Pauley Stirs the Pot: Federal Judge Still Making an Impact as BofA Settlement Approaches Critical Crossroads in State Court

Posted on April 18, 2012 by igradman

On April 24, Judge Barbara Kapnick will hold a hearing in New York Supreme Court on whether Bank of American’s $8.5 billion settlement proposal should be evaluated under the restrictive Article 77 vehicle, or whether investors challenging the deal can open up the proceedings to broader inquiry.  And though all eyes will be focused on Judge Kapnick and which direction she appears to be leaning on this critical decision, it’s difficult to ignore the influence of a certain federal district court judge, whose name keeps popping up throughout the parties’ pleadings.

When mortgage backed securities (MBS) bondholders removed Bank of America’s (BofA) settlement with Bank of New York Mellon (BNYM) to federal court this past fall, they were betting that District Judge William Pauley’s court would prove to be a friendlier forum to litigate their objections to the controversial deal.  In that regard, they were right – Pauley’s October 19 decision to keep the case evinced not only an understanding of the national implications of the issues raised in the suit and the potentially serious conflicts of interest at play, but also a strong desire to be the one to parse through those issues.

Unfortunately for him and for the bondholders objecting to the deal, the Second Circuit disagreed, overturning Pauley’s denial of remand and sending the case back to Judge Kapnick in New York state court.  Nevertheless, Pauley continues to have a noticeable impact on the Article 77 proceeding, stemming both from the short time that he presided over this case and from his ongoing decisions in related proceedings.

With respect to the latter, Pauley recently issued a decision in a separate lawsuit by a group of pension funds against BNYM that provides investors with an additional direct avenue to threaten MBS trustees with liability.  As to the latter, in addition to both BNYM and the intervening investors repeatedly citing language from Pauley’s orders in making their arguments to Judge Kapnick, the New York Attorney General recently used Judge Pauley’s approval of his right to intervene as persuasive authority for why Kapnick should do the same.  I will examine each of these developments in turn.

Pauley Confirms that Trust Indenture Act Applies to MBS

On April 3, 2012, Pauley issued an Order (hat tip reader Deontos) in a case called Retirement Board of the Policemen’s Annuity and Benefit Fund of the City of Chicago et al. v. Bank of New York Mellon, Case No. 11-CV-5459 in the Southern District of New York, that is still reverberating through legal and financial circles two weeks later.   Therein, Pauley held that a group of investors could pursue a class action for damages directly against BNYM as Trustee pursuant to the Trust Indenture Act (TIA) of 1939.

The group of investors was arguing that the Trustee had violated the TIA and breached its contracts and fiduciary duties by failing to confirm the proper transfer and documentation of the mortgage loans at the outset, to assist investors with repurchase claims, or to enforce servicer obligations.  Though Pauley dismissed the investors’ claims relating to Trusts in which they did not hold securities, he confirmed that the TIA did apply to the mortgage backed securities held by the investors because the certificates qualified as debt rather than equity securities.  (Order at 12)

For investors who have been slogging through the onerous procedural hurdles required to obtain standing to sue banks for mortgage repurchases or “putbacks” (including the recent decision by Judge Kapnick herself that seemed to raise the bar for investor standing), this decision is music to their ears.  It means that they can pressure MBS Trustees to assist them with putback claims and sue on their behalf (obviating the need for investors to obtain standing as third party beneficiaries) by using the threat of direct legal liability (in federal court, no less) against the Trustee as leverage.  Yves Smith of Naked Capitalism calls this a game-changer in mortgage investor litigation in general, and I would have to agree.

For investors holding Countrywide bonds, however, Pauley’s opinion created an even sweeter song.  No sooner had Pauley’s decision been published than the Steering Committee representing aggrieved Countrywide investors filed a motion to convert the Article 77 proceeding into a plenary action, in which they cited the decision prominently and even attached a copy of the ruling for Judge Kapnick’s benefit.  Their take on Pauley’s decision was that because it found that MBS were debt securities, Article 77 did not apply, as by its own terms it exempted “trusts for the benefit of creditors.”

