The Bell Tolls for BofA

Posted on May 28, 2013 by igradman

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.

Posted in Adam Levitin, AIG, allocation of loss, Alt-A, appeals, Attorneys General, bad faith, Bank of New York, banks, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, damages, Federal Home Loan Banks, Flagstar, global catastrophe defense, global settlement, incentives, Investor Syndicate, investors, irresponsible lending, Judge Barbara Kapnick, Judge Eileen Bransten, Judge Jed Rakoff, Judge Paul Crotty, Judge William Pauley, Judicial Opinions, Kathy Patrick, lawsuits, liabilities, litigation, loan files, loss causation, MBIA, MBS, monoline actions, O'Melveny & Myers, private label MBS, procedural hurdles, putbacks, rep and warranty, repurchase, RMBS, securitization, sellers and sponsors, sole remedy, standing, statistical sampling, successor liability, summary judgment, Trustees, vicarious liability | 3 Comments

Mortgage Lit Roundup: Five Signs That Plaintiffs Are Winning the RMBS War

Posted on December 17, 2012 by igradman

A lot can happen in a few months.  I’ve largely taken a break from blogging over the last quarter, as the demands of becoming a new father and joining a new law firm (see “Legal Practice” link in the header) have kept my plate plenty full.  But of course the world of mortgage litigation takes no breaks, and in fact things have been heating up in a big way over the last few months in the lawsuits over soured mortgage backed securities.

While the mainstream media has seemed to tire a bit of this story over the last year, in part as a result of the lack of headline-grabbing criminal prosecutions or dramatic case resolutions, it is just now starting to return to the topic in a big way.  Notably, the New York Times made waves with a story last week about the toll this litigation is taking on banks’ balance sheets – something folks like Manal Mehta and yours truly have been talking about and predicting for years.

Nevertheless, I can’t help but agree that we’re reaching a critical point of reckoning in the arc of post-crisis litigation – the inflection point at which banks can stall no longer and must either acknowledge the true cost of their and their affiliates’ irresponsible lending or risk trials and adverse judgments.  Importantly, we are beginning to see clear victors emerge in the litigation battles that had been raging in board rooms and court rooms over the last four years.  This, in turn has forced banks to launch flank attacks at some of their most ardent litigation counterparties.  In the face of these efforts, I’ve compiled my top five signs that this war of attrition is tilting in favor of RMBS plaintiffs.

Sign No. 5: Walnut Place (Baupost) Back from the Dead

This past summer, I started hearing rumblings that investors were packing it in, cashing in their chips and giving up on RMBS litigation.  The poster child for this theory was The Baupost Group hedge fund, also known by its litigation alias Walnut Place, which had been among the most vocal objectors to the $8.5 billion global settlement between Bank of New York and Bank of America over Countrywide RMBS.  After suffering the disheartening dismissal of its claims against BofA at the hands of Judge Kapnick, and the confirmation of that dismissal by the New York appellate court, Walnut Place withdrew its objections to the global settlement and soon began offloading its positions in Countrywide bonds.

However, it turns out that rumors of the fund’s demise in the world of RMBS litigation were greatly exaggerated.  On September 4, the Law Debenture Trust Co. of New York, as trustee for a Bear Stearns RMBS trust, filed an amended complaint against Bear Stearns lending unit EMC (now owned by JP Morgan), demanding that it buy back more than 1,000 loans that allegedly breached one or more reps and warranties.  A status report filed prior to the filing of the Amended Complaint (available here courtesy of Reuters) identified the Ashford Square Entities, wholly owned subsidiaries of Baupost, as the owners of 50.4% of the Trust and the representative of the certificateholders who are directing the trustee.

What’s interesting about this filing (redline version available here), is that it’s direct evidence of a development I’ve predicted for some time – that discovery obtained by the monolines in their more advanced litigation against the banks would embolden bondholders and provide them with a treasure trove of ammunition to use in their own lawsuits.  Indeed, Baupost’s Amended Complaint now includes allegations of a fraudulent “double-dipping” scheme at EMC/Bear Stearns/JPMorgan that first appeared in a lawsuit by Ambac against EMC back in January 2011 (these allegations have now popped up elsewhere, as we will see later in this post).

This is the first bondholder suit of which I’m aware to include these charges, as the Amended Complaint notes that discovery obtained in other suits against EMC shows a pattern of denying investor repurchases while seeking compensation from third party originators for the very same defects.  On top of that, the Amended Complaint contains the detailed results of an extensive file review of the loans at issue, revealing that well over 80% of the loans in the Trust were found to materially breach reps and warranties, and laying out some of most egregious underwriting errors.   Though BofA has born the brunt of mortgage litigation attacks over the past couple of years, JP Morgan is beginning to hear the drum beat of an RMBS army advancing in its direction.

Sign No. 4: Regulators (Finally) Jump Into the Fray

It has certainly been a long time coming, but it appears that regulators are finally starting to take discernible steps towards bringing accountability to at least some of those who contributed to the mortgage crisis.

As most are aware, New York Attorney General Eric Schneiderman filed a lawsuit against JP Morgan on October 1 that was premised on the same double dipping conduct by Bear Stearns and EMC that was the subject of Ambac’s Amended Complaint in January 2011.  The lawsuit was touted in a DOJ press release as “the first legal action from the RMBS Working Group.” It accused JP Morgan of two claims under New York law: securities fraud under Article 23-A of the Martin Act (the General Business Law) and persistent fraud or illegality under Section 63(12) of the Executive Law.

Schneiderman also announced that he hoped this case would be a “template for future actions” against other players in the securitization market, sending a signal that this would be the first of several lawsuits on this topic.  On November 20, Schneiderman made good on this promise, suing Credit Suisse over similar charges related to a fraudulent double dipping scheme.  The similarity of these two lawsuits is striking – and I’m not sure if this is more a result of Schneiderman using the JP Morgan action as a literal template (he has been accused of using a cut-and-paste style of lawyering) or the fact that the big banks tend to engage in the same exact types of fraud at the same times (but if you listen to the bank defenses in the LIBOR cases, “rogue traders” came up with all of the same brilliantly fraudulent schemes independently and without any collusion of any sort, and certainly without the knowledge or participation of upper management).

Most commentators who have written about these filings have been largely critical, and I have my own gripes, so I’ll get those out of the way first.  Primarily, I’m disappointed by the fact that the allegations in the complaints (here are links to the complaints against JP Morgan and Credit Suisse, so you can view them for yourself) are essentially carbon copies of those leveled by Ambac and other bond insurers against EMC and JP Morgan, and those leveled against Credit Suisse by MBIA, respectively, allegations that were first made nearly two years ago.  I would have thought that with all of the subpoena and investigative powers that the RMBS Working Group purportedly had at its fingertips, it would have had something to add to the evidence that private plaintiffs had already obtained through ordinary discovery.

If they weren’t going to add anything of their own, then why did it take the Working Group two years to file its first complaint?  Waiting until a month before the election likely had political benefits, but the running of the statute of limitations has cost the AG the ability to go after conduct occurring prior to 2006.

Moreover, I’m disappointed that these are entirely civil complaints, meaning that more than four years after the onset of this crisis, we still have seen no criminal charges brought against players who contributed to the mortgage meltdown.  As I have said repeatedly, only criminal charges against firms or individuals would truly deter this sort of complex financial fraud and prevent firms from simply “pricing in” civil penalties into the cost of doing business.  The complaint does not even bring any civil claims against individuals, even further guaranteeing that no decisionmakers will feel any real pain from this suit.

Finally, the suits appear to have been brought entirely under the auspices of the NYAG’s office, featuring only claims under New York law and taking advantage of none of the federal powers to which Schneiderman was reported to have access.  If Schneiderman really wanted to demonstrate the power and support that his Working Group carried, he likely would have preferred to list the DOJ as a co-plaintiff.

All complaining aside, however, I have to say that I was gratified to see that these complaints were filed at all.  After months of seeing little activity from the RMBS Working Group, we finally have something to point to as a sign that regulators really do give a hoot about the massive fraud that was and continues to be perpetrated against institutional investors, insurance funds and taxpayers in connection with mortgage bonds.  Rather than focusing on a symptom of the bigger problem, such as the both-sides-of-the-deal type allegations that the SEC brought against JP Morgan, Goldman, Citigroup and others for selling their clients collateralized debt obligations (securitizations of other securitized assets) as they became aware of the collapsing house of cards, this lawsuit focuses on the heart of the problem – the sale and securitization of knowingly defective loans on which the subprime securities were built.

This is an important development because it gives credence to all the private lawsuits surrounding this conduct, showing that third party regulators consider the banks’ conduct to have been illegal and worthy of their attention.  This provides private litigants with the political cover to continue their existing legal battles and bring new actions, while also promising to uncover additional evidence to aid in those pursuits.

