New York Judge Strikes Blow to Investor Putback Claims

Posted on April 4, 2012 by igradman

Update: it appears that Walnut Place has already filed an appeal of the dismissal of its lawsuit against BofA and Countrywide – IMG.

Investors in Countrywide mortgage backed securities (MBS) were dealt a setback last Wednesday in their efforts to force the former subprime lender to repurchase defective mortgage loans.  Judge Barbara Kapnick’s decision, in New York Supreme Court, held that investors going under the name Walnut Place (revealed in court papers to be the hedge fund Baupost) did not have standing to pursue mortgage repurchase claims against Countrywide and Bank of America, as those claims were being pursued by the Trustee of those securitizations.  This decision sets the stage for all issues surrounding Bank of New York Mellon’s (BNYM) conduct in pursuing Countrywide mortgage putbacks to be adjudicated in a single forum, in the context of BNYM’s proposed $8.5 billion state court settlement with Countrywide and Bank of America.

While discovery battles are providing investors with potential leverage in the BNYM-BofA settlement proceedings – also in New York Supreme Court before the same Judge Kapnick and in which Walnut Place is a leading objector – the decision to dismiss the separate and earlier-filed Walnut Place lawsuit can only be viewed as a setback for investors, as it sets a significantly higher procedural bar to investor putback suits than investors had anticipated.

Though at least one commentator (hat tip reader Deontos) has suggested that the key holding in Judge Kapnick’s opinion was that “Plaintiff’s filing of this lawsuit… was premature under the circumstances,” the Judge actually makes two independent findings in favor of the defendants.  In fact, after cutting through the fog of this somewhat opaque decision, I’ve concluded that the first finding – that plaintiffs failed to establish the right to sue under the trust agreements – could actually be more favorable to the banks and damaging to MBS bondholders in the long run.

Defendants’ initial argument is that plaintiffs failed to allege an Event of Default under Section 10.08 of the Pooling and Servicing Agreements (PSAs), which is known as a “no action” or “collective action” clause and which is found in most PSAs.  Designed to eliminate “greenmail” or the hijacking of the trust by a self-interested bondholder, this clause provides that bondholders cannot sue unless a group holding no less than 25% of the voting rights in the Trust first provides the Trustee with written notice of an Event of Default, provides reasonable indemnity, and waits 60 days for the Trustee to take action before filing an action on their own.

The problem is that “Event of Default” is defined in the PSA as a narrow category of servicing breaches, which have nothing to do with the breaches of reps and warranties (primarily breaches of underwriting guidelines and standards at the time of origination) of which Walnut Place is complaining.  While the PSA provides a procedure for the Trustee to request that the originator or depositor repurchase loans that materially breach reps and warranties, there’s no clear procedure for how bondholders would enforce that right as third party beneficiaries.

Faced with this unfavorable contractual language, Walnut Place is left to argue that the Event of Default requirement should be read out of Section 10.08 completely, or at least when underwriting breaches are being alleged, and that they should be allowed to sue because they’ve complied with the other requirements of the no action clause.  These procedural requirements were first established in one of the only other cases to evaluate MBS bondholder standing to sue, Greenwich Financial v. Countrywide, in which the New York State Supreme Court tossed a proposed bondholder class action for failing to show 25% voting rights, make a demand on the Trustee and wait 60 days for action.  The irony is that this decision was also issued by – you guessed it – Judge Kapnick.

Yet, Judge Kapnick doesn’t buy the argument that the Event of Default requirement should be read out of the no action clause in this instance.  In fact, she says categorically that “plaintiffs’ reliance on Greenwich is misplaced.” (Opinion at 11)  Her explanation in this regard is not a model of judicial clarity, but it seems that Her Honor is saying that an Event of Default must be established even before the Court reaches the question of whether the other procedural hurdles have been met.  Here’s the full excerpt from the Opinion on that topic, in case you’d like to try to sort it out yourself:

In [Greenwich], this Court considered defendants’ contention that the plaintiffs had failed to allege an Event of Default, as required by the no-action clause.  Then, in rejecting plaintiffs’ argument that they were not subject to the no-action clause because they were suing for the benefit of all certificateholders, this Court emphasized that plaintiffs had also failed to comply with the other procedural requirements of Section 10.08. (Opinion at 11)

The Court ultimately holds that, unless there is an allegation that the Trustee is incapable of satisfying its obligations, then any claim that can be enforced by the Trustee on behalf of all bonds is subject to the no action clause, and thus the requirement of alleging an Event of Default.  Finding that “there is no allegation of misconduct or breach by the Trustee in the administration of the trusts” (Opinion at 14), Judge Kapnick concludes that plaintiffs must satisfy all requirements of the no action clause.

Since plaintiffs already conceded that they had not alleged an Event of Default in this case, this finding meant that plaintiffs had not satisfied the requirements of the no action clause, and thus could not pursue contractual claims for relief as third party beneficiaries.  This holding does not rest on the later finding that Walnut Place’s lawsuit was “premature,” as we will see.  Instead, the holding rests entirely on the notion that bondholders must allege a servicing violation to even get a foot in the courthouse door.  And while creative arguments could be fashioned that bondholders should be allowed to sue for origination breaches after first notifying the Trustee of a servicing breach, this holding could also be read to suggest that bondholders simply have no right under the contract to enforce mortgage loan repurchases.  That is by far the more damaging takeaway from this case for bondholders, and will likely result in a decision to appeal by Walnut Place.

Let’s now take a look at the second piece of this opinion.  Having already found that plaintiffs had not satisfied their procedural requirement to obtain standing to sue under the contract, Judge Kapnick next considers whether plaintiffs can sue derivatively.  Generally, in order for party to sue derivatively, it must show either 1) that made a demand on the party with the express right to sue, and that party unreasonably failed to do so; or 2) that the party with the right to sue was so conflicted or otherwise incapable of doing so that a demand would have been futile.

