Memorial Day Weekend is always cause for some reflection, but as we draw closer to the May 30, 2013 merits hearing on Bank of America’s (BofA) proposed $8.5 billion settlement of Countrywide mortgage liabilities, this last one seemed particularly appropriate for reflecting on the battles that have come to pass since Bank of New York Mellon (BNYM) first proposed the settlement on BofA’s behalf back in June 2011. Though there has been some speculation that a recent win for settlement objectors would delay the merits hearing in BofA’s legacy mortgage D-Day, the lawyers on both sides must prepare as if they’re going to war on Thursday.
The odds have certainly been stacked against the investors who object to this settlement (the “Steering Committee”), as the accord is being presented for approval in New York’s commercial division under Article 77, an obscure vehicle designed to obtain rapid approval for trustees who are performing administrative actions for trusts. Is BNYM’s decision to release over $100 billion of mortgage backed securities (MBS) contract claims across 530 different Trusts in exchange for $8.5 billion a reasonable administrative action for trustee? That’s for Judge Barbara Kapnick to decide.
But she need not make this decision in a vacuum. Many guiding decisions have been handed down in the most prominent MBS cases over the last few months, and most of them point to flaws in the assumptions made by BNYM in deciding whether this was a good deal for the investors whose trusts it represents.
Earlier this month, MBIA announced that it had finally settled its long-running battle royale with Countrywide and BofA, resulting in a payment to MBIA of over $1.7 billion in cash plus various additional consideration, bringing the total settlement value to somewhere north of $2.7 billion. This announcement was both vindicating and bittersweet for me; while I had long been predicting a settlement along these lines (see, e.g., here and much earlier, here), MBIA had achieved so many victories in the meantime that I was starting to look forward to seeing BofA get hammered at trial for refusing to acknowledge these liabilities.
And indeed, while BofA saved itself from near-certain disaster by preventing this case from proceeding to trial, it may have waited too long to avoid serious damage to BNYM’s $8.5 settlement of mortgage repurchase or “putback” claims, the centerpiece of its legacy mortgage strategy.
Today, I will looking back on recent events, including evaluating the read-through from the MBIA settlement, but I will also be looking forward to the upcoming merits hearing on the Article 77 proceeding and the challenges BofA and other banks will be facing in putting legacy mortgage issues behind them. And the more I look at these recent developments, the more I can hear foreboding bells tolling for BofA and the largest issuers of MBS.
In fact, “For Whom the Bell Tolls,” in all of its embodiments, appears to be the perfect theme for this analysis. My younger readers will probably associate this reference with the heavy metal classic from Metallica, which opens with the ominous tolling of bells followed by the driving guitar riffs that suggest the end is coming soon. So I will begin there, as when I consider the predicament of the Big Four Banks, I can’t help but hear the final lines of this song, suggesting that the reality of legal liability cannot be denied forever:
Now they will see what will be
Blinded eyes to see
For whom the bell tolls
Time marches on
Where do Investors Stand?
With MBIA’s multifaceted litigation against BofA now coming to a close, it’s clear to me that we are entering the most critical period yet in the war over who will bear the losses from the country’s pre-crisis credit binge. The settlement between MBIA and BofA can only be read, as the markets did, as a win for MBIA and monoline insurers in similar positions. But I also view it as validation for the position that commentators such as myself have been espousing for nearly five years now – that banks are on the hook for billions in bad loans based on faulty underwriting. Yet, while bond insurers such as MBIA, AGO and Syncora have been overwhelmingly successful in their MBS litigation, and have now settled most of their outstanding disputes on favorable terms, investors have yet to obtain similar results.
As we’ve discussed at length on this blog, this difference stems from a variety of factors, including less robust contractual rights, standing issues, and lack of organization. However, certain motivated investors have now banded together with like-minded investors to form critical mass, overcome standing issues by wrangling MBS Trustees into acting on their behalf, and compelled those Trustees to institute litigation. These plaintiffs are now poised to follow the roadmap laid down by the monolines and recoup a significant portion of the Trust’s losses. That is, of course, unless the largest banks pull off the equivalent of a legal Hail Mary
As my readers are well aware, I have viewed the Article 77 proceeding from the beginning as exactly that – a desperate and aggressive move by an institution with its back against the wall. Further, as many observers still don’t seem to realize, this was not a typical arms-length settlement between adverse parties. Instead, this was a sweetheart deal struck between BofA and a small number of conflicted institutions who desired to keep BofA happy and look like they were taking meaningful action, rather than squeezing all they could out of the nation’s former No. 1 bank.
