It has been just over a month since I published my series on the Top 5 RMBS Cases to Watch this Summer. In case you missed it, here’s a quick recap of my top five cases:
- No. 5 – Syncora v. EMC
- No. 4 – Retirement Board v. Bank of New York Mellon
- No. 3 – ABN AMRO Bank v. Dinallo (Article 78)
- No. 2 – In re the Application of Bank of New York Mellon
- No. 1 – MBIA v. Countrywide
Already, some of the developments I predicted in the first installment of this series – including a favorable ruling for Syncora on summary judgment in its case against EMC, which I will discuss today – have come to fruition, engendering important consequences. With Syncora having just struck a $375 million settlement this past week with Countrywide and Bank of America, I decided it was time to make good on my promise to write a follow-up to this series – an epilogue, if you will.
My goal was to write an article walking through the most likely end-game scenarios in this morass of residential mortgage backed securities (RMBS) litigation and offer some predictions on the ultimate subprime shakeout. Yet, upon sitting down to write this article, I realized that there were various and distinct end game scenarios depending on who held the RMBS claims and the nature of the claims they were asserting. To avoid burdening my loyal readers with a 5,000 word tome, I will be dividing up this discussion into a series of posts addressing recent developments and their impact on end games. Today, I address the impact of Judge Crotty’s summary judgment decision in Syncora v. EMC in finally bringing some clarity to mortgage putback litigation.
Just over a month ago, at the start of the NBA Finals, I was having an interesting conversation with a friend about the concept of proof. He was excited about the prospect of Kevin Durant and the Oklahoma City Thunder getting to square off in the Finals against LeBron James and the Miami Heat.
“Durant has won three consecutive NBA scoring titles by age of 23,” he said, “Nobody has ever done that. He’s the best player in the league already, but most people won’t recognize it until he beats the Heat.” My friend was suggesting that while he already knew that Durant was the league’s best player, Durant still had to “prove it” to the rest of the world by leading his team to a championship on the game’s biggest stage against the consensus number one team and player. While there would be endless argument and speculation prior to the Finals, a championship – the generally accepted method of proof in sports – would end the debate, and few would dispute who the best really was.
Of course, the 2012 NBA Finals did establish who the best player in the game was, but it wasn’t Durant. While Durant is clearly a gifted scorer – and at 23, has plenty of room to grow – James proved himself to be the better all-around player, playing solid defense while averaging 10.2 rebounds and 7.4 assists to go along with 28.6 points per game. Durant, by contrast, averaged 30.6 ppg, but chipped in only 2.2 assists and 6.0 rebounds. James walked away with his first championship and the NBA Finals MVP award, and largely put to rest the debates about his greatness, at least for now.
All of this got me thinking about the concept of proof in the context of RMBS liabilities. Whereas proof in basketball is established on the court, proof in legal disputes is established in the courtroom – where facts and arguments are presented by way of an adversarial process, and the factfinder settles issues and assigns liability. Once liability has been assigned, the distribution of losses can be assessed, the market and its participants can adjust, and life can move on.
Until recently, with RMBS legal proceedings progressing slowly, we had few precedents to which to look to form a consensus on which side – be it investors and insurers or Wall St. banks – had the better of these arguments. I could write until my fingers ached about how weak I thought banks’ defenses were in these cases, but until we had proof in a court of law, the debate would rage on. Banks could continue to under-reserve for RMBS losses based on various versions of the “global catastrophe defense,” while trustees like Bank of New York Mellon (BNYM) could justify minimal settlement values based on these defenses and the purported protections of the corporate veil. But all of that is beginning to change.
Crotty Takes a Stand
In the first article in my Top 5 series, I discussed how bond insurer Syncora’s patience would finally be paying off this summer, when federal Judge Paul Crotty was expected rule on the insurer’s summary judgment motion in the 2009 case, Syncora v. EMC. Therein, I predicted that, based on his prior rulings in the case, Crotty would decline to adopt EMC and J.P. Morgan’s narrow view of the materiality requirement for mortgage putback claims (that the breach must actually have caused the borrower to stop making mortgage payments), and instead find that a breach must merely have a material impact on the risk profile of the loan. On June 19, 2012, Crotty finally issued the ruling that was more than six months in the making, adopting Syncora’s much broader definition of materiality and giving both bond insurers and MBS holders hope that the years of litigation would eventually pay off.
Understanding exactly what Judge Crotty decided and what it means for litigants is essential to understanding how these cases are likely to play out, so I thought it was worth walking through this opinion in some detail. His Honor was asked by Syncora to rule on three distinct issues: (1) that EMC was required pursuant to the securitization trust agreement to repurchase loans that breached reps and warranties as of the closing of the securitization, regardless of whether those breaches caused any loan to default; (2) that Syncora could establish that EMC materially breached the insurance agreement between the parties by showing that a breach materially increased Syncora’s risk of loss on the Transaction (again, even if the breach did not directly cause a claim payment); and (3) notwithstanding that Syncora’s insurance policy was irrevocable, the Court could grant Syncora equitable relief equivalent to rescission (awarding them claim payments less premiums).
If you’ll recall, Judge Eileen Bransten was faced with a very similar set of questions from MBIA on summary judgment in its case against Countrywide. In response, Bransten ruled that MBIA need not show a direct causal link between a misrepresentation or a breach of the insurance agreement to prove its claims of fraud or breach of contract, respectively. She also ruled that rescissory damages were available to MBIA in lieu of actual rescission. These were important victories for all monolines pursuing claims based on RMBS losses. However, Her Honor punted on the key question of the causation or materiality standard for loan putbacks, the loan-level claims at the heart of BofA’s $8.5 billion settlement with BNYM, leaving RMBS investors out in the cold with little “proof” or even guidance on the strength of their claims.