It is only with respect to plaintiffs’ right to sue derivatively – requiring a determination of whether the Trustee unreasonably failed to take action or was incapable of doing so – that Judge Kapnick reaches the issue of the timing of Walnut Place’s filing.  In that regard, Her Honor finds that plaintiffs failed to make a viable allegation that the Trustee unreasonably refused to act, as it requested more time to evaluate Walnut Place’s demands and eventually did act, by filing its $8.5 billion Article 77 action in state court.  While some commentators have questioned whether Judge Kapnick was unreasonably expanding the 60-day period in the no action clause for the Trustee to take action (by finding that plaintiffs must grant the Trustee’s requests for more time), my reading is that this finding is being made entirely outside of the context of the PSA language.

Instead, Kapnick is determining whether the Trustee made an unjustifiable refusal to act, sufficient to constitute an abuse of discretion, which would open the door for plaintiffs to sue derivatively.  In this context, it makes sense that Judge Kapnick would find that a request for additional  time by the Trustee and the ultimate filing of a settlement action belie plaintiffs’ allegations that the Trustee unreasonably failed to act.

Finally, Kapnick addresses the question of whether the Trustee was conflicted or otherwise incapable of suing, such that a demand would have been futile.  Here, it seems that Kapnick simply does not have enough information to go on, as Walnut Place only raises the allegation of conflict “for the first time” in the context of this motion to dismiss.  Further, plaintiffs’ lone argument in support of a conflict of interest is that the Trustee’s fee is based on the principal balance of the loans in the pool, such that forcing repurchases of those loans would reduce the Trustee’s fee.

With the Trustee’s fee being pretty minimal to begin with, I can think of several better reasons that one could argue that the Trustee is conflicted in this case, including that BNYM gets over 60% of its Trustee business from Bank of America (so it wants to keep the bank happy) and that BNYM is largely motivated by a desire to avoid litigation losses stemming from its conduct in overseeing MBS trusts.  This is why BNYM’s side letter agreement with Bank of America, which guarantees Countrywide’s indemnification obligations and extends the indemnification of BNYM through its conduct in negotiating the settlement, is so important.

However, these are the exact arguments that Walnut Place and the other intervenors are making in the Article 77 proceeding to establish that BNYM was conflicted and should not be granted the right to settle putback claims on behalf of all 530 trusts.  Though Judge Kapnick could have granted Walnut Place leave to amend to beef up its allegations of Trustee conflict, it seems she would rather adjudicate that issue only once, in the context of the Article 77 proceeding.

Left only with an allegation that the Trustee unreasonably failed to act, it makes sense that Judge Kapnick would ultimately find that Walnut Place jumped the gun and filed its derivative suit prematurely.  But it was only because plaintiffs could not establish a direct right to sue under the PSAs that Kapnick even reached this conclusion.  This first holding is far more troubling – it suggests that the parties never even contemplated that bondholders would have a right to enforce putbacks.  While I don’t agree that this is the case, and think there are provisions of standard PSAs that demonstrate otherwise, this is clearly the issue that deserves the bulk of bondholder attorneys’ attention right now, and overcoming this contractual interpretation should be the primary focus of any eventual appeal.

Posted in Alison Frankel, appeals, Bank of New York, banks, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, derivative lawsuits, Event of Default, global settlement, Greenwich Financial Services, hedge funds, incentives, investors, irresponsible lending, Judge Barbara Kapnick, Judicial Opinions, lawsuits, lending guidelines, litigation, MBS, motions to dismiss, pooling agreements, private label MBS, procedural hurdles, putbacks, rep and warranty, repurchase, research, RMBS, securitization, settlements, standing, Trustees, underwriting guidelines, underwriting practices, Walnut Place | 5 Comments

MBS Discovery Battles Heating Up, Impacting Litigation Timelines and Leverage

Posted on March 28, 2012 by igradman

If litigation is war, then discovery is the hand-to-hand combat that takes place in the trenches, costing plenty and potentially having a major impact on the outcome of the war in the aggregate.  With most of the major MBS litigation still slogging through some phase of the discovery process, I thought I would highlight two cases in particular where the outcome of discovery battles could have major implications.

One case, the proposed Bank of New York settlement in New York Supreme Court, is in the very earliest stages of this trench warfare, as the parties are debating the scope and timing of discovery.  Another case, MBIA v. Countrywide, is at the tail end of the process, but the plaintiff is finding that important battles still remain.  Let’s take a look at each these in turn and explore how discovery – the process by which parties request and produce evidence to one another during litigation – could provide additional negotiating leverage and drive ultimate recoveries.

MBIA v. Countrywide

The case of MBIA v. Countrywide is already fairly far along in the discovery process.  Actually, fact discovery officially closed in that case in August 2011.  Nevertheless, there have been a whole host of issues surrounding discovery since that time, stemming primarily from the number and scope of depositions that MBIA has sought to take of current and former Countrywide and BofA employees.

These issues came to a head earlier this month, when MBIA sent and filed a letter to Judge Eileen Bransten, in which the monoline insurer accused Countrywide and Bank of America of an ongoing effort to “sabotage the discovery schedule” as part of “an indefensible pattern of delay and discovery abuses.”  The March 8 letter accused the defendants of failing to produce, or even reveal the existence of, several categories of documents concerning fraud in loan originations, and then revealing certain documents the defendants believed to be favorable on the eve of, or during, depositions.  Based on these allegations, the letter sought leave of court to file a motion seeking sanctions for discovery abuses.

Though MBIA criticized BofA in its letter for its delay tactics and for improperly withholding hundreds of thousands of documents as “privileged,” it reserved its most scathing language for Countrywide, which it accused of a “willful and contumacious disregard of its discovery obligations and of the Court’s scheduling orders and other discovery directives.”  This language appears to have been chosen to create a record that might justify discovery sanctions down the road.  A few of the categories of the abuses alleged by MBIA are worth noting:

  • Delaying and withholding documents related to the depositions of whistleblowers such as Eileen Foster (see part 1 of great series by Michael Hudson on Foster here), then “cherry picking” favorable documents in preparation for the depositions and producing them just prior to or during depos;
  • Harassing and bullying whisteblowers during depositions;
  • Failing to disclose an entire database of documents concerning allegations of fraud at Countrywide (the so-called “FACTS” database) until its existence came to light during depositions; and
  • Failing to disclose the existence of an internal Countrywide “Fraud Hotline” until it came out during depositions.