Today, we find the settlement proceeding rapidly approaching an approval hearing before Judge Barbara Kapnick in New York State Court, scheduled for May 30. Battle lines have been drawn between the institutional investors that support the deal, BNYM as the trustee, and BofA/Countrywide on the one hand; and on the other hand the steering committee of institutional investors who oppose the deal, comprised primarily of AIG, Triaxx, and a three of the Federal Home Loan Banks (up until recently, at least on paper, it included the attorneys general of New York and Delaware; however, these entities turned out to be paper tigers once they were allowed to intervene, saying little in court and doing less, making their exit from the Steering Committee less important than widely thought).
Central to the outcome of the case is the determination of whether BNYM’s decision to settle over $100 billion of potential liabilities for just $8.5 billion was reasonable. Much is at stake for both sides, as Bank of America’s current loss reserves rest on the assumption that this deal will be approved, and other banks are beginning to use this settlement to estimate their own MBS liabilities.
As far as Hail Mary plays go, this play was drawn up rather well – file an action in a favorable court using a favorable, but obscure, legal vehicle with little precedent regarding its application; have the Trustee file the suit so it appears to be acting on behalf of all investors; and then cross your fingers and hope the judge doesn’t have the gall or the depth of understanding to reject one of the largest settlements (by gross dollar amount) in history.
The problem, of course, is that this is a sweetheart deal parading as an arms-length transaction, and its justifications are illusory. And, like any illusion, the more you poke and prod and ask questions about it, the more shaky this deal begins to look. True to form, a flurry of legal rulings and evidentiary developments in recent months has threatened to decimate this settlement.
Punches to the Gut
To supporters of the Article 77 settlement, each of the past few months’ developments must have felt like punches to the gut, continuing to undermine the foundation on which this settlement was built. For these entities, I’m sure the merits hearing could not come fast enough.
Most prominent among the legal developments was the February 5, 2013 decision of Judge Jed Rakoff in the Southern District of New York in a case brought by monoline bond insurer Assured Guaranty against lesser-known MBS issuer Flagstar Bank. This was the first MBS repurchase case to go to trial, and after hearing weeks of testimony regarding alleged breaches of the underwriting guidelines, Rakoff awarded Assured more than $90 million, an amount sufficient to cover all of its claims payments to date.
In doing so, Rakoff ruled that that the bond insurer need not show that the underwriting defects actually caused the loans to go into default, but only that the defect increased the risk profile of the loan. Specifically, Rakoff held that, “it is irrelevant to the Court’s determination of material breach what Flagstar believes ultimately caused the loans to default, whether it is a life event or if the underwriting defects could be deemed ‘immaterial’ based on twelve months of payment. Risk of loss can be realized or not; it is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach.” This holding effectively sounded the death knell for issuing banks’ best defense to mortgage rep and warranty claims.
Following this holding, on April 2, 2013, New York State’s First Department Appellate Division had occasion to consider the question of whether the putback standard turned on materiality or loss causation, when Judge Bransten’s partial summary judgment holdings from nearly a year ago in MBIA v. Countrywide were finally decided on appeal. Though Bransten had punted on the question of loss causation for loan-level putbacks, the First Department made the unusual move of ruling that Bransten should have issued a judgment in favor of MBIA on this issue. Citing Judge Rakoff’s holding in the Flagstar case with approval, the First Department held that MBIA,
is entitled to a finding that the loan need not be in default to trigger defendants’ obligation to repurchase it. There is simply nothing in the contractual language which limits defendants’ repurchase obligations in such a manner. The clause requires only that “the inaccuracy [underlying the repurchase request] materially and adversely affect the interest of” plaintiff. Thus, to the extent plaintiff can prove that a loan which continues to perform “materially and adversely affect[ed]” its interest, it is entitled to have defendants repurchase that loan.
