Way Too Big to Fail Goes to Washington (Book Tour Day 3)

Posted on January 23, 2012 by igradman

After a hiatus over the holidays, I return with Part IV of this five-part series on my experiences during a recent book tour to promote the release of Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System.  Use the following links to read Parts I, II, and III.

Way Too Big to Fail, by Bill Frey, ed. by Isaac Gradman

I again woke before dawn on the third day of our East Coast tour to promote the release of Way Too Big to Fail (WTBTF).  Over the last two days, author Bill Frey and I had met with numerous individuals in finance, academia and the media, but today would be different.  That’s because today we would be flying directly into the mouth of the beast—Washington D.C.—to meet with some of our nation’s elected officials.

The cover of WTBTF (see left or visit the book’s Facebook page for more detail) depicts a cartoon of Uncle Sam playing a game of Mortgage Crisis Strategy Whack-A-Mole, futilely swinging the hammer of “Loan Mods” at the various mortgage problems that pop up, while the “U.S. Economy” leg of the game’s table cracks and money flows out of the back of the machine into a bag labeled “Banker’s Bonuses.”  Suffice it to say that WTBTF’s cover does not paint the most complimentary picture of Washington’s efforts to solve the mortgage crisis, so it would be interesting to see what the folks at Capitol Hill would say when we handed them a copy.

Our flight into D.C. arrived around 8:30 AM and we jumped on the Metro to get to our first meeting of the day: with Georgetown Law Professor Adam Levitin.  Levitin was one of the few academics who consistently had been willing to speak the truth regarding the depth of the banks’ problems stemming from their subprime origination and securitization activities.

In one particularly memorable instance, Levitin was hired by Citigroup as a guest speaker and asked to give his assessment of problems associated with improper foreclosures, robosigning and broken chain of title.  The resulting report, entitled “Foreclosures Gone Wild,” was released by Citigroup despite being, in Citi’s own words, “one of the bleaker portraits of these matters and their ultimate resolution.”  It then summarized Levitin’s findings as follows:

[i]t appears that in many instances during the mortgage securitization process over the past few years, the paperwork was not properly transferred. If the paperwork was not transferred in the legally required manner, it raises  questions  not  only  about  who  owns  the  mortgages  in  question  but  also about  the  validity  and  tax  exempt  status  of  the  trusts  in  which  the  mortgages reside.

Not surprisingly, this report and it’s conclusions made waves instantly among commentators and analysts, prompting me to write that someone at Citi was likely on the Budweiser Hot Seat for having hired Levitin to be the featured guest in the first place.  Citigroup’s legal team ultimately pulled the report from the Internet, stating that it was simply standard practice to “investigate any misuse of Citi’s intellectual property,” but the damage had been done.  Interestingly, the report can still be found here and here.

I had first started talking to Levitin in early 2011 when he linked to some of my articles on Credit Slips.  Later, I asked him to read an advanced copy of Way Too Big to Fail and offer us his thoughts.  Despite his busy schedule, he had made the time to do so, and reported back that he thought the book was great.  He ultimately provided extensive feedback, both positive and constructive, as well as a blurb, which now appears on the back cover (you can read Levitin’s blurb, along with other testimonials, here).  Frey, Levitin and I had since had several productive conversations, and everyone seemed to benefit from the ongoing exchange of ideas.

I was excited to finally meet in person the man who had been willing to tell the banks what he thought, not what they wanted to hear.  I sat down in Levitin’s office at Georgetown Law Center and took a quick look around.  The décor did little to suggest that Levitin was anything other than the typical law professor.  His bookshelves were lined with legal texts and memorabilia from some of the most famous legal cases (he even had a framed certificate of original shares in Erie Railroad from the famous choice of law case Erie Railroad v. Tompkins).

Yet, Levitin was not the typical law professor, consumed solely with esoteric questions about subtle distinctions in legal interpretation or trends in Supreme Court precedent.  Levitin had a decidedly macro perspective that evinced a much deeper interest and understanding in global finance and politics than most of his peers.  And, importantly, he was not afraid to share his views on this diverse array of topics in both published papers and on the Credit Slips blog.

Today, Levitin was focused on trying to understand why Bank of America had moved its derivatives into a depository, and what this revealed about its deeper problems.  In particular, he was focused on the gap between BofA’s then-book value of about $220 billion and its then-market cap of about $70 bn.  This, he felt, could only be explained by the market’s perception that BofA had bogus assets and/or unrecognized liabilities.  But in that case, why had the bank made such a large investment in the bonds of troubled European sovereigns (the so-called PIIGS)?

Frey had a response: the banks will use these positions to hold the PIIGS, and the U.S. Treasury, hostage.  “Remember that scene in Blazing Saddles,” Frey said, “where the Sherriff comes to town and is about to be lynched because he’s black?  So he holds a gun to his own head and says, ‘Don’t make a move or the black guy gets shot!’?”  [This was the first I knew that Frey was a Mel Brooks fan.]  “That’s essentially what the banks are doing.  They’ll go to Geithner and say, ‘Now that we hold these bonds, you better bail out the PIIGS or they’ll take us down with them and you’ll have a much bigger problem on your hands.’”

This was a point that Frey had also made in WTBTF – that it was dangerous for a country to let a bank or any other entity exist without capital but with implied government backing.  Such a state of affairs could lead to reckless “double-or-nothing” type bets that, while rational for the bank, would be grossly detrimental to the country and the taxpayer in the long run.

Levitin was intrigued.  A week later, he published this article on Credit Slips entitled, “Is Bank of America Gambling on Resurrection (or Is BoA Holding the US Hostage)?  Therein, he explored further the possibility of the banks using European debt to hold the U.S. over a barrel.

That day in his office, we also spoke about Way Too Big to Fail, and Levitin offered some suggestions of other people in the industry who might benefit from reading the book or have valuable feedback.  He reiterated that he thought WTBTF was a valuable resource and that the folks in Washington should take notice, though there was no guarantee they would.  “Everyone else seems to want to stick it to the banks these days and see someone go to jail,” Levitin said.  “When will Washington get that?”

We were determined to find out.  We said goodbye to Levitin, as he was heading out to teach a first year class on contract law, and we headed to Capitol Hill.  We had a full slate of meetings planned that day with the staffs of a half dozen congressmen.  Frey had done this sort of thing before, but it was my first time, and I was apprehensive about what I might encounter.  Exactly how far behind the curve were our elected officials?

Our first meeting did little to reassure me.  We met with the “housing policy expert” on the staff of a senator who will remain nameless.  The staffer was a spitting image of Frey’s description in WTBTF of most staffers he had met while lobbying against the Servicer Safe Harbor:

[f]or those unfamiliar with the lobbying process, as I was at the time, it turns out that one rarely gets to meet with any elected officials.  Instead, each official is usually represented by a young adult with a freshly minted law degree who, while ostensibly well intentioned, is a self-described “policy wonk” with little experience in the subject matter. (WTBTF at xxxvi)

After handing the staffer a copy of our book, our first order of business was to understand how much the staffer already knew so we could decide where to start.  “You can rebuild securitization privately through reforming the standard PSA,” Frey began, “but it can be done faster and more uniformly by having the government enact certain measures that get the ball rolling in the right direction.”