Finally, this action encourages other regulators to jump on the RMBS litigation bandwagon or risk looking like wallflowers while more active agencies gain positive publicity and potential returns for their constituents.  We’ve already seen some evidence of that last point.  On October 9, the Manhattan U.S. Attorney, in conjunction with HUD, sued Wells Fargo Corp. over allegations of falsely certifying mortgages that were federally insured.  This comes on the heels of similar suits against CitiMortgage, Flagstar, Deutsche Bank, and Allied Home Mortgage.

While not an entirely novel type of suit, the tone of the fraud allegations against Wells Fargo and the fact that they extend to Wells’ alleged fraudulent cover-up when faced with subpoena, suggest an increasingly aggressive campaign by the DOJ.  This was later confirmed when U.S. Attorney Preet Bharaha, on behalf of the DOJ, filed a civil fraud complaint against Countrywide and BofA on October 24, seeking over $1 billion in damages for systematically deceiving the GSEs about the loans it was selling to them, and then refusing to honor contractual obligations to repurchase defective loans.  This is by far the most aggressive legal action taken by the DOJ to date with respect to improper origination practices.

In addition, regulators responsible for conserving the assets of failed institutions have become more active in recent months.  On August 10, the FDIC sued a dozen banks over misrepresentations in the offerings of $388 million in securities sold to the failed Colonial Bank.  Apart from attorney’s fees and court expenses, this lawsuit seeks $189 million in damages.  On August 21, the FDIC sued Goldman Sachs, JP Morgan, BofA, Deutsche Bank and Ally Financial’s Residential Funding Securities LLC in three separate lawsuits in Texas over misrepresentations in the offerings of $5.4 billion of securities sold to the failed Guaranty Bank.  These three suits seek over $2 billion in damages.

The National Credit Union Administration (“NCUA”), a federal regulator that supervises and insures the nation’s credit unions, was forced to step in as conservator for five credit unions that failed in 2009-10 due in large part to their massive RMBS holdings.  Having been saddled with approximately $50 billion in battered RMBS from these institutions, the NCUA proceeded to take aggressive legal action with respect to certain issuers of private label RMBS, beginning with lawsuits against Royal Bank of Scotland, Goldman Sachs, and J.P. Morgan in June, July and August 2011, respectively.  Several more suits followed over the next year.

The NCUA later became the first regulator to recover losses on behalf of failed banking institutions when it settled three such suits – against Citigroup, Deutsche Bank and HSBC – to the tune of $170 million.  Since September 2012, the agency has now filed three additional lawsuits on behalf of now-defunct credit unions, including a suit against Credit Suisse surrounding alleged misrepresentations in the sale of $715 million worth of RMBS, a suit against Barclays over the sale of $555 million in RMBS, and a suit against UBS over the sale of $1.1 billion in RMBS.  At last count, the NCUA had nine lawsuits pending against various issuers of RMBS securities on behalf of failed federal credit that collectively paid $8.45 billion for the bonds.

If regulators acting on behalf of failed institutions feel compelled to bring actions to recover losses associated with MBS, you would think we’d see more such lawsuits from private institutions.  But, alas, agent-principal conflicts and political considerations prevent more investors from becoming active litigants.  Still, the recent actions by regulators show that the private investors who have sued are making headway, and they’re now gaining political cover and additional ammunition that can only help their efforts.

Sign No. 3 – Smoke Meet Gun

Establishing a claim of civil fraud requires knowing misrepresentation, made with the intent to mislead, on which the intended target reasonably relies to its detriment.  As I have been quick to point out, without smoking gun evidence that shows knowledge of falsity and intent to mislead, it is incredibly hard to prove civil fraud in a court of law.  Though the double dipping charges discussed above certainly suggest bad faith on the part of the banks, they don’t necessarily fall squarely into this tight definition of fraud.  With the latest lawsuit by MBIA, however, I think plaintiffs have found the smoke for their guns.

On September 14, MBIA sued JP Morgan (as successor to Bear Stearns) over conduct that, if proven, can only be described as blatant fraud.  MBIA accuses Bear of duping the bond insurer to provide financial guaranty insurance for a GMAC securitization by showing it a doctored due diligence report that concealed the true rate of defects in the deal’s loans.

I have heard whispers about this type of conduct for years, but no evidence had ever emerged publically to back it up.  It was common industry practice for issuers to provide potential insurers with a supposedly independent due diligence report provided by a third party, like Clayton or Bohan.  This report, evaluating the conformance of a sample of loans to the governing laws, contracts and underwriting guidelines, was supposed to provide the insurer with an accurate picture of the risk of the underlying loan pool, allowing it to gain comfort with accepting and pricing the risk.

However, as MBIA now alleges, it ultimately learned that the report it was shown by the issuer had been “scrubbed” or doctored, and the adverse findings had been deleted from the report before it was turned over to the insurer.  How did MBIA find this out?  It got the original due diligence report from Mortgage Data Management Corporation.  By comparing the findings in both, MBIA was able to discover that 50 columns of adverse findings in the spreadsheet had simply been removed by Bear Stearns to make the loans appear far rosier.  If this isn’t evidence of blatant civil (and criminal) fraud, I don’t know what is.  Prosecutors looking to make a name for themselves, take notice (and if you’re looking for individuals to prosecute, how about the person who went into the document to delete the adverse findings, as well as the manager that instructed this person to do so?).

The important takeaway from this case is that it further erodes the “global catastrophe” defense that banks have been hiding behind for years – that they had no knowledge of how the market would turn, and that it was this unforeseen catastrophe of housing price collapse, unemployment and credit crunches that caused these deals to fail, not anything they could have controlled.  This evidence of scrubbing shows that banks were well aware of how poor these loans were underwritten (and thus how likely they were to fail), and shouldn’t be able to have that conduct whitewashed by the crisis that followed.  Though the mantra of Wall St. may have been to make sure some other patsy was holding the bag when the music stopped, the law allows these transactions to be reversed in certain situations.  And when that unsuspecting third party can show that someone went into a spreadsheet, erased problematic findings of an independent due diligence provider, and then passed the report of as authentic, that third party has as good a chance as any of winning in court.

Sign No. 2 – We Finally Have a Trial

As I mentioned above, the mainstream press seemed to grow tired of RMBS litigation news of the last year due to the slow pace of these lawsuits.  More than four years after their filing, many were still winding their way through discovery and motions for summary judgment, and no trials or dramatic resolutions were available to report.  That all changed this fall, when bond insurer Assured Guaranty went to trial against Flagstar seeking $116 million in a case over soured RMBS in the Southern District of New York.

Presiding over the trial was Judge Jed Rakoff, who should be familiar to readers of the Subprime Shakeout for his outspoken opinions and willingness to challenge both regulators and the big banks over their handling of the mortgage backed securities problem.  And if Rakoff’s reputation didn’t make Flagstar nervous heading into a bench trial, the opinion Hizzoner issued just before trial certainly should have.  Though he had denied Flagstar’s motion for summary judgment back in February, he issued his explanation for this ruling in September, and it was a godsend for RMBS plaintiffs.

I’ve written extensively about the banks’ most important and oft-repeated defense — that there were intervening causes that were responsible for the damages investors and insurers suffered, and those plaintiffs must prove that their losses were directly caused by poor underwriting.  Every judge to have reviewed this issue has ruled that this was not the case — plaintiffs must only show that poor underwriting increased their risk, not that it led directly to default.

However, these opinions had been limited to the bond insurance context.  Though Rakoff’s was similar, and he explicitly noted that he agreed with Judge Crotty’s analysis from Syncora v. EMC, the logic of Rakoff’s opinion could much more readily extend to investor putbacks. Rakoff’s primary holding, similar to prior holdings on this topic, was that Assured “must only show that the breaches materially increased its risk of loss. Put another way, the causation that must here be shown is that the alleged breaches caused plaintiff to incur an increased risk of loss.”  But in support of this holding, Rakoff noted that:

the Transaction Documents do not mention “cause,” “loss” or “default” with respect to the defendants’ repurchase obligations. If the sophisticated parties had intended that the plaintiff be required to show direct loss causation, they could have included that in the
contract, but they did not do so, and the Court will not include that language now “under the guise of interpreting the writing.” (Rakoff Summary Judgment Opinion at 11-12 (citations omitted))

By focusing on the language in the pooling and servicing agreements – the same language to which investors will look to assert their own repurchase claims – rather than solely on the “interests” of the party asserting the claim, Rakoff has given bondholders a large hook on which to hang their hats when they reach this stage of their lawsuits (which are about two years behind bond insurer suits).  More immediately, Rakoff has given Flagstar and Assured an indication that he’s not buying the bank’s defenses.

