Six Challenges to Countrywide RMBS Settlement Already; Rundown Shows Pact Will Be No Easy Sell for BofA

Posted on July 19, 2011 by igradman

The BofA settlement blowback has already begun.  If you’ve been following my recent posts (here and here) about the proposed Bank of America (“BofA”) settlement involving the Bank of New York (“BoNY”) and the Kathy Patrick-led investor group (the “Investor Group”), you know that I suspected that we would see a number of challenges levied against various aspects of the accord.  However, I never expected these challenges to come so quickly or from so many different angles.

Let’s take a quick rundown of the various responses we’ve seen already:

  1. Walnut Place.  The first investors to challenge the proposed pact were various entities going by variations on the name Walnut Place.  Represented by litigator David Grais, the Walnut Place entities already made waves back in February by filing a $1+ billion lawsuit, not only against BofA to force loan repurchases, but also against BoNY because it “unreasonably failed” to force BofA to incur buy back loans.  In its February lawsuit, Walnut Place alleged that Countrywide had made false representations about 1,432, or nearly 66 percent, of the 2,166 loans it investigated.  The Walnut Place LLCs were set up to allow certain unnamed hedge funds to pursue repurchases anonymously.On July 5, these entities moved to intervene in the BofA settlement on three general grounds: 1) the settlement amount is too low; 2) the investor group pushing for the settlement is conflicted; and 3) BoNY did not represent all investors because it negotiated the settlement in secret with certain investors without consulting others.  The full petition is available here.  According to the WSJ, David Grais is “in discussions with other investors about also moving to intervene.”
  2. Public Pension Fund Committee. Also on July 5, a group of public pension funds issued a press release stating that they would file a petition in New York Supreme Court to intervene and take discovery on the fairness of the BofA settlement.  According to Bloomberg, the funds that have asked to intervene include the Policemen’s Annuity & Benefit Fund of Chicago, the Westmoreland County Employee Retirement System, City of Grand Rapids General Retirement System, and City of Grand Rapids Police and Fire Retirement System.David Scott, the attorney representing the Public Pension Fund Committee, stated that, “Public pension funds purchased billions of dollars of Countrywide mortgage backed securities.  They need to be given a seat at the table to make sure that the settlement is fair, reasonable and in the best interests of the entire class of investors.” The Committee has voiced several concerns regarding the accord, including: 1) no public pension funds were included in the Investor Group; 2) many in the Investor Group have “significant ongoing business dealings with Bank of America, raising conflict-of-interest concerns”; 3) the settlement proceeds are being allocated through the payment waterfall, providing some investors with a windfall gain while not compensating others for actual losses; 4) the settlement does not provide notice and ability for investors to opt-out; and 5) the settlement provides broad indemnification for BoNY.
  3. Rep. Brad Miller. On July 8, 2011, Congressman Brad Miller (D-N.C.) sent a letter to the FHFA, as conservator of Freddie Mac and Fannie Mae, expressing concerns regarding the BofA settlement.  In the letter (full version available here), Miller questions whether the value of the settlement (approximately two cents on the dollar based on the original value of the Countrywide RMBS and five cents on the dollar based on the current value of the securities, according to the letter) was adequate and whether investors should be permitted to opt out of the settlement, as they would with a class action.The letter further notes that, “The polar star for FHFA in the conservatorship of [Freddie and Fannie] must be minimizing taxpayer losses. I have urged that FHFA zealously pursue all available legal claims to limit those losses, including claims against issuers of ‘private-label’ mortgage-backed securities, such as the RMBS subject to the proposed settlement.”  Miller then asks acting FHFA director Edward DeMarco several questions regarding the settlement.First, would the FHFA be joining investors who are objecting to the settlement?  In connection with this question, Miller points out investor challenges stating that 60% of BoNY’s trustee business comes from BofA, that BoNY would be indemnified under the agreement, and that BofA and BoNY have denied the investors loan-level information to determine whether reps and warranties were breached with respect to the RMBS.  Miller notes that, “Independent investigations show that perhaps two-thirds of the mortgages did not comply with the representations and warranties.

    Second, Miller asks DeMarco what has become of the 64 FHFA subpoenas issued roughly one year ago.   Miller states that he understands that “very little information has been provided in response to the subpoenas,” and asks whether the subpoenas pertained to the Countrywide RMBS, whether BofA and BoNY have complied with those requests, and whether the FHFA intends to take additional action to determine whether it should support the settlement.

    Third, Miller asks whether the FHFA has tolling agreements with BofA and other potential defendants, given that the statute of limitations may be expiring with respect to put-back claims.

    Finally, Miller asks what information the FHFA will make available to the public, or at least Congress, for the purposes of providing oversight of the actions of the FHFA. These are all excellent questions, in particular the questions regarding the 64 FHFA subpoenas.  The FHFA has superior subpoena power over private litigants, and can force banks to turn over substantial information about the underwriting of the toxic loans at issue.  While the FHFA seemed like it was going to exercise this authority to investigate put-back issues when it issued scores of subpoenas one year ago, why has almost nothing been reported regarding these subpoenas since then?  And what has the FHFA done with the information (if any) that it has received?  Has it shared that information with private investors managing the retirement and pension funds of ordinary Americans?  As Miller notes, “It is important that the American people know that their government is acting on their behalf, not on behalf of powerful financial institutions.  It is important that the public and Congress be able to assess whether the enterprises settled claims that would limit taxpayer losses on a tough, arm’s length basis, rather than providing another indirect subsidy to the banking industry.”