“What’s a PSA?” the staffer responded.  This came as a bit of a surprise, as a housing policy expert probably should have been familiar with a Pooling and Servicing Agreement, the central contract governing a mortgage securitization.  It was then that Frey and I realized the enormity of the task that lay ahead – educating our nation’s decision-makers and their staffs about the complexities of housing finance that stood in the way of housing market recovery.

But of course, the reason that we had published WTBTF in the first place was to provide an educational tool to those who wished to improve this very system.  This necessarily involved teaching those without a background in structured finance about the history and legal underpinnings of securitization, its inherent conflicts of interest, and the steps that should be taken if it was to be rebuilt so that it survived.

Patiently, we spent the next hour explaining some of these concepts to the staffer.  At the end of this meeting, we felt fairly confident that the staffer knew far more about mortgage backed securities than he or she had going in, but we still knew we had barely scraped the surface.  This was certainly going to be no easy task, but it was one that we were excited about finally undertaking in earnest.

It turns out that most of the staffers we met that day were more knowledgeable about mortgage issues than the staffer from our first meeting, but there were still plenty of gaps in their knowledge that we felt we could fill in.  A common refrain we heard was that most congressmen had one staffer who was his or her “housing policy expert” and one staffer who was their “finance expert,” but that “housing finance” fell somewhere in between.  This was more than a little disconcerting, considering that this market was as large as $11 trillion at its peak and should hardly have been considered a niche expertise, let alone something that fell through the cracks.

Later in the day, we had the pleasure of meeting with a few staffers who understood many of the issues plaguing housing finance and the importance of rebuilding this market.  It was refreshing to speak at last to folks in Washington who were on the same page about the need for reform in this area, and who could speak intelligently about the challenges they faced in trying to do so.  While I won’t disclose their names, as I don’t want to suggest a partisan bent to this plainly bipartisan issue, I will say that this understanding of the issues is reflected in the public statements and legislation that has been authored by their offices.

It made me realize that behind every reasonably-coherent statement by an elected official on a matter of housing finance is a wise staffer or two that actually gets it.  After handing out copies of WTBTF to more than a dozen such staffers today, I’m hoping that we can at least add a few more individuals’ names to those ranks in the coming months.

Follow @WTBTF on Twitter for real time updates on the book and its impact.

Posted in Adam Levitin, bailout, balance sheets, banks, BofA, book tour, chain of title, Citigroup, conflicts of interest, Congress, foreclosure crisis, Government bailout, improper documentation, legislation, lobbying, MBS, mortgage market, negligence and recklessness, pooling agreements, regulation, Regulators, RMBS, robo-signers, Senate staffers, Servicer Safe Harbor, Timothy Geithner, too big to fail, Treasury, Way Too Big to Fail, William Frey | Leave a comment

MBIA Celebrates Bransten Decision on Loss Causation; Bondholders Still Looking for Guidance

Posted on January 9, 2012 by igradman

As loyal readers will recall, I laid it on the line a few weeks back and predicted that MBIA would win its loss causation argument against Countrywide/BofA, making the nation’s largest bank wish it had settled this bellwether piece of New York litigation. Well, I was right… to a point.

MBIA and other bond insurers with MBS exposure were certainly smiling after MBIA won the majority of its claims in Tuesday’s opinion on summary judgment (the “Order”). In particular, MBIA succeeded in convincing Judge Bransten that it did not have to tie specific claims payments to particular misrepresentations in order to prove its claims of fraud and breach of contract and recover the insurance proceeds it has paid on defective loans.  “We are very pleased by today’s ruling,” MBIA Chief Executive Jay Brown said. “The ruling provides us with a straightforward path to recovery of our losses.”

However, the Judge stopped short of providing the complete relief that MBIA was seeking – to bar Countrywide’s defenses regarding intervening causes entirely. The Judge also kicked the can down the road on providing MBS plaintiffs with their first piece authority as to whether the materiality standard for mortgage putbacks required a showing that the breach in question caused the loan to go into default. Unfortunately, her Honor punted on this last (and arguably most important and far-reaching) issue, leaving bondholders without guidance on the strength of repurchase claims.

As per my MO, I will break down Bransten’s recent Order in a bit of detail. This time, I’ll include my real-time reactions from last Tuesday as I read each section of analysis in the Order.

Section 1 – Summary of Arguments on Fraud and Breach of Warranty

In this first section, Judge Bransten reiterates MBIA’s argument that in order to succeed on its claim for insurance fraud, it need only prove that the application for insurance contained a material misrepresentation that, had MBIA known the true facts, would have led it to change the terms or provision of insurance coverage.  Bransten also notes that MBIA makes a similar argument on loss causation with respect to its claims for breach of warranty in its insurance agreements: it must only prove that the breach of warranty materially increased the insurer’s risk.  Bransten then recites the counterargument from Countrywide: that MBIA must instead establish that the claims payments it made were caused directly by Countrywide’s misrepresentations or breaches of reps and warranties, and not by some intervening cause (e.g., the economic downturn, the housing market crash, or the price of tea in China).

At this point, it strikes me again how strained an interpretation of causation Countrywide/BofA is trying to sell the court.  They’re essentially saying, “we can lie all we want to induce you to insure our bonds, and our lies might actually succeed in inducing you to insure our bonds when you wouldn’t have otherwise.  But, if you can’t prove that our lies led directly to your payment of a claim, tough luck.”  I’m as confident as ever that Bransten will side with MBIA.

Section 2A – Causation

Bransten next identifies the “base issue before this court… when causation occurs in claims for insurance fraud and breach of representations and warranties.”   In reaching this issue, she must first address Countrywide’s argument that the First Department (New York’s Court of Appeals) had already held that MBIA must prove that Countrywide’s alleged wrongdoing caused MBIA’s losses.  Bransten has little trouble disposing of this argument, holding:

the court disagrees with Countrywide’s characterization of this court’s holding and the Appellate Division’s June 30, 2011 decision with regard to causation.  The Appellate Division decision did not hold, as Countrywide argues, that this court must determine which of MBIA’s losses were caused by countrywide’s alleged wrongdoing and which were caused by the “Mortgage Market Meltdown.”  Rather, in the section that Countrywide quotes, the First Department rejected Countrywide’s contention that MBIA’s fraud claim must be dismissed for failure to plead a causal link between Countrywide’s alleged misrepresentations and MBIA’s alleged damages. (Opinion at 9-10 (citations omitted))

You may recall from my article analyzing these pleadings that I didn’t see how the First Department’s decision lent any support to Countrywide’s global catastrophe defense.  Apparently, Bransten sees it the same way as she goes on to determine that no decision exists that must be treated as “the law of the case.”  So far, so good.

Bransten next turns to MBIA’s arguments that its claims under New York law are informed and influenced by New York Insurance Law Sections 3105 and 3106.  First, she holds that MBIA’s insurance law claims are valid in this action for damages and that Countrywide is the proper defendant for the misrepresentations alleged by MBIA.  The court then finds that MBIA’s common law claims are indeed informed by New York common law and Insurance law Sections 3105 and 3106.

This is a critical win for MBIA and the first sign that MBIA might score a complete victory on its motion.  Remember that the familiar understanding of materiality in the insurance context under New York common law and Insurance Law is that a misrepresentation that would have affected the insurer’s willingness to insure the risk or the terms on which it would have insured the risk constitutes a material misrepresentation.  The fact that the court will be using these sources to determine causation and materiality bodes extremely well for MBIA.