This indication was only further confirmed by the trial itself, which was simply fascinating (at least to me).  Because this was a bench trial, meaning that the case was not tried before a jury and Judge Rakoff was the sole factfinder, Rakoff had broad latitude to insert himself into the trial proceedings, and he took advantage.  Repeatedly throughout the trial, Rakoff interrupted counsel presentations or questioning of witnesses to ask his own questions and point out inconsistencies he found in the loan documents.

One example, discussed at length by commentators, including Alison Frankel here, was when Rakoff questioned Flagstar’s underwriting manager regarding a borrower who listed himself as both a Detroit police officer and the president of a mortgage broker.  Rakoff expressed extreme skepticism about whether it was plausible that this individual held both jobs, and whether he should have received a loan at all.

Though Rakoff had chosen this loan at random from a pool of 20 loans being reviewed at trial, in my experience, it was more an example that proved the rule than an anomaly.  What I found when I began coordinating reviews of subprime and Alt-A loans for clients at the outset of the Mortgage Crisis was that the overwhelming majority had no business being made, and you couldn’t throw a dart at these loan files without finding a red flag.  It was based on this experience that I concluded that investors had hundreds of billions of dollars worth of valid putback claims on their hands, if only they had the intestinal fortitude to pursue them.

I also had experience presenting these sorts of underwriting defects to mediators during attempts to settle mortgage putback cases on behalf of mortgage insurance clients.  These mediators were often retired judges with no experience evaluating mortgage backed securities or underwriting guidelines, but all had expertise in evaluating contracts.  It was thus relatively simple to educate them about the meaning of representations and warranties in the trust agreements, and all came away agreeing that, were they to have to make a ruling, they would agree that the overwhelming majority of our adverse findings constituted material rep and warranty breaches.  It does not surprise me that Rakoff, a seasoned and well-respected jurist, would have little trouble finding blatant underwriting defects in the subject loan files.

Even more striking was the straightforward manner in which Rakoff cut through the continued efforts of Flagstar to frame the claims in a backward-looking, results-oriented manner based on the borrower’s payment or employment history post-origination.   Manal Mehta of Sunesis Capital highlights the following three passages as directly debunking the banks’ logic for their minimal private label putback reserves:

THE COURT:  I don’t understand the relevance of what the witness just said at all.  At the time the borrower applies to the bank for the loan, there is no way of knowing whether he’s going to be paying for the next three years or not, so you have to assess the risk as it stands at the moment of application, true?

***

THE COURT:  The information that was available at the time was that, in fact, it appeared that he had substantially misrepresented his income, and his income was less, considerably less than he had represented, yes?

***

THE COURT:  But I am still missing the point.  It is true, of course, that someone who may have made all sorts of misrepresentations on their loan application may still wind up paying the mortgage for a while.  They may have hit the lottery or they may have a relative who helped them out or a hundred other possibilities.  But the relevant thing is, in assessing risk, is the risk at the time the loan was approved, yes?

From my perspective, Rakoff has nailed it.  The reps and warranties made by originators and issuers were made as of the date the securitization trust closed and the securities were sold to investors.  The question is whether a reasonable underwriter using an objective methodology should have found that the borrower was likely to repay the mortgage.  Whether the borrower ultimately paid is immaterial – underwriting is all about trying to control the risk at the outset.  In other words, even a blind underwriter can sometimes find a bone (a risky borrower who actually does repay the mortgage), but that doesn’t mean it was acceptable for him or her to ignore underwriting guidelines just to push more loans through to closing.

Insurance companies, like investors, had a right to rely on the loan origination process that was represented in the contracts and offering documents.  The abandonment of that process, in and of itself, entitles these aggrieved parties to recover, regardless of whether borrowers made one payment or 60.

Thus, it seems likely that Rakoff is going to come back with a sledge hammer of a ruling against Flagstar on the merits of Assured’s putback claims.  And though he did not rule directly on this issue, based on the way the trial proceeded with a focus on a small pool of 20 loans, it appears that Rakoff will allow summary evidence to be presented as a proxy for the remaining 15,000 loans in the pool (a.k.a. sampling).  If he does, this will  be the biggest nail yet in the coffin of the banks’ loan-by-loan defense.

Sign No. 1 – BofA Resorts to Flank Attacks

Readers of this blog know that one of the cases I’ve been covering in the most depth, and the one that will likely have the biggest impact on handicapping legacy RMBS exposure, is MBIA v. Countrywide, BofA.  As one of the earliest-filed RMBS cases, and featuring two of the strongest legal teams on either side in an all-out bet-the-company litigation, this case has generated important rulings in every major facet of securitization case law.

Now in its fourth year of litigation, the case has finally reached the last pleading hurdle before trial, and each side has presented two motions for summary judgment – one on Countrywide’s liability for fraud and breach of contract, and one on Bank of America’s liability as a successor-in-interest to Countrywide.  Hearings on these motions began last week, with MBIA’s attorney, Philippe Selendy, from the New York office of Quinn Emanuel Urquhart & Sullivan, raising eyebrows by announcing in court that at least $12.7 billion in Countrywide loans were materially defective.

I could write an entire article about the arguments raised in these motions, and how they’re likely to play out, but I will leave that for another day.  The long and short of it is that neither side is likely to knock out the other side’s case in summary judgment, and while the issues may be narrowed significantly by Judge Bransten, we are going to see a trial in this case if it doesn’t settle first.

Apparently sensing this, BofA has begun leaning even more heavily on a strategy of flank attacks against MBIA, turning the dispute between the parties into a conflagration of all-out corporate warfare.  This, to me, is the most important takeaway from the latest developments in this case – the indication from BofA that it doesn’t believe it can win on the papers or knock out MBIA’s legal claims head on.

We’ve already seen some of this in the battle between the parties.  BofA has emerged as the leader in a consortium of banks that sued MBIA and the New York Insurance Department in separate cases over MBIA’s transformation, hoping to unwind that transaction and push the parent to the brink of insolvency.  Though we’re approaching six months and counting since the conclusion of the merits hearing in the first transformation case (the Article 78 proceeding before Judge Kapnick), my initial assessment still holds: that BofA is unlikely to obtain a victory at this stage, as the judge is obligated to give broad deference to the Insurance Commissioner’s decision to approve MBIA’s transformation.

But this has not stopped the nation’s former number one bank from trying to squeeze the monoline six ways from Sunday.  The latest skirmish began when MBIA announced that it was seeking to change the terms governing almost $900 million of bonds, to eliminate cross-default provisions that would allow bondholders to immediately demand payment from the parent company if MBIA Insurance was seized by regulators.  In layman’s terms, MBIA was seeking to shore up the parent by isolating the insurance company and preventing the troubled subsidiary from dragging the parent down with it.  Of course, if you believe MBIA, the insurance company is only in trouble because BofA refuses to buy back the defective loans that it duped MBIA into insuring.

Of course, BofA wasn’t about to let MBIA get away with this.  So, BofA came back with a tender off of its own – seeking to buy $329 million worth of MBIA bonds to block the insurer’s efforts.  BofA justified the move by saying that if the insurer succeeded with its consent solicitation, “the risk of MBIA Insurance Corporation being placed in rehabilitation or liquidation will increase, which would jeopardize all policyholder claims, including Bank of America’s.”

MBIA’s request to bondholders was accompanied by an offer to pay $10 per $1,000 of notes to those who consented.  Meanwhile, in its counter offer, BofA offered to pay bondholders as much as a 22 percentage point premium on bonds governed by one of two indentures MBIA was trying to amend.  MBIA’s stock went on a roller coaster that week, as theses various developments played out.

Ultimately, MBIA announced that it was successful in its consent solicitation but that didn’t stop BofA from purchasing $136 million worth of MBIA bonds, anyway.  Christian Herzeca posted a couple of great articles on his blog (available here and here) regarding the strategy (or lack thereof) behind this move by the banking giant.

Herzeca’s takeaway was that BofA was gearing up to settle with MBIA, and was gathering assets that they could wrap up into an eventual settlement to cloud the bottom line dollar amount (a la the Syncora Settlement).  I tended to think that BofA was gearing up for the opposite – a long, drawn out battle to the death, in which they were gathering any tools they could use to put pressure on MBIA to cave cheaply.

Well, we didn’t need to linger in suspense for long.  This past Friday, BofA sued MBIA yet again, claiming that the insurer had tortiously interfered with BofA’s tender offer to buy MBIA bonds.  Yes, that’s right – BofA tried to block MBIA’s consent solicitation, and when that failed, it sued MBIA for tortiously interfering with BofA’s attempted tender offer.  It goes without saying that there is no love lost between these companies, but their escalating battle is starting to take on a certain Through the Looking Glass kind of flavor.