  4. New York Attorney General. On July 12, New York AG Eric Schneiderman sent letters to the 22 institutions in the Investor Group, asking for information “regarding participation by both your firm and clients” in the BofA settlement.  In addition to the fact that investors will not be able to opt out, The New York Times suggests that a driving force behind this challenge may be the evidence that the deal will speed up foreclosures for BofA-serviced properties. Schneiderman has already made a name for himself by opting out of the broad AG effort to reach a settlement with the major servicers over foreclosure problems and launching his own investigation.  This latest action is a further signal that the New York AG will continue to pursue a broad and independent investigation of mortgage securitization issues, including potentially lodging his own challenge to the BofA deal.  Speculation has abounded that other state AGs may follow suit in challenging the accord over Countrywide RMBS, as they have with respect to the proposed servicer settlement, but nothing has been reported as of yet.
  5. TM1. On July 13, a third investor group sought to intervene in BoNY’s petition for approval of the BofA settlement.  Again, it was an anonymous group of investors represented by David Grais.  This group is proceeding under the name TM1 Investors, LLC, and states in its filing that it is not convinced that BoNY adequately protected its rights in negotiating the accord.  “After much investigation, TM1 believes that many of the loans that Countrywide sold to the trust in which it owns securities did not comply with the representations and warranties” made about them, its lawyer David Grais wrote in the filing.  Grais further stated that TM1 was considering suing BofA separately to enforce repurchases related to the MBS that were once worth over $400 million.
  6. Six Federal Home Loan Banks. Also on July 13, the Federal Home Loan Bank (FHLB) branches in Boston, Chicago, Indianapolis, Pittsburgh, San Francisco and Seattle sought to intervene in the BofA settlement.  The banks said that they had received “very little information” to help decide whether the Countrywide settlement was fair.  They noted that they had paid more than $8.8 billion, a sum exceeding the entire settlement amount, for securities in 73 trusts backed by home loans from Countrywide.  Several of the FHLBs have been active in the MBS litigation space, having filed separate actions against various securitization participants for violations of securities law (see articles on the Pittsburgh, San Francisco, and Seattle FHLBs).  Interestingly, the FHLB of Atlanta is part of the Investor Group.  The Reuters article on the FHLB challenge quotes Sharon Cook, a spokeswoman for the Atlanta FHLB as saying, “The federal home loan banks operate independently.  We support the settlement, and the right of other federal home loan banks to further evaluate it.”

In addition to these challenges, the proposed settlement has also brought with it an intriguing array of sideshows.  For one, WSJ reports that BofA has said that the settlement will not be final until the IRS signs off.  The trusts are currently granted favorable REMIC status, and BofA wants to make sure it won’t engender additional liability for violating REMIC requirements based on the payment of settlement funds into the Trusts.  Another drama that has unfolded is the back and forth over whether David Grais was offered an opportunity to participate in settlement negotiations with BofA, BoNY and the Investor Group.  Grais has said that his clients were not offered a chance to participate, while BoNY’s lawyers now say that he was invited to the table, but opted instead to file the Walnut Place lawsuits.  A third piece of controversy has surrounded the whopping $85 million contingency fee that Kathy Patrick and her firm, Gibbs & Bruns, stand to receive if the deal goes through.  The Naked Capitalism blog has cited this figure as evidence that Patrick “is working for the deal,” and not for the investors she purports to represent, while The New York Times’ Deal Book blog was prepared to award Patrick a “lawyer of the day award” for staring down BofA and winning the $85 million payday.

If BofA’s strategy was to force any potential challengers to come out of the woodwork and enable the bank to resolve all Countrywide RMBS put-back issues in one fell swoop, it appears that this strategy is working.  Certainly, this proposal has managed to stir affected RMBS investors from their collective slumber and convinced them that they must take action, or watch their claims disappear for 9 cents on the dollar (based on an assessment by Moody’s).  By bringing all potential litigants together to fight it out over these liabilities in a single proceeding, BofA is hoping that it can put these legacy Countrywide issues behind it.  Already, commentators have begun congratulating the lawyers from BofA and BoNY for their election to proceed under Article 77, pointing to the high “abuse of discretion” hurdle that challengers face under this special proceeding for express trusts.  However, this vehicle has never been applied to RMBS Trusts of this scope or nature, and the trust agreements don’t specifically provide the trustee with the power to settle claims–especially as to Trusts where the Investor Group lacks standing.

If the would-be intervenors have their way, they may throw a monkey wrench in BofA’s plans, either by forcing BofA to throw more cash at the problem, or by convincing Judge Kapnick to release their bonds from the settlement.  The latter would force BofA to continue litigating these released claims in a piecemeal fashion.  Ultimately, the conflicts of interest present for BoNY and the Investor Group, the less-than-transparent manner in which the deal was negotiated, and the less-than robust investigation that was performed as to these claims provide ample cause for Judge Kapnick to take a hard look at whether the settlement is kosher under Article 77.  One need only read the opinion of BoNY’s “expert,” who found that only 36% of Countrywide loans likely breached reps and warranties, and that of those, only 40% would likely be bought back by BofA (based on inapposite experience from the GSE’s pursuit of putbacks and a phony loss causation haircut), to see that even under an abuse of discretion standard, this deal will be no easy sell for BofA, either to investors or to the New York courts.

