Federal Home Loan Bank of Pittsburgh Scores Important Early Victory in Pennsylvania Lawsuit

Posted on December 7, 2010 by Isaac Gradman

In the first substantive decision handed down in any of the five major lawsuits by the Federal Home Loan Banks (FHLB) over RMBS losses, the Hon. Stanton Wettick, Jr. of the Court of Common Pleas of Allegheny County, Pennsylvania dealt a blow to JPMorgan Chase, Countrywide and other securitizers of subprime and Alt-A mortgage loans, while letting the ratings agencies largely off the hook.  In the Order on Defendant’s Motion to Dismiss (full copy available here), Judge Wettick found that the FHLB’s claims for fraud, negligent misrepresentation and Securities Act violations could proceed against J.P. Morgan Securities, Inc., the entity that actually offered the mortgage backed securities for sale to investors and put together the securities’ offering documents.

The crux of the FHLB’s claims are that the securitizers (also known as depositors or sellers and sponsors) of various MBS offerings it purchased allowed those securities to be sold as AAA-rated or investment grade debt (which, according to the FHLB, indicated that they were virtually riskless), despite the fact that these securitizers knew that the ratings agencies had no way of determining the likely default rate of the underlying loans. Though the Court dismissed these claims as to the other JPMorgan entities that had acquired and transferred the loans earlier in the securitization chain, the Order was definitely a win for the FHLB because it confirmed that at least one investment bank entity would be on the hook for the sale of these toxic securities.

Meanwhile, the various ratings agency defendants were pleased with Judge Wettick’s Order, as it dismissed all claims against them except the claims of fraudulent (also known as intentional) misrepresentation.  The Judge ruled that the plaintiff had stated a claim for fraud based on the theory that the ratings agencies did not actually believe their own ratings (note that considerable evidence has recently emerged to support this argument, in particular, the findings of the Financial Crisis Inquiry Commission that the ratings agencies ignored evidence that these loans were unsound, as testified by former Clayton president D. Keith Johnson).  The Court further held that while the First Amendment protected the ratings agencies from liability for negligent misrepresentation, it did not protect the agencies from claims of fraud.  The Court further dismissed the Securities Act claim against the ratings agencies based on Section 11 of the Act, finding that the defendants were not “underwriters” subject to the statute, as defined therein.

Judge Wettick’s Order is an important early bellwether in investor litigation over losses from RMBS, because it shows that plaintiffs should be able to survive a motion to dismiss and get into the discovery phase without having a ton of hard evidence.  Indeed, as the first of the FHLBs to file suit (Pittsburgh’s suit was followed by the FHLBs of Seattle, San Francisco, Chicago and, most recently, Indianapolis), plaintiff’s counsel had not yet developed or taken advantage of the analytical tools used later in the Seattle and San Francisco complaints to show that specific representations made in the offering documents were false (see prior post on the Subprime Shakeout).  As we are still very early in the timeline of investor RMBS litigation, and do not have much precedent for how judges will treat these types of loss-related claims, this opinion bodes well, not only for the FHLB lawsuits, but for other impending investor actions.

Without access to loan files, plaintiffs are often caught in a tough position of having to make claims that the loans did not meet guidelines or representations without having the evidence to support such claims.  While the massive losses related to these products indicate investors were sold a defective bill of goods, servicers have largely refused to turn over documents that might confirm or disprove these claims.  Indeed, that is what the discovery process is intended to do, but there has long been speculation as to whether plaintiffs had enough to go on to surmount a motion to dismiss.  This Order reinforces my belief that the massive RMBS losses suffered by plaintiffs are enough to overcome this initial hurdle, meaning that plaintiffs will eventually get access to these treasure troves of misrepresentation fodder when banks are forced to turn over loan files in discovery.  And this decision bodes especially well for the later-filed FHLB complaints, which cite stronger evidence of widespread breaches of reps and warranties, thanks to the analysis provided by due diligence firm, CoreLogic.