What I read from these shenanigans is that MBIA is trying to buy some time to see its putback litigation against BofA through to completion.  It realizes that every day that goes by without obtaining any of the recoveries it booked from this litigation makes the insurance subsidiary’s balance sheet look that much weaker, and thus at greater risk of intervention from regulators.  BofA also knows this, which is why the bank’s primary strategy is to drag out these recoveries as long as possible, hoping that liquidity pressure and/or pressure from regulators will force MBIA to settle otherwise ironclad claims at pennies on the dollar. And since this case is such a widely-watched bellwether, a cheap settlement here sets the ceiling for the torrent of other putback litigation BofA is beating back.

By amending the cross-default provisions in its bonds, MBIA is basically saying, we’re not afraid to go down with this ship.  We are betting the company (at least the insurance subsidiary) on this putback litigation, and we will litigate as long as we have to in order to get the recoveries we deserve.  BofA apparently felt this move was dangerous enough that it was willing to launch it’s own tender offer, and then file a lawsuit when they lost, in an attempt to undo the amendment MBIA achieved. This, in turn, means that MBIA has exposed BofA’s litigation strategy for what it is, and has come up with an effective plan of attack.

When all is said and done, watching these elaborate corporate machinations play out is somewhat gratifying, because it confirms a hypothesis I formed over four years ago when I first began covering this litigation: that these insurer and investor putback claims were so strong, and based on such powerful and extensive evidence of irresponsible lending in the pre-crisis loan files, that the banks had no viable defense.  Nor could the banks acknowledge the liability because the magnitude of the potential payouts could reveal the banks to be insolvent.  Therefore, the only logical response was for the banks to try to drag out the recoveries as long as they could (the “loan-by-loan” strategy), and to try to earn their way out of this problem.  Nothing I have seen in four years since has persuaded me otherwise; instead, this flurry of collateral attacks by Bank of America has only convinced me that my assessment was spot on.

One of the main purposes of the rule of law and the civil justice system is to redistribute losses in a socially expedient manner.  It’s just too bad that the wheels of justice grind so slowly that aggrieved parties can run the risk of going bankrupt before they can recover what they’re owed.

Epilogue

I don’t mean to paint an overly rosy picture of RMBS litigation and imply that there have been no adverse decisions for RMBS plaintiffs.  Certainly, we’ve seen a few oddball decisions that have limited recoveries where financial guaranty insurers continued to accept premiums after realizing there were breaches in the pools, or limiting putback recoveries to loans that had not yet been charged off, but as I will explain in future posts, these non-binding decisions are largely idiosyncratic and difficult to justify in any logical manner.  For that reason, they are unlikely to be seen as persuasive by the other judges who are wrestling with these cases.  Instead, the overwhelming majority will go the way that Bransten, Pauley, Crotty, and Rakoff have gone thus far, and conclude that even in Wonderland, the banks can’t escape the inevitable conclusion that they’re on the hook for the shoddy mortgages they sold.

Hat tips to Manal Mehta, Deontos, Alison Frankel and Sari Krieger for keeping me up-to-date on many of these developments.

Posted in Alison Frankel, allocation of loss, Ally Bank, Alt-A, Attorneys General, Bank of New York, bankruptcy, banks, Bear Stearns, bench trials, BofA, bondholder actions, borrower fraud, Citigroup, Clayton Holdings, conflicts of interest, contract rights, counterparty risk, Countrywide, damages, Deutsche Bank, due diligence firms, emc, FDIC, Flagstar, fraud, global catastrophe defense, Goldman Sachs, improper documentation, Insurance Department, investigations, investors, irresponsible lending, JPMorgan, Judge Barbara Kapnick, Judge Eileen Bransten, Judge Jed Rakoff, Judge Paul Crotty, Judge William Pauley, judicial momentum, Judicial Opinions, lawsuits, lenders, lending guidelines, liabilities, LIBOR manipulation, liquidity, litigation, loan files, loss causation, MBIA, MBS, media coverage, misrespresentation, monoline actions, monolines, mortgage fraud, mortgage insurers, NCUA, pooling agreements, private label MBS, probes, public perceptions, putbacks, quinn emanuel, re-underwriting, Regulators, rep and warranty, repurchase, reserve reporting, RMBS, SEC, securities, securities fraud, securities laws, securitization, sellers and sponsors, sole remedy, standing, stated income, statistical sampling, subpoenas, subprime, successor liability, summary judgment, Trustees, underwriting guidelines, underwriting practices, vicarious liability, Walnut Place, Wells Fargo | 2 Comments

Upcoming Presentation: Trends in MBS Litigation

Posted on November 14, 2012 by igradman

I am pleased to announce that I will be speaking in and presenting at an upcoming Strafford live phone/web seminar, “Mortgage-Backed Securities Litigation: Latest Developments” scheduled for tomorrow, Thursday, November 15, 1:00pm-2:30pm EST. This will be largely geared towards attorneys (CLE credit available), but should have relevance for anyone participating in or following MBS litigation, so I thought this might be of particular interest to the readers of this blog.  Plus, as a reader of The Subprime Shakeout, you are eligible to attend this seminar at 50% off (note: the author derives no compensation for participating in or promoting this seminar). There is a link at the bottom of this post that will automatically give the discount to anyone interested in participating.

The following is a description of the subject matter to be covered:

The credit crisis and multi-billion dollar write-down of mortgage-backed securities (MBS) have spawned suits by investors against issuers and underwriters alleging securities fraud, contractual claims and claims of misrepresentation.  In addition to individual suits, investors have initiated class actions.

Recent federal and state court rulings have sharpened substantive and procedural issues, although many issues remain to be addressed. Settlement announcements have accelerated and may shape the course of ongoing cases.  My fellow panelist, James Goldfarb, and I will update counsel on recent trends involving residential and commercial MBS suits and outline approaches to prepare for the complexities involved in representing the various stakeholders.

We will offer our perspectives and guidance on these and other critical questions:

  • What are the bases for suits regarding MBS?
  • What challenges do plaintiffs’ counsel face in pursuing MBS claims?
  • What challenges do defendants’ counsel face in defending MBS claims?
  • How will recent and pending rulings in individual and class actions impact MBS litigation?
  • What are the most recent developments in settlement of MBS suits?

After our presentations, James and I will engage in a live question and answer session with participants — so we can answer your questions about these important issues directly.

I hope to hear from some of you tomorrow.

Follow this link or more information or to register at half price, call 1-800-926-7926 ext. 10 (ask for Mortgage-Backed Security Litigation on 11/15/12 and mention code: ZDFCT)

 

Posted in bondholder actions, broader credit crisis, class actions, Complaints, conflicts of interest, contract rights, costs of the crisis, counterparty risk, damages, derivative lawsuits, discovery, education, fraud, gatekeeper litigation, global catastrophe defense, global settlement, impact of the crisis, investors, irresponsible lending, Judicial Opinions, jury trials, lawsuits, liabilities, litigation, loss causation, MBS, misrespresentation, monoline actions, pooling agreements, Presentations, private label MBS, putbacks, rep and warranty, repurchase, research, responsibility, RMBS, securities, securities laws, securitization, sellers and sponsors, settlements, standing, statistical sampling, statutes of limitations, summary judgment, The Subprime Shakeout, Trustees, underwriting practices | 1 Comment

Investor End Games: All Is Not Well in the Garden

Posted on August 29, 2012 by igradman

“As long as the roots are not severed, all is well.  And all will be well in the garden.”

– Chance the Gardener, Being There (1979)

With Judge Barbara Kapnick announcing earlier this month that the approval hearing in Bank of New York Mellon’s (BNYM) proposed $8.5 billion Article 77 settlement over Countrywide bonds will take place in May 2013, this next year will be truly one of reckoning for mortgage investors and the U.S. mortgage market as a whole.  Though Her Honor’s proposed timetable may be a bit ambitious, what is clear is that the window of opportunity for investors be made whole for the toxic waste they were sold is finite and rapidly shrinking.

In the case of Countrywide, the end game will depend on the evidence that objecting investors can uncover prior to the approval hearing that might demonstrate that BNYM was conflicted or that its assumptions were unreasonable, both of which would suggest that the settlement number is too low.  For example, the Steering Committee of objecting investors has now sought to intervene in MBIA v. Countrywide to persuade Judge Bransten to remove Countrywide’s confidentiality designations from evidence that MBIA will be presenting to support its summary judgment motions.  Should these documents become public, they would not only encourage Bank of America to settle its 4-year battle with the bond insurer, but they would provide objecting investors in the separate Article 77 action with evidence that might undermine Bank of New York’s assumptions that BofA could ring fence Countrywide.

Meanwhile, the end game scenarios for MBS issuers other than Countrywide will depend on how well investors can get organized over the next six months to a year before the expiration of New York’s six-year statute of limitations on rep and warranty claims.