Indeed, the 3% gain in BofA’s stock price after news of the settlement leaked was all but erased once news of the subsequent petitions to intervene came out.  Based on the number of challenges and issues raised by affected entities, it appears that it will take several years before this settlement is approved, if at all.  As some indication, BofA has included language in the settlement agreement allowing it to withdraw from the settlement if it is not approved by 2015.  With big names lining up on both sides of this issue, the proceedings should make for entertaining drama as they play out (see BoNY’s website on the settlement to follow along with the latest); just don’t expect a resolution anytime soon.

Posted in Attorneys General, Bank of New York, banks, BofA, bondholder actions, conflicts of interest, contract rights, Countrywide, Federal Home Loan Banks, FHFA, global settlement, Grais and Ellsworth, improper documentation, incentives, investigations, investors, lawsuits, lenders, liabilities, litigation, MBS, oversight, pooling agreements, private label MBS, procedural hurdles, putbacks, rep and warranty, repurchase, RMBS, securities fraud, servicers, settlements, standing, statutes of limitations, subpoenas, toxic assets, Trustees | 9 Comments

Creditor Rights: Use Them All!

Posted on July 14, 2011 by igradman

by Steve Ruterman, guest blogger

Much of the focus of mortgage crisis-related litigation and news coverage has been directed at put-back rights as a potential source of loss mitigation for mortgage creditors, including investors and bond insurers.  However, far less attention has been paid to creditors’ rights to fire servicers for noncompliance, also known as “servicer termination rights.”  Servicer termination rights can be the basis of inexpensive leverage on the servicer, and the potential benefits to creditors can be substantial.

Isaac has previously detailed the trench warfare aspects of formulating loan put-back claims against uncooperative RMBS issuers, so I’ll just summarize them briefly.

Assuming that you have the right as a creditor to begin the put-back process (meaning you have overcome onerous standing prerequisites), you have to obtain the underwriting loan files and the underwriting guidelines in effect at the time of loan origination directly from the seller.  If the trustee is the entity with the right to enforce loan eligibility rights, you must obtain the trustee’s cooperation.  Despite its contractual obligation to do so, the trustee will not always cooperate.  You then have to find someone with unassailable expertise in loan re-underwriting to examine the files, and determine whether the loans were underwritten in conformance with the seller’s guidelines, and were therefore eligible for inclusion in the loan pool at the time of the sale.  Demand on the seller for repurchase of the ineligible loans must then be made.  Given the very material potential costs of such demands on the largest loan sellers, litigation is very likely to ensue.

Worst of all, anyone commencing this process should be prepared to shoulder the expense of such a litigation right from the start; meanwhile, any recovery would not be realized for several years, and may be distributed through the credit waterfall to free-riding creditors if and when it is.  At the end of the day, few investors are prepared to undertake these costs for such remote gains, and this is probably why more investors are not actively pursuing enforcement of their repurchase rights.

However, RMBS creditors typically have additional points of leverage with sellers when the sellers are also the servicers of the loan pool.  These leverage points are cheaper to enforce, and in most cases, work more quickly, as well.  In particular, I am referring to servicer termination rights.

I do not wish to overstate the degree of leverage available to creditors, given the steady erosion of creditor rights which occurred as the frenzy of RMBS issuance accelerated after 2005.  Post-2005 deals typically contain servicer covenants that are more diluted than those found in earlier deals.  Most of these deals contain servicer covenants such as an obligation to make all payments to the trust when due, provide all required reports when due, take no actions that will damage the value or collectability of the loans, and so forth.  Failure to perform may constitute events of servicer default, subject to potential notice and cure periods, depending on the terms of the pooling and servicing agreements (PSAs).

Moreover, I have seen PSAs that define a number of servicer events of default, but are silent on the topic of creditor remedies.  In these cases, there are servicer covenants to do and not do certain things, but there are no contractual remedies or penalties imposed on the servicer if it fails to comply.  That said, these pro forma covenants can often be a source of inexpensive leverage on the servicer, and the potential benefits to creditors can be very substantial.  Indeed, just the credible threat of servicer termination may possibly spur a servicer to cooperate with creditor demands.

Why might a servicer default on covenants to perform seemingly mundane duties?  We are in the process of living through one of the most chaotic periods of the last two RMBS business cycles.  During the last shakeout in the late 1990s, the damage was largely confined to asset classes such as subprime and high loan-to-value, which were relatively tiny compared to the rest of the non-agency market.  The issuers involved were themselves tiny– typically independent, specialty lending shops– and are now defunct.

This time, the value of substantially all classes of non-agency mortgage loans has been drastically reduced, including subprime, Alt-A, jumbo and second lien.  This is because some industry players disregarded their loan underwriting guidelines.  Their abandonment of underwriting guidelines has deservedly garnered a lot of attention, and spawned creditors’ subsequent pursuit of put-back claims.