Another interesting aspect to note about this case is the Judge’s handling of defendants’ “sole remedy” argument.  Namely, JPMorgan and the other defendants have argued, as have other banks in RMBS litigation, that plaintiffs may not assert claims for fraud, negligent misrepresentation, or other torts, because the language in the Pooling and Servicing Agreements (“PSA”) makes clear that the repurchase or replacement of a defective loan is the sole remedy for a breach of originators’ or underwriters’ reps and warranties.  Judge Wittick dismissed this argument, finding that the repurchase remedy was only available to the Trustee, and not to investors, so this could provision could not have been intended to apply to bondholders.  Though I have not reviewed these particular PSAs in detail, I would be surprised if they did not provide that investors could petition the trustee for such relief, should they amass a sufficient percentage of Voting Rights (generally 25%).

While I have often discussed the procedural hurdles investors face in taking advantage of this remedy, it is simply not the case that the repurchase re
medy is entirely unavailable to investors.  Thus, Wettick reached the proper conclusion, but for the wrong reasons.  I think the better-reasoned approach is to find that while repurchases are the sole remedy for contractual breaches of reps and warranties, the claims being made by the FHLB of Pittsburgh do not seek damages for breaches of reps and warranties in the underlying loans–they seek damages for material misrepresentations in the offering memoranda related to the ratings of the securities.  While breaches of reps and warranties may be related to the reasons the securities underperformed their ratings, I think that what the securitizers knew about the ratings when they made these representations is an entirely different question, only tangentially related to breaches of reps and warranties.  In fact, the securitizers could have been entirely unaware that there were breaches of reps and warranties, but still could have known that ratings agencies were not capable of estimating the risk of loss in these securities, and thus should have included disclaimers in the offering documents.  Simply put, relief for misrepresentation in prospectus and other offering documents should not be limited by the “sole remedy” language applicable to breaches of reps and warranties made by the originators of these mortgages in separate contracts.

Update on Other FHLB Actions
Several readers have requested updates on the actions brought by the FHLBs of Seattle and San Francisco.  The going has been slow in those cases (they are months behind the Pittsburgh case, which just now passed the motion to dismiss phase), but here is what I’m able to tell you: both cases were removed from state court to federal court by the defendants, in an attempt to obtain federal court jurisdiction over the plaintiffs’ claims.  So far, most of the action in these cases has been related to adjudicating the removal issue.  The way this works is that the cases are automatically moved to federal court upon the filing of a procedurally proper notice by a defendant. The plaintiff(s) may then file what’s called a Motion to Remand, arguing that the federal courts do not have jurisdiction over the claims and that the case should be remanded to state court.

The FHLBs filed Motions to Remand in both cases.  The Motion was granted in the Seattle case in September, Case No. 2:10-CV-00148-RSM, and the case was remanded back to Kings County Superior Court.  The San Francisco case is still before Judge Conti in the Northern District of California, Case No. 3:10-CV-03039-SC. The judge has taken the Plaintiff’s Motion for Remand under submission, and all other dates have been postponed pending the outcome of that decision.  Note that the Pittsburgh case discussed above is proceeding in Pennsylvania state court, rather than federal court.  I’ll keep readers apprised of any developments in these cases, as I become aware of them.

Posted in Countrywide, Federal Home Loan Banks, investors, JPMorgan, lawsuits, loan files, misrespresentation, ratings agencies, remand, removability, rep and warranty, repurchase, sole remedy, toxic assets | 8 Comments

Barron’s Article Pulls No Punches in Assessing Bank Putback Liability

Posted on November 22, 2010 by Isaac Gradman

If you’re looking for a great primer on the latest developments in the legal saga over who will ultimately bear the losses for the detritus that passed as subprime and Alt-A mortgage loans from 2004 to 2007, check out this article published by Jonathan Laing at Barron’s over the weekend.  In the article, entitled “Banks Face Another Mortgage Crisis,” Laing does a great job of bringing the casual observer up to speed on the various efforts by investors and insurers to force originating and securitizing banks to buy back souring mortgage loans that are found to breach the guarantees made when the loans were first originated and sold.