That all changed with Crotty’s opinion. Crotty, of course, was well aware of Bransten’s prior summary judgement decision when making his ruling and decided to reference it explicitly in his Order. Therein, Crotty sides with Bransten on the question of loss causation in the context of the insurance agreement. Drawing from well-established insurance law that holds that an insurance company may avoid a policy and/or recover losses if a breach materially increases the risk covered by the contract, Crotty holds that, “Syncora may establish a material breach of the [Insurance and Indemnity Agreement (I&I)] by proving that EMC’s alleged breaches increased Syncora’s risk of loss on the Policy, irrespective of whether the breaches caused any of the HELOC loans to default” (Crotty Order at 16).
This turns out to be the only issue on which the two judges could explicitly agree. Where Bransten finds that rescissory damages were available, Crotty punts that issue down the road. Yet, more significantly, where Bransten punts on the issue of the standard for loan-level putbacks, Crotty steps into the breach.
In the section on putbacks, the most robust section of his Order, Crotty begins by noting that the trust agreements did not require a breach to have caused a default to trigger a repurchase, but only that a breach “adversely affects the interests of the Note Insurer” or the value of those interests (Crotty Order at 7). The question, therefore, was the nature and scope of the insurer’s “interests” (Id.)
Crotty then goes on to conduct an extensive analysis of insurance law and the well-known principles that insurers have a right to know the risks they are undertaking, that insurers rely on representations and warranties in assessing and pricing risk, and that breaches of those warranties are deemed material if they would have affected in the insurer’s willingness to insure the risk at the agreed price. He then goes on to make findings specific to Syncora and EMC, including that the truthfulness of the reps and warranties was a condition precedent to Syncora issuing its Policy, and that a breach of those reps would have adversely affected Syncora’s interests (Crotty Order at 8).
Crotty rejects EMC’s argument that “adverse affect” really means “pecuniary loss,” finding that the parties’ agreements did not reflect this understanding (Id. at 9). He goes on to point to several sections of the trust agreements that suggest that even current loans could be put back under certain circumstances (Id. at 9-10).
Finally, he addresses head-on Judge Bransten’s prior finding that the trust agreement language was “ambiguous” and that there might be meaningful variation between the language in the various trust agreements at issue. His Honor first notes that “there is no suggestion that the Operative Documents did not apply uniformly to all of the HELOC loans in the Transaction” (Crotty Order at 13). He then goes on to find that the Court in MBIA v. Countrywide “did not explain its reasoning” that the repurchase provisions were subject to varying interpretations and that Bransten’s opinion “is not persuasive” to the extent that it found ambiguity in those provisions. This clears the way for Crotty’s ultimate holding in that regard, which could not be clearer, and is worth quoting in full:
[T]he requirement in Section 7 of the [Mortgage Loan Purchase Agreement (MLPA)] that a breach of a representation and warranty must “adversely affect the interests of the Note Insurer” is not ambiguous. EMC’s proposed construction has no basis in the plain language of the parties’ agreements. Syncora need not prove that the allegedly breached representations and warranties caused any of the HELOC loans to default in order to show that its interests as an insurer were adversely affected for purposes of triggering EMC’s repurchase obligation under the MLPA. (Id. at 15)
Now, this is plainly a win for the monolines – and the fact that EMC has already filed a Motion for Reconsideration shows that the lender is concerned. Assuming that Crotty declines to reconsider his order (a quick read-through of the motion shows little new information or basis for reconsideration) and that other courts addressing this issue find Crotty’s Order persuasive (likely given that he’s a respected federal judge who wrote a reasoned, logical opinion), monolines will no longer have to go through the onerous task of proving exactly why a borrower stopped making payments in order to put a loan back to an issuer or originator. Proving simply that a breach of reps and warranties made the loan riskier is far easier to do. But what would this mean for investors?
Essentially, this holding, if it stands, will give investors a solid platform from which to argue for the same putback rights as monolines. Though Judge Crotty limited his holding to monolines (and indeed, it would have been overreaching had he purported to rule on the interests of investors, when that issue was not before him), His Honor’s reasoning could just as easily be applied to investors seeking to enforce repurchases. Just as an insurer has an interest in understanding the risk that it is insuring, an investor has an interest in understanding the risks underlying its investment. In fact, this principle forms the foundation for state and federal securities laws, which allow investors to recover their losses when they can prove that a risk was materially misstated in the offering documents.
What Crotty’s Order would do is provide persuasive authority for knocking out a fundamental piece of the banks’ argument – that a breach of rep and warranty is measured at the time of default and must be shown to have caused a default to trigger the repurchase remedy. When the analysis changes from such a loss causation perspective to one in which courts consider whether an underwriting breach as of the trust closing had other adverse effects, investors will almost certainly win. It does not require much of a logical leap to argue that, just like an insurer, an investor’s interests are adversely affected by a breach that makes a loan more likely to default in the future, even if it was not the ultimate or proximate cause of any default.
This ruling should embolden investors who were sitting on the sidelines, unsure about the strength of their claims, to come forward and assert repurchases. However, as I will be discussing in later posts in this series, those who have not yet started down this path may have now lost out on their chance to do so. While we’re starting to hear rumblings that German bondholders are getting active and considering collective action against U.S. banks to recover their losses (the U.S. effort to do the same lost steam when Kathy Patrick’s group pulled out), the statute of limitations window is quickly closing, and it now appears that the fix is in when it comes to some of the largest lenders.
Keep an eye out next week as I tackle potential end game scenarios for the various types of claims, starting with the monoline litigation.