However, the collapse of internal credit and quality controls at some of the large mortgage loan sellers adversely affected every aspect of their operations.  Recently, for example,  there has been increased reporting on defective and deficient loan documentation, incomplete transfer of loans to securitization trusts, robo-signing of foreclosure documents, industry vendors dedicated to the manufacture of missing loan documents, and so on.

I have found that the internal control trouble extends to basic operational bread and butter issues such as proper remittance of collections due to securitization trusts.  In one case to which I was a party, the servicer accurately recorded daily obligor payment amounts deposited into its collection account, but subsequently made deposits in different amounts into the relevant trust account.  In other words, the servicer took the trouble to account for payments deposited into the collection account properly, but did not use those same records to size the subsequent deposits into the trust account.  This was an obvious lapse in the most basic internal servicing controls, on which the entire concept of securitization relies.  It was also the basis of a servicer event of default and the servicer’s subsequent termination.

What is the process by which events of default can be discovered?  It begins by exercising a creditor right contained in every PSA I have seen– the right to inspect the servicer’s books and records during normal business hours (sometimes the trustee or the trustee’s agent possesses this right).  In order to exercise audit rights associated with uninsured RMBS, the creditor is usually required by the PSA to hold at least 25% to 50% of either a tranche or a class of certificates.  There may be separate contractual language defining the voting control rights necessary to terminate servicers, or to instruct trustees to do so.  When notifying the servicer that such an inspection is forthcoming, it should be made clear that no loan re-underwriting is intended.  This usually results in an adequate level of servicer cooperation, as they are often audited by many different people.

Next, the creditor should engage a forensic auditor to do the work.  Forensic auditing of servicer compliance is cheaper than the put-back work described above, and can usually be completed in a few months rather than a few years.

The benefits of terminating an unsatisfactory servicer and transferring servicing to an independent party in whom creditors have more confidence are potentially immense.  Creditors no longer have to worry about whether the monthly cash transfers are correct, or that monthly reporting is accurate.  I have also found that servicers with poor internal controls are usually poor collectors and loss mitigators.  Thus, improved loan pool performance often results from a successful transfer.

Finally, the new servicer will be in a position to identify several types of ineligible loans that may be put back.  These include fraudulent loans and those with incomplete documentation.  Broader loan put-back efforts are not precluded by a servicing transfer and may proceed in parallel with servicer termination.  In other words, servicer termination, as a cheaper and easier precursor to exercising put-back rights, will ultimately aid creditors in enforcing those rights, on top of the benefits received from improved servicing of their loan pools.  While much of the focus in recent years has been on enforcing put-back rights, and there has been talk of broader efforts to replace servicers, creditors would be wise to make better use of this complementary strategy going forward.

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 terminated over 20 mortgage loan servicers.  Mr. Ruterman welcomes your comments, and can be reached by email at Steve.Ruterman@yahoo.com.

Posted in auditing, banks, bondholder actions, chain of title, contract rights, due diligence firms, Event of Default, firing servicers, freeriders, guest posts, improper documentation, incentives, investors, irresponsible lending, lenders, lending guidelines, loan files, MBIA, MBS, negligence and recklessness, pooling agreements, private label MBS, putbacks, re-underwriting, rep and warranty, RMBS, robo-signers, securitization, servicer defaults, servicers, standing, The Subprime Shakeout, Trustees, underwriting practices | Tagged , , , | Leave a comment

$8.5 Billion BofA Settlement of Countrywide Trusts Raises Questions for Investors on Sidelines

Posted on June 29, 2011 by igradman

As more details emerge about Bank of America’s proposed $8.5 billion settlement with Kathy Patrick’s bondholder group and Bank of New York Mellon (“BoNY”) as Trustee, the deal looks even worse for Countrywide RMBS investors.  Now, it is apparent that BofA is trying to settle all past and future repurchase and servicing claims with respect to all 530 Countrywide trusts, whether the involved bondholder group has standing in those trusts or not.  What’s even more apparent is that my original assessment of this effort was correct: the investors supporting this deal had conflicts of interest that prevented them from pursuing an aggressive settlement.

Here’s a quick summary of the key facts about this settlement, from what we know.  This information has been gleaned from the press release posted on the website of Kathy Patrick’s firm, Gibbs & Bruns, the press release issued by BofA, the Bank of New York settlement agreement, the separate settlement agreement with the 22 participating investors, and the investor call held by BofA this morning:

  • Settlement covers all 530 Countrywide trusts, that is, RMBS trusts issued by Countrywide itself;
  • Prominent investors involved include BlackRock, PIMCO, New York Life, New York Fed, Goldman Sachs Asset Management, Prudential, Western Asset Management, MetLife, TIAA-CREF and the Federal Home Loan Bank of Atlanta (Freddie Mac is listed as a client of Kathy Patrick, but not as one of the 22 supporting investors);
  • Combined original unpaid principal balances of trusts at issue was $424 billion;
  • Current unpaid principal balances of trusts at issue is $221 billion;
  • $47 billion from these trusts has already gone into default;
  • Another $59 billion is severely delinquent;
  • $203 billion has been paid off;
  • The settlements release all rep and warranty (i.e., putback) claims for Countrywide RMBS bondholders, as well as all past and future servicing claims (so long as BofA services according to newly agreed-upon standards) and any chain of title claims;
  • The settlement proceeds of $8.5 billion will flow through the trust waterfalls to all investors, and be allocated to the trusts pro rata based on BoNY’s assessment of which have suffered the greatest losses; and
  • Because the settlement deals with potential claims under New York state law, a New York state court will have to approve the settlement.

