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

Posted on November 30, 2011 by igradman

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted on November 22, 2011 by igradman

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

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

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

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

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

Loss Causation Background

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

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

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

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

Countrywide’s Loss Causation Arguments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

MBIA’s Loss Causation Counterarguments

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

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

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

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

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

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

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

Loss Causation Fallout

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

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

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

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

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

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

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

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

WTBTF Book Tour Day 2: Meeting, Marketing and Mentoring in Manhattan

Posted on November 15, 2011 by igradman

I woke Tuesday morning, Nov. 8 on the second day of the Way Too Big to Fail book tour to the news that Kathy Patrick, legal architect of Bank of America’s Hail Mary Countrywide settlement (background here and here), had struck again.  This time, as disclosed in Morgan Stanley’s quarterly report, Patrick’s firm Gibbs & Bruns had sent a letter to the bank on October 18 on behalf of investors in $6 billion worth of Boom-era RMBS.

As of the writing of this post, the letter has not been made public, so I’m not sure if any particular investors behind it were named, but I would bet that two of the driving forces rhyme with Packrock and Blimco.  Only time will tell whether the settlement that will inevitably result from this effort will be as obvious a sham as the $8.5 billion settlement with Bank of New York that has now been diverted into Federal Court, but applying the same settlement calculation to the original face amount in this new case would mean about $120 million in potential damages for Morgan Stanley (zzzzzzz……).

There was little time to digest this news, however, as I was out the door by 7:00 am that morning to head into the Greenwich Financial Services’ offices to write more note cards (see part I in the WTBTF book tour series) and sign copies of the book before taking Metro North from Greenwich, CT into Manhattan for a full day of meetings.  I had finally managed to get a decent night of sleep, but it wasn’t nearly enough to recover from my redeye flight the night before.  It’s these sorts of mandatory caffeine mornings that make me glad I’m not a Mormon.

I met Bill Frey at the Cornell Club again, and proceeded upstairs for our first meeting of the day – with publicist Peter Zorich.  Zorich, son of actor parents Louis Zorich and Olympia Dukakis, has worked in the television industry for twenty years, producing shows for the likes of Bill O’Reilly, Hannity & Colmes, and Dylan Ratigan, and most recently working for Bloomberg and MSNBC.

Zorich is now a media consultant, helping people like Bill and I gain exposure for our story and ideas through the medium of TV.  Zorich thought that Bill had a story that would interest many television producers—as the man who had been vilified as a financial predator for suggesting that mortgage contracts had to be honored and who was now being looked to as the only one with the knowledge and experience to rebuild mortgage finance.

For those unfamiliar with his story, Bill has been through hell and back since the first time he came out publicly against government-sponsored “solutions” to the mortgage crisis back in 2008.  Of course, Bill can now laugh at the fact that he was unceremoniously summoned before Congress by Barney Frank and five of his colleagues (see link to Appendix II of WTBTF here), and that 400 protestors showed up on his front lawn and dumped a load of furniture on his porch, but at the time I would imagine that these episodes were unnerving, to say the least.  Still, Bill’s financial independence allowed him to weather those incidents without fear of financial repercussion.  Today, in fact, Bill credits Frank for engendering the ultimate in unintended consequences – it instantly brought Bill notoriety as a bondholder advocate and attracted the attention of the international investment community.

Drinks at Bill’s Greenwich office are still placed on coasters that pay tongue-in-cheek homage to those days – bearing Bill’s picture with the word “PREDATOR” stamped across it in red (see picture at left).  The funny thing is that Bill’s message today is the same as it was in 2008—and we include as Appendices I and III in WTBTF the letters Bill wrote on this subject in 2008 for comparison—that loan modifications are a good thing for both investors and homeowners if open dialogue between the two groups is enabled.  Yet, the reception this message is receiving today is markedly different.

After the meeting with Zorich, I headed to a coffee shop in Midtown for my next meeting of the day – with an investment manager/analyst at a big New York hedge fund to whom I had been speaking since my earliest days of writing this blog.  The analyst told me that he was thrilled to be getting a copy of WTBTF, but that the thing he was most interested in reading was “how the hell the system got so f-cked up.”

He was less interested in reading about Bill and my proposed solutions, as he felt that the gridlock in Washington would prevent any meaningful reform, but he reiterated the refrain I had heard from many in the investment community – that getting the wheels of foreclosure turning again was essential to restoring investment in the U.S. housing market.  “It’s like an electrical circuit,” he said, “if the foreclosure process at the end is broken, the entire circuit is broken, originations will languish and the housing market will remain stagnant.  Fix the foreclosure process, and even though people may lose their homes in the short term, they’ll ultimately benefit from more affordable mortgages in the future for homes they can actually afford.”