I have been covering these developments for nearly five years, and blogging about them for four, and I can say with little hesitation that this year will tell us more about the ultimate subprime shakeout than any since the onset of the Mortgage Crisis.  The outcome of BNYM and BofA’s ambitious global settlement as well as investor efforts to file claims before the statutory deadline should lead to a flurry of activity before this time next year, giving us some degree of closure regarding who will bear the losses for the irresponsible lending of 2006 and 2007.  With these developments already starting to unfold, I thought it was high time for my long-promised article on investor end game scenarios.

A Quick Look Back

I launched this blog in July 2008 (link to my first post) in part to help keep readers informed of the latest developments in a market that affects us all in one way or another, and usually in more ways than one.  If you pay taxes, own investments or pay a mortgage in the U.S., you have and continue to be impacted by the fallout from this country’s worst housing crisis since the Great Depression.

But another purpose of this blog was to try to understand what investors were doing about this mess, and if I could, to help push investors towards taking proactive steps to help get this country back on track.  With the government response sorely lacking in cohesiveness and sophistication, only concerted action by investors could restore the integrity of our mortgage market, an essential cog in the economy that was valued at $11 trillion at its peak.

I came at this issue from a background in mortgage insurance litigation, through which I was exposed to shocking truths about how the subprime and Alt-A sausage was made in the years leading up to the crash.  We had been able to obtain favorable results for mortgage insurance clients based on the strength of their contractual representation and warranty claims that held lenders and issuers to concrete underwriting standards.  But I kept asking myself, if mortgage insurers were having success suing and/or forcing settlements over loans that didn’t meet lending guidelines, why weren’t investors doing the same?

Four years later, with only a fraction of potential investor suits having been pursued, I have gained some of the answers to that question, but none are satisfactory.  Yes, investors are conservative by nature, they usually wish to avoid the spotlight, and they are (rightfully) skittish about suing the powerful banks with whom they do business on a regular basis.  The procedural hurdles in their contracts are onerous, the path of litigation is long and costly, and the prize at the end of the road is uncertain and difficult to quantify.

All these things are true, and yet the returns from this type of litigation could be enormous – far exceeding the returns investors could achieve just about anywhere else in the market.  More importantly, I would argue that this type of litigation engenders critical redistribution of wealth from banks to investors, which both deters banks from engaging in shoddy lending and securitization practices, and helps to encourage investors to return and support a private mortgage market in the future.  Still, nobody ever said that doing the right thing and unwinding one of the most complex and extensive Ponzi schemes in history would be easy.

An Unexpected Source of Inspiration

One of the great things about living in Petaluma (other than getting to watch our boys finish third in the Little League World Series this past weekend – so proud!) is that most homes have decent-sized backyards and there’s great weather for gardening.  Each year, I like to grow a few standards – tomatoes and jalapeños for homemade salsa, at a minimum – and a few novelties, just to keep things interesting.  This year, I tried my hand at Japanese eggplant, curly kale, and tomatillos.  I even grew some padron peppers, known as the Russian roulette peppers because every half dozen or so are deadly spicy, which turned out to be a hit in my family.  This year, as in years past, some plants flourished, while others never seemed to catch on.

I was working in my garden this past weekend, getting a healthy reprieve from mortgage crisis litigation, when I stopped to evaluate a couple of potted herbs that had once been strong, but that had for some time been languishing in various states of poor health.  I had tried everything on these – watering them more, watering them less, giving them more sun, giving them less sun, cutting them back, letting them grow – but nothing seemed to work.  The stalks had become ossified, the leaves rust-colored, and there was little growth or production to speak of.

I decided I might try transplanting these sickly specimens, but when I removed the pots from around the root balls, I realized that their roots had withered and died, and these plants were beyond help.

It was only then, when I finally decided to let those plant go, and went out and bought new, vibrant replacement plants, that I realized what a drag the old plants had been on my garden.  Sure, it hadn’t “cost” me anything in the monetary sense to prop these plants up, beyond perhaps the cost of the water I poured into their pots.  But in reality, there were significant non-monetary costs that had to be taken into account.

There were the favored places in the garden that got the most sunlight that the plants had been occupying, there was the time and effort that I put into keeping them alive, there was the emotional drag of seeing the plants failing to recover day after day, and there were the opportunity costs of not having fresh herbs to use because I didn’t want to go out and buy replacements when the old plants in my garden were still technically alive.  Suddenly, a light bulb went off.

My saga with my plants on life support was the perfect metaphor for the societal costs of propping up the “too big to fail” (TBTF) banks and allowing fatally wounded “zombie” banks to continue to suck scarce resources from the economy.  Just as it pained me to give up on plants that had once been productive, the politics surrounding “too big to fail” banks make regulators irrationally averse to allowing nature to run its course and take down sickly financial institutions.  The fear is that the interconnectedness of the market, just like the interconnectedness of a root system, means that allowing a major financial institution to fail will disrupt the entire market. But the alternative brings its own costs that must be taken into account, such as the creation of perverse incentives for anti-competitive and inefficient behavior.

Of course, this wasn’t the first time someone had drawn the analogy between botany and economic health.  I immediately thought of the 1979 movie Being There (based on the book by Jerzy Kosinski), featuring Peter Sellers in a unique role as the simpleton gardener who gets mistaken for a brilliant sage (watch original trailer here).

Knowing nothing about the outside world except what he had seen on TV and learned in his garden, Chance the Gardener wanders out into the world to become known as Chauncey Gardner, whose simple statements about gardening come to influence national economic policy.  I had not seen the movie in many years, so I decided to rent it, and was bowled over by its continued relevance.  Take the following exchange:

Chance the Gardener: In the garden, growth has it seasons. First comes spring and summer, but then we have fall and winter. And then we get spring and summer again.

President “Bobby”: Spring and summer.

Chance the Gardener: Yes.

President “Bobby”: Then fall and winter.

Chance the Gardener: Yes.

Benjamin Rand: I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature, but we’re upset by the seasons of our economy.

This axiom immediately called to mind my economics classes in college, in which the pejorative word “recession” was rarely used when describing down cycles in the market.  Instead, these downturns were referred to as “corrections,” a word with a much more positive connotation.

The idea was that down cycles were necessary and ultimately beneficial parts of the business cycle, as they corrected inefficiencies in the market by exposing and eliminating the weakest players.  This, in turn, cleared the way for new, more efficient players to enter, enabling greater long-term growth.  In other words, to paraphrase Jefferson, the tree of capitalism must be refreshed from time to time by the blood of insolvency.

An Economy on Life Support

Unfortunately, during this recent recession, little has actually been “corrected” in the U.S. market, and it’s a big reason we continue to languish in a tepid economy, bouncing along the bottom.  The continued lethargy in the housing market across most of the country is one of the primary culprits, and this, in turn, can be blamed on a failure to deal effectively with distressed properties and the failure to correct fundamental problems with housing finance that might pave the way for the return of the private market.

Bill Frey and I published Way Too Big to Fail precisely to address and offer solutions for these ongoing problems, but few of these suggestions have been implemented as of this writing (I would note that Redwood Trust, one of the few funds that has been issuing MBS in the last few years, has implemented several reforms in its securities that mirror those discussed in the book, and has demonstrated solid performance as a result).

The truth remains that loan aggregators and sellers have not been forced to pay for the harm they have inflicted on the economy – not in any meaningful sense.  Sure, some of them got caught holding the bag with some of these toxic assets on their own books when the music stopped, and some have settled with certain aggressive investors or insurers, but they have not been held accountable for the bulk of the toxic assets they sold during the Boom Years.

And what did these issuers do that was so wrong?  Weren’t they victimized like the rest of us when the world unexpectedly fell apart?

As I’ve gone into at great length in prior posts, at a minimum, loan aggregators and sellers (i.e. most of this country’s largest banks and investment banks) sold over a trillion dollars’ worth of securities backed by loans that were nowhere near the quality that they represented (let’s use the technical legal term “crappy loans”).  These institutions agreed to repurchase these crappy loans at par should they fail in any material respect to meet extensive warranties regarding their quality and characteristics.

In some cases, major investment banks profited multiple times off of the sale of the same crappy loans: 1) by bargaining down the price they paid for the crappy loans using the results from their own due diligence samples and then selling loans they knew were defective to investors at a profit; 2) by going back to loan sellers and shaking them down for settlements when the crappy loans went bad; and 3) by placing strategic bets against the securities themselves or the industry participants like monoline insurers who would be saddled with the losses from these crappy loans.

This and other irresponsible or outright fraudulent conduct has contributed to the complete collapse of the private mortgage market.  More than 95% of new loans today are backed by our government, and thus by you, the taxpayer.  There is no private market to speak of, save for a few jumbo deals with high-quality collateral, and there will be no serious private market for the foreseeable future.

There is a massive crisis of confidence – and deservedly so – surrounding our largest financial institutions and the rule of law.  Our pension funds, college endowments, and insurance funds have taken the bulk of the losses thus far.  And investors will not return to this market if some measure of loss sharing (I won’t go so far as to call it “justice”) is imposed on the banks that created and sold these crappy loans in the first place.