Sure enough, in the following paragraph of the Order, the court finds that, “no basis in law exists to mandate that MBIA establish a direct causal link between the misrepresentations allegedly made by Countrywide and claims made under the policy.” (Order at 14)  Instead, Bransten holds that to recover for fraud or breach of warranty, MBIA must prove only that Countrywide’s misrepresentations were material to MBIA’s decisions to issue the insurance policies, and that materiality means that Countrywide’s statements,

induced MBIA to take action which MBIA might otherwise not have taken, or would have taken in a different manner… MBIA must prove for its fraud claim that it issued the Insurance Policies on representations made in the policies’ applications, and that it would not have done so or would have issued the policies on different terms had the alleged misrepresentations not been made.  Similarly, MBIA must prove for its breach of warranty claim that Countrywide’s alleged misrepresentations materially increased MBIA’s risk of loss. ” (Id. at 14-15)

At this point, the court’s analysis has squared precisely with my own, and I am as confident as ever that the court will strike a decisive blow to Countrywide’s loss causation argument across the board.  If common law claims for fraud and breach of insurance contract reps and warranties only require a showing of a material misrepresentation, then why should putbacks require anything more, especially when the contract language is “materially adverse impact” on the insurer’s interest in the mortgage loans?

Section 2B – Rescissory Damages

Before handing down what I’m certain will be a sparkling affirmation of MBIA’s argument on putbacks, Bransten first deals Countrywide another crucial setback.  As part of its Partial Summary Judgment Motion, MBIA had sought a declaration that it could recover its alleged economic injury through rescissory damages.  Countrywide had countered that to recover under New York Insurance Law, MBIA could seek only to rescind or avoid the policies, which would be both unfair to the bondholders and barred by the provisions of MBIA’s financial guaranty policy.

Here, though there was little governing case law in New York regarding the application of rescissory damages in lieu of actual rescission, Bransten shows a surprising openness to the idea that rescissory damages may be awarded as the economic equivalent to rescisison where rescission is not practical.  After finding that rescission would indeed be impractical in this case, even though it may ultimately be warranted, Bransten finds that “rescissory damages are appropriate in this instance under persuasive case law and this court’s power to award relief.” (Order at 17-18)

To support this finding, which has MBIA and the other monolines smiling because it will provide them with the most direct and complete pathway to recovery, the court is forced to rely on cases from such diverse sources as the Delaware Chancery Court, the U.S. District Court for the Southern District of New York, and the U.S. District Court for the District of Arizona. The fact that the court is willing to broadly interpret the law and the scope of its powers in this regard, and to apply substance over form in fashioning an equitable remedy for the insurer, bodes well for MBIA’s chances on the rest of this motion.  Bransten seems to be going out of her way to ensure that MBIA has an avenue for recovering its losses.

At the end of this section called “Causation,” Bransten sums up her findings: MBIA may prove fraud or breach of warranty based upon a misrepresentation by Countrywide that induced action resulting in damages, and rescissory damages may make MBIA whole for any wrongdoing which it is able to prove.  She then writes: “However, the court does not find that this disposes of Countrywide’s fourteenth and fifteenth affirmative defenses.  The burden of proof remains upon MBIA to prove all elements of its causes of action.”

Recall that Countrywide’s 14th Affirmative Defense is that Defendants were not the proximate cause of MBIA’s losses.  Countrywide’s 15th Defense is that there were superceding or intervening causes which were the actual cause of MBIA’s losses, “including but not limited to macroeconomic and mortgage industry events.”  Based on Bransten’s other findings in her Order, that MBIA must still show proximate causation connecting the misrepresentations that induced it to issue the insurance policies and its losses, it makes sense that she would leave these defenses intact.  She certainly could have been more proactive here and barred any defenses suggesting that proximate causation must connect a policy payment and a misrepresentation, or any defenses pertaining to intervening causes that occurred after MBIA insured the policies, but I can understand that Bransten would want to stick to addressing MBIA’s particular request to bar the defenses entirely, and not go too far afield.  I still have little inkling that all is not rosy in Loss Causation Land.

Section 3 – MBIA’s Claims for Breach of the Repurchase Obligation

Finally, the moment I have been waiting for.  I have been saying for years that insurers’ and bondholders’ putback claims were relatively strong because the standard was “materially adverse impact” rather than “proximately causes loss.”  Since this is the first post-crisis MBS case to reach this question, it’s the first real guidance we’ll have on a critical and far-reaching issue in MBS litigation.

Yet, if I was hoping that Bransten would come right out of the box with an answer, I was sorely disappointed.  Instead, the court takes the next five pages to lay out in excruciating detail each side’s arguments on this issue.  Her Honor had summed up the parties’ arguments in the prior sections with a few sentences or a paragraph at the most.  The fact that Bransten is now going into this much detail in recapping the same arguments we’ve read in the pleadings and heard at oral argument sets off alarm bells in my head: the court is setting up a genuine dispute of material fact.

You see, summary judgment is only appropriate if there is no genuine dispute of material fact; that is, looking only at the facts agreed upon by both parties, it is apparent to the court that judgment must issue for one side or the other.   Contractual disputes are usually particularly well-suited for summary judgment because the parties agree that the contracts are the contracts, and the court is thus left to interpret the contracts and the parties’ intent based on the plain language of their written agreements.

Summary judgment seems especially appropriate here in MBIA v. Countrywide, as we have heard little about any oral agreements or other facts outside of the four corners of the contracts that might inform their interpretation.  Thus, I would have expected Bransten at this point to be running through her analysis of the contractual language on putbacks, not the parties’ arguments.  The fact that she’s instead spending pages rehashing the parties’ interpretations feels distinctly like a football team running a draw play on 3rd and 14 – they’re playing it safe and preparing to punt.

Sure enough, at the bottom of the fifth page of recap, Bransten finally reaches her conclusion.  Noting that “MBIA has posited a strong argument,” she nonetheless finds that “summary judgment is not here appropriate.” (Order at 23)  Her reasons?  MBIA only cites contract language from one of the 15 MBS Trusts, and though it states that a similar repurchase remedy exists across all 15 trusts, it hasn’t sufficiently laid out the contract language for those 15 trusts in its Rule 19-a statement of material facts.  Then, as if it was an afterthought, Bransten throws in an extra sentence about how the words “interest” and “aggregate” in the contracts are subject to varying interpretations.

Suddenly, Bransten has gone from flexible rulings, bending to give MBIA a pathway to recovery, to strict rulings that rely on technicalities for support.  Yes, technically, the particular facts upon which a party wants the court to rely must be laid out in its statement of facts.  But, must MBIA go through and lay out the relevant contract language from multiple sections of every one of 15 trusts?  Isn’t it sufficient for MBIA to provide a sample and to state that this is representative of the other contracts – a fact that can be verified from the record?

Keep in mind, this is the same judge that approved statistical sampling to present loan-level evidence because the court did not want to spend the time going through every one of the 300,000+ loans at issue.  Wasn’t it reasonable for MBIA to assume that this judge would not want to see 15 separate factual statements for each trust?  Moreover, if Bransten had wanted to rule on this issue, she certainly could have had her clerk go through the pertinent sections of the various Trust Agreements (which are presumably part of the record) and determine whether there was any relevant difference in their language.