Among the highlights: the article frankly admits that with $2 trillion in subprime, Alt-A and adjustable rate mortgages having been originated during the last years of the housing boom, the losses on these loans could reach approximately $700 billion.  Laing also accurately assesses that the biggest battles the banks will face will come from investors in private label (i.e. non-agency backed) securities, and that banks may seek another government bailout to help ease the significant pain these private label putbacks may cause.  Laing also does not mince words about whether the banks deserve to be on the hook for these mortgages.  My favorite passage:

Certainly, some of the major banks amply deserve to suffer additional putback losses. By almost any measure, they were either negligent or willfully culpable in issuing securities with such glaring defects on the global investment markets. They had little incentive to worry much about investment quality, since the securitized loans passed off their balance sheets, ladling all the credit risks onto the credulous buyers.

The banks had created such a fee-rich securities sausage factory during the middle of the current decade that the ingredients going into their products were of little concern. It was merely important to keep production levels elevated even after the pool of creditworthy mortgage borrowers had run dry, only to be replaced by dead-beat subprime borrowers and alt-A mortgage-financed home speculators ready to mail their home keys to their lenders at the first whiff of home-price weakness.

Bankers argue that economic woes rather than shoddy loan underwriting are to blame for most of the lamentable financial performance of the mortgage market. Therefore, the pugnacious CEO of Bank of America, Brian Moynihan, has promised that the bank will engage in “hand-to-hand” combat to fight putback claims. “People who come back and say, ‘I bought a Chevy Vega, but I wanted it to be a Mercedes with a 12-cylinder [engine].’ We’re not putting up with that,” he insisted during a recent conference call.

Yet there’s plenty of evidence that the banks during that key three-year period in the middle of the decade passed off some Yugos as sleek sedans.

Laing also does a great job of pulling some of the juiciest pieces of evidence into his article that suggest that the banks were more than just sloppy–they may have knowingly duped investors regarding the quality of the loans they were selling.  Particularly damning is the testimony provided by the former president of Clayton Holdings, D. Keith Johnson, regarding the due diligence firm’s findings and the fact that they were often ignored by the securitizing banks, who “waived” deficient loans into securitizations.

But, I must disagree with a few of the points made in this article.  First, Laird refers to the legal principles under which investors will likely proceed to remedy defective mortgages–i.e., the representations and warranties found in the trust agreements–as “arcane.”  This wording implies that the legal principles are esoteric or overly complicated, and that investors’ reliance on them to putback loans seeks to take advantage of an obscure technicality.  Quite to the contrary, though Pooling and Servicing Agreements (PSAs) were often overly complicated, the reps and warranties provided by lenders were the key contractual guarantees that investors received when agreeing to purchase securities backed by the loans at issue.  These guarantees provided investors with the comfort that, though they lacked the capacity to review every loan to make sure it met certain quality thresholds, they could rely on lenders’ statements regarding the loans, and could rest assured that lenders would take back any loans that didn’t comply.  Thus, rather than “arcane” legal principles, reps and warranties are fundamental building blocks of any securitization, and the investors have every right to hold banks to their collective word.

Second, Laing describes the content of these reps and warranties as “at best, vague.”  I have to respectfully disagree.  The reps and warranties provided by subprime and Alt-A lenders were often extensive, and commonly included a representation that the lender would follow its published underwriting guidelines.  And even though these were “non-conforming” loans, and thus had more lenient underwriting standards than those for agency-backed or “conforming” loans, they were still underwritten with concrete guidelines about what characteristics they had to possess and the procedure that had to be followed by the lender when determining whether the borrower qualified for a loan.

A commonly misunderstood aspect of these loans is that many were so-called “stated income loans,” that is, the borrower did not need to provide proof of income, but simply stated it on the loan application.  Many take this to mean that the lender had no responsibility to confirm the accuracy of this statement, and instead could take at face value whatever the borrower claimed to make as income.  Yet, originators of stated income loans generally included in their published guidelines that they would confirm that the borrower’s stated income was reasonable and in line with the borrower’s occupation and years of experience.  Originators had extensive databases they were supposed to use to perform this review function.  When going back and reviewing a loan file after the fact, it is relatively easy to determine whether the originator followed this procedural step.  If it did not, it’s a clear breach of the underwriter’s guidelines, regardless of whether the borrower’s stated income turned out to be true or false.  It has long been my view here at The Subprime Shakeout that once loan files are turned over to investors, it will not be difficult to prove that there were widespread breaches of lenders’ underwriting guidelines and procedures.