The federal government, for its part, has responded primarily by bailing out those same banks and “foaming the runway” for a soft landing.  In actuality, the Treasury and the TARP bailout gave the banks such as soft landing that they largely bounced back without experiencing the healing pain of austerity, downsizing or – gasp – failure.

As illustrated in Neil Barofsky’s eye-opening new book, Bailout, this was the result of an intentional policy decision – the decision to inject capital and confidence into the economy by propping up the largest banks.  This path has failed completely to boost the capital available for the middle class, and has succeeded only in postponing the correction and keeping bloated institutions on life support.  Meanwhile, it has created perverse incentives for banks to misrepresent their financial health by manipulating LIBOR and take risky double-or-nothing-style bets to try to earn their way out.  

Again, I am reminded of the scene in Being There where Chance is asked by the President to weigh in on economic policy:

President “Bobby”: Mr. Gardner, do you agree with Ben, or do you think that we can stimulate growth through temporary incentives?

[Long pause]

Chance the Gardener: As long as the roots are not severed, all is well. And all will be well in the garden.

The roots of our biggest financial institutions are withered and rotting, and the costs of keeping them alive are mounting.  And yet, with little appetite in Washington for another federally-funded bailout of Wall Street, and continued strains being placed on bank balance sheets, there is still hope for that much-needed correction to take place.

Tough Love

What will drive a correction in this market?  Given the aversion of government to crack down on the banks with civil or criminal sanctions or redistributive tax and spend policies, the only hope we have is that private litigants will turn to the court system.

This process comes intuitively to most of us: if someone were to steal a significant amount of your money and refuse to return it when confronted, you would probably take the thief to court.  It may take time and expense, but if you’re in the right, you should be able to recoup far more than your costs (hopefully a above-market ROI) through a judgment from the court (provided the thief is not judgment-proof).  This is how the court system and the rule of law were designed, and the act of going through the court process not only helps the victims recover what’s rightfully theirs, but it helps the entire system by deterring future theft.  The same can be said about enforcing contractual reps and warranties.

I believe our court system still largely functions as it was designed to, albeit more slowly than we might like.  This is why I have been advocating for years for investors to get organized and enforce their contractual and common law rights to recompense.

In the putback space, contractual requirements of 25-50% voting rights for investors to have standing mean that investors must band together to make any progress.  There have been several efforts to do so on behalf of investors, but most have fallen apart, save for attorney Kathy Patrick’s efforts on behalf of 22 institutional investors (more on that later).

The problem here is that there are intermediaries between those who are currently bearing the losses and those who should be bearing the losses.  There are money managers who value their relationships with liquidity providers over the dispersed individuals whose money they manage.  There are RMBS Trustees who likewise value their relationships with the banks that hire them over the Certificateholders whose interests they arguably have the obligation and sole power to protect.

This makes the process even more complex and tedious because it means that those whose money was stolen may be forced to sue the intermediaries for failing to act on their behalf in addition to, or in lieu of, suing the thieves themselves.  That is already beginning to happen, and investors have made some encouraging strides in their suits against particularly obstreperous RMBS trustees.

So what about Kathy Patrick’s efforts that resulted in a proposed $8.5 billion settlement on Countrywide bonds, a proposed $8.7 billion settlement on ResCap bonds, and potential future settlements with other large banks?  As I’ve discussed at length, this group is led by some extremely conflicted investors who are dedicated to preserving the status quo.  They would like to create the appearance that they are doing something to enforce their own investors’ rights and recover some of their money so that they can avoid being sued themselves (see above) for wasting valuable claims and failing in their fiduciary duties to their investors.

But, they don’t want to do so much as to make it too painful for BofA, JPMorgan Chase and the other banks on whom they depend for financing in a variety of other areas.  So, they put together a settlement at pennies on the dollar and hope to get the court to bless (read: rubber stamp) it.

Sure, there are investors who oppose these global settlements, but the number that is willing to speak up is small and dwindling.  Walnut Place, represented by Grais and Ellsworth, was one of the most vocal and active objectors in the $8.5 billion Countrywide settlement.  They had intervened, in part, to preserve their claims in their separate putback lawsuit against BofA.  However, when they’re separate suit got dismissed for failure to comply with procedural prerequisites, and the dismissal was upheld on appeal, Walnut Place dropped its objections to the $8.5 billion deal and eventually put its Countrywide MBS holdings up for sale.

Rest assured that the Steering Committee of intervenors in the settlement has not disbanded; however, there is now one fewer vocal investor driving the Committee’s efforts.  It appears that AIG, represented by Reilly Pozner, and the Triaxx CDOs, represented by Miller Wrubel, are stepping into Walnut’s place, and ably representing the remaining objectors.  But many investors have kept quiet as this deal has been foisted upon them, and those who are spending money to object are starting to question whether it’s worth their time and money.

In their more cynical moments, investors are starting to feel that fix is in and question whether they’re throwing good money after bad.  Plus, we have heard scant little from the New York and Delaware Attorneys General, who after fighting so hard for the right to intervene, have been little more than window dressing in the Article 77 hearings over the last few months.

It remains to be seen how difficult the Steering Committee can make things for BofA and BNYM over the next year by demanding detailed discovery.  Already, the Committee has succeeded in obtaining court approval to review 150 Countrywide loan files for breaches of reps and warranties, over the strenuous objections of BofA.  Though not a statistically significant sample size, the review could uncover indications of a significantly higher rate of breaches of reps and warranties among Countrywide trusts than was assumed by Bank of New York when reaching the settlement figure.  This, in turn, could prompt Judge Kapnick to order a more extensive sampling of loan files.

Most recently, Reilly Pozner filed a letter in MBIA v. Countrywide (h/t Manal Mehta), seeking to persuade Judge Bransten to unseal reams of potentially damaging documents regarding BofA’s purchase of Countrywide, which were unearthed by MBIA after years of hand-to-hand discovery battles in that case.  On Monday, Bloomberg LP also threw its hat into the ring, filing a motion for leave to intervene to encourage Judge Bransten to remove confidentiality restrictions on the documents (another h/t Manal Mehta).  Judge Bransten has set a hearing for today to consider this issue, which beyond having major ramifications for MBIA in this case, could provide valuable ammunition to all plaintiffs seeking to hold BofA accountable for Countrywide’s liabilities.

But as far as the Article 77 case goes, it’s hard to gauge just how much evidence Judge Kapnick would require to find that BNYM’s proposed settlement is unreasonably low.  MBIA v. Countrywide should certainly provide a fair amount, if it goes much further without settling.  While the Article 77 should continue to yield interesting developments for the next year or so (remember that Kapnick has now set an approval hearing for May 2013), it’s starting to look more and more like this deal will go through as proposed.  Barring a major collective action push by institutional investors, it’s only a matter of time before Patrick begins cutting similar deals with the other major issuers.

Don’t Put Your Trust in Trustees

What can we expect from trustees like Bank of New York Mellon, who have the strongest legal standing to enforce breaches of reps and warranties?  BNYM recently filed an action against WMC Mortgage and GE Mortgage Holding (h/t Manal Mehta), joining the ranks of trustees like Deutschebank, Wells Fargo, and U.S. Bank (going after BofA and WMC), which have filed putback lawsuits on behalf of investors.

We’ve also seen BNYM negotiate an $8.5 billion settlement with Countrywide.  Do these developments mean that trustees are finally acting in investors’ best interests?  The short answer is: not really.

BNYM is essentially motivated by the same fears as the major institutional investors – doing nothing would expose the trustee to liability for wasting valuable claims.  To avoid that, trustees like BNYM want to take some action that makes it look like they addressed the problem.  This is especially true when motivated investors are taking aggressive action behind the scenes to review loan files, share their findings with trustees, and petition those trustees to take action.  The trustees can (and did) drag their feet for a while, but at some point they have to act or risk becoming the target of a lawsuit.  This doesn’t mean that trustees will suddenly find their moral compass and start taking action on behalf of the bulk of investors who aren’t hounding them day after day to take action.

Keep in mind that trustees are “bankers’ banks,” providing banking services for the largest banks, like BofA (which accounts for 60% of BNYM’s custodial business).  BNYM is paid relatively little to oversee a massive dollar value of custodial accounts.  BNYM simply wants to keep BofA happy and avoid incurring liabilities that would dwarf what they were paid to oversee RMBS Trusts.

Enter Kathy Patrick with a sweet deal – float our minimal settlement to the court and BofA will indemnify you for any losses.  This allows the deals to carry the imprimatur of fairness without trustees having to bite (or cripple) the hands that feed them.  Meanwhile, nobody can argue that the trustees aren’t doing anything to help investors – in fact, trustees and banks can use these types of settlements to argue that investor claims are improper or “premature” because trustees are actively enforcing putback claims.