Similarly, relying on the fact that there are “varying interpretations” regarding the word “interest” without making any value judgment about the strength of those interpretations falls short of the judicial diligence I expected.  There will always be varying interpretations of any contract in litigation.  It is entirely within the court’s province to decide which one most closely effectuates the intent of the parties.  This is especially true when Bransten has just called MBIA’s argument “strong.”  Heck, she just walked through the case law providing that insurers are entitled to know the nature of the risks they’re assuming.  How difficult would it have been to find that an insurer’s interest in the loans is the same as its interest in the policies – the riskiness of the asset it was insuring?  All told, this portion of the Order feels distinctly like a cop-out – the judge guided us 3/4 of the way across a rickety rope bridge, and had everything she needed to get us to the other side, but for some reason stopped short and told us “good luck!”

Loss Causation Fallout

Of course this decision, and the mirror-image decision Bransten issued in the case of Syncora v. Countrywide, et al., do provide the monolines with fodder that they can use in their ongoing MBS cases.  But applying this decision to bondholder cases will be more of a stretch.  Shortly after reading the opinion, I tweeted, “J. Bransten goes 3/4 of way toward giving MBIA & Syncora complete wins v. BofA on MSJ but stops short of applying same reasoning to putbacks.”  Soon, a response came from Scott Walker (@scottleewalker), a litigator in the Structured Finance group at Lowenstein Sandler: “@isaacgradman — I had the exact same thought. Have been waiting for some guidance in that area. Oh well.”

All of which raises the immediate question: why did Bransten stop short?  I have a theory, but obviously this is just speculation on my part.  By way of the first 3/4 of the Order, Bransten provided MBIA with a shorter, cheaper and more complete pathway to recovery than putbacks by allowing it to seek rescissory damages.  Now, instead of having to go loan-by-loan (at least through a sample of some 6,000+ loans), and being able to recover only those losses on loans it can prove were defective, MBIA can just prove that it was induced to issue the policies by a misrepresentation and thereby recover all of its losses.

Maybe Bransten hopes that MBIA be happy with that decision (they were), not appeal her on putbacks (still an open question) and opt to go down the fraud and breach of insurance contract paths exclusively, saving Bransten one huge headache of a trial.  Or at least she hopes that by providing MBIA this weapon in its arsenal, it will make BofA more likely to settle.

Bransten also made several comments on the record during oral argument on this motion recognizing the unique attention this case was attracting and the impact it would have.  She stated,

It is a very full courtroom so we’re going to have a few things that we have to talk about before I even address my attorneys here today. In the first place, I have my other attorneys sitting the jury box, am I right? Okay. Usually I wouldn’t permit any standing room. However, I understand that this has a major impact on lots of people and some people didn’t get here quick enough to get a seat, so if there is an empty seat anywhere I want it filled and we can squeeze as much as we can, that’s number one.

Number two, the strict rule that I will enforce is I do not want anyone to speak during any of our arguments. We have to be absolutely silent. For those of you standing, the only thing I can say is if you get uncomfortable or you want to speak or you have anything to say, just go outside and do it. I think from now on, this is it. I think we have reached maximum capacity, so that will be it. Anybody who is here, if we take a break and come back, no new people, because I really do think that we’re maxed out. (Transcript, Oral Argument on MBIA’s Motion for Partial Summary Judgment at 3:2-22 (emphasis added))

These comments certainly don’t give me the impression that Bransten presides over cases with this much national interest very often.  With this decision, Bransten avoids the spotlight on appeal and possibly avoids having to try this dog of a case.  Let’s be clear: as an analyst following these issues, I find this case fascinating and important, but to a state court judge, a case dealing with hundreds of thousands of loans and 15 complex mortgage securitizations that has taken 3 years just to get this far is probably beginning to look distinctly dog-like.

So maybe she was hesitant to stick her neck out, risk getting overturned on appeal, and at the very least have her opinion bandied about in every MBS case in the country.  I get it, but part of me was hoping that Bransten would be inspired by the judicial courage shown recently but Jed Rakoff and put to rest an issue that IMHO was plenty ripe for determination.

Posted in appeals, banks, BofA, bondholder actions, broader credit crisis, causes of the crisis, contract rights, damages, investors, Judge Jed Rakoff, Judicial Opinions, lawsuits, liabilities, litigation, loss causation, MBIA, MBS, misrespresentation, monoline actions, monolines, pooling agreements, private label MBS, putbacks, rep and warranty, repurchase, rescission, RMBS, securitization, statistical sampling, The Subprime Shakeout | 5 Comments

Federal Home Loan Bank Litigation Update: MBS Cases Moving Slowly, But Steadily, Ahead for FHLBs

Posted on December 22, 2011 by iautry

By Isaac Gradman and India Autry

The Federal Home Loan Bank (FHLB) litigation against MBS underwriters, some of the first to arise out of the sale of toxic mortgage backed securities post-crisis, is progressing slowly but surely towards trial, without any major setbacks for the plaintiffs. As these suits have been followed closely since their inception by The Subprime Shakeout and its readers, and since it’s been a year since our last article on this front, we thought it was a good time for an update.

In the first of the six FHLB suits, brought by the Pittsburgh Bank, discovery is well underway and the court has ordered defendants to turn over extensive loan files. As previously reported on The Subprime Shakeout, the Bank’s complaint initially withstood dismissal without much hard evidence of wrongdoing, most of which could only be found in loan files that defendants and servicers had not been willing to turn over.  Now that the bank is beginning to obtain loan files, one can only imagine what other evidence and/or claims of wrongdoing they will find.

The plaintiffs in the other FHLB suits are just now reaching the beginning stages of discovery, having overcome their defendants’ respective motions to dismiss.  At the outset of most of these suits, the defendants employed the common tactic of removing the cases to federal court, in an effort to prolong the cases and drive up costs for the plaintiffs. Though the FHLBs of San Francisco, Seattle and Indianapolis have since been successful in having their cases remanded back to state court (to be heard by judges presumably more likely to broadly construe their own states’ Blue Sky laws), defendants have succeeded in delaying these cases for years.  Motions to remand still are pending in the cases brought by the FHLBs of Chicago and Boston.

The good news for plaintiffs in these cases is that defendants’ motions to dismiss largely have failed.  We’re going to dive into the Order on Defendants’ Motion to Dismiss in Seattle as an example.  In that case, Washington state judge Laura Inveen shot down, on all but one issue, the consolidated motion of the eleven defendants that sought to dismiss the FHLB’s claims.

The Seattle Bank had asserted claims against the defendants pursuant to the Washington Blue Sky law allowing for rescission based on false or misleading statements.  In particular, the FHLB focused on four types of misrepresentations in the MBS Prospectuses, which have since been repeated verbatim by the FHFA in its later-filed suits:

  1. Misreps regarding loan-to-value (LTV) ratio;
  2. Misreps regarding borrowers’ intent to occupy properties as primary residences;
  3. Misreps regarding originators’ and underwriters’ adherence to their own guidelines; and
  4. Misleading statements regarding the ratings of the certificates.

The defendants countered that the court must dismiss these claims for a number of reasons:

  1. The statements were just opinions;
  2. The statements were actually non-actionable statements of third parties;
  3. The trust documents contemplated the repurchase of non-performing loans, so the statements in the prospectuses could not have been considered absolute; and
  4. The Prospectuses contained sufficient disclaimers to warn investors not to trust the statements or the loan quality.