Next up was Bloomberg reporter Jody Shenn, long one of the most respected journalists on the credit markets and mortgage crisis legal issues.  Jody and I had been discussing developments in subprime mortgages since he first called me for a quote for an article he was writing for Bloomberg Businessweek back in October 2010.  He has since quoted me and Bill several times in mortgage litigation articles, probably because we lack the filter that most sane folks have when commenting about bank efforts to avoid MBS putback liability (see example here).

Over yet another cup of coffee in Midtown, we talked generally about what Bill and I were hoping accomplish with WTBTF—namely, to change the conversation in Washington and among private investors regarding the ideal structure for the mortgage finance market and provide a blueprint for setting it up.  Jody had read a draft of WTBTF early on and had responded very positively.  He was looking forward to hearing how our efforts were received.  Later that day, Jody tweeted, “@isaacgradman nice seeing you on your magical mystery “Way Too Big to Fail” book tour. Frey offers great insight on mortgage mess @WTBTF.”  I’m a sucker for a good Beatles reference.

Soon, it was off to Greenwich Village, where I had agreed to speak to a group of NYU Law students about alternative career paths, and specifically, how to turn legal blogging into a career.  I decided to begin my talk with one of my favorite pieces of advice, received from a friend who would often hear me rant and rave about the incompetence or injustice I encountered in the world.  He had told me, “whenever you find yourself getting frustrated with the way things are, try to view it as an opportunity to innovate and make things better.”

Blogging for me had actually arisen out of one such moment of frustration – when I began searching on the Internet during my early days of representing PMI for legal analysis or coverage of ongoing MBS litigation, and found none.  I went on to explain to the NYU law students how legal blogging was a great way to build expertise and a reputation while working at a law firm, and how you just never know what’s going to happen when you start putting yourself and your ideas out to the public.

The students in attendance, who ranged from 1Ls just beginning their law school careers to 3Ls who already had jobs, seemed intrigued by the idea of blogging, but unsure exactly how to proceed.  We discussed how get started, how to pitch the idea to your law firm employer, and most importantly, how to choose your topic.  On the last point, I told them:

  1. It should be a topic that really interests you, because it’s going to be hard to get motivated to write after a full day of billable work unless you’re passionate about your topic;
  2. It should be an area that’s relatively new, or which hasn’t been explored the way you’d like to explore it, so you can distinguish yourself and become a leading thinker on that subject within a relatively short period of time; and
  3. It should be an area ripe for growth and/or business development.

For example, 3L student Ryan Williams told me he was very interested in the emerging topic of crowd funding (you can support this aspiring blogger by following him @rdavidwill and checking out his website here).  I told him I thought it was a great idea, because it seemed to satisfy all three requirements – he was clearly passionate, the subject matter was novel and cutting edge, and there was a ton of opportunity for business development in that emerging field.

I was thrilled when Ryan wrote me after the talk to say that, “Your trip was very timely for me as I’ve been considering starting a blog for some time now. Thanks for demystifying the experience and offering to serve as a resource as I begin the process.”  It was humbling to think that a blog born from frustration has placed me in a position to mentor future legal entrepreneurs.  Ryan later tweeted to his followers (of which he already has far more than I do), “Great convo w @NYULaw alum @isaacgradman re using #blogging 2 become own #boss. Thx 4 giving back 2 your alma mater. #lawschool #startup #law.”  I’m really starting to enjoy the immediacy of this whole Twitter thing.

The talk at NYU wrapped up at about 5:30, and I was about to head to another meeting, but realized that I had forgotten something important – lunch.  So, I made a quick stop at Mamoun’s – the iconic falafel joint on MacDougal street near Washington Square Park, which claims to be the oldest falafel joint in NYC (est. in 1971).  After wolfing down a falafel and a babaganoush, I headed to my last meeting of the day – with India Autry, a recent NYU Law graduate, who has been awarded The Subprime Shakeout’s first internship.

As the demands of the blog have increased with each passing day, I have decided to bring someone on to help with research and writing, while giving another jurist an opportunity to weigh in on these significant legal battles.  India’s first assignment was to research the arguments made by MBIA and Countrywide/BofA before Judge Bransten on loss causation (discussed here) and challenge me on the idea that this should be a slam dunk victory for MBIA.  Judging from the brief overview of her findings that she gave me at our meeting at the Olive Tree Café on MacDougal (another familiar haunt from my law school days), BofA has a tough hill to climb, but stay tuned for the final analysis later this week.

With another day of the Magical Mystery Book Tour in the – ahem – books, I began to feel a growing confidence that we had something special and important brewing with Way Too Big to Fail. With each additional meeting, I became more convinced that no one else had both Bill’s expertise and the financial independence from the big banks necessary to lay out a truly logical blueprint for the future of mortgage finance.  Of course, I decided to refrain from getting too excited until the next day’s meetings in Washington, when I would get to see how our elected officials in Washington were approaching this issue, and whether our recommendations for change would fall on deaf ears.  Stay tuned for more from the road.