It is important to note that there are several potential liabilities that are not covered by this settlement.  BofA stated in its investor call this morning that the settlement covers half of its private label exposure.  The other half includes things like:

  • Fraud and securities law claims with respect to Countrywide-issued RMBS;
  • All potential claims as to loans that Countrywide sold to third parties, which third parties then securitized them; and
  • All potential claims as to loans sold by other BofA entities (e.g., Merrill Lynch).

Thus, servicing and foreclosure documentation problems (i.e., the 50 State AG efforts) are still on the table.  The settlement also does not cover new repurchase claims submitted by Fannie Mae, which unlike Freddie Mac, did not release all future putback claims as part of its settlement with BofA at the beginning of this year.  As part of its announcement of this settlement, BofA stated that it will have to up its repurchase reserve for GSE claims because of the soft housing market and because GSE “behavior has changed,” as well as up its reserves for private label rep and warranty issues from an estimate of up to $10 bn at the end of 2010 and an estimate of up to $14 bn at the end of 1Q11, to an estimate of at least $19 billion for 2Q11.  Whether that number will continue to climb upwards depends, in large part, on whether the investors sitting on the sidelines step out of the shadows.

All of this leads me to the main point of this article: investors must — and, in my opinion, will — challenge this settlement as not in the interests of the majority of bondholders.  BoNY, which has filed the settlement petition in New York state court and will be advocating for its approval, has no financial interest in recovering additional money for investors.  In fact, it has a far greater economic incentive to keep BofA happy, as BofA has the potential to hire the bank for many more trustee gigs and other financial services roles in the future.  Further, BoNY has proven since the onset of the mortgage crisis to be one of the least cooperative trustees for investors, throwing up roadblock after roadblock to its having to work with investors to resolve putback issues.  This is likely why BofNY has so readily thrown its weight behind this settlement, which will allow it to end the back and forth with investors over all of its Countrywide deals (as far as I know, BofNY is the trustee on all Countrywide-issued RMBS deals).

Thus, outside investors cannot rely on the trustee to act as a fiduciary for its interests.  And there are several issues that investors will want to make sure the court considers.  As an initial matter, according to Kathy Patrick, the 22 investors involved have voting rights in only 502 out of the 530 trusts.  This means that they are releasing claims for 28 trusts in which they hold absolutely no interest (this is no small number – the $1.6 billion AGO settlement with BofA covered a portion of 29 RMBS trusts).

Second, the 22 investor group does not have 25% of the voting rights (the threshold to acquire standing to sue under most pooling and servicing agreements) in all of those 502 trusts.  Reuters reports that, in a May securities filing, BofA stated that these investors had standing in only 230 trusts.  I doubt very much that this number grew to more than 250 trusts in the last month.  Thus, the investors who negotiated this settlement lacked standing in over half the trusts affected by the deal.  Judge Barbara Kapnick, who has been assigned to review the proposed settlement, may find those sorts of facts important.  After all, she was the same judge who threw out Greenwich Financial’s lawsuit against Countrywide for failing to strictly adhere to the procedural requirements for standing contained in the PSAs at issue.

Third, even in the trusts where the investors own 25% of the voting rights, they do not necessarily hold at least 50% of those rights.  Thus, while they technically may have standing to sue for relief in those trusts, they can’t say that they necessarily represent the interests of the majority of bondholders.  This may help to persuade the judge that the objections of other investors should be carefully considered and given substantial weight.

Fourth, the court will have to weigh whether this settlement is reasonable in comparison to the amount of potential damages at issue.  To that end, it should take into account the deficiency rates in each of the trusts at issue and, given proper discounting for litigation risk, the time value of money, etc., whether $8.5 billion is a reasonable amount for investors to receive to give up all of those claims.  The press release issued by Kathy Patrick states that BofNY retained National Economic Research Associates (NERA) as its expert to estimate the size of the trusts’ potential repurchase claims.  But, I would be curious how many loans NERA sampled, how deep a dive it conducted, and what guidelines and exceptions standards it used to determine which loans breached reps and warranties.  I would guess that an investor-retained expert might find a significantly greater number of loans subject to repurchases.

Finally, the court will have to consider whether the trustee’s proposed methodology of allocating the settlement proceeds is reasonable.  Patrick’s press release makes a point of parroting BofA’s consistent refrain that, “not every loss suffered on a mortgage loan is the result of a Seller’s violation of a representation or warranty.”  Of course, as I’ve discussed many times in the past, the legal standard for determining whether a breach of rep and warranty engenders a repurchase is materiality, not causation, so this statement, while true, is besides the point.  Even so, if Patrick recognizes that losses are not a good proxy for breaches, then why are settlement proceeds being allocated exclusively based on the losses suffered by the trusts?  Why not base the allocation on the percentage of deficient loans found by NERA across each trust?  It’s likely because NERA didn’t sample loans in each trust.