The court ended up denying the defendants’ motion to dismiss as to each of plaintiffs’ categories of alleged misrepresentations, with the exception of borrowers’ statements regarding their intent to occupy the premises as a primary residence (more on that below).  The court pointed out that the standard for a motion to dismiss was high, especially since there were no allegations by the plaintiff of fraud. Also, the court refused to conduct a choice-of-law analysis, which would have resulted in the application of New York law with its more limited protections, since Washington’s Blue Sky laws provided investors greater protection than New York’s, and the court found that the state of Washington had a sufficient nexus to the litigation to apply its own law.

The court then addressed defendants’ arguments that the allegations of false and misleading statements were non-actionable opinions or statements of third parties. With respect to three out of the four categories of alleged misrepresentations (LTV, guidelines and ratings misreps), the court found there was enough verifiable information to make the material actionable and that the defendants sufficiently restated third-party statements and adopted them as their own, such that dismissal was not appropriate. As to the allegation regarding intent to occupy, however, the court held that,

Plaintiff was aware that occupancy assertions were based solely on the say-so of the borrower — an individual with a pecuniary motive to obtain a loan, with little, if any risk in being deceptive when misstating the occupancy status to obtain a favorable rate and terms. As a matter of law, it was not reasonable for Plaintiff, the sophisticated investor that it was, to rely upon statements about occupancy. (Order at 4)

This finding is notable, not so much because it rejected this category of misrepresentations – which seemed to be the weakest of the four categories – but because it pointed to the sophistication of the investors as one reason for dismissal.  As discussed previously on The Subprime Shakeout, investor sophistication has been widely cited by defendant banks as a defense in MBS securities suits, and this argument is being pounded especially hard in cases where the investor was the presumably sophisticated Freddie or Fannie.

However, federal securities laws do not seem to allow for this consideration.  Washington Blue Sky laws may be different, but the court does not cite to any case that so holds, so it’s not clear whether this opinion is an anomaly or whether other judges will follow this reasoning.  Note also that Judge Inveen held that information regarding intent to occupy could still come in to prove other allegations, such as failure to adhere to underwriting guidelines.

Finally, as to defendants’ argument that there was sufficient qualifying language, such as disclaimers, in the underlying agreements, such that the investors should have been on notice that some of the loans would not turn out as described, the court ruled that this language was either not applicable to the loans at issue, was not specific enough, or amounted to issues for a trier of fact to decide.

We tend to think that unless there were disclaimers in the Prospectuses that “the underlying loans will be approved without regard for the borrower’s ability to repay, no matter how bad the credit risk appears,” the boilerplate language that “exceptions to the guidelines will be permitted where compensating factors are present” does not exempt issuer banks from liability.  Exceptions were meant to be exactly that – occasional deviations from the guidelines – and the Prospectuses, as well as the originators’ underwriting guidelines themselves, generally provided that any exceptions had to be documented and supported by compensating factors.  The practice of simply ignoring ones own underwriting guidelines for no good reason (except profit) was neither permitted by the guidelines nor disclosed to investors.

At the end of the day, Judge Inveen’s holding bodes well for the Federal Home Loan Bank cases and the securities law claims of other MBS investors.  You can expect these cases to continue moving forward, and to begin settling or finding their way to their courts’ respective trial calendars sometime in the next year or two.

Posted in banks, Blue Sky laws, choice of law, discovery, Federal Home Loan Banks, investors, lawsuits, litigation, loan files, LTV, MBS, misrespresentation, motions to dismiss, ratings agencies, remand, removability, securities fraud, securities laws, securitization, sophistication, subprime, underwriting guidelines, underwriting practices | 8 Comments

Rakoff’s Rejection of SEC Settlement with Citi Sends Stern Message to Wall Street’s Primary Regulator

Posted on November 30, 2011 by igradman

Two days after the release of one of the most scathing judicial opinions in recent memory, the importance of federal Judge Jed Rakoff’s rejection of the SEC’s $285 million settlement with Citigroup is just beginning to sink in.  In just 15 pages of moving prose that harken back to Rakoff’s undergraduate degree in English literature, the opinion rips the SEC for its lack of transparency and respect for separation of powers, failure to establish facts or allegations against Citigroup or deter future misconduct, and failure to uphold its obligation to uncover the truth and protect the public at large from financial fraud.

As Matt Taibbi of Rolling Stone magazine most aptly describes the opinion in his article, Federal Judge Pimp-Slaps the SEC Over Citigroup Settlement, it was “one of the more severe judicial ass-whippings you’ll ever see.” The ruling prompted Tyler Durden at ZeroHedge to call for the resignation of SEC Chairman Mary Shapiro. Below is an entertaining clip of Taibbi discussing the impact of Rakoff’s ruling on Countdown with Keith Olbermann.

So, what is the gist of Hizzoner’s objections?  First off, Judge Rakoff points out that in a parallel complaint filed by the SEC against a Citigroup employee for his role in putting together the CDO at issue, the SEC alleged that 1) Citi created Class V Funding III (the “Fund”) to dump dubious assets on misinformed investors as the market was tanking, 2) Citi helped select and then took a short position in the assets placed in the Fund, and 3) Citi knowingly misrepresented to investors that the assets had been selected by an independent third-party investment adviser in order to place the Fund’s liabilities. Rakoff notes that while these allegations would be tantamount to a showing of knowing and fraudulent intent (the scienter necessary for a fraud claim), the SEC left many of them out of the complaint against Citigroup itself and chose to charge Citi only with negligence (i.e., a failure to exercise due care rather than an intentional lie).  That was the first sign of a problem.

Next, Rakoff points out that through its complaint, the SEC seeks to invoke the court’s injunctive powers – an extraordinary remedy – without having proven any facts or coerced an admission of wrongdoing out of Citi.  By contrast, the SEC’s settlement with Goldman Sachs over the Abacus CDO required the bank to admit to “a mistake” and to “regrets” that the marketing materials for the CDO were inadequate.  This opened the door for civil lawsuits to further deter the bank from misleading investors in the future.  With respect to the Fund, the Judge noted that Citi made clear in open court that it was not admitting to the allegations in the complaint and reserved the right to contest the facts in parallel litigation.

Based on this, Rakoff found that the court was unable to determine whether the settlement was “fair, reasonable, adequate, and in the public interest.” (Opinion at 4)  In particular, Rakoff held that,

a court, while giving substantial deference to the views of an administrative body vested with authority over a particular area, must still exercise a modicum of independent judgment in determining whether the requested deployment of its injunctive powers will serve, or disserve, the public interest.  Anything less would not only violate the constitutional doctrine of separation of powers but would undermine the independence that is the indispensable attribute of the federal judiciary. (Id. at 4-5)

Next, Rakoff takes issue with the size of the penalty imposed on Citigroup and its impact in deterring future misconduct.  In one of the more remarkable passages from the Opinion, Rakoff notes that,

a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, especially in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. (Id. at 10)

Rakoff is pointing out in no uncertain terms what Taibbi, filmmaker Charles Feguson, and many in the Occupy movement and elsewhere have been saying for some time – Wall Street continues to look at law enforcement as simply the cost of doing business and will not be deterred from illegal conduct unless the size of the penalties increases dramatically or people start going to jail. Essentially, Rakoff is saying that Wall Street has become accustomed to paying off the SEC when it gets caught.