If Rakoff’s decision in the Southern District of New York sounded the death knell for BofA’s best putback defense, the New York State Appellate decision put the final nail in the coffin. This is because the majority of MBS deals from this period are governed by New York law, and a New York Appellate Court decision interpreting the language of those deals is binding precedent for virtually all of them. Why is this particularly relevant to the Article 77 proceeding? Because, as we will discuss later in this article, Bank of New York Mellon’s “expert” gave a 60% haircut to his calculation of a reasonable settlement value based on the availability of this defense.
Finally, on April 29, 2013, Judge Bransten handed down her long-awaited rulings on MBIA and Countrywide/BofA’s motions for summary judgment on the separate issues of primary liability for Countrywide and secondary or successor liability for BofA. Though Bransten did not issue judgment for either side on either of these issues, she did issues several preliminary rulings that were nearly unanimously favorable to MBIA and other MBS plaintiffs.
Though I could devote an entire article to analysis of these decisions – the most detailed and well-informed yet on putback liability - I will simply summarize for the purposes of this article the most important points of read-through for the Article 77 proceeding. The biggest impact on the settlement proceeding arises out of Bransten’s holdings on successor liability. MBIA had based its case for successor liability on two grounds: 1) that there had been a merger in fact though not in form (a.k.a. “de facto merger”) and 2) that BofA had voluntarily assumed Countrywide’s liabilities by holding itself out to the public as doing so.
If you’ll recall, one of the major justifications for the low settlement amount in the Article 77 proceeding was the fact that Countrywide had insufficient resources to pay a large settlement, and BNYM’s expert, Stanford Professor Robert Daines, had opined that a court was unlikely to hold that BofA was on the hook for Countrywide’s liabilities. On de facto merger, Professor Daines had discounted the likelihood of such a holding based primarily on his findings that Delaware law would likely govern this question and that the “fair value” test would prevent a court from piercing the corporate veil.
On summary judgment in MBIA v. Countrywide, Bransten rejected both of these arguments. First, she held that New York law governed the question of BofA’s successor liability for Countrywide. As I’ve written in the past, this determination is hugely significant, as New York law is much more favorable to a finding of de facto merger than Delaware law. While Delaware law requires a showing of bad faith and values form over substance in making this determination – resulting in Delaware almost never finding that a de factor merger took place – New York law does not require a showing of bad faith and looks at the substance of the transaction over its form.
Second, Bransten rejected BofA’s assertion that MBIA’s successor liability claim failed as a matter of law because BofA paid “fair value” for the assets of Countrywide. Specifically, Bransten held that,
[w]hether fair value is paid for the assets required has no bearing on whether a New York court will look at a transaction or series of transactions and deem them “in substance a consolidation or merger of seller and purchaser.
Compare this with Professor Daines’ opinion that, “I think a successor liability case would be difficult to win if a court concluded that BAC paid a fair price in the Transactions,” (h/t Manal Mehta) and you see that, once again, BNYM’s settlement determination is on shaky ground. In fact, based on these holdings and Bransten’s comments on the record throughout this case, I pegged the likelihood at 75% that Bransten would have found for MBIA on the question of successor liability if this case had gone to trial.
Note also that Bransten kept alive MBIA’s alternative successor liability claim against BofA based on the theory that BofA impliedly assumed the liabilities of Countrywide when it made public statements to that effect. Professor Daines dismissed the value of such a claim based on the express disclaimers to successor liability that were included in the acquisition deal documents and on the fact that MBIA could not have relied on these public statements since it entered into the bond insurance agreements prior to these statements being made.
However, Bransten also rejected these arguments, finding that the express disclaimers did not preclude a finding that BofA impliedly assumed these liabilities at a later date and that subjective third party reliance is immaterial to the question of successor liability (this is why I’ve been saying that the case for successor liability does not differ or depend on who is bringing it).
Now, to be clear, this holding does not constitute binding precedent in New York State – other judges would have had the discretion to find differently. However, as a well-respected judge that has been the closest to this issue and has been handling mortgage crisis cases since the outset, I believe that Bransten is highly influential in the New York commercial division, and her opinion would have been quite persuasive to other judges in her jurisdiction. This means that BNYM’s assumption that BofA would not have successor liability for Countrywide was likely inappropriate, further undermining the diligence of its settlement determination.
