to act as a fiduciary for its interests. And there are several issues that investors will want to make sure the court considers. As an initial matter, according to Kathy Patrick, the 22 investors involved have voting rights in only 502 out of the 530 trusts. This means that they are releasing claims for 28 trusts in which they hold absolutely no interest (this is no small number – the $1.6 billion AGO settlement with BofA covered a portion of 29 RMBS trusts).
Second, the 22 investor group does not have 25% of the voting rights (the threshold to acquire standing to sue under most pooling and servicing agreements) in all of those 502 trusts. Reuters reports that, in a May securities filing, BofA stated that these investors had standing in only 230 trusts. I doubt very much that this number grew to more than 250 trusts in the last month. Thus, the investors who negotiated this settlement lacked standing in over half the trusts affected by the deal. Judge Barbara Kapnick, who has been assigned to review the proposed settlement, may find those sorts of facts important. After all, she was the same judge who threw out Greenwich Financial’s lawsuit against Countrywide for failing to strictly adhere to the procedural requirements for standing contained in the PSAs at issue.
Third, even in the trusts where the investors own 25% of the voting rights, they do not necessarily hold at least 50% of those rights. Thus, while they technically may have standing to sue for relief in those trusts, they can’t say that they necessarily represent the interests of the majority of bondholders. This may help to persuade the judge that the objections of other investors should be carefully considered and given substantial weight.
Fourth, the court will have to weigh whether this settlement is reasonable in comparison to the amount of potential damages at issue. To that end, it should take into account the deficiency rates in each of the trusts at issue and, given proper discounting for litigation risk, the time value of money, etc., whether $8.5 billion is a reasonable amount for investors to receive to give up all of those claims. The press release issued by Kathy Patrick states that BofNY retained National Economic Research Associates (NERA) as its expert to estimate the size of the trusts’ potential repurchase claims. But, I would be curious how many loans NERA sampled, how deep a dive it conducted, and what guidelines and exceptions standards it used to determine which loans breached reps and warranties. I would guess that an investor-retained expert might find a significantly greater number of loans subject to repurchases.
Finally, the court will have to consider whether the trustee’s proposed methodology of allocating the settlement proceeds is reasonable. Patrick’s press release makes a point of parroting BofA’s consistent refrain that, “not every loss suffered on a mortgage loan is the result of a Seller’s violation of a representation or warranty.” Of course, as I’ve discussed many times in the past, the legal standard for determining whether a breach of rep and warranty engenders a repurchase is materiality, not causation, so this statement, while true, is besides the point. Even so, if Patrick recognizes that losses are not a good proxy for breaches, then why are settlement proceeds being allocated exclusively based on the losses suffered by the trusts? Why not base the allocation on the percentage of deficient loans found by NERA across each trust? It’s likely because NERA didn’t sample loans in each trust.
Already, Reuters reports that many investors are hopping mad over this proposed deal (that same article contains a good summary of my thoughts on the potential challenges to this deal and why BofA has recently shifted its approach). This report squares with the feedback I’ve received, including the assessment of one person familiar with these matters, who called the deal a “screw job” for investors. This source estimated that the potential losses from defective loans in these deals (that is, loans eligible for repurchase) amounted to $100 bn, meaning investors were receiving about eight pennies for every dollar of their potential putback claims. We agreed that, if that damages estimate was correct, a more reasonable settlement would be in the range of $25 to $50 bn. Based on the fact that BAC’s stock price jumped 3.5% in after-hours trading once the deal was announced, the market seems to concur that this was a great deal for BofA.
As is the case with so many of the trends in mortgage crisis litigation, the fallout from this major development will depend on how quickly investors can organize, and how willing they will be to stand up and speak out about the losses they’re suffering at the hands of the banks and conflicted trustees. But I agree with Bill Frey’s assessment, attributed to him in the Reuters article, that “the silver lining of the settlement offer is that it should force a resolution — either the majority of investors in the bonds at the center of settlement accept it, or they fight for a better deal.”