This letter eventually led to a full-blown and fully-briefed motion to compel, which is currently pending before Judge Bransten.  In its most recent brief on this motion, MBIA accuses Countrywide of, time and time again, taking a “catch me if you can” approach to discovery:

Countrywide has concealed the existence of the most damning evidence, and forced MBIA to waste its time and money sorting through a 12 million page haystack, only to discover that the proverbial needle was intentionally omitted. (Reply Brief at 1)

According to Countrywide/BofA, this is just a push for “air time” as many of the issues identified in the letter have now been resolved.  MBIA, on the other hand, states in its Reply Memorandum that it still seeks documents relating to the whistleblowers, the Fraud Hotline, Countrywide’s alleged “fraud cover-up,” and other internal fraud investigations, even if they don’t deal specifically with the loans in the securitizations at issue in the lawsuit.

Many of the requests identified by MBIA appear reasonable, and given Judge Bransten’s growing impatience with the speed of discovery (she’s already granted other MBIA motions to compel and castigated Countrywide for heel dragging in discovery), it’s likely that the defendants will be compelled to produce additional documents relating to loan origination fraud and their knowledge thereof.  Such documents would provide MBIA with significant litigation leverage, as they would support MBIA’s own claims of fraud, which carry the threat of punitive damages.

Even more significant from a leverage standpoint, once these documents are produced and cited as evidence in summary judgment or at trial, other existing or potential litigants could use them against Countrywide/BofA to prove their own claims of fraud.  Already, the mere fact that the existence of the FACTS database and an internal Fraud Hotline at Countrywide have been disclosed will provide litigants with a road map to obtaining those documents through their own discovery processes.  Should the contents of those databases prove dangerous enough, they may force BofA to settle the case rather than opening the lid on Pandora’s box any further.

The BNYM-BofA Settlement Over Countrywide Put-Backs

As previously reported, the proposed $8.5 billion settlement by Bank of New York Mellon (BNYM) over Countrywide loan repurchase claims has now been remanded back to state court.  The first order of business before Judge Barbara Kapnick in New York Supreme Court will be to determine whether the action should proceed under Article 77, as proposed, or proceed under some other form, such as a plenary action.  This, in turn, will bear directly on the scope of discovery and the timeline for potential approval of the settlement.

Though no pleadings have officially been filed in this case since it was remanded, the parties have filed a series of letters that demonstrate just how critical this issue will be to the outcome of this case.  On March 12, 2012, attorney Matthew Ingber, on behalf of BNYM as Trustee, filed a letter asking the court for a ruling on two issues: 1) that the single issue in the proceeding was whether the settlement was within the scope of BNYM’s reasonable discretion and 2) that the scope of discovery be limited to that one issue.  (Ingber March 12 Letter at 1)  Under Ingber’s proposed schedule, a final hearing on the settlement would take place a mere 120 days after the completion of fact discovery. (Ingber March 12 Letter at 7)

On March 16, 2012, attorney Daniel Reilly, on behalf of the Steering Committee formed to organize the more than 125 intervenors in the action, wrote to Judge Kapnick in response. Noting that “transparency is particularly important here since no lawsuit was ever filed on the claims BNYM seeks to settle,” Reilly asked the court to first rule that Article 77 was not an appropriate format for the action, prior to ruling on the scope of discovery.  (Reilly March 16 Letter at 1-2)  With respect to the scope of discovery, Reilly pointed out that the Trustee’s request for a ruling on the “sole issue” in the case of abuse of discretion “flatly contradict[ed] BNYM own Proposed Final Order and Judgement,” which requested an Order:

  1. Approving the terms of the settlement;
  2. Stating that the settlement “is the result of factual and legal investigation by the Trustee”;
  3. Stating that BNYM “appropriately evaluated the terms, benefits and consequences of the Settlement and the strengths and weakness of the claims”;
  4. Stating that the negotiation of the settlement was “arm’s length”;
  5. Stating that BNYM acted in good faith;
  6. Enjoining all certificateholders from bringing an action against Bank of America and/or Countrywide for the settled claims; and
  7. Enjoining all certificatehalders from bringing an action against BNYM for its settlement-related conduct. (Reilly March 16 Letter at 2)

Reilly went on to discuss several categories of documents that would have to be included in discovery if the court were to rule on all of the issues listed above.  Included in these categories were settlement communications and loan files.

That same day, the Attorneys General from Delaware and New York, who have also sought to intervene in the case but who are not represented by the Steering Committee, filed their own letter, adopting the arguments made by Reilly.  On March 19, Judge Kapnick held a telephonic conference with the parties, in which she asked them to meet and confer regarding a briefing schedule.  One day later, the parties responded that they had agreed to the following schedule:

  • April 3: Orders to show cause filed
  • April 13: Response briefs due
  • April 19: Reply briefs due
  • April 24: Hearing on orders to show cause

Debtwire (subscription only) has since reported that Judge Kapnick will rule on April 24 whether the case will proceed under Article 77.  The publication also quoted a source as saying that Kapnick “seemed much more critical of the settlement” than she had during initial hearings.

So, what does all this mean for the case?  As I’ve discussed in the past, this settlement was only attractive to BofA because it promised to be a quick process with a favorable standard of review, limited discovery, and and end result that bound all participants.  If the case instead proceeds as a plenary action, such as a class action, or an action to adjudicate substantive claims against BNYM or BofA, it will no longer be quick, favorable, or limited, and may not bind all bondholders (for example, bondholders may be able to “opt-out” of the settlement if it proceeds as a class action).  This may torpedo the deal, causing BNYM or BofA to pull out.