As I’ve written before, this is the end game scenario as pictured by Kathy Patrick and her merry band of investors – enter into favorable global deals for issuers that bind all investors.  This allows investors and trustees to avoid liability for ignoring their fiduciary duties while spraying more foam on the runway for the major banks with which they do significant business.  The banks get to put their mortgage issues behind them, the investors get a small payday, Patrick gets a huge payday, and everybody wins.  Everybody, that is, except taxpayers, investors and the housing market.

A Chance for Optimism?

Chance the Gardener: Yes! There will be growth in the spring!

Benjamin Rand: Hmm!

Chance the Gardener: Hmm!

President “Bobby”: Hm. Well, Mr. Gardner, I must admit that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time.

If U.S. institutions are proving to be reluctant to pull the trigger on collective efforts, and therefore will let their claims go for little in return, what hope do we have that anyone will compel this much-needed correction to take place?  On the investor side, the lone hope appears to be the European banks.

European institutions, and in particular the large German land banks, hold hundreds of billions of dollars in U.S. private label MBS.  Many of the holders are German “bad banks” that have been split from the solvent portions of the institutions and are receiving pressure from their regulators to take action to recover their losses.  Articles have begun to appear in the German press questioning what these banks are doing to address their massive losses, such as an article that appeared last month in Handelsblatt entitled, “Deutsche Landesbanken erwägen gemeinsame Klagen gegen US-Institute.  Es geht um Milliarden, doch das Vorhaben birgt Risiken” (roughly translated as “German Landesbanks consider joint action against U.S. firms.  It’s about billions, but the project is risky”).

The European investors are not as dependent on large U.S. banks for liquidity as their U.S. brethren, and there is not nearly the same level of political aversion to taking on TBTF institutions as there is in the U.S. so there is some reason to believe that these European institutions will enter the litigation fray.  Indeed, over the last six months, we have started to see increasing legal action in the U.S. by European institutions focused on MBS losses (see suits by the German Landesbanks or Sealink Funding, for example); however, these suits have tended to be comprised of fraud claims only.

Fraud claims are generally characterized as “easy to file, hard to win” because, while they do not require that investors overcome onerous procedural hurdles, they also have heightened pleading requirements and necessitate proof of knowledge of falsity, intent to mislead, and detrimental reliance by the plaintiff.  While there is some evidence to support these findings, the suits would have a much greater chance of success if the Europeans did the leg work to organize and bring contractual-based rep and warranty claims.

While it sounds like many of these European institutions are still on the fence about bringing aggressive legal action against U.S. institutions, what’s clear is that if the collective investor movement will not come from Europe, it may not at all.  Investors must truly speak now or forever hold their peace.  The window of opportunity to object to contrived global settlements or file their own claims will slam shut within a year.

And if investors think that all they stand to lose is the right to pursue legal claims to recover existing MBS losses, think again.  To the contrary, if investors show they’re not willing to band together to enforce their rights, their assets will continue to be plundered and pillaged in increasingly creative (some would say diabolical) ways.

Take the ongoing debate surrounding eminent domain as Exhibit A.  The proposal originally floated by Mortgage Resolution Partners and gaining steam in municipalities all over the country proposes having local governments seize performing but underwater mortgages at 75-80 cents on the dollar.  These mortgages would then be restructured and sold to new investors, allowing homeowners to refinance into positive equity situations.

Bondholder and banker advocacy groups have raised hell, but that hasn’t stopped these proposals from moving forward.  Now, there is a constitutional requirement that governments pay just compensation if they seize property, but who will stand up and challenge these takings?  Trustees certainly don’t have the incentive to do so, and have all but proven as much.  And investors may not even have standing to do so in many states if they don’t unite and form coalitions of 25-50% (some states provide only trustees with standing to participate in condemnation proceedings).

Banks, backed by lobbying groups like SIFMA and ASF, could still challenge, as they are concerned that their second lien holdings could be seized along with underwater firsts.  But should plan proponents agree to resubordinate these second lien holdings to the new, restructured senior liens, bank resistance would probably evaporate.  This, according to many with knowledge of these plans, is the most likely direction of these eminent domain proposals.  This would mean distressed second liens held by banks would be recapitalized at investor expense, in yet another closet bailout of our struggling financial institutions.

So, as bad as things might look in the garden for investors, they must recognize that things could still get worse.  Now is the time to take stock of the root system in the financial markets and take proactive steps to clear out the detritus of failed business models if we ever want to see a new spring of growth in U.S. housing.

Posted in AIG, allocation of loss, ASF, Attorneys General, Bank of New York, banks, BlackRock, Bloomberg, BofA, bondholder actions, causes of the crisis, conflicts of interest, consitutionality, contract rights, costs of the crisis, Countrywide, damages, Deutsche Bank, discovery, eminent domain, fiduciary duties, foreclosure crisis, fraud, global settlement, Grais and Ellsworth, impact of the crisis, incentives, investors, irresponsible lending, Judge Barbara Kapnick, Judge Eileen Bransten, junior liens, Kathy Patrick, lawsuits, lenders, lending guidelines, liabilities, LIBOR manipulation, liquidity, litigation, litigation costs, lobbying, MBIA, MBS, misrespresentation, monoline actions, monolines, mortgage fraud, mortgage insurers, mortgage market, negative equity, Neil Barofsky, private label MBS, procedural hurdles, putbacks, recession, rep and warranty, repurchase, Residential Capital, responsibility, restructuring, RMBS, securities, securitization, sellers and sponsors, settlements, standing, statistical sampling, statutes of limitations, successor liability, summary judgment, The Subprime Shakeout, too big to fail, toxic assets, Treasury, Trustees, underwriting guidelines, underwriting practices, US Bank, vicarious liability, waiver of rights to sue, Wall St., Walnut Place, Way Too Big to Fail, Wells Fargo, William Frey | 2 Comments

Monoline End Games: String of Legal Wins Will Snowball Until Settlement

Posted on July 31, 2012 by igradman

Last week, I wrote about a few developments that should boost RMBS litigation recoveries, especially for bond insurers – Judge Crotty’s summary judgment decision in Syncora v. EMC (JPMorgan) and Syncora’s subsequent settlement with BofA, resolving all of the parties’ ongoing relationships.  It appears I’m not the only one who has concluded that banks may need to reassess their potential payouts as a result of recent legal setbacks.

In this July 27 client alert, major financial services firm O’Melveny & Myers, which represents BofA in MBIA’s putback suit in New York, addressed the impact of Crotty’s Opinion [hat tip Manal Mehta from Sunesis Capital for passing this along].  While the alert is short and worth reading in its entirety, the gist of O’Melveny’s conclusion is as follows:

In light of a recent federal court ruling, banks may wish to reevaluate litigation risk from plaintiff insurers claiming injury from alleged breaches of representations and warranties regarding mortgage securitization notes that they insured…

Institutions facing such lawsuits may wish to re-evaluate their exposure, and possibly adjust reserves set aside to cover such risks, based on the type of plaintiff and the specific language of the securitization agreements at issue.

Hold the phone – so BofA’s own law firm in its putback litigation with MBIA is publishing an alert saying that banks may need to adjust their loss reserves associated with monoline putback litigation?  This is essentially an admission that the firm sees the tide turning against the banks in these suits.  Shouldn’t this have generated some serious pushback from O’Melveny’s powerful client?

Short answer: yes.  According to Mehta, this alert was pulled from O’Melveny’s website shortly after publication, only to be re-posted today.  We can only speculate as to why the alert was pulled and then re-published (without significant revision), but I can imagine that there were a few heated phone calls in between.

Regardless, now that we finally have a definitive decision from a respected court on the proper standard for mortgage putbacks, we have enough guidance to begin discussing RMBS litigation end games in earnest.  Today, we’ll begin by looking at the bond insurer suits.

These, along with mortgage insurer suits, were some of the earliest filed pieces of RMBS litigation and have been prosecuted aggressively since the onset of the mortgage crisis by some of the most skilled and aggressive private legal teams in the business. And for good reason: the monolines issued what are known as “financial guaranty” policies, which included a guarantee that insurers would make policy payments if losses mounted; they could not deny claims or rescind coverage.

This means that bond insurers have already suffered massive, company-crippling losses as a result of insuring pools of misrepresented loans, and have been forced to pursue years of contentious litigation just to try to recover the funds they paid out.  The good news for them, is that after 4+ years of litigation, they’re finally beginning to see the light at the end of the tunnel.