Rakoff further underscores the inadequacy of the penalties imposed on Citi in this proposed settlement by comparing it to Goldman’s Abacus settlement – which itself has been criticized as inadequate, since it punished Goldman for only one of several CDOs that were marketed in the same manner.  Rakoff points out that in the Abacus deal, Goldman only made $15 million in profits (compared to the $160 million in profits for Citi from the Fund deal) and that Goldman’s alleged conduct was arguably less blameworthy as Goldman didn’t directly short the assets in the CDO, but just failed to disclose that Paulson & Co., which had helped select the assets, was also shorting the deal.  Yet compared to Citi, Goldman was required to pay a bigger penalty ($535 million as opposed to a $95 million penalty for Citi), admit to certain mistakes, implement broader remedial measures, and cooperate with authorities.  (Opinion at 13 n.7).  It’s thus not surprising that Rakoff was unable to conclude that the Citi settlement was fair, reasonable, or adequate.

Finally, Rakoff reserves his most biting criticism for the SEC itself in failing to uphold its mandate.  After noting that this case “touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives,” Rakoff writes that,

the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances. (Id. at 15)

With that, Judge Rakoff rejects the settlement and orders the parties to prepare for trial on the SEC’s complaint on July 16, 2012.

I was left with chills after reading through the end of this Opinion.  It was if I had been waiting for years to hear a member of our judiciary stick out his or her neck to confront the inadequacy of the SEC’s long established “enforcement” patterns – slaps on the wrist, no admissions of guilt and certainly no jail time.  Indeed, while the cozy relationship between the SEC and Wall Street (with most at the SEC either having worked on Wall Street or harboring aspirations to work on Wall Street in the future) has been called out repeatedly by journalists, writers and commentators, I had never heard a member of the judiciary stick out his or her neck in such a bold manner and confront the SEC.

But Rakoff’s frequent reference to the core principles of the Constitution and the independent judiciary, as well as his reference to “much of the world, [where] propaganda reigns, and truth is confined to secretive, fearful whispers,” (Opinion at 15) reveal just how important this issue was to the fundamental values that set the United States apart.  Still, it took tremendous courage for Rakoff to speak out in the face of pressure from such a powerful government agency and refuse to simply wield his rubber stamp like so many of his peers had done before him.  Rakoff is correct – passive judicial acceptance of these sorts of bargains (even between two willing parties) does not protect the public interest one iota.  In fact, it does worse, by essentially ending the inquiry and withholding from the public the facts it needs to enforce its rights or recover its losses.  As Rakoff points out, there is no guarantee that the money recovered by the S.E.C. by way of such settlements (including the $154 million recovered from J.P. Morgan in connection with the Magnetar deal) will actually go to reimbursing defrauded investors.

If we hope to restore confidence in the U.S. financial system and attract private investment, we need to begin by showing those investors that the rule of law will be enforced with more than a wink, a nod and a slap on the wrist.  I hope that Rakoff’s opinion gives more members of the bench the courage to stand up and declare that their rubber stamps for agency actions are out of commission.

Posted in abacus, banks, CDOs, Citigroup, Complaints, consitutionality, costs of the crisis, damages, Goldman Sachs, investigations, investors, JPMorgan, Judge Jed Rakoff, Judicial Opinions, lawsuits, liabilities, litigation, media coverage, negligence and recklessness, oversight, Paulson and Co., probes, regulation, Regulators, SEC, securities laws, settlements, Uncategorized | 1 Comment

MBS Litigation Update: Why BofA Will Lose the Loss Causation Argument and Wish It Had Settled with MBIA

Posted on November 22, 2011 by igradman

With all eyes in the mortgage litigation world glued to the pending decision on Partial Summary Judgment in MBIA v. Countrywide, et al., commentators are beginning to speculate that a settlement may be in the offing between the two MBS heavyweights.  However, as we get closer to a decision on MBIA’s fully briefed motion with each passing day, and as BofA continues to suffer heavy casualties with each stroke of Judge Eileen Bransten’s pen, the nation’s largest bank by total deposits is running out of time to avoid another potentially disastrous result.

Indeed, rumors were already swirling as early as this past July that BofA had settled this lawsuit, sending the bond insurer’s stock soaring, but all gains were quickly erased as the market recognized the news as exactly that – just a rumor.  Then, last month, another rumor emerged that again reported that a settlement was in the works, and this time the rumor revealed a purported price tag for this settlement – $5 billion.

Of course, every rumor contains a kernel of truth, and this one made sense – given the devastating precedent this lawsuit could set for BofA, it must be carefully considering, and is likely in the process of discussing, a settlement with MBIA.  This past week, in fact, BofA reportedly settled a class action suit regarding Merrill Lynch securities to the tune of $315 million (interestingly, this settlement was first reported by Alison Frankel, who has also been suggesting that an MBIA settlement may be forthcoming).  If this report is true, could a settlement with one of the most dogged and successful plaintiffs in the slew of MBS suits against BofA be far off?

Having already suffered tough-to-swallow losses on the issues of statistical sampling, scope of discovery, fraud claims and successor-in-interest liability, BofA is now facing an even more significant loss.  At risk if BofA does not settle quickly is an adverse decision on the causation standard to be applied to putback claims – one of the key defenses cited by the bank (and by Bank of New York in justifying its settlement number on behalf of BofA) in maintaining that its obligations to repurchase defective subprime and Alt-A mortgages will be contained.

Aside from BofA’s string of losses before Judge Bransten, all signs from a legal perspective point to MBIA winning its Motion for Partial Summary Judgment on the issue of whether it can exclude BofA’s post-closing defenses (i.e., that the housing downturn, not Countrywide’s poor underwriting, caused MBIA’s losses) and focus on whether reps and warranties were breached at the time of the MBS Trusts’ closing.  But with this motion having been fully briefed for over a month, it seems that if BofA was going to head off this loss with a settlement, it would have done so by now.  So, assuming that this case does not settle in the next few weeks, I’m going to tell you why the next decision in this case – in one of the earliest-filed pieces of mortgage crisis-related litigation – will produce more bad news for the beleaguered Big Four Bank.

Loss Causation Background

For readers unfamiliar with the issues at stake, we’ll start with a little background.  Countrywide, in conjunction with dozens of other subprime and Alt-A originators, sold trillions of dollars worth of loans to Wall Street during the 2000s and provided the purchasers with certain guarantees – known as reps and warranties – regarding the quality of the loan underwriting they would employ and the loan guidelines they would follow.  The purchase and sale contracts for these loans specified that if any of these reps and warranties were breached with respect to a particular loan, and the breach materially and adversely impacted the value of the loan or the interest in the loan of the investor or bond insurer, the originating bank would have to buy back the loan at par (the original face value).

Though this description of banks’ so-called putback liability is noncontroversial, a major dispute has emerged over what is meant by “material and adverse impact.”  Countrywide/BofA, along with many other banks with legacy loan origination liability, has argued since these MBS lawsuits were first initiated that the “material and adverse” language created essentially a loss causation standard.  That is, plaintiffs were required to prove that each breach of reps and warranties identified actually caused the loan to go into default.

Plaintiffs like MBIA, on the other hand, have argued that the standard means what it says – that the breach has to simply impact the value of the loan by making it riskier and more likely to default.  They point to several provisions of standard Pooling and Servicing Agreements (the contracts governing the creation of MBS) that provide specifically for situations in which performing loans are required to be bought back.