While speed is certainly a major factor, I would argue that scope of discovery is even more important to the parties pushing for the settlement.  They would prefer the limited review of whether the Trustee acted in good faith during the settlement process, and to avoid getting into the details of how the trusts were formed, whether the parties met their obligations during that process and after the trust closed, and whether conflicts of interest led the Trustee to put its own interests ahead of the bondholders it was supposed to protect.  As I’ve discussed in the past, New York Attorney General Eric Schneiderman wants to blow the cover off of every aspect of mortgage securitization in the context of this action (including improper mortgage transfers, misrepresentations in the sale of securities and loan origination fraud), which would open the door to a flood of civil and regulatory actions (none of which were released under the recent Attorney General Foreclosure Settlement).

Thus, while BNYM-BofA dodged a bulled with the Second Circuit’s remand of the settlement action to state court, they could again face a critical threat should Judge Kapnick decide to disregard Article 77 and broaden the scope of discovery.  Given the multifaceted Final Judgment sought by BNYM, even proceeding under Article 77 may require the Judge to dig deeper than making a surface-level good faith determination.

BofA, through BNYM, will certainly fight hard up front to keep the action constrained and avoid having to engage in such a long slog.  However, should BNYM lose this early battle and should Judge Kapnick decide to try the case as a plenary action, it could result in investors dredging up damaging evidence in the trenches of discovery, driving the settlement price higher and causing significant litigation casualties for BofA (in this lawsuit and others).  BofA would likely beat a rapid retreat from this deal long before that was allowed to happen.

Posted in Attorneys General, bad faith, Bank of New York, banks, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, discovery, fraud, global settlement, improper documentation, investors, lawsuits, liabilities, litigation, MBIA, MBS, misrespresentation, monoline actions, monolines, mortgage fraud, private label MBS, putbacks, remand, rep and warranty, repurchase, RMBS, securities, securitization, settlements, subprime, successor liability, Trustees | 8 Comments

My Take On Newly Filed AG Foreclosure Settlement: As Bad As We Thought It Was

Posted on March 12, 2012 by igradman

“They are who we THOUGHT they were — and we let ’em off the hook!”

This famous postgame rant from former Arizona Cardinals coach Denny Green after his team’s epic meltdown on Monday Night Football against the Bears could just as easily apply to my reaction to reading the official terms of the Attorney General Foreclosure Settlement (the “AGFS”), filed today.  The nation’s largest banks get off with a relatively small penalty (much of it paid by investors or in “credits” for things the banks should already be doing) in return for releases across a broad spectrum of misconduct that pervades just about every dark corner of mortgage servicing.  The categories of servicer misconduct are laid out in detail in the complaint filed today in D.C. Federal Court, and include the following:

  • Providing false or misleading information to borrowers,
  • Overcharging borrowers and investors for services of dubious value,
  • Denying relief to eligible borrowers,
  • Foreclosing on borrowers who were pursuing loan mods in good faith,
  • Submitting forged or fraudulent documents and making false statements in foreclosure and bankruptcy proceedings
  • Losing or destroying promissory notes and deeds of trust,
  • Lying to borrowers about the reasons for denying their loan mods,
  • Signing affidavits without personal knowledge and under false identities,
  • Improperly charging excessive fees related to foreclosures,
  • Foreclosing on servicemembers on active duty,
  • Making false claims to the government for insurance coverage, and
  • Being unorganized, understaffed, and generally slower than molasses to respond to borrowers desperately in need of relief, while servicing fees continue to accrue.

The list goes on and on, but I can sum it up in one phrase, from the Honor Code of University of Virginia: lying, cheating and stealing.  Such conduct would have broken every tenet of my alma mater’s Honor Code. There, we had a strict no-tolerance policy and a single sanction – violating any tenet of the Code resulted in automatic expulsion.

But what’s the result when lying, cheating and stealing is perpetuated on the largest scale imaginable, by five of the largest banks in the country, thereby exacerbating the worst financial crisis since the Great Depression?  A broad release of liability, no admission of guilt, and a monetary settlement that pales in comparison to the size of the problem, even if it were paid in full by the banks themselves (which it will not be, as we’ll get into in a moment).

Ally, BofA, Wells Fargo, Citigroup and Chase get to continue on with their business (Ally’s purportedly received a discount so that it would have the means to pay), having agreed to process reforms that they generally should have already had in place, and only 5% of the nation’s 10 million underwater borrowers have even the faintest prospect of relief.  What’s that you say, Denny? “WE LET ‘EM OFF THE HOOK!”

The Nitty Gritty

So, we now have confirmation about the actual terms of the monetary penalties and how they’ll be credited (conveniently summarized in Exhibits D & D1 of the Consent Judgments, or starting on p. 170 of the J.P. Morgan Chase Judgment, which I’ll use as a reference throughout).  Frankly, there are few surprises here, as most of the key details have already been made public.

Of the $25 billion announced value of the settlement, only $5 billion will be paid in cash to state and federal regulators as penalties for the alleged misconduct.  Another $3 billion will be paid in refinancing packages to lower borrowers’ interest rates.  The bulk of the settlement – $17 billion – will be “paid” with credits that banks receive for engaging in various types of homeowner assistance.

The first problem is that, as the Wall Street Journal recently noted, the actual amount of loan forgiveness isn’t large relative to the problem of underwater debt.  The WSJ attributes to Ted Gayer, co-director of economic studies at the Brookings Institution, the estimate that the settlement’s complex set of requirements mean that about 500,000 borrowers, or 5% of those who are underwater, may be eligible for help.  Let me repeat that so it sinks in – if you are one of this nation’s 10 million underwater borrowers, you have only a 1 in 20 chance of getting any semblance of relief.