Given the prominence of this line of reasoning in the Steering Committee’s brief, you get the impression that the Steering Committee believes this to be a strong argument.  At the very least, it’s a colorable argument that Article 77 is inappropriate on its face, which would force Judge Kapnick to convert the action into a plenary action, or something more akin to a fair fight on whether the $8.5 billion settlement is reasonable.

Of course, BNYM disagrees, and has now responded with an opposition brief in which it argues that “trust for the benefit of creditors” is a term of art that applies only to a specialized type of trust, in which a pre-existing creditor assigns assets to an assignee in trust for the purposes of paying off that creditor’s pre-existing debts.  If indeed the term is to be given such a particularized definition, mortgage backed securities trusts certainly would appear to fall outside the bounds of this narrow exception to Article 77.

The Trustee also makes sure to throw a jab at Pauley in footnote 3 of its opposition.  BNYM begins by noting that the Trustee “respectfully disagrees” with Pauley’s decision in Retirement Board, “holding that any security issued by a trust that holds mortgage loans is debt for purposes of the federal Trust Indenture Act.”  Somewhat more pointedly, BNYM goes on to say that:

[Pauley’s] decision is unprecedented and admittedly contradicts rulings from the SEC (to which the Retirement Board court expressly refused to give any deference), and from other government agencies, as well as secondary authority on this question, including a treatise written by counsel for one of the objectors in the proceeding, Talcott Franklin (whose clients declined to join in this Motion). (BNYM Opposition Brief at 4 n.3)

Though I haven’t yet seen an appeal filed to Pauley’s Retirement Board Order, this footnote appears to preview such an appeal, and I would not be surprised at all to see that case go up to the Second Circuit on more than one occasion before all is said and done.

In the meantime, Judge Kapnick will have her work cut out for her, parsing through the statutory language of Article 77 and trying to wrap her arms around whether it’s a proper vehicle to adjudicate the settlement of MBS putback claims in 530 separate trusts at once.  BNYM seems to have the better of these arguments, since there is little authority precluding an Article 77 proceeding in a case like this (indeed, there’s little authority on Article 77 at all, and no precedent on a case like this).  But as I’ve written before, this deal stinks to high heaven, so there’s always a chance that Judge Kapnick will use her considerable discretion to follow her conscience rather than the path of least resistance.

Pauley Cited as Persuasive Authority

Though Judge Pauley’s decision to deny remand of the Article 77 proceeding and keep the case in federal court was ultimately overturned, that has not stopped the case’s intervenors and would-be intervenors from citing his decisions as persuasive authority.  For example, in its Memorandum in support of converting the Article 77 proceeding into a plenary action (“Memo ISO Plenary Action”), the Steering Committee notes that Judge Pauley adopted the reasoning from an “unbroken line of cases” in finding that BNYM should be treated as a separate legal entity for each of the 530 Countrywide trusts that BNYM administers.  Though there are other cases that the Steering Committee could and did point to in support of this principle, it seems particularly relevant that a federal judge ruling on the exact same facts at issue here agreed with the reasoning of the intervening investors that the Trustee had to consider each trust individually.

Similarly, in describing the procedural history of the case, the Steering Committee makes sure to point out that Judge Pauley stated that he “ha[d] found no authority suggesting that a single Article 77 proceeding may evaluate the actions of 530 trustees with respect to 530 trusts.” (Memorandum ISO Converting Proceeding to Plenary Action at 3)  The Committee then goes on to cite Pauley’s holding that Article 77 proceedings, in sharp contrast to the one at issue, are typically “uncontested” and present “garden variety matters of trust administration.” (Id.)  Interestingly, in citing these holdings, the Steering Committee notes that Pauley’s decision was “reversed on other grounds,” implying that the cited holdings are still good law.

As BNYM is quick to point out, however, the Second Circuit’s reversal was based on jurisdictional grounds, meaning that Pauley did not have subject matter jurisdiction over the case in the first place and thereby nullifying his prior rulings.  Though this argument speaks to the fact that the rulings have no precedential value, the greatest value of these rulings likely lies in their persuasive impact, which may be considerable.  In fact, Kapnick already seems to have been influenced by the events that have taken place in this case since the time it was removed from her court.