Already, Reuters reports that many investors are hopping mad over this proposed deal (that same article contains a good summary of my thoughts on the potential challenges to this deal and why BofA has recently shifted its approach).  This report squares with the feedback I’ve received, including the assessment of one person familiar with these matters, who called the deal a “screw job” for investors.  This source estimated that the potential losses from defective loans in these deals (that is, loans eligible for repurchase) amounted to $100 bn, meaning investors were receiving about eight pennies for every dollar of their potential putback claims.  We agreed that, if that damages estimate was correct, a more reasonable settlement would be in the range of $25 to $50 bn.  Based on the fact that BAC’s stock price jumped 3.5% in after-hours trading once the deal was announced, the market seems to concur that this was a great deal for BofA.

As is the case with so many of the trends in mortgage crisis litigation, the fallout from this major development will depend on how quickly investors can organize, and how willing they will be to stand up and speak out about the losses they’re suffering at the hands of the banks and conflicted trustees.  But I agree with Bill Frey’s assessment, attributed to him in the Reuters article, that “the silver lining of the settlement offer is that it should force a resolution — either the majority of investors in the bonds at the center of settlement accept it, or they fight for a better deal.”

    Posted in allocation of loss, Bank of New York, banks, BlackRock, BofA, bondholder actions, chain of title, conflicts of interest, contract rights, Countrywide, damages, Federal Home Loan Banks, Federal Reserve, fiduciary duties, Freddie Mac, global settlement, Goldman Sachs, improper documentation, incentives, investors, irresponsible lending, Kathy Patrick, lawsuits, lenders, lending guidelines, liabilities, litigation, litigation costs, loss causation, loss estimates, MBS, MetLife, PIMCO, pooling agreements, private label MBS, procedural hurdles, putbacks, re-underwriting, rep and warranty, repurchase, responsibility, RMBS, securities, securitization, sellers and sponsors, settlements, standing, subprime, successor liability, The Subprime Shakeout, TIAA-CREF, Trustees, underwriting practices, valuation, waiver of rights to sue, William Frey | 17 Comments

    Breaking News: BofA Close to Reaching $8.5 bn Settlement with BlackRock, PIMCO (100th Post)

    Posted on June 29, 2011 by igradman

    As part of the Subprime Shakeout’s 100th Post (woo-hoo!), I bring you an analysis of some big, breaking news: today, the Wall Street Journal reported that Bank of America was closing in on an agreement with the investor group led by Kathy Patrick to pay $8.5 billion to settle claims over mortgage backed securities.  If true, this would be the largest MBS settlement to date arising out of the mortgage crisis.

    I first reported on this investor effort back in October 2010.  You can find my initial take here, a link to the demand letter sent by Patrick here, and a link to the response fired off by BofA here.  While we heard early in 2011 that the parties would extend all deadlines while they negotiated, we had heard very little about the progress of these efforts until today.

    While the details of the purported settlement are sketchy, the WSJ report states that the current investor group includes 22 institutions, including BlackRock, PIMCO, the New York Fed, MetLife and Freddie Mac, which collectively hold $56 billion worth of mid-2000s vintage MBS.  Though it did not report on any impending settlement, Bloomberg also published an article today on these negotiations, and stated that the value of the securities at issue was $84 billion, while the original principal value of the securities was $182 billion.  While it is not entirely clear how these numbers line up, my best guess is that the investor group holds approximately $56 billion of the $84 billion outstanding.

    What’s also unclear is how much of the reduction in the value of the bonds at issue is as a result of pay-downs and prepayments, and how much is as a result of the trusts taking losses on foreclosed properties.  Thus, it is difficult to assess what percentage of potential damages from investor claims is being born by BofA under the settlement.  My initial reaction is that, while the absolute dollar amount sounds large, this settlement is ultimately fairly small compared to the potential damages.

    This result would be consistent with the consensus among commentators regarding this investor group, including some of the comments contained in today’s Bloomberg article and my initial take on this effort: namely, the investors involved have significant other business dealings with BofA (a.k.a. conflicts), and thus would not seek an aggressive settlement.  At the same time, BofA has exhibited a growing interest in resolving its legacy RMBS liability, and thus would be interested in entering into a sweetheart settlement with a prominent group of investors that would set a precedential ceiling on future recoveries and discourage other investors from coming forward.

    Without seeing the terms of the settlement and the details of the group’s holdings, it’s impossible to know what claims are being released in this settlement and how the proceeds are to be shared.  For example, if the group is being paid outside of the trust waterfalls, and thus receiving the entire $8.5 billion, then the investors would actually be recovering much larger proportion of their potential damages (while potentially throwing the other investors who did not participate in the settlement under the bus, either by purporting to release their claims, or by making it impossible for those other investors to gain standing to sue).

    However, sources have indicated that the settlement funds will actually be paid into the trust waterfalls.  This would be ostensibly more equitable, in that all bondholders would be entitled to receive a share of the settlement proceeds, depending on their seniority.  However, query how equitable it really is for a portion of the bondholders (and most likely the senior portion, since these are primarily institutional investors) to set the settlement amount for the rest of the non-participating bondholders, and to receive the lion’s share of the benefits based on their more senior bond position.  Whether the investor group could or would engineer such a settlement remains to be seen.