The second problem is that the banks have a right to “earn” credits towards that $17 billion bill by modifying loans held by investors.  For every $1 of loans modified from securitized portfolios (i.e. loans in mortgage backed securities trusts), banks will get $0.45 of credit.  Keep in mind, the defendant banks no longer have any ownership interests in these loans, they merely get paid a fee by the owners to protect their investments.  And these owners typically have contracts that prevent the unauthorized modification of loans they own.

Now, regulators clearly intended this reduced credit to incentivize banks to modify more loans on their own books, for which they get a full $1 of credit for principal reductions for the portion of principal below a 175% loan-to-value (“LTV”) ratio.  But when you actually think about how these incentives will play out, it quickly becomes apparent that they will lead to unintended conequences.

Let’s say Brutus, the school bully, has been stealing kids’ lunch money for a few years.  When he’s finally caught, the principal, who knows Brutus has stolen at least $20, says, “Ok, Brutus, your penalty for these crimes is to give $1 back to the poor kids of this school.  You can either pay that $1 out of your own pocket, or go and steal the money from others and give it to the kids.  But, you’ll actually have to steal $2.22 from others and give it to the kids you bullied to satisfy your $1 punishment.”

Now, Brutus has been stealing money for years, and has developed a plethora of clever ways to do so.  And even if he might have had some fear of running afoul of authority, the principal has essentially condoned the act of paying the fine with someone else’s money.

What do you think Brutus will do?  What would you do?  It would be one thing if banks shared in the cost of modifying a loan in securitization, and the credit was proportionate to the cost they paid.  But aside from transaction costs, banks absorb not one cent of a reduction of principal or interest on a loan held by investors.  Thus, by giving banks the opportunity to pay their settlement amount with investors’ money, regulators may be encouraging banks to modify twice as many loans, but they are also encouraging banks to impose the costs of those loan mods on the investors who had absolutely nothing to do with these servicing atrocities.

Investors have said as much in initial responses to the AGFS, including this response from the Association of Mortgage Investors, as quoted by Bloomberg:

It is unfair to settle claims against the robosigners with other people’s funds… While we request that it not be done, at a minimum we request that a meaningful cap be placed on the dollar amount of the settlement satisfied by innocent parties. Restitution should come from those who are settling these claims, and lien priority must be respected.

Ah yes, and then there’s the topic of lien priority.  Recall that second liens, which are overwhelmingly owned by the banks and held on their balance sheets at close to par, are subordinate to first liens and should be wiped out if the first lien is modified.  Under the terms of the AGFS, seconds are only to be written off completely if they’re over 180 days delinquent – meaning the borrower hasn’t made a payment in 6 months and should probably be written off, anyway (servicers get $0.10 of credit for writing these nearly worthless loans off, by the way).

If the loans are less than 180 days delinquent, they will be written down a minimum of 30% of the unpaid principal balance or to 115% LTV, whichever results in less forgiveness, consistent with the oh-so-successful HAMP Second Lien Modification Program.  In other words, rather than respecting lien priority, the AGFS resorts to the tired mantra of proportionate write-downs for subordinated second lien loans.  This may be the biggest backdoor bailout in the entire settlement, as banks own $400 billion worth of these junior liens.

The Process Reforms

You’ll hear a lot of supporters of the AGFS tout in the media the process reforms to which servicers have agreed as a major success of the settlement.  While it is true that many reforms will be put in place by way of this settlement that are necessary and will improve servicing, most of them are simple mandates that banks should have already been following.  I won’t linger on this point for long, but I think it makes sense to point out some of the agreed “process reforms,” just to understand the consideration that taxpayers, homeowners and state and federal governments are receiving in exchange for granting the banks broad releases of liability (discussed next).  These reforms may be found starting at Exhibit A (page 93 of the Chase Consent Judgment), and include:

  • Servicers will ensure that factual assertions made to courts and borrowers are true,
  • Servicers will ensure that people signing affidavits actually have personal knowledge of the facts to which they’re attesting,
  • Servicers will ensure that affidavits properly identify the name and title of the affiant,
  • Servicers will comply with state and federal law,
  • Servicers will ensure they have a documented interest in the mortgage loan and note before foreclosing,
  • Before servicers submit lost note affidavits, they must make a good faith effort to look for the note,
  • Servicers will not intentionally lose or destroy notes (!), and
  • Servicers will only charge default service fees for reasonable and appropriate services that are actually rendered.

Again, while some reforms called for in this section are steps in the right direction – elimination of dual tracking, single points of contact, and additional borrower disclosures, for example – the fact that the AGs had to include the above in the list of reforms speaks volumes to how far mortgage servicing has careened off the track.

The Release

We now have the language of the actual release, which the banks have been given in return for the penalties and reforms discussed above.  As expected, the release is fairly broad in the arena of servicing activities, releasing essentially any claim that any regulator may have based on mortgage servicing, loss mitigation, collection or accounting of borrower payments, or foreclosure or bankruptcy practices.  In other words, this is the last we’ll see of any government agency digging into the who, what, where, when and how of robosigning and forged affidavits.

However, to give credit where credit is due, the release does not appear to encompass the vast majority of claims based on the origination, purchase, securitization, transfer or sale to investors of mortgage loans, nor does it release the actions of securitization trustees.  The state releases very clearly spell out that they will not apply to origination or securitization activity, while the federal releases state that they’ll apply to all origination or securitization activity except for certain exemptions (which include most of the origination or securitization issues that may engender liability for the banks).  Either way, regulators appear to have done a good job of only releasing activity covered by their allegations and investigations (what little there were), and nothing more.

But here’s the rub.  In the face of the litany of charges brought against them, the banks are not forced to admit to any wrongdoing.  The language in the Federal Release (p. 231 – Chase Consent Judgment) makes this explicit:

This Release is neither an admission of liability of the allegations of the Complaint or in cases settled pursuant to this Consent Judgment, nor a concession by the United States that its claims are not well-founded.

The state release is not so explicit, but conspicuously absent is any language by the bank admitting to fault, mistake or wrongdoing.