At the outset, Kapnick seemed determined to push the case through her court as quickly as possible under the assumption that it would proceed under Article 77.  According to the transcript of Kapnick’s first hearing in the case on August 5, the Judge chastised those objecting to the limited form of the proceeding, saying:

It’s important to remember that this petition was brought as an Article 77 petition, which I personally have hardly ever seen before, so I had to go into the C.P.L.R., which doesn’t have too much about Article 77, and read it.  That’s what they did. That’s the proceeding they brought.

It’s not a class action. There aren’t provisions in there to opt out that you are talking about. That’s not what this is. If you started it, maybe that’s what you would have done, but they started it and that’s what they did. I have to work, at least now, within the confines of the proceeding that is before me. (Transcript of Aug. 5, 2011 Hearing at 18:21-19:6)

However, according to the transcript of the telephonic hearing she held on March 19, 2013 post-remand, Kapnick seemed hyper-conscious of the subsequent input of federal judges in the case, and willing to entertain the notion that the action could take other forms, saying:

this is an Article 77 proceeding, if you don’t think — and there aren’t too many Article 77 proceedings to look at and see what the scope of discovery is, but certainly, it’s much more limited than a plenary action, which at the moment it is not.  If you think that this should be a plenary action, then you have got to do something like bring an order to show cause or a motion. I mean, you mentioned it in your papers, but I can assure you sua sponte I am not going to turn this into a plenary action.

You can argue, both of you, which I think you did a little bit in your papers, about what the Second Circuit said in their decision, which I reread last night. I don’t think they said, you know, that this is it and that’s the last word, it can never be something else. But it certainly is what it is at the moment, an Article 77 proceeding… If you think that it should be transferred, then you have got to do something to immediately make an application. (Transcript of March 19, 2012 hearing at 14:11-15:13)

Thus, Her Honor ultimately invited the parties to brief that issue.  This is how we wound up at the critical crossroads at which we find ourselves today.

Complicating matters even further, on April 10, 2012 (after the parties had filed their initial briefs on the Article 77 issue), NYAG Schneiderman sent a letter to Judge Kapnick (another hat tip reader Deontos) requesting that the Court grant his motion to intervene and allow him to “participate fully in the resolution of [these] questions.”  Schneiderman also cites to (you guessed it) another Pauley decision – the one in which Pauley granted Schneiderman’s prior motion to intervene – and attaches a copy of the ruling for Judge Kapnick’s benefit.

The reason that this complicates matters is that Her Honor has not yet ruled on whether the NYAG can intervene.  Though it sounds like the parties were in discussions over resolving the NYAG’s right to participate, those negotiations fell through, meaning that Schneiderman’s petition will almost certainly be contested (in the past, BNYM and the Institutional Investors supporting the deal argued that the New York and Delaware AGs lacked standing to intervene).  If Schneiderman seeks to participate fully in the proceedings, it would seem that Kapnick would want to first rule on his right to do so and, if she grants his petition, allow him to respond to the Plenary Action Motion prior to ruling on that important pleading.

The other reason that the NYAG’s participation complicates this proceeding, at least from BNYM’s perspective, is that the prosecutor seems hell-bent on exposing the Trustee’s conflicts of interest and allegedly negligent and illegal conduct in carrying out its duties as trustee.  Though Schneiderman has dropped the aggressive counterclaims that he sought to file initially in state court (perhaps realizing that a separate action would be the more appropriate forum for those claims and that dropping them would improve his chances of being allowed to intervene), his Petition to Intervene remains virtually unchanged from its original, aggressive form.  If the prosecutor raises enough thorny issues for BNYM, forcing Kapnick to address them through motion practice and discovery, it could wrench the proceedings out of the more limited (and more comfortable for BNYM and BofA) confines of Article 77.

The hearing on the Plenary Action Motion (and the Steering Committee’s related motion on the scope of discovery) is scheduled for April 24, and Judge Kapnick should issue her ruling within a few weeks thereafter.  How she comes out on the proper form for this proceeding will dictate the scope of discovery and the standard of review – two vital elements to BofA’s strategy of dealing with its mortgage repurchase exposure in a quick and favorable manner.  Though I still view it as highly likely that Kapnick will decide to continue to adjudicate the case under Article 77, paving the way for a rubber stamping of the deal, the Steering Committee, NYAG and Judge Pauley have raised enough thorny issues with the state law vehicle that Kapnick will at least be forced to think hard about its propriety.  This is indeed a critical crossroads in mortgage putback litigation, and investors, lawyers, bond insurers and the nation’s largest banks will be watching closely.