    Regardless, the fact that these investors got any money at all out of the nation’s largest bank, let alone a material dollar amount, might actually encourage other investors to come forward.  A settlement of this size would reveal that BofA’s initial rhetoric, that it would fight these claims tooth and nail until they were forced to pay, was just that–empty rhetoric.  For example, BofA CEO Brian Moynihan stated during the company’s third quarter 2010 earnings call that, “we will go in and fight this.  It’s worked to our benefit to—we have thousands of people willing to stand and look at every one of these loans.”  Further, this settlement undermines BofA’s recent estimate that the cost of its legacy RMBS putback issues would not exceed $10 billion.  BofA cannot seriously assume that this is the only large investor group with which it will have to tangle over defective Countrywide loans.

    The simple truth is that investors have significant amounts of viable repurchase and Securities Act claims stemming from their purchase of Countrywide-issued or originated MBS, and BofA will be forced to confront many additional claims by investors in the coming years.  These additional investors might not have the same level of business dealings with BofA and thus might be willing to take more aggressive steps in pursuing reimbursement for its losses.  In that case, BofA’s strategy of creating a lowball settlement to discourage investors from coming forward might end up backfiring and further eroding the already strained capital on BofA’s balance sheet.

    Posted in allocation of loss, balance sheets, banks, BlackRock, BofA, bondholder actions, contract rights, Countrywide, damages, demand letter, Freddie Mac, investors, Kathy Patrick, lawsuits, liabilities, loss estimates, PIMCO, private label MBS, putbacks, RMBS, settlements | 3 Comments

    FDIC Sues LPS and CoreLogic Over Appraisal Fraud; Shows Investors Leaving Money on the Table

    Posted on May 30, 2011 by igradman

    In another sign that the Federal Government is turning its focus towards prosecuting the securitization players who may have contributed to the Mortgage Crisis, the FDIC filed separate lawsuits against LSI Appraisal (available here) and CoreLogic (available here) earlier this month.  In the suits, both filed in the Central District of California, the FDIC, as Receiver for Washington Mutual Bank (“WAMU”), accuses vendors with whom WAMU contracted to provide appraisal services of gross negligence, breach of reps and warranties, and other breaches of contract for providing defective and/or inflated appraisals.  The FDIC seeks at least $154 million from LSI (and its parent companies, including Lender Processing Services and Fidelity, based on alter ego liability) and at least $129 million from CoreLogic (and its parent companies, including First American Financial, based on alter ego liability).

    As we’ve been discussing on The Subprime Shakeout this past month, the U.S. Government has stepped up its efforts to pursue claims against originators, underwriters and other participants in mortgage securitization over irresponsible lending and underwriting practices that led to the largest financial crisis since the Great Depression.  This has included the DOJ suing Deutsche Bank over reckless lending and submitting improper loans to the FHA and the SEC subpoenaing records from Credit Suisse and JPMorgan Chase over so-called “double dipping” schemes.  The FDIC’s lawsuit is just the latest sign that much more litigation is on the horizon, as it focuses on yet another aspect of the Crisis that is ripe for investigation–appraisal fraud.

    Granted, those familiar with the loan repurchase or putback process have long recognized that inflated or otherwise improper appraisals are a major category of rep and warranty violations that are found in subprime and Alt-A loans originated between 2005 and 2007.  In fact, David Grais, in his lawsuits on behalf of the Federal Home Loan Banks of San Francisco and Seattle, focused the majority of his allegations against mortgage securitizers on inflated appraisals (ironically, the data Grais used in his complaints was compiled by CoreLogic, which is now one of the subjects of the FDIC’s suits).

    Grais likely zeroed in on appraisals in those cases because he was able to evaluate their propriety after the fact using publicly available data, as he had not yet acquired access to the underlying loan files that would have provided more concrete evidence of underwriting deficiences.  But, appraisals have been historically a bit squishy and subjective–even using retroactive appraisal tools–and absent evidence of a scheme to inflate a series of comparable properties, it can be difficult to convince a judge or jury that an appraisal that’s, say, 10% higher than you would expect was actually a negligent or defective assessment of value.

    The reason that the FDIC/WAMU is likely focusing on this aspect of the underwriting process is because it’s one of the few avenues available to WAMU to recover its losses.  Namely, the FDIC is suing over losses associated with loans that it holds on its books, not loans that it sold into securitization.  Though the latter would be a much larger set of loans, WAMU no longer holds any ownership interest in those loans, and would not suffer losses on that pool unless and until it (or its new owner, JPMorgan) were forced to repurchase a significant portion of those loans (read: a basis for more lawsuits down the road).

    Which brings me to the most interesting aspect of these cases.  As I mentioned, the FDIC is only suing these appraisal vendors over the limited number of loans that WAMU still holds on its books.  In the case against LSI, the FDIC only reviewed 292 appraisals and is seeking damages with respect to 220 of those (75.3%), for which it claims it found “multiple egregious violations of USPAP and applicable industry standards” (LSI Complaint p. 12).   Only 10 out of 292 (3.4%) were found to be fully compliant.  Yet, the FDIC notes earlier in that complaint that LSI “provided or approved more than 386,000 appraisals for residential loans that WaMu originated or purchased” (LSI Complaint p. 11).