Finally, Laing takes it as a given that banks will be on their own this time, i.e., that the federal government will have no appetite to provide the banks with any financial assistance to ease the pain of this latest mortgage crisis.  I am not so sure that this can be assumed.  Instead, I think regulators are eager to avoid another financial panic like the one that was touched off by the failure of Lehman Brothers.  Should one of the Big Four banks become dangerously undercapitalized upon the crystallization of putback liability, I’m afraid that the government will be asked (and be under intense political pressure) to step in once again.  I don’t necessary agree with this approach, but given what we’ve seen over the last two years, it certainly can’t be ruled out.

All told, though I take issue with some of the finer points contained within this article, I commend Mr. Laird on this fine piece of journalism and encourage readers looking for a concise and intelligible summary of banks’ potential subprime mortgage liabilities to check it out.

Thanks to Manal Mehta at Branch Hill Capital for first alerting me to this story – IMG.

Posted in allocation of loss, Barron's, Clayton Holdings, Lehman Brothers, loan files, private label MBS, rep and warranty, repurchase, responsibility, stated income, too big to fail, underwriting practices | 2 Comments

Bank of America Fires Off Response to BlackRock and PIMCO Demand Letter, Accuses Lawyer of "Ulterior Agenda"

Posted on November 9, 2010 by Isaac Gradman

In a response that can only be described as indignant, Bank of America fired back on November 4 at the group of investors that demanded that Countrywide/BofA repurchase loans in connection with $47 billion worth of private-label mortgage backed securities.  In the strongly-worded letter, a full copy of which is embedded below, BofA attorneys Theodore Mirvis of Wachtell, Lipton, Rosen & Katz; Brian Pastuszenski of Goodwin Procter and Marc Dworsky of Munger, Tolles & Olson railed against the allegations contained in the October 18 letter authored by attorney Kathy Patrick of Gibbs & Bruns, stating that Patrick’s letter contained “misleading statements,” alleged claims that were “utterly baseless,” and appeared to have been “written for an improper purpose, or in furtherance of a [sic] ulterior agenda.”

Much has made of Patrick’s October 18 letter, which was signed by such major institutional investors as BlackRock, PIMCO, MetLife, the New York Fed and Freddie Mac, making it the the most high-profile investor repurchase demand to date as to non-conforming mortgages.  In fact, BAC’s stock slid nearly 5% when news of the letter first emerged.

Yet, as I noted when I first posted about this letter and when I posted a copy of the letter a few days later, this first high-profile investor putback effort featured some serious deficiencies that might prevent it from succeeding – namely, that it failed to identify specific breaches of reps and warranties with respect to specific loan files or provide any evidence supporting those specific breaches.  Indeed, this turns out to be the very first point BofA’s attorneys make in responding to the letter.  In pointing out some of the “glaringly evident” deficiencies in the letter, BofA’s attorneys state:

Your letter fails to set forth a single fact in support of any of your allegations, but rather relies solely on conclusory and often misleading statements. (emphasis in original)

The BofA letter goes on to demand that the investors provide “sufficient factual basis for their allegations” and “identify the specific provisions of the specific PSA that is alleged to have been breached.”  Pursuant to the procedural roadmap from Judge Kapnick’s opinion dismissing the plaintiffs’ case in Greenwich Financial v. Countrywide, I would agree that Kathy Patrick’s investors will have to make this showing to survive a motion to dismiss for lack of standing if they eventually file suit against BofA/Countrywide.

However, the BofA letter also makes a number of points that are far less grounded in fact and appear designed to place political pressure on investors hoping to recover a portion of their MBS losses.  For example, BofA characterizes Patrick’s letter as demanding that Countrywide hasten foreclosures and reduce loan modifications.  The letter even accuses Freddie Mac’s involvement with Patrick’s group as “patently inconsistent” with the GSEs and federal government’s stated goal of helping troubled borrowers stay in their homes.  While this has historically been a hot button political subject, BofA’s statements are not an accurate representation of what the investors are seeking.