Monoline End Game Scenarios

As I mentioned at the top of this article, Syncora and Countrywide just reached a settlement of all their outstanding RMBS litigation and other issues, in which Syncora will receive a cash payment of $375 million and a return of certain of its preferred shares, surplus notes and other securities.  It’s no coincidence that this settlement comes on the heels of several wins for the monolines in their suits against the major Wall St. banks.  It demonstrates that the banks (or at least Bank of America), are beginning to realize that the bond insurers’ claims in these suits are potentially expensive and difficult to defeat.  This settlement, in conjunction with BofA’s settlement with Assured Guaranty (AGO) back in April of 2011 and its proposed settlement of investor putback claims initiated in June 2011, show that BofA is making a concerted effort to put legacy Countrywide liabilities behind it.

This bolsters my long-held view that the most likely end game scenario for the monolines consists of party-by-party settlements with their various bank counterparties that address all of the outstanding legal issues between the parties.  As I’ve discussed in the past, the last thing that an issuing bank wants is for one of these cases to go to trial and to see the parade of horribles that the monoline will trot out before the factfinder, showing clear breaches of underwriting guidelines time and time again.  Not only would such a trial be long and embarrassing, but it would open up the banks to paying upwards of 75-80 cents on the dollar of losses to the insurers, rather than the 25-30 cents they might be able to pay in settlement.

Of course, the tougher questions surround the timing and the ultimate size of these potential settlements.  If we could get our arms around the size of prior settlements, this might help give us a ballpark of the size of the settlements to come.  In my prior article on the Assured Guaranty settlement (at item No. 4),  I noted that based on BofA’s estimates, they were covering about 55% of AGO’s losses.  The Syncora-Countrywide settlement is much more difficult to parse as the deal, according to Syncora’s press release was part of “an effort to terminate other relationships between the parties,” aside from simply the putback disputes.  My guess is that the putback disputes constituted the bulk of the outstanding liabilities, but it’s difficult to assess the exact proportion, as well as the value of the other consideration received by Syncora.

What we do know is that in the five deals that were the subject of Syncora’s lawsuit against Countrywide, Syncora had already paid out $145 million in claims to policyholders and had received another $257 million in claims as of the filing of the Amended Complaint.  That’s $402 million in existing claims, and future losses and claims in those deals could drive that number even higher.  Plus, the settlement covered nine other MBS Trusts not at issue in the lawsuit.  Barclays projected out the lifetime losses for Syncora in those trusts and reached a figure of up to $1.4 billion (though I know it’s hard to trust anything Barclays says since the emergence of the LIBOR scandal, other commentators have checked Barclay’s work, and it appears to hold up).  Assuming this is a reasonable estimate, and putting aside the value of the other consideration given to Syncora and the value of the non-RMBS liabilities it released, the $375 million cash payment works out to about 27 cents on the dollar of claims.

So what does this mean other monolines, such as MBIA, might receive in settlement?  In my opinion, Syncora’s settlement with Countrywide merely sets a floor for MBIA’s case against Countrywide – that is, it is the minimum amount per dollar of claims that MBIA can expect to receive from settling that case.  This is because MBIA is in a better position in many respects than Syncora.

For one, while Syncora claimed to have found approximately 75% of the loans it had reviewed to be in material breach of Countrywide’s reps and warranties, MBIA has alleged that over 90% of the loans in the deals it insured were materially defective.  A higher breach rate means a potentially higher judgment per dollar of claims should the putback claims go to trial, driving settlement values higher.  The fact that MBIA has actually sued on all of its Countrywide transactions, whereas Syncora only sued on 5 of 14, implies that MBIA’s deals may have been worse across the board, further elevating settlement projections.

MBIA is also further along in its case against Countrywide/BofA than Syncora was, having conducted significant potentially damaging discovery on issues such as Countrywide’s internal fraud reporting and successor liability.  MBIA is on track to present its summary judgment motion on Countrywide’s liability (referred to as “primary” liability) on August 31, and its summary judgment motion on BofA’s liability (referred to as “successor” liability) on September 21.  BofA is keen to avoid even the presentation of such motions by MBIA because they will publicly disclose (to the extent the information is not treated as “confidential” and sealed) all facts that MBIA has uncovered in support of its positions.

This is especially true with respect to MBIA’s motion on successor liability, as the facts MBIA will use to establish that BofA should be on the hook for Countrywide’s liabilities could be used by any plaintiff suing Countrywide and wishing to bring BofA into the case as a guarantor.  That is, the facts supporting successor liability in MBIA’s case will be directly applicable to every other plaintiff’s case for successor liability against BofA.  Apparently recognizing this, just this week MBIA asked the Court for permission to file a motion lifting the confidentiality restrictions on certain documents received in discovery.  MBIA’s attorneys know that the threat of public disclosure of items like Brian Moynihan’s deposition transcript may be the best leverage they have to force BofA to the negotiating table.

Finally, MBIA has filed a fraud claim against BofA that is fairly well developed.  This claim has survived a motion to dismiss (and appeal of that decision) and a motion for partial summary judgment on loss causation.  Should that claim be successful, MBIA could receive compensatory damages for the full amount it has lost in connection with insuring the Countrywide trusts at issue (not tied to any breach rate of the underlying loans) plus punitive damages of up to several times compensatory damages.  Though punitives are rarely awarded, the treat of punitives will certainly increase MBIA’s settlement leverage (and what better case for the imposition of punitive damages if Countrywide is shown, as MBIA suggests, to have been engaged in the systematic encouragement and coverup of mortgage fraud?).

All this leads me to believe that MBIA will be able to force BofA into a much larger settlement per dollar of claims than the one Syncora received (the same goes for Ambac in its case against EMC/JPMorgan, as it has uncovered significant evidence of a fraudulent “double-dipping” scheme in that case).  Of course, MBIA also has to contend with BofA’s litigation counterweight, in the form of its Article 78 and plenary actions challenging MBIA’s Transformation.  But as the Article 78 decision seems likely to go against BofA (and will be appealed, regardless), and the plenary action is falling way behind the putback action due to inactivity during the last several months, MBIA will likely feel as though it has all the leverage when it comes time to seriously talk settlement.

According to MBIA’s first quarter 10-Q, the bond insurer has incurred $4.8 billion of losses on its portfolio of insured first- and second-lien RMBS deals.  The monoline has also booked $3.2 billion in expected recoveries from putbacks (it has booked no expected recoveries from its non-contractual claims).  That works out to a 66.7% expected recovery rate per dollar of incurred losses.  This would be higher than the global settlements Syncora and AGO struck with BofA, but given MBIA’s superior position, at least in its BofA case as discussed herein, I can’t say those estimates are unreasonable.

In fact, I think MBIA would recover a much higher percentage of its losses should it proceed to trial against counterparties like BofA.  The insurer could recover compensatory damages at 100% of losses if it wins its claims for fraud or rescissory damages, and damages in the range of 75% of losses if it’s forced to go the putback route, as my experience in these types of cases leads me to believe that at least 80% of MBIA’s alleged ineligible loans to be upheld by the factfinder.  Compared to these end game scenarios, a settlement in the 66% range may begin to look attractive as MBIA continues to pile up victories in its litigation.

This brings me to probably the tougher question on monoline end games – timing.  Settlement timing is always difficult to estimate since so many factors are at play.  But there are certain points in litigation that I term “inflection points” – junctures at which settlement becomes more likely because of the threat of adverse legal developments.  The presentation of MBIA’s summary judgment motions in its case against Countrywide/BofA (especially the one on successor liability) create just these sorts of inflection points.  The time between when the summary judgment motions are fully briefed and Judge Bransten issues her rulings also constitutes an inflection point, as BofA may feel pressure to avoid yet another scathing Bransten decision.  Based on these upcoming inflection points in the case, I will go out on a limb and say that MBIA’s litigation against BofA is likely to settle before the end of this year.

This timing will be different for each monoline action depending on the individual circumstances, but what they all have in common is that they all are very likely to settle before trial.  Given the lack of viable defenses that banks have at their disposal, and the parade of damaging evidence that will paraded before a factfinder should trial ensue, I don’t see how any financial institution can logically allow any of these cases to go to trial.  Doing so would only expose the banks to potentially devastating precedent and damage awards, which they call ill afford at this time.

There are important differences between the monoline cases and the cases of RMBS investors, the other major group of plaintiffs attempting to recover their losses from the major banks.  Stay tuned over the next week as I tackle those differences and the status of investor recovery efforts in my next installment in my series on end game scenarios.

Posted in allocation of loss, banks, BofA, contract rights, Countrywide, damages, emc, fraud, global settlement, irresponsible lending, JPMorgan, Judge Eileen Bransten, Judge Paul Crotty, Judicial Opinions, junior liens, jury trials, lawsuits, lenders, liabilities, litigation, litigation costs, loss causation, loss estimates, MBIA, MBS, misrespresentation, monoline actions, monolines, mortgage insurers, O'Melveny & Myers, private label MBS, putbacks, rep and warranty, repurchase, RMBS, securitization, settlements, successor liability, summary judgment | 6 Comments