In fact, this glaring omission may be the best source of leverage for investors and others seeking to challenge the propriety of the settlement.  Ever since Judge Rakoff issued his scathing order rejecting the SEC’s proposed settlement with Citigroup, judges have been more conscious about rubber stamping government settlements where there is no admission of wrongdoing by the defendant and few details provided supporting the allegations.  I would imagine that the federal judge assigned to oversee this case will have to contend with the same sort of misgivings – that he or she is being asked to enforce a $25 billion settlement in which the defendants have made no admissions of wrongdoing and the government has provided few specific details that would support their allegations.

Perhaps objectors can seize on Rakoff Fever to hold up the settlement in return for stiffer fines, admissions of guilt or caps on the amount of the penalty that should be born by innocent third parties.  Now that we know these servicers are who we thought they were, maybe there’s still time to keep our elected and appointed officials from letting ’em off the hook.

Posted in allocation of loss, Ally Bank, Attorneys General, bailout, bankruptcy, banks, Bloomberg, BofA, broader credit crisis, chain of title, Citigroup, Complaints, contract rights, costs of the crisis, damages, foreclosure crisis, global settlement, Government bailout, homeowner relief, Hope For Homeowners, impact of the crisis, improper documentation, incentives, interest rates, investigations, investors, JPMorgan, Judge Jed Rakoff, judicial momentum, junior liens, lawsuits, liabilities, litigation, loan modifications, loss causation, LTV, MBS, misrespresentation, mortgage fraud, negative equity, oversight, Regulators, Residential Capital, RMBS, robo-signers, SEC, securities, securitization, servicer defaults, servicers, settlements, stipulated judgments, waiver of rights to sue | 7 Comments

Why Mortgage Loan Servicers Behave as They Do

Posted on March 5, 2012 by igradman

Editor’s Note: It seems that we can’t go three months without hearing about yet another species of misconduct by mortgage servicers that shifts losses onto the lienholders they are supposed to protect.  We’ve read reports about force-placed insurance, inflated appraisal and maintenance fees, robosigning and other foreclosure irregularities, interference with loan mods and short sales due to second lien holdings, and, most recently, reports of the ongoing collection of fees by servicers for loans that have already been liquidated.  Why do we seem to be facing a near-constant stream of news stories about mortgage servicers behaving badly?  It turns out that this problem is nothing new, and traces back to a fundamental issue that we discuss at length in Way Too Big to Fail – misalignment of incentives.  In this revealing guest post, former insider Steve Ruterman draws on his experiences to illustrate the roots of this fundamental problem. – IMG

By Steve Ruterman, guest blogger

The Principal – Agent Problem: Part I – RMBS Data Integrity

Back near the dawn of time when I was in business school, and the faculty was hard-pressed to find topics to fill up the curriculum, they introduced the Principal – Agent Problem.  As future corporate managers and agents of the stockholders, I suppose they wanted to explain to us that our economic interests were not identical to those of the owners.  This wasn’t exactly the most shocking news we had ever received, but that was all that was said about the issue, back then.

Of course, there is considerably more to this multi-faceted problem. According to Wikipedia, “The principal–agent problem arises when a principal compensates an agent for performing certain acts that are useful to the principal and costly to the agent, and where there are elements of the performance that are costly to observe,” primarily due to asymmetric information, uncertainty and risk.

Let’s look at the relationship between the RMBS bondholder (principal) and the mortgage loan servicer (agent) in this context.  The bondholder relies completely on the servicer to collect principal and interest each month, remit cash collections to the trust, report monthly collateral performance data accurately, send out monthly bills to borrowers, encourage borrowers to pay on time, persuade them to catch up if they fall behind, and foreclose and sell the underlying property if all else fails.  For these services the bondholder pays the servicer a fee which is a flat percentage of the aggregate unpaid balances of the loans owned by the trust.

Like all businesses, the goal of a servicer is to maximize its profits from the flat fee which is its revenue.  The main route to this goal is to minimize its expenses, of which labor comprises approximately 80%.

The owner of the servicer has its own subset of Principal – Agent issues with respect to its employees.  The incentives it provides its employees add several layers of complexity to the bondholder – servicer relationship.  In this first part, I am going to discuss the effects of Principal – Agent and Owner – Employee relationships on the integrity of the data reported to the bondholder each month, using examples from my past experiences.

By 2001, MBIA, my former employer had about $3 billion of exposure to ten manufactured housing (“MH”) loan pools serviced by an affiliate of the bond issuer.  We’ll call it MH Servicer I. In January 2002, MH Servicer I’s parent, had concluded from the rapidly increasing delinquency levels in the MH loan pools that it wanted to be out of the MH financing business. They present-valued MH Servicer I’s assets and liabilities over their remaining 25- to 30-year lives, and carried the net asset value as the residual value of the now discontinued business.

The parent had a problem to solve.  How could it retain the management of MH Servicer I over an extended period of time, and how could it motivate the servicer to increase the value of a large run-off pool of badly performing MH loans?  The solution was reasonably simple: the management team was awarded above-market base salaries, together with incentive compensation which paid them attractive bonuses if they could increase MH Servicer I’s residual value.  If the residual value went up each year, they stood to make a lot of money.

Calculation of the residual value each quarter was performed by an outside vendor, and the methodology was based on delinquency trends.  If delinquency went down, the value went up.  Because MBIA was at risk if principal and interest collections of the ten trusts were inadequate to pay bondholders, we were delighted to see the elevated delinquency levels go down in 2002.  We were happy, that is, until we found out why they were going down.

During a visit to MH Servicer I’s main collection site, I noticed a white message board which was posted with following two suggestions to the collections staff:

  • Ask for the payment in full.
  • If you can’t get it, offer an extension.

“What’s an extension?” I asked.

“Oh, if a borrower is 90 days past due, offer to extend the next due date by, say, 60 days,” responded a member of MH Servicer I’s staff.

“How is the resulting delinquency reported?”

“Extended borrowers are reported as current until they miss their next payment on the next due date.”