Posted in appeals, Attorneys General, Bank of New York, banks, BofA, bondholder actions, class actions, conflicts of interest, Countrywide, discovery, Event of Default, global settlement, investors, Judge Barbara Kapnick, Judge William Pauley, Judicial Opinions, jurisdiction, lawsuits, liabilities, litigation, MBS, motions to dismiss, private label MBS, procedural hurdles, putbacks, remand, removability, repurchase, RMBS, SEC, securitization, servicer defaults, settlements, standing, Trustees, Walnut Place | 3 Comments

Guest Post: The Migratory Patterns of Yield-Hungry Investors

Posted on April 12, 2012 by igradman

Editor’s Note: in this guest post, former bond insurance insider Steve Ruterman discusses important considerations for investing in private label MBS beyond credit risk analysis, including how investors can benefit from understanding the differences in servicer behavior and business models.  Such analysis can be combined with a strategy of selecting bonds that have the potential for significant upside from the enforcement of creditor rights, such as servicer termination and/or loan put-backs, to generate even greater returns for fixed income investors.  Those who wish to learn more about how to take advantage of either of these types of analyses with respect to MBS investments are welcome to reach out to me or Mr. Ruterman – IMG.

By Steve Ruterman, guest blogger

Speaking as a major consumer of televised nature programs, it has been a lot of fun to watch the ongoing cyclical migration of yield-hungry fixed income investors.  Just now, they are approaching subprime mortgage backed securities, which they know to have been dangerous in the past (see here, for example).  They are doing so because they believe the past danger came from the terrible credit quality of the loans in the pool, and that such risk may be exaggerated in the current pricing of the bonds.

Keep in mind that 2005 vintage pools have almost seven years of seasoning, so the downside risk of future defaults must have been at least somewhat mitigated.  Seasoning used to be considered a good thing: prices are low, and yields are attractive.  Other members of the ecosystem are now crowding around the pools.  We live in a competitive world, after all, so why not jump in?

My answer to the question is, “Jump in if you must, but first take the trouble to understand what kinds of critters also live in these pools.”

I refer, of course, to the loan servicers and the risks they may represent to investors.  These risks are independent of loan credit quality, and are often discounted by fixed income investors, despite their potentially significant impact.

I’m sure that readers of The Subprime Shakeout can readily accept the proposition that some loan servicers are better or worse than others.  So, how might an investor go about understanding those differences, and how might they reflect them in their valuations and projections of risk adjusted returns on RMBS?

In theory, it should be possible to run some objective analytics and conclude which servicers are doing a better job for bondholders than others.  A simple comparison of prepayment speeds, delinquency rates, and net credit loss experience across several servicers should do the trick, particularly if the analyst compares like asset classes and vintage origination years.

However, as previously discussed here, servicers may be incentivized to misreport speeds, delinquency rates, and/or losses.  Examples include:

  • A widespread industry practice in effect at present actually results in increased unpaid loan balances due to the modification of loan terms.  This is because the purpose of the modification is to claw back servicer advances on an accelerated basis.  Since servicers do not always report the volume of claw-back modifications monthly, there are no simple means for adjusting reported speeds.
  • The reported delinquency status of loans in loss mitigation or modification queues is flexible and can really be whatever the servicer wants it to be.

These are just a few examples of known servicer reporting issues which can materially affect the investor’s analytic efforts.

As in the last subprime mortgage cycle, many subprime loan pools have new servicers that have replaced the originals (see Moody’s comment).  Even if the same servicers are still in place, recent increases in servicing costs and regulatory pressures (such as the AGFS) have forced changes in old business models. Some original and replacement loan servicers have their own agendas, and in the pursuit of their own perceived best interests, they often act against the best interests of investors.  In fact, some servicers often take actions which cause dollar-for-dollar losses to the investors that rely on them.