On the issue of primary liability, Bransten’s summary judgment opinion was helpful to Article 77 objectors in several ways. First, she adopted the First Department’s loss causation holding, discussed above, and extended it from the single trust that the Appellate Court had ruled upon to every trust in the lawsuit.
Second, she laid down plaintiff-friendly interpretations of several important reps and warranties, including the “no default” rep - that there would be no default of a material obligation with respect to any loan – which is found in many deals. Rejecting arguments by Countrywide that the representation referred only a default in the payment of the loan, Bransten held that this provision related to any material obligation, including borrower misrepresentations.
Finally, Bransten held that Countrywide could not use “blanket rebuttals” to dispute loan-level breaches found by MBIA, but instead had to go loan-by-loan and provided specific bases for rebutting each breach identified. This finding took BofA’s loan-by-loan argument and turned it on its head, placing the burden on the bank to come up with specific reasons to rebut every breach. Further, while BofA had also argued that MBS plaintiffs were only entitled to a loan-by-loan remedy, Bransten ultimately held on summary judgment (just as Judge Crotty had in the Southern District of New York in Syncora v. EMC) that MBIA would be entitled to other forms of monetary relief besides loan-by-loan repurchase.
In addition, Bransten’s opinions on summary judgment were not the only source of ammunition for MBS plaintiffs. In reading Countrywide’s opposition to MBIA’s summary judgment motion on primary liability, it occurred to me that one of their arguments could be used effectively against them in the Article 77 proceeding. As to MBIA, Countrywide argued that the monoline could not prove its fraud claim because it had the opportunity to conduct loan-level due diligence before entering into the deals but declined. This meant that MBIA could not have “justifiably relied” on Countrywide’s misrepresentations. Countrywide even went so far as to argue that no reasonable bond insurer should have entered into an MBS deal without conducing loan level due diligence to understand the types of loans and risks at issue. Bransten ultimately rejected this argument, as it was not clear that MBIA even had access to loan files to conduct such a review.
However, in the Article 77 proceeding, the Trustee and BofA have been arguing since the beginning that no loan level due diligence was necessary for the Trustee to determine whether and at what price to settle over $100 billion worth of potential claims! There, the settlement proponents argued that it was unnecessary and would have been too costly for the Trustee to actually look at loans in these pools to find out how many breaches were present. But, in this case, the Trustee had full access to loan files and even the Institutional Investors that support the current deal were offering to show the Trustee loan-level data on similar pools.
This will not be lost on the Steering Committee of objectors, who has pointed out the hypocrisy in BofA’s position on this issue in the past. I would imagine that the Steering Committee will seize on this latest both-sides-of-its-mouth argument by Countrywide to show that it was entirely unreasonable for the Trustee to accept BofA’s representations of its breach rate with respect to Freddie and Fannie conforming loans (a whole different ballgame) in lieu of loan-level review of the actual non-prime loans in these deals.
No Man is An Island
This brings up another appropriate reference to “For Whom the Bell Tolls,” this time to the original 1624 poem by John Donne that is credited with originating the phrase. In the poem of the same name (also known as “No Man is an Island”), Donne wrote:
No man is an island
Entire of itself
Each is a piece of the continent
A part of the main
Therefore, send not to know
For whom the bell tolls
It tolls for thee
These words summarize for me both the state of BofA’s settlement with BNYM and the state of the other large MBS issuers and originators watching from the sidelines. As to the former, BofA’s settlement is not an island, self-contained and removed from important legal developments in other MBS cases.
As to the latter, no bank is an island, and the mere fact that BofA has been the earliest target of mortgage litigation due to its acquisition of Countrywide does not mean that plaintiffs will not turn their sights on the other large banks next. In fact, the same group of institutional investors that initiated the BNYM settlement, still represented by Kathy Patrick, has also initiated negotiations and/or legal notices with respect to Morgan Stanley, Wells Fargo and JP Morgan Chase.
Let’s address the former first. BNYM has now admitted in the Article 77 settlement proceedings that it reached the $8.5 billion number based entirely on the work of one expert, Brian Lin, of the relatively unknown firm, RRMS Advisors. Lin is a former Merrill Lynch trader with no disclosed experience in evaluating MBS settlements and no disclosed clients other than BNYM. He reached his number based on a number of questionable assumptions that resulted in “haircuts” applied to the original loss estimates for the 530 trusts.