Extensions certainly brought reported delinquency down, while MH Servicer I’s residual value and management’s incentive compensation went up.  Extensions also increased the amount of the trust’s non-earning assets without reducing the par value of the trust’s liabilities.  This dynamic crushed the credit enhancement of each deal in accelerated fashion, and rendered delinquency reporting useless from an analytic perspective.

We had another $600 million of MH exposure coming from 11 trusts involved in the 2003 bankruptcy of another MH servicer we’ll call MH Servicer II.  In this case, the delinquency situation was the reverse of the MH Servicer I story.  These trusts issued bonds which were 3- to 5-years old at the time of the filing.  Despite a vintage profile similar to the MH Servicer I trusts, the Conseco trusts consistently reported 30+ day delinquency in the 3% range.  At least they did so until the month after the bankruptcy filing.

From that point on, delinquency increased each month for over a year, ultimately reaching peaks in the 18% range.  I was not privy to the incentive compensation plans provided to MH Servicer II’s management and employees, but it is easy to infer that reported delinquency trends were somehow suppressed (i.e., held down) for several years.  Once the bankruptcy filing occurred, delinquency increased to MH Servicer I levels and beyond, until a new management team came on board and began to exert control over the loan pools beginning in late 2003.

The point of these two examples is to illustrate how the Principal – Agent Problem, or its subset, the Owner – Employee Problem, can destroy the integrity of reported collateral performance data over extended periods of time.

The Principal – Agent Problem: Part II – Asymmetric Information

In this second part, I’m going to discuss a different facet of the Principal – Agent problem: asymmetry of information.  It is difficult to imagine a business relationship which features greater information asymmetry than that of an RMBS bond investor (owner) and the mortgage loan servicer (agent).  In this case, the servicer is in a position to know everything there is to know about each individual loan in the loan pool and its past and expected future performance. The bondholder gets a monthly remittance report from the servicer via the trustee (another problem for another day), and, in some cases, historical loan level data about loan attributes and payment status from the servicer’s website.  If he wants anything over and beyond these basics, he has to buy it from third party vendors (e.g., Intex, Bloomberg, CoreLogic, Lewtan).

At the end of the last subprime crisis (circa 1999 – 2001) MBIA found itself doing business with several new replacement servicers.  We had to find new replacement servicers in a hurry because the original servicers were affiliates of the subprime issuers. Each of these issuers was in bankruptcy and ultimately in liquidation.  The issuers included ContiMortgage, Delta Funding, First Alliance, Southern Pacific Mortgage and American Business Financial Services.  Our new servicers included Litton Loan Servicing, Ocwen Financial Services and Fairbanks.

Before getting into the details of various asymmetric situations, a brief discussion of servicer advances is required.  Servicers are generally required by the Pooling and Servicing Agreements (“PSAs”) to advance to the trust delinquent principal and interest payments due from but not paid this month by obligors.  The servicer is obliged to continue advancing until he deems that the unpaid note balance plus the cumulative advances will exceed the net liquidation value of the underlying property.  When the property is liquidated, the servicer is first in line for reimbursement.  If the liquidation proceeds do not cover its advances, the servicer then has access to all funds collected by the entire trust in order to recover its “non-recoverable” advances.  In this way, the servicer is not at risk of non-payment for its advances.

For its part, the trust receives the servicer advances and applies them to the monthly cash distribution waterfall.  However, the trust does not recognize any new liability or note payable to the servicer, and remittance reports often do not report monthly advances and reimbursements.

In 2002, during a routine visit to subprime servicer Fairbanks (now Select Portfolio Servicing), we asked about an amount being billed to a borrower.  We were told that it was for interest on a servicer advance.  The following exchange ensued.

MBIA: “You can’t charge borrowers (or anyone else) interest on servicer advances.”

Fairbanks: “Where does the PSA say that we can’t?”

While Fairbanks had a point, and the relevant PSAs were silent on interest on advances, they were also silent on the general topic of imposing new costs on borrowers who were having difficulty meeting their monthly mortgage obligations in the first place.  It hadn’t occurred to anyone that servicers might pursue various means of parasitizing borrowers and trusts to the direct detriment of RMBS investors.

In 2003 Fairbanks paid the FTC and HUD $40 million to settle charges that it had engaged in “unfair, deceptive, and illegal practices in the servicing of subprime mortgage loans.”  Clearly, Fairbanks employees believed they would be rewarded for thinking up new revenue generating ideas, and they certainly showed great ingenuity in these endeavors.

Years later, as MBIA’s insured subprime loan pools liquidated down to relatively small numbers of remaining loans, another anomaly began to show up in the remittance reports.  In some cases, trusts began to report negative principal collections on a monthly basis.  It is certainly possible that an older trust supported by a small number of (possibly delinquent) loans might have zero principal collections, but how could collections equal some negative number?

In 2008, this was the question MBIA had regarding the subprime servicer reporting the negative collections.  Under what circumstances could a trust experience a negative principal collection amount?  Several tortuous weeks later, the answer was finally extracted.  The subprime servicer was modifying loans in the following fashion:

  1. First, it found a delinquent borrower willing to sign a new note with a larger unpaid principal balance and a significantly lower interest rate so that the monthly payment would decrease at least a little.
  2. The amount of the increase in the note balance was equal to the servicer’s cumulative servicer advances to date.
  3. Because this transaction had the effect of transferring the servicer’s unsecured loan balance to the trust, the servicer advances to the borrower became “non-recoverable”, and the servicer could be reimbursed in the month of the loan modification from the top of the collections waterfall – that is, from all principal collected that month by the trust from all obligors. In this way, the servicer didn’t have to wait until the loan liquidated for reimbursement of its advances.

This particular servicer was the replacement servicer for several subprime deals insured by MBIA.  Some of the related PSAs required the servicer to obtain MBIA’s consent to the modification of any loan in the affected trust.  As a result, I noted that approximately two thirds of the borrowers I reviewed for modification consent purposes had negative equity 10 years or more after loan origination, and before the addition of the servicer advances to the modified note balance.