The key to assessing the relative risk to an investor’s returns from any loan servicer is assessing the loan servicer’s business model. The investor always wants the servicer’s business model to achieve the following goals:

  1. Aggressively prevent current loans from rolling into early stage delinquency.
  2. If loans do roll into delinquency, take all necessary steps to cure the delinquency.
  3. Should any loans roll into the late stages of delinquency, take all steps necessary to mitigate potential losses and cure as many as possible.
  4. If all else fails and foreclosure is necessary and desirable in order to protect positive loan values, act quickly to minimize foreclosure and REO timelines.

Sounds simple, right? Unfortunately, this recipe does not describe the business model of some loan servicers, who spend as little money as possible on 1) and 2), above, for example, because they prefer to maximize the number of delinquent borrowers paying them late fees.

If the current disastrous state of the mortgage markets has anything to teach us, it is this: investors are going to have to do more to protect themselves than they have been accustomed to doing [Editor’s note: and they won’t be able to rely on the AGFS for meaningful change in servicer behavior -IMG].  Risks from servicers’ business models are quite material, and can only be avoided by understanding what each servicer’s model is, and is not.

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

Posted in Attorneys General, bondholder actions, conflicts of interest, firing servicers, foreclosure rate, guest posts, hedge funds, incentives, investors, junior liens, loan modifications, loan seasoning, MBIA, MBS, moral hazard, mortgage market, pre-investment due diligence, private label MBS, projecting risk adjusted returns, putbacks, regulation, Regulators, servicer defaults, servicer reports, servicers, subprime | Leave a comment

Under AG Foreclosure Settlement, Servicers Get Credit for Things They’re Supposed to Do

Posted on April 10, 2012 by igradman

Last week, District Court Judge Rosemary Collyer approved the Attorney General Foreclosure Settlement (“AGFS”) without a hearing, and without any objection from investors.  According to the Judge, the Consent Judgment between the nation’s five largest servicers and the Attorneys General from 49 states is now “final and non-appealable.”

With that, investors have lost their chance to push for protections in the AGFS, and servicers have officially been let off the hook for the mountain of servicing abuses of which they were originally accused.  In return for broad releases, servicers are to provide some cash to regulators and evicted homeowners, but the bulk of the “penalties” will come in the form of a purported $17 billion in “homeowner assistance” measures.

While the rant I was hearing as I first read through the proposed settlement was that of former Arizona Cardinals head coach Denny Green, the rant I hear now as I read about the various ways in which the banks will satisfy that $17 billion in homeowner assistance is that of Chris Rock complaining about people who take credit for the things they’re supposed to do.  Though Rock’s 1996 rant was an over-the-top riff on racial stereotypes, his complaint could just as easily apply, with a slight bit of paraphrasing, to this country’s largest servicers:

[Servicers] always want credit for some [stuff] they’re supposed to do. They’ll brag about stuff a normal man just does.

Now, as many critics of the settlement have noted, the enforcement of the AGFS’s terms will be a major problem.  Yves Smith of Naked Capitalism, in her post about the propaganda surrounding the settlement, called my original post a “good overview,” but suggested that I was “far too positive about the servicing reforms,” since servicers will never be able to meet those higher standards.  That may be the case, as these reforms will simply be too expensive to implement and/or too vague to enforce, but at least they attempt to create a model for what quality servicing should look like.

The homeowner assistance provisions are a different story.  Attorney Abigail Field, on her blog Reality Check, has a great summary of some of the reasons why the enforcement provisions of the AGFS are fairly weak, and won’t result in any meaningful change in servicing conduct.  I agree with much of what she says – vague compliance metrics, deferential notice and cure requirements, and a lack of political will to file enforcement suits will likely lead to gross underenforcement of the settlement.

However, it would be one thing if the settlement terms themselves evinced an understanding of the problems that caused the robosigning and foreclosure crises, imposed sensible penalties that encouraged better behavior, and only fell short in their failure to set forth a workable enforcement structure.  At least then you could say that the AGs had their heads and hearts in the right place, but could have done a better job of actually inducing the borrower assistance set forth in the settlement.