    In the case against CoreLogic, the FDIC says that it reviewed 259 appraisals out of the more than 260,000 that had been provided (CoreLogic Complaint pp. 11-12).  Out of those, it found only seven that were fully compliant (2.7%), while 194 (74.9%) contained multiple egregious violations (CoreLogic Complaint p. 12).  And it was the 194 egregiously defective appraisals that the FDIC alleges caused over $129 million in damages.

    Can you see where I’m going with this?  If you assume that the rest of the appraisals looked very similar to those sampled by the FDIC, there’s a ton of potential liability left on the table.

    Just for fun, let’s just do some rough, back-of-the-envelope calculations to provide a framework for estimating that potential liability.  I will warn you that these numbers are going to be eye-popping, but before you get too excited or jump down my throat, please recognize that, as statisticians will no doubt tell you, there are many reasons why the samples cited in the FDIC’s complaints may not be representative of the overall population.  For example, the FDIC may have taken an adverse sample or the average size of the loans WAMU held on its balance sheet may have been significantly greater than the average size of the loans WAMU securitized, meaning they produced higher than average loss severities (and were also more prone to material appraisal inflation). Thus, do not take these numbers as gospel, but merely as an indication of the ballpark size of this potential problem.

    With that proviso, let’s project out some of the numbers in the complaints.  In the LSI/LPS case, the FDIC alleges that 75% of the appraisals it sampled contained multiple egregious violations of appraisal standards.  If we project that number to the total population of 386,000 loans for which LSI/LPS provided appraisal services, that’s 289,500 faulty appraisals.  The FDIC also claims it suffered $154 million in losses on the 220 loans with egregiously deficient appraisals, for an average loss severity of $700,000.  Multiply 289,500 faulty appraisals by $700,000 in losses per loan and you get a potential liability to LSI/LPS (on just the loans it handled for WAMU) of $202 billion.  Even if we cut the percentage of deficient appraisals in half to account for the FDIC’s potential adverse sampling and cut the loss severity in half to account for the fact that the average loss severity was likely much smaller (WAMU may have retained the biggest loans that it could not sell into securitizations), that’s still an outstanding liability of over $50 billion for LSI/LPS.

    Do the same math for the CoreLogic case and you get similar results.  The FDIC found 74.9% of the loans sampled had egregious appraisal violations, meaning that at least 194,740 of the loans that CoreLogic handled for WAMU may contain similar violations.  Since the 194 egregious loans accounted for $129 million in losses according to the Complaint, that’s an average loss severity of $664,948.  Using these numbers, CoreLogic thus faces potential liabilities of $129 billion.  Even using our very conservative discounting methodology, that’s still over $32 billion in potential liability.

    This means that somewhere out there, there are pension funds, mutual funds, insurance funds and other institutional investors who collectively have claims of anywhere from $82 billion to $331 billion against these two vendors of appraisal services with respect to WAMU-originated or securitized loans.  For how many other banks did LSI and CoreLogic provide similar services?  And how many other appraisal service vendors provided similar services during this time and likely conformed to what appear to have been industry practices of inflating appraisals?  The potential liability floating out there on just this appraisal issue alone is astounding, if the FDIC’s numbers are to be believed.

    The point of this exercise is not to say that the FDIC necessarily got its numbers right, or even to say that WAMU wasn’t complicit in the industry practice of inflating appraisals.  My point is that these suits reveal additional evidence that investors are sitting on massive amounts of potential claims, about which they’re doing next to nothing.  Where are the men and women of action amongst institutional money managers (and for that matter, who is John Galt?)?  Are they simply passive by nature, and too afraid of getting sued to even peek out from behind the rock? Maybe this is why investors don’t want to reveal their holdings in MBS – they’re afraid that if unions or other organized groups of pensioners realized that their institutional money managers held WAMU MBS and were doing nothing about it, they would sue these managers and/or never run their money through them again.

    The better choice, of course, would be to join the Investor Syndicate or one of the other bondholder groups that are primed for action, and then actually support their efforts to go after the participants in the largest Ponzi scheme in history (an upcoming article on TSS will focus on the challenges that these groups have faced in getting their members actually motivated to do something).  It seems that these managers should be focused on trying to recover the funds their investments lost for their constituents, rather than just acting to protect their own anonymity and their jobs.  If suits like those brought by the FDIC don’t cause institutional money managers to sit up and take notice, we have no other choice but to believe these individuals are highly conflicted and incapable of acting as the fiduciaries they’re supposed to be.  Of all the conflicts of interest that have been revealed in the fallout of the Mortgage Crisis, this last conflict would be the most devastating, because it would mean that the securitization participants who were instrumental in causing this crisis, and who were themselves wildly conflicted, will largely be let off the hook by those they harmed the most.

    Posted in allocation of loss, appraisals, causes of the crisis, Complaints, conflicts of interest, CoreLogic, FDIC, Federal Home Loan Banks, fiduciary duties, irresponsible lending, lawsuits, liabilities, loan files, loss causation, LPS, private label MBS, re-underwriting, rep and warranty, RMBS, statistical sampling, subprime, successor liability, underwriting practices, valuation, WaMu | Tagged , , , , | 2 Comments