In fact, the Patrick letter specifically states that investors “do not seek to halt bona fide modifications of troubled loans for borrowers who need them.”  Instead, investors take issue with the Countrywide settlement with state Attorneys General in which, in exchange for the AGs dropping claims of predatory lending against Countrywide, Countrywide agreed to modify 400,000 loans, the large majority of which it no longer held on its books.  Patrick’s group seeks simply to hold Countrywide to its contractual agreement to repurchase loans that it modifies as a cure for predatory lending.

Similarly, Patrick’s letter does not demand that Countrywide force borrowers out of their homes.  To the contrary, the investors are simply demanding compliance with the Countrywide pooling and servicing agreement provision (Section 3.11(a)) that states that the Master Servicer must,

use reasonable efforts to foreclose upon or otherwise comparably convert the ownership of properties securing such of the Mortgage Loans as come into and continue in default and as to which no satisfactory arrangements can be made for collection of delinquent payments. (emphasis mine)

In other words, Patrick’s letter simply asks that Countrywide modify where it is reasonable to do so (and where it is not a remedy for Countrywide’s own predatory lending) and foreclose promptly where it is apparent that no satisfactory modification is to be had.  Patrick’s letter is thus better characterized as a demand that Countrywide perform its fundamental role as servicer, rather than as a heartless demand that Countrywide start kicking people out of their homes.

Finally, BofA’s letter sets forth a plethora of additional information from investors that it demands be provided prior to Countrywide taking any action.  Included in this is a demand that Patrick provide, for each bondholder who signed onto the letter, the names of the individuals who authorized that signature, whether the bondholder’s board of directors authorized that letter, and whether any of the bondholder’s controlling shareholders authorized the letter.  I’m not sure from where BofA derives the authority to demand this information, but it clearly suggests that BofA is not convinced that the internal management within each of the signing entities was unanimous in support of the Patrick letter.  BofA may also be trying to dissuade others from authorizing similar letters in the future for fear of their names being publicly revealed, something that institutional investors and their managers have thus far been reluctant to do.

Ultimately, though the BofA letter contains a lot of bark, the only bite that I can discern is the demand for more specific information.  Everything else is, well, politics as usual.

BofA Response Letter to Patrick Group http://d1.scribdassets.com/ScribdViewer.swf?document_id=41592157&access_key=key-13u1yigrl82ah6i4l1rm&page=1&viewMode=list

Posted in Attorneys General, BlackRock, BofA, Countrywide, Event of Default, Federal Reserve, Freddie Mac, Kathy Patrick, MBS, PIMCO, procedural hurdles, rep and warranty, repurchase, servicers, specificity | Leave a comment

Countrywide Loan Modification Settlement Becomes Issue In Connecticut Senatorial Race

Posted on November 2, 2010 by Isaac Gradman

The ramifications of the Mortgage Crisis are being felt on this Election Day 2010, as the issues of foreclosures, loan modifications and MBS-related losses to pensionholders’ portfolios are being brought to the forefront in some key political battles.  As a prime example, take the heated race for Chris Dodd’s open Senate seat in Connecticut, where Democratic candidate Richard Blumenthal still held a single-digit lead over Republican candidate Linda McMahon in polls leading up to today’s vote.

Embedded below is a television spot by McMahon, entitled “The Biggest Lie,” which attacks Blumenthal’s participation in the settlement between Attorneys General from 44 states and Countrywide over the lender’s alleged predatory lending practices.  The ad suggests that while Blumenthal has stated that taxpayers would not pay a dime for the settlement, taxpayers would end up footing the entire bill for the loan modifications Countrywide agreed to perform.  The ad quotes an article by Alex Ulam called “The Bank of America Mortgage Settlement Fiasco” in the left-leaning publication, The Nation.

To be fair, taxpayers will not be footing the entire bill for the Countrywide settlement, as Countrywide/BofA still owns some of the loans at issue (the article in The Nation reports that the number is a paltry 12%), and The Nation article itself states that, “as it turned out later, much of the settlement’s cost would be covered by taxpayers…” (emphasis mine).  Thus, McMahon’s ad is not entirely forthright, either.  Furthermore, it’s unclear that Blumenthal fully understood the way the settlement would play out (see prior post), and The Nation suggests that Blumenthal “seems to have missed it entirely,” so calling his statement a “lie” smacks of political rhetoric.  But, the point is still a good one – the Countrywide settlement shifted the majority of losses to taxpayers and largely let Countrywide and BofA off the hook for its irresponsible lending practices.