Instead, the bigger problem that I see, and what I want to focus on today, is that even if the banks complied with every term of the settlement, the AGFS will not achieve meaningful relief.  In part, this is because the size of the relief is so small in comparison to the size of the problem (estimates I’ve discussed previously say about 5% of underwater borrowers will receive any semblance of relief).  However, this failure also stems from the fact that the banks have too much freedom in deciding how to comply with the settlement, such that they can select the “penalties” most favorable to their bottom lines rather than those most beneficial to housing market or the victims of their misconduct.  Not to mention the things they’re getting credit for are generally things that they’re already supposed to be doing.

One of the major themes of this blog has been the misalignment of incentives in standard MBS trust agreements from the years leading up to the Mortgage Crisis, which both contributed to the flood of irresponsible lending that engendered the Crisis and to the poor servicing of loans post-Crisis that has dragged it out.  Much of Way Too Big to Fail, the book I published with Bill Frey, discusses how to realign the incentives in mortgage securitization going forward so that we can avoid these problems and allow the powerful tool of securitization to create a functioning housing finance market.

That’s why it’s so frustrating to see the AGs providing the major servicers (who just got caught red-handed forging documents and lying to courts) with a menu of options (the settlement itself actually calls them “menu items”) for satisfying their penalties.  These options fail to recognize servicers’ inherent conflicts of interest and the incentives they create for self-interested conduct at the expense of real benefit to investors and homeowners.

Returning to the analogy from my last post on the AGFS to Brutus the bully, who got caught by the principal stealing kids’ lunch money, it’s as if the principal is giving Brutus a broad list of options for paying his debts – including some options that Brutus is already obligated to satisfy.  Thus, for example, if Brutus had already been sentenced to community service for other misconduct, and could satisfy the principal’s demands by completing that same service, what do you think Brutus will do?  Rarely does law enforcement defer to the preferences of perpetrators; sanctions are meant to be inconvenient and painful (that’s how they deter future misconduct).

A recent article in the New York Times highlights how, under the settlement, banks are getting credit for “routine efforts” and “standard bank practices.”  The article quotes Neil Barofsky, the former inspector general of TARP, as saying, “The $17 billion [in borrower assistance] is supposed to be the teeth of this settlement.  And yet they are getting all this credit for practices that they do every day.”

The article points to credits for waiving deficiency judgments and donating or demolishing abandoned homes as two examples of practices that banks already do on a regular basis.  Georgetown law professor and Credit Slips contributor Adam J. Levitin is quoted as saying, “[The settlement] accomplishes remarkably little in the form of real relief for homeowners because it gives the banks credit for far too much.”

Another article, from Rachel Kurzius at Inside Mortgage Finance, does a great job of highlighting how different banks will choose different means of satisfying the AGFS, depending on their unique circumstances.  Because this article is only available by subscription, and because it’s an interesting read, I’ve re-posted it in its entirety below, with the permission of IMF.  As you read the IMF and NY Times articles, just see if you can get Chris Rock’s toothy grin out of your head as he talks about people taking credit for things they’re supposed to do.

Investors Worry About Their MBS Holdings Under $25B Settlement

Many non-agency MBS investors are upset with the $25 billion servicing settlement involving 49 state attorneys general, eight federal agencies and the nation’s five largest servicers, the full terms of which were filed in U.S. District Court this week.

Bank of America, Wells Fargo, JPMorgan Chase, Citigroup and Ally Financial will receive some credit for modifying loans they service but do not own, although several of these firms have indicated that they plan to focus their efforts on portfolio loans. The Association of Mortgage Investors said the settlement establishes a precedent under which the bad debts of some are paid by innocent, responsible parties.

Investor concern has been over the part of the settlement dealing in credits instead of hard cash. The banks are obliged to provide $16.3 billion of consumer relief, namely principal reductions, short sales, deficiency waivers, forbearance and anti-blight provisions. Each of these “menu items,” as the settlement calls them, have a correspondent credit towards paying off their penalties.

While principal forgiveness on a first-lien mortgages held in portfolio has a dollar-for-dollar credit, principal forgiveness on first liens held by investors has $0.45 credit per dollar of writedown. Servicers receive additional credit if the modifications are performed before March 1, 2013.