One of these assumptions was that only 30 percent of loans that were between 60 and 179 days delinquent would eventually default (the actual percentage is closer to 90 percent). Another assumption, as mentioned above, was that it was reasonable to forego reviewing individual loans from the Countrywide MBS for defects in favor of borrowing data from BofA’s experience with Freddie Mac and Fannie Mae on higher-quality conforming loans. Finally, the analysis relied on the aforementioned “loss causation” haircut – the assumption that BofA would not be compelled to repurchase 60 percent of the loans that contained defects because the identified breaches could not be tied to the reason the borrower stopped paying the mortgage.
In a March 13 filing in the Article 77 proceeding, the Steering Committee of investors who oppose the deal submitted the expert report of Dr. Charles Cowan. Cowan marched through Lin’s expert report methodically and scientifically, dismantling several of the assumptions on which it relied. Notably, he argues that Lin had better evidence at his disposal than the Freddie and Fannie repurchase experience, and could have used that to estimate the pool’s breach rate rather than swallowing whole the non-analogous number provided by BofA itself. He also discussed why Lin had not used proper estimates of default and loss severity rates, and why Lin’s 60 percent “success rate” haircut was entirely improper.
Using what he represented as a “scientifically valid approach to the use of the limited information provided to Mr. Lin,” Dr. Cowan concluded that “the estimated average total repurchase liability is $56.34 billion” rather than the $8.5 billion that was at the low end of Lin’s range of reasonableness and which figure the Trustee eventually accepted. Dr. Cowan also noted that this was not his view on the actual repurchase liability, but only the logical conclusion that Mr. Lin should have reached had he pursued “a scientifically sound approach to the task.”
While I found Dr. Cowan’s analysis compelling, I don’t think the outcome of the Article 77 proceeding will come down to a battle of the experts and whose number was more accurate or appropriate. Instead, it will turn on an analysis of the process - that is, did the BNYM undertake a reasonable approach to determining whether to settle and at what price. Dr. Cowan’s report does an excellent job of addressing this aspect, as well, pointing out the fact that Mr. Lin ignored better data at his disposal.
But the subsequent legal decisions we’ve discussed above will likely be most influential in showing that many of the legal assumptions and others underpinning the settlement were unreasonable when made. As noted above, the loss causation defense has been rejected by every court that considered it, showing it never had legs in the first place. Even BofA’s own attorneys in the MBIA case, O’Melveny & Meyers, published a client alert back on July 27, 2012 (before Rakoff or the First Department had issued their opinions) warning that banks that issued MBS may have to increase reserves due to the failure of the losss causation defense. This defense, which has been repeated by every major MBS defendant in the fallout from the mortgage crisis, is simply not supported by the governing trust agreements themselves.
Bank of America has itself acknowledged the importance of this defense, stating in its 2010 third quarter 10-Q that, “if courts, in the context of claims brought by private-label securitization trustees, were to disagree with our interpretation that the underlying agreements require a claimant to prove that the representations and warranties breach was the cause of the loss, it could significantly impact the estimated range of possible loss.” BofA has also stated that its reserves may have to increase if courts reject its argument that statistical sampling should not be allowed in these types of cases, and that plaintiffs should have to prove their claims on a loan-by-loan basis. Both of these arguments have now been rejected in every MBS case to have reached that determination.
Still, even more influential to Judge Kapnick’s decision may be the allegations that the Trustee was conflicted when it made its determination. The Steering Committee has argued this from the beginning, and this argument has now been supported by the expert opinion of Georgetown Law Professor Adam Levitin, who pointed out how much of BNYM’s custodial business is based on keeping BofA happy, and how the structure of MBS transactions does not provide Trustees with the incentives to act on behalf of investors.
Just last week in the Article 77 proceeding (h/t Manal Mehta), Judge Kapnick held that the Steering Committee had alleged a colorable claim of conflict of interest on the part based on, “1) the event of default and the Trustee’s related decision to enter into a forebearance agreement; 2) the Trustee’s decision not to provide notice to the certificateholders at any point before settlement was reached; and 3) the broad release of claims BNYM sought for itself at any point before settlement was reached.” (J. Kapnick, May 20, 2013 Order at p. 16.)