I had a chance to meet with Alex Ulam, the author of “The Bank of America Mortgage Settlement Fiasco,” a number of times in San Francisco when he was first beginning his research for this story and was relatively new to the issues surrounding securitizations and loan servicing, such as servicer conflicts of interest and loan repurchase liability.  He came to me for some background on the Countrywide settlement (note that BofA spokesman Terry Francisco is quoted in the article as calling it an “agreement,” not a “settlement”) and an explanation of who would bear the costs of the agreed-upon modifications.  By the time Ulam’s article was published some months later, he evinced a firm grasp of the issues, and wrote a thorough and scathing piece for The Nation regarding the shortcomings of the resolution between the Attorneys General and the country’s largest subprime lender.
To be certain, this issue has been discussed previously in The Supbrime Shakeout (articles here, here and here) and in this article in the Daily Journal and California Lawyer Magazine.  However, Ulam’s article was one of the first in a nationwide publication to understand and explain to its readers that by agreeing to modify loans that it no longer owned, Countrywide was shifting the losses associated with its troubled loans to the pension funds, hedge funds, insurance funds and other investors who had purchased MBS backed by these loans.  And the article has made its impact, prompting McMahon to raise the issue as an attack on Blumenthal, and garnering a good deal of local media coverage in Connecticut, such as this article in the Greenwich Times/Stamford Advocate.
It remains to be seen whether the allocation of losses relating to the Mortgage Crisis will be a major factor in this year’s elections, but it is clear that these issues are beginning to seep into the mainstream consciousness.  I would imagine that politicians all over the country are watching the Connecticut senatorial election closely to see whether voters care enough about these issues to make them pay at the polls for their role in the crisis or their failure to effectively clean it up.

Posted in allocation of loss, Attorneys General, BofA, Christopher Dodd (D-CT), Countrywide, global settlement, Linda McMahon, loan modifications, political ads, Richard Blumenthal, senate races, The Nation | 2 Comments

Full Text of BlackRock, PIMCO Letter to Bank of New York and Bank of America Available

Posted on October 21, 2010 by Isaac Gradman

Below, please find the full text of the letter sent by Kathy Patrick and the law firm of Gibbs & Bruns to Bank of New York and BofA/Countrywide on behalf of private label mortgage investors, including BlackRock, PIMCO, MetLife, Freddie Mac and the New York Fed.  This letter represents one of the first formal attempts by a group of bondholders to issue binding instructions to a Trustee to take action on their behalf.

As you read through, keep in mind that the bondholders must identify a specific breach or event of default in order to meet the procedural preconditions to Trustee action and gain standing to sue if the Trustee does not act within 60 day (see recent article on procedural preconditions to bondholder standing).  See if you think Patrick’s allegations regarding Countrywide’s knowledge of breaches of underwriting reps and warranties, based on its modification of loans and its lawsuits with bond insurers, or her allegations regarding Countrywide’s improper maintenance of loan documents, overcharging for maintenance services or failure to notify the Trustee of defects in the loans constitute the specific evidence of breaches necessary to meet her procedural requirements.  Given that she does not identify a single loan by loan number or provide any specific evidence supporting any of her allegations (the closest she comes is citing a press release issued by the FTC), I remain skeptical.

[Many thanks to the folks at Branch Hill Capital for providing me with a copy of this letter – IMG.]
Bondholder Letter to BofNY and BofA Over Countrywide Loans http://d1.scribdassets.com/ScribdViewer.swf?document_id=39838424&access_key=key-9ff9j4kbi9sxm0s3l2u&page=1&viewMode=list

Posted in Bank of New York, BlackRock, BofA, bondholder actions, Countrywide, Federal Reserve, Freddie Mac, Kathy Patrick, loan modifications, MetLife, PIMCO, private label MBS, procedural hurdles | 6 Comments