You would think that the presence of provisions allowing for the repurchase of current loans would end this discussion – but BofA and other banks with repurchase liability have continued to argue this point.  I will run through each of these arguments in turn – as detailed in Countrywide’s Opposition to MBIA’s Motion for Partial Summary Judgment – and explain why none of them hold water.

Countrywide’s Loss Causation Arguments

Countrywide spends the first three-plus pages of the loss causation section of its memorandum making the unremarkable point that a breach of rep and warranty must have a material and adverse impact – that a breach alone is not enough.  This amounts to the quintessential straw man argument: Countrywide sets up a flimsy characterization of MBIA’s argument only to batter it into the ground.

It accomplishes this by seizing on one admittedly imprecise line in MBIA’s Motion, that “MBIA may invoke the repurchase provisions upon showing that the characteristics of a loan was [sic] not as represented by Countrywide” (Motion at 22), to suggest that MBIA is denying the existence of a materiality requirement.  Yet Countrywide ignores that in the very next sentence of its brief, MBIA states that Countrywide’s repurchase obligation is triggered “if MBIA’s interest in the loans is ‘materially and adversely’ affected by Countrywide’s breach…[meaning there is a] material increase in the risk profile.” Id. I doubt that Judge Bransten will have much patience for the creation of a dispute where none exists.

Assuming that both sides agree that the contract says what it says, and that it includes the “materially and adversely impacts” language, Countrywide is left with three arguments that are far flimsier than any straw man it set up for MBIA.  First, it attempts to counter MBIA’s argument that other provisions of the PSA expressly provide that non-defaulted loans may be put back to the originator.  To this, Countrywide responds that nothing in those provisions undermines the fact that a breach must “materially and adversely impact” the insurer’s interest in the loans. (Countrywide Opp. at 20)  Of course, this is true, but not if Countrywide’s interpretation of the materiality provision is that the breach must cause the loan to go into default.

Countrywide states that the PSA does contemplate the repurchase of performing loans, but only in “very limited circumstances… which are not at issue here.” (Countrywide Opp. at 20)  Again, that’s not the point.  The point is that if the PSA contemplates the repurchase of performing loans, then the “materially and adversely impacts” language cannot possibly mean that the breach must cause the loan to go into default, because that would create a contradiction, which courts are expressly instructed to avoid in interpreting contracts.  Thus, even if the circumstances under which performing loans can be put back are not present here, the presence of that language authorizing repurchase of performing loans undermines Countrywide’s interpretation of the governing contract.

Countrywide follows up this red herring with an argument that couldn’t beat its way out of a wet paper bag.  Essentially, it argues that MBIA’s insistence that a materially adverse impact could consist of an increase in the risk profile of the loan ignores the “plain meaning” of the contract language.  It then launches into an etymological exploration of the word “affects” that would have made Webster proud.  Because, according to Countrywide, “affects” means “to produce a change in,” then the breach must have actually caused harm to MBIA. (Opp. at 21)  A breach that makes the loan riskier is simply a potential adverse impact, and not an actual one, according to Countrywide.

This argument ignores the concept of risk entirely.  I’ll illustrate with a brief hypothetical.  Say we’re playing a card game where we’re betting on whether the next card you draw will be black or red.  You put up even money that the next card will be red.  When you’re not looking, I remove 5 red cards from the deck.  Now, I present you with the deck and ask you to pick a card.

Let’s freeze it at the moment before you draw.  Now, have I caused any direct harm to you?  Well, you haven’t actually lost any money yet, so technically there’s no “loss” and under Countrywide’s argument, no direct harm.  But, I have certainly adversely impacted your interest in our transaction, as I have made it more likely that you would draw a black card.  In this case, you would be justified in arguing that I harmed you by making it more likely that you would suffer a loss.  It makes no difference whether you end up drawing a red card or a black card once the game resumes.

In my mind, the argument over reps and warranties is identical to this scenario (or, if you don’t like that analogy, try the one often used by MBS plaintiffs attorneys – if the brakes on your car are defective, you don’t need to wait to get into a car accident to return the car to the dealer).  Countrywide has (allegedly) ignored its underwriting guidelines and issued loans without screening for certain risk factors (such as excessive debt-to-income ratios, inflated appraisals, inflated borrower incomes, etc.).  Now, even if Countrywide “got lucky” on these loans and some are still performing, the fact that nobody checked the borrower’s characteristics or ignored red flags means that those loans are more likely to default sometime in the future.

MBIA is essentially drawing from a stacked deck and will be forced to pay insurance claims based on how many black cards it draws going forward.  This certainly constitutes a material and adverse impact on the loans, notwithstanding whether or not it has actually resulted in a loss.  In other words, this argument conflates actual loss with actual adverse impact, and thus it is Countrywide, not MBIA, that is seeking to change the plain meaning of the pooling and servicing agreements.

Moreover, as MBIA is quick to point out, it is a familiar understanding of materiality in the insurance context that a misrepresentation that decreases the insurer’s willingness to insure the risk, or insure the risk at a particular price, constitutes a material misrepresentation.  Insurers, in other words, are entitled to know the nature of the risks they are assuming, and may avoid a policy based on a misrepresentation as to a risk, even if that particular risk does not materialize.

In further support of its “plain language” argument, Countrywide states that the First Department of the New York State Appellate Courts has already rejected MBIA’s risk profile argument in an appeal related to this very case. (Opp. at 21)  If true, this would certainly be an important fact, but alas, it’s yet another creative presentation of the truth by Countrywide’s attorneys.  You see, what the First Department actually did was affirm the lower court’s denial of Countrywide’s motion to dismiss MBIA’s fraud claim.  Countrywide had argued that the housing downturn was an intervening cause of MBIA’s loss, and thus MBIA could not as a matter of law make out its fraud claim, which requires a showing that its losses were caused by Countrywide’s fraud.  The appellate court simply held that it could not establish as a matter of law that the housing downturn was an intervening cause – that this would be a factual determination for the trial court.  How this translates into support for Countrywide’s argument that the contract language requires that actionable breaches must actually cause loan defaults is beyond me.

Finally, Countrywide adopts the familiar contract dispute refrain that adopting MBIA’s interpretation would render certain contract language “meaningless.”  (Opp. at 22)  The argument goes that a breach that adversely impacts the loan’s risk profile is nothing more than a “material breach,” thus rendering the language “adversely impacts” meaningless.  Yet, if the language simply stated a “material breach,” it could refer to a breach that was material to any number of participants or factors, such as material to the originator’s ability to sell the loan, the issuer’s ability to securitize the loan, or the servicer’s ability to service or modify the loan.  Instead, the language specifies that the breach must materially adversely affect the investor’s or the bond insurer’s interest in the loan.  The language thus specifies that the breach must impact the risk that the loan will not be repaid.  Thus, MBIA’s interpretation gives meaning to the entire clause, and would not render any language in that clause meaningless.