These experiences with servicers have led me to believe that the current mortgage market meltdown, documentation deficiencies, robosigning and related foreclosure problems all stem from the same cause:  the collapse of any regime of internal controls at some mortgage originators, sellers and servicers resulting from a misalignment of incentives.  Once the loan underwriter sells all of its originations, and expects to do so in the future, it concludes that it can do without the internal control provided by things like underwriting guidelines.  In fact, it finds that it can dispense with all of its former internal controls, which only cost it money.

Once all internal controls are dispensed with, management and employees pursue the incentives given them by the owners, and you get the fiasco in the mortgage markets we are living with today.

Steve Ruterman is an independent consultant to institutions and institutional investors with significant RMBS exposures and a fan of The Subprime Shakeout.  He recently retired after a 14 year career with MBIA Insurance Corporation, during which he transferred over 20 mortgage loan pools to new servicers.  Mr. Ruterman welcomes your comments, and can be reached by email at Steve.Ruterman@yahoo.com.

Posted in accounting fraud, allocation of loss, appraisals, auditing, banks, broader credit crisis, causes of the crisis, conflicts of interest, contract rights, costs of the crisis, firing servicers, foreclosure crisis, improper documentation, incentives, investigations, junior liens, lending guidelines, loan modifications, MBIA, MBS, monolines, mortgage fraud, private label MBS, RMBS, robo-signers, securitization, servicer defaults, servicers, settlements, subprime, underwriting guidelines, underwriting practices, Way Too Big to Fail | 4 Comments

BREAKING: BoNY-BofA Settlement to Return to State Court After Second Circuit Reverses Pauley

Posted on February 27, 2012 by igradman

Some rare good news for Bank of America: the Second Circuit just reversed the ruling of District Court Judge William Pauley in the highly-publicized $8.5 billion settlement between BofA, Bank of New York (BoNY), and Kathy Patrick’s institutional investors over mortgage putbacks; meaning the case will be sent back to state court to be tried as an Article 77 proceeding, rather than a class action.  In doing so, the Court of Appeals held that the “securities exception” to the Class Action Fairness Act (CAFA) applied, because the case related solely to the rights and duties created by or pursuant to a security.  This means BofA will have to weather only limited scrutiny of its proposed settlement and benefit from a much more deferential standard of review (“abuse of discretion” versus “entire fairness”)

In speaking to folks last week who attended the hearing before the Second Circuit on Feb. 15, it was clear that the three-judge panel was uncomfortable with the idea of this case remaining in federal court.  Originally filed in state court under Article 77, the case had been removed by intervenor Walnut Place to federal court, as the aggrieved bondholder had argued that the case was more akin to a federal mass action and should be treated as such, including allowing dissatisfied bondholders to opt out.  Judge Pauley in the Southern District of New York agreed, holding that this was the very type of case that Congress had directed be tried in federal court under CAFA.

However, rather than reversing Pauley on the threshold hurdles to CAFA jurisdiction, such as its requirements that the case be about monetary relief, have more than 100 plaintiffs, and involve common issues of law and fact; the Second Circuit relied solely on the securities exception to CAFA to support its decision.  In this regard, it found that, having first characterized the Trustee’s claim as seeking a “declaration authorizing the exercise of a trustee’s powers,” the Trustee’s claim thus related solely to “the rights, duties (including fiduciary duties), and obligations relating to or created by or pursuant to any security. 28 U.S.C. § 1453(d)(3).” (Opinion at 23-24)

What’s novel about this finding is that prior Second Circuit holdings, such as Greenwich Financial v. Countrywide,  indicated that the securities exception only applied to claims relating to the rights of Certificate holders as holders.  The mere fact that a claim involved a security was not enough – it had to be a claim by the holder of the security to enforce the duties or rights created by or pursuant to the security.  This latest decision extends that holding to trustees of a security acting as trustees – something that likely was not contemplated by Congress when passing CAFA, or even by the Second Circuit when issuing its prior holdings.

Regardless of the propriety of this decision, and barring a Hail Mary appeal to the Supreme Court by Walnut Place, it’s clear that this decision is a big win for Bank of America and other institutions with large exposure to legacy private label mortgage issuance.  State court provides a much more favorable forum to the banks, as previously discussed, as it ensures that Article 77’s shortened procedures and deferential standard of review will be applied.  New York Supreme Court Judge Barbara Kapnick will still have her hands full determining how to deal with the impressive slate of intervenors opposed to the settlement, including the New York Attorney General Schneiderman, when ruling on the scope and timing of discovery.  But BoNY and BofA can rest assured that any decision approving the settlement will ultimately bind all bondholders in the affected trusts.

This ruling will also mean that other issuers will likely try to emulate the structure of this deal in reaching global settlements with friendly bondholder groups and trustees, in an effort to rid themselves of RMBS overhang. The challenge for bondholders wishing to avoid this result is to press as loudly and publicly as possible to be included in negotiations, so they can create a record of having been shut out of settlement talks.  On the flip side, the challenge for other issuers will be to create a process that appears to solicit, or at least allow, other bondholder opinions on the deal, while still reaching a settlement dollar figure that is relatively low compared to what bondholders could recover through aggressive court proceedings.

Regardless, this challenge is small compared to the challenge that BofA would have faced if the case remained in federal court, so there is certainly cause for celebration in Charlotte today.

The full Second Circuit Opinion may be accessed here.

Posted in appeals, Attorneys General, Bank of New York, banks, BofA, bondholder actions, CAFA, class actions, contract rights, discovery, fiduciary duties, global settlement, investors, Judicial Opinions, jurisdiction, lawsuits, liabilities, litigation, MBS, pooling agreements, private label MBS, procedural hurdles, putbacks, remand, removability, rep and warranty, repurchase, RMBS, securities, securitization, settlements, Trustees | 3 Comments