Based on this, Judge Kapnick forced BNYM to turn over attorney-client communications on those three subjects. It is unclear whether this additional discovery will force the postponement of the May 30 hearing date, but at the very least it provides an indication that Kapnick is questioning BNYM’s good faith and independence, and provides the Steering Committee with a pathway to evidence that could potentially prove a breach of fiduciary duty by the Trustee.
I further expect the Steering Committee to pull out all the stops in the merits hearing, examining how Kathy Patrick’s efforts came about in the first place, and questioning whether she was really the only game in town, as she claimed. As I’ve written about at length in the past, there is plenty of documentation showing that this was not the case, and that Patrick steered her investor clients away from the more aggressive and effective strategy of Tal Franklin’s Investor Syndicate.
I consult on developments in RMBS litigation on a regular basis, and while most of my clients are interested in a detailed analysis of timing, inflection points and influential precedent, they always ask for a bottom line estimate of the odds that the case will go one way or another. As a reward for making it through this lengthy post, I’d love to give my readers the same on the Article 77 proceeding. But while I’ve made strong predictions in the past (see here on MBIA), I’m simply not as confident in doing so when it comes to the Article 77 settlement hearing.
Yes, many of the assumptions on which the settlement were based were unreasonable, even at the time they were made. Yes, the process the Trustee followed likely ran afoul of due process, as they consulted with a small group of interested investors and failed to give Certificateholders notice and an opportunity to respond until the deal was done. And yes, BNYM was operating under several conflicts of interest. But all of this serves, in my mind, only to even the scales, which were decidedly tilted in BofA’s favor at the outset. This inherent advantage to BofA was based on 1) the deference provided under Article 77 to the Trustee’s decision; 2) the fact that Judge Kapnick is not as proactive or assertive a judge as say a Jed Rakoff, William Pauley or Eileen Bransten (see her reluctance to delve into the details of MBIA’s transformation in BofA’s Article 78 proceeding); and 3) the fact that the Trustee of all 530 trusts and a large group of investors support the deal, while only a small group of investors have spoken out against the deal.
Add to this the fact that there is virtually no precedent for a proceeding like this, and I’m left feeling like the outcome of this proceeding is pretty close to a coin flip. I probably give a slight edge to BNYM-Bofa (say 55% likelihood of approval), but this is down from the 65-75% likelihood of success that I would have given it after the case returned to state court and before all of the aforementioned legal developments were handed down in related cases. Still, this is a far greater probability of the settlement being rejected than I feel like most observers are giving the deal.
For Whom Does the Bell Toll?
This brings me to a final comment about the impact of this proceeding on the rest of the RMBS landscape. As discussed, Bank of America has made it abundantly clear in its earning statements that its loss reserves on its private label putback liabilities are predicated on the success of the BNYM settlement, and that if final court approval is not obtained, the bank’s representations and warranties provisions could prove insufficient. Given the aforementioned developments in the last few months and other losses for BofA in its epic battle against MBIA (including losing its Article 78 challenge to MBIA’s 2009 transformation), it appears that BofA will be making its stand on a settlement with numerous cracks in its foundation.
Should it lose, it may finally have to face the music and recognize that the bulk of Countrywide’s non-prime mortgage loans met no semblance of their stated underwriting guidelines. But, no bank is an island, and the other major issuers will soon have to face the same reality. As I have seen during my representation of investors and mortgage insurers, irresponsible lending was not confined to Countrywide, it was endemic.
As the battle over approval of the $8.5 billion settlement unfolds over the next few weeks, I’m reminded of yet another reference to “For Whom the Bell Tolls,” this one to the final chapter of Ernest Hemingway’s famous book:
Today is only one day in all the days that will ever be. But what will happen in all the other days that ever come can depend on what you do today…All of war is that way.
The world’s largest banks take notice: BofA is in a particularly bad position because of its ill-conceived of Countrywide, but it is not on an island by itself. What happens this week and in the weeks to come in the Article 77 proceeding will affect the other major players in the non-prime mortgage securitization game from 2005 to 2007. Either the deal goes through and becomes a template for how to extract oneself from this mess, or it gets rejected and signals that far more pain is coming down the pike. Either way, do not ask for whom BofA’s bell tolls, it tolls for thee.