The Brookings Institution estimates that these principal reductions will help about 5 percent of homeowners who are currently underwater. Department of Housing and Urban Development Secretary Shaun Donovan defended the relatively small figure by saying that the settlement would induce the banks to perform more principal reductions.

Matthew Stoller, a fellow at the Roosevelt Institute, called such thinking the “Lays Potato Chip Theory,” noting that government officials are banking on the fact that the servicers “won’t be able to stop at just one” once they start modifying loans. The problem with the theory, though, is that many of the country’s loans are held by Fannie Mae and Freddie Mac, which have so far refused to perform principal reductions.

Wells Fargo, Citibank and Ally have stated that they will limit modifications to loans they hold in portfolio, at least for the time being. Considering that the settlement includes incentives to complete mods within a year’s time, it may make sense to focus on the loans with the fewest strings attached.

Bank of America has already identified 200,000 borrowers for loan modifications, and plans to reduce principal by an average of $100,000. If the bank were planning to get dollar-for-dollar credit for this, i.e., portfolio loans, they would far exceed the $7.6 billion of credits required of them. From this, Barclays deducted that BoA will perform writedowns on a large number of non-agency mortgages.

JPMorgan Chase has yet to tip its hand on its strategy. Deutche Bank expects JPMorgan will “perform most principal modifications on its portfolio loans given that it did not have a separate deal with the government earlier.”

Why is BofA going for investor loans, when at least three of the other banks said they won’t? Isaac Gradman, managing member of IMG Enterprises, chalks it up to BoA’s upcoming settlement with Bank of New York regarding a dispute over Countrywide MBS representations and warranties.

“Bank of America has a sense that the settlement with Bank of New York will go through and they’ll be able to modify investor loans without fear,” said Gradman. “Other banks don’t have that assurance yet.”

HUD, in a new fact sheet, said the notion that “the settlement will be paid on the backs of teachers, firefighters and unions because of pension or other investments in private label securities” is a myth. The agency pointed to the fact that “participating banks own the vast majority of the mortgage loans that this settlement is expected to affect,” and that net present value positive tests will ensure that “any loan modification tied to this settlement will result in more of a financial return for an investor than a foreclosure would.”

Several observers pointed out that large banks have considerable flexibility in implementing NPV models. In addition, the treatment of second liens has rankled investors.

The settlement terms make clear that, if the first lien is modified and the related second is owned by the servicers in the settlement, the second lien must also be modified. Deutsche Bank analysts characterize it as a “major concession” for the banks.

“The settlement will undo contractual obligations,” said the Association of Mortgage Investors.

Gradman concurred. “The contract obligates banks to wipe out the second lien altogether, but the settlement doesn’t respect that and treats the subordinated lien on par with the first lien,” he said.

The AMI suggested that the settlement be modified before it is approved by a federal court. AMI requests transparency in regards to the net present value model used, a monetary cap for principal reductions on loans not held by the servicers, monthly public reports on the banks’ progress and more investor participation in the proceedings.

Neil Barofsky, the former inspector general for the Troubled Asset Relief Program, said in an interview on Bloomberg News that he doubted the settlement would change. The political will behind it, he said, was much too strong.

Reprinted with permission of Inside Mortgage Finance Publications, Inc., from March 16, 2012.
Posted in Adam Levitin, Ally Bank, Attorneys General, auditing, bailout, Bank of New York, banks, BofA, Citigroup, conflicts of interest, contract rights, costs of the crisis, Countrywide, damages, foreclosure crisis, foreclosure rate, global settlement, homeowner relief, improper documentation, incentives, investors, JPMorgan, junior liens, liabilities, MBS, mortgage market, Neil Barofsky, pooling agreements, press, private label MBS, RMBS, robo-signers, servicer defaults, servicers, settlements, Wells Fargo | 2 Comments

New York Judge Strikes Blow to Investor Putback Claims

Posted on April 4, 2012 by igradman

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

MBS Discovery Battles Heating Up, Impacting Litigation Timelines and Leverage

Posted on March 28, 2012 by igradman

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

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

MBIA v. Countrywide

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

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

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

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

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

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

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

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

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

The BNYM-BofA Settlement Over Countrywide Put-Backs

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

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

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

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

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

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

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

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

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

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

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

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

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