Countrywide goes on to cite a number of cases that employ a “materially adversely impacts” standard to the breach of a rep and warranty.  None of these holds that a breach that causes a loan default is required to satisfy this standard.  For example, Countrywide cites LaSalle Bank, N.A. v. Citicorp, 2002 WL 181703, at *3 (S.D.N.Y.) for the proposition that “a plaintiff states a claim for breach of a repurchase agreement when it has alleged a causal link between the breach of a representation and warranty and the defaulted loan.” (Opp. at 23) Essentially, that case said that if a breach causes a default, it constitutes a material adverse effect.  It did not say that a default was the only material adverse effect that would qualify.  Instead, just one paragraph later, when addressing a separate breach of reps and warranties, the court in LaSalle held that:

a determination of materiality is a fact-intensive matter.  These factual issues relate to whether the breach was material and whether any breach had a material adverse effect on the value of the mortgage loan. (Id. (emphasis added))

Need I go on?  At this point, I feel like I’m just piling on.  Suffice it to say that none of Countrywide’s cases hold that a default is the only permissible evidence of a material adverse impact.  It’s not that Countrywide’s attorneys are doing anything wrong by making these arguments – it’s just that they have been asked by their clients to defend a position that is not supported by the documents or the law.  In fact, the best thing that Countrywide has going for it is that there is very little case law directly on point.  The best case that MBIA can offer is Wells Fargo Bank v. LaSalle National Association, 08-CV-1125, a case governed by Oklahoma law, rather than New York law. This does not mean that Judge Bransten will be unable to interpret the plain meaning of the governing contracts – this is something that judges do quite often and with competence, even when the case law is unsettled.

MBIA’s Loss Causation Counterarguments

At the end of the day, MBIA’s best argument – other than the plain language argument – is that other provisions of the contracts provide expressly for the repurchase of performing loans.  Though they could have done a better job of hammering this point home in their briefs, MBIA’s attorneys made the argument a central point during the hearing before Judge Bransten, which is worth quoting at length:

So the important point here is [Section 2.10 of the Sales and Servicing Agreement] says that with respect to any mortgage loan that is not in default, so it is performing, no repurchase pursuant to Sections 2.02, 2.03 and 2.04 shall be made unless you get that tax agreement.  Now, Section 2.04, which you’ve also just been shown, is the law that contains the material and adverse language. What 2.04 says, in order to have a breach of this section, this section is not breached unless there is a showing of material and adverse affect.

So if you put these two clauses together, by referring to 2.04 and 2.10, what they are saying is that… you can put-back a performing loan that is in breach of 2.04 if you get this tax opinion, and in order to put-back the performing loan under 2.04, you have to show that it had a material and adverse affect.

When you put those two things together, your Honor, you have to come to the conclusion that what this contract necessarily says is that material and adverse is measured at the time that the transaction occurred. It cannot be measured based on whether a loan defaulted or not because, of course, performing loans which you can put-back and which could have a material and adverse affect, performing loans are never defaulted, and therefore the contract cannot as a matter of logic mean what Countrywide says it means. (October 5, 2011 Transcript at 40:7-41:6)

What MBIA also has going for it is the logical appeal of its interpretation. As illustrated by the stacked deck and the faulty brake hypotheticals, it can’t be the case that Countrywide could engage in the shoddiest underwriting in history, but get away with it if the loan still somehow performed.  There are plenty of examples in the law of scenarios in which parties are found liable for dangerous, illegal, or improper conduct pursuant to a contract, even if such conduct does not result in direct harm (think about attempted robbery, possession of a machine gun or driving under the influence, to name a few).

I could go on, but I think Philippe Selendy, MBIA’s lead attorney from Quinn Emanuel, said it as well as anyone, so I will just end this section with a quote from his oral argument before Judge Bransten:

The housing crisis does not give Countrywide a defense to its Day One misconduct and its misconduct leading into these transactions. There would be no insurance policies and no losses but for that fraud… When you think about it, what Countrywide is trying to do here, having first caused the housing crisis, together with other reckless loan originators and underwriters, they want to turn around and profit from it again. They want you to rule that the crisis is in effect a Get Out of Jail Free card that allows them to escape liability for their fraud and shift the costs to innocent parties. Well, luckily we’re in a country governed by the rule of law, and the law doesn’t work that way. (October 5, 2011 Transcript at 35:4-25)

Loss Causation Fallout

I don’t mean to belabor the point here, but I want to make it crystal clear what a bad position BofA has backed itself into.  For years, it has been telling its shareholders and regulators that its exposure to private label putback liability will be circumscribed, based in large part on this loss causation argument.  Take CFO Chuck Noski’s statement on BofA’s earnings call back in Q3 2010:

We believe many of the losses observed in these [private label] deals have been, and continue to be, driven by external factors, like the substantial depreciation in [home] prices, persistently high unemployment and other economic trends, diminishing the likelihood that any loan defect should one exist at all, was the cause of the loan’s default.

Or take the statement of Bank of New York’s “independent expert” in substantiating the $8.5 billion settlement amount for Countrywide putback claims in part with the finding (which Countrywide cites in its Opposition, in a classic lesson in bootstrapping) that, “based solely on general contract principles, and taking the language of the provision at face value, it appears to be a reasonable position that a determination of whether a breach materially and adversely affects the interests of Certificateholders should turn on the harm caused by the breach.”

Now, we all know that there are no guarantees in litigation, and there is always some chance that BofA will succeed in establishing the viability of its defenses (or at least Judge Bransten will find that there is a genuine issue as to whether BofA’s post-closing defenses are relevant).  Indeed, if BofA’s permitted to stand behind these defenses in MBIA v. Countrywide and in other cases across the country, it could be an enormous boon for originating banks.  Suddenly, it would open the case up to arguments of intervening causes – that it wasn’t our shoddy underwriting at issue but the global credit crisis, the collapse of the housing market, the soaring unemployment rates and a whole host of other factors that caused these loans to go into default.  It would also place the burden on MBS plaintiffs to prove not only a breach of reps and warranties but that such breach was the actual and proximate reason that the borrower stopped making his or her mortgage payments.  You don’t have to be a lawyer to understand what a monumental task that would be in cases like MBIA v. Countrywide, where hundreds of thousands of loans are potentially at issue.

On the other hand, if BofA loses this motion, it could cause a hugely detrimental chain reaction.  Proving that a breach simply made the loan riskier is not all that difficult.  Most reps and warranties are designed to control the risk of the loans, and plenty of extrinsic evidence is available to show that breaches of these reps result in a decrease of the price that purchasers were willing to pay for the loans.

In fact, back in August, San Francisco hedge fund Branch Hill Capital estimated that a loss on this materiality interpretation could cost Bank of America as much as $9 billion.  And that estimate was made before bondholders managed to move the settlement with Bank of New York to federal court, where Judge Pauley will have far more freedom to evaluate the settlement number and methodology proffered by Bank of New York than Judge Kapnick would have had in state court under Article 77.  If Pauley has an opinion from Judge Bransten before him holding that the housing downturn is not a valid defense to putback claims, it could undermine that entire settlement.

So you can see why BofA might have wanted to settle this case before such a potentially devastating decision could be rendered.  But with a decision expected to be handed down by Judge Bransten any day now, the window of opportunity for Bank of America to side step this potential train wreck is rapidly closing.  I would imagine that BofA’s attorneys can hear that train whistle blowing as we speak.

[Many thanks to The Subprime Shakeout’s new intern, India Autry, for her meaningful contributions to this article – IMG]
Posted in Alison Frankel, allocation of loss, Bank of New York, banks, BofA, branch hill capital, causes of the crisis, Countrywide, irresponsible lending, lawsuits, lenders, lending guidelines, liabilities, litigation, loss causation, MBIA, MBS, misrespresentation, motions to dismiss, Philippe Selendy, pooling agreements, private label MBS, putbacks, quinn emanuel, rep and warranty, repurchase, RMBS, securitization, statistical sampling, Uncategorized, underwriting practices | 10 Comments