[All names used with permission – IMG]

Posted in BlackRock, Bloomberg, BofA, book tour, Countrywide, foreclosure rate, Fox News, Greenwich Financial Services, investors, Kathy Patrick, litigation, loan modifications, loss causation, MBIA, MBS, media coverage, Morgan Stanley, mortgage market, MSNBC, PIMCO, Presentations, Regulators, The Subprime Shakeout, Uncategorized, Way Too Big to Fail, William Frey | Leave a comment

Book Tour Day 1: Pessimism, Hope and Note Cards

Posted on November 8, 2011 by igradman

My first day in New York City to promote the release of Way Too Big to Fail was a whirlwind, as expected.  I arrived into JFK at 6:00 AM and headed into Manhattan for my first stop at the Cornell Club, which would serve the base of operations for Bill Frey and me during our day of meetings.  After quickly changing out of my traveling clothes and into a suit, I ran around the corner to my first meeting – a breakfast with Daniel DeMonte, a former whole loan portfolio manager who had reinvented himself as an MBS putback transaction manager.

DeMonte had already read about 60% of the book, and was generally positive about the ideas presented therein.  In particular, he thought that the idea of more states passing laws to allow recourse to borrowers’ assets in the event of default on home loans would go a long way towards reducing strategic default.  As we traded stories about some of the absurd mortgages we had seen when overseeing loan file reviews over the past few years, it occurred to me that even those of us who earned our livelihood by cleaning up the mess left behind by the mortgage crisis would like to see the market rebuilt and functioning again.  It was a productive meeting, and I was able to get some food in my stomach, to boot.

After that, I returned to the Cornell Club, where I met up with Bill for a meeting I had been anticipating for several weeks.  We were meeting with Neil Barofsky, the former Assistant U.S. Attorney for the Southern District of New York and former Special Inspector General for TARP.  Barofsky resigned from his post at SIGTARP earlier this year with some choice words for regulators regarding the failures of the program and the problems at our nation’s largest banks, and took a gig as a professor at NYU School of Law.  The Office of Career Services at the law school had put us in touch, and Barofsky had graciously agreed to meet.

I had long respected Barofsky’s courage in speaking out about the abuses he was observing, both during his time as SIGTARP and since.  During his time at SIGTARP, Barofsky released a report to Congress in which he warned that the problem of “too big to fail” had not yet been solved:

The continued existence of institutions that are “too big to fail” — an undeniable byproduct of former Secretary Paulson and Secretary Geithner’s use of TARP to assure the markets that during a time of crisis that they would not let such institutions fail — is a recipe for disaster.  These institutions and their leaders are incentivized to engage in precisely the sort of behavior that could trigger the next financial crisis, thus perpetuating a doomsday cycle of booms, busts, and bailouts.

Since that time, Barofsky has remained outspoken about his prognosis for this country, including the famous statement he made to Dan Rather in response to the anchor’s comment upon hearing about the projected costs of the next financial crisis, “Counselor, you’re scaring me,” to which Barofsky replied, “you should be scared.  I’m scared.  I mean, you can’t not be scared.  You can’t look at what happened in the run-up to 2008 and see how it’s not going to repeat itself, given what we’ve done.”  Needless to say, I was looking forward to hearing what Barofsky had to say.

When the professor arrived, we went upstairs to the Club’s library and began to talk about the book, the mortgage crisis, and the political climate in Washington.  I found that Frey and Barofsky had very little disagreement about the ideas for reform that were presented in the book.  However, Barofsky was skeptical about whether we would be able to build a consensus around sweeping mortgage financing reform after the passage of Dodd-Frank, as its supporters would be loath to admit that the program was a failure.  Though Bill and I shared several stories about meetings with policymakers on both the left and the right who had agreed wholeheartedly with our ideas, Barofsky felt that getting these folks to agree privately was a far cry from getting them to agree publicly.  Two hours flew as we spoke, and I left the meeting feeling that I had received a necessary dose of reality from someone who had been through the political meatgrinder and had seen how the sausage was made.

After we parted ways, Bill and I headed back up to Greenwich to meet with a former partner in a hedge fund, who had sold his stake and was now semi-retired, but looking for opportunities.  This gentleman had several contacts with the New York pension funds and felt that these investors were starved for products that would provide an investment-grade rating with a return in excess of U.S. Treasuries, but there was little out there.  We agreed and suggested that some of the ideas laid out in WTBTF, pointing to the copy we had just handed him, could pave the way for the return of the MBS market.  He was polite, but his sense was that housing (and employment) would not bounce back until the foreclosure process was fixed and investors had confidence that they could collect on the underlying assets if there were credit problems in the structure.  Since the AG settlement over foreclosure problems seemed to be losing steam by the day, he felt that this possibility was remote.

After lunch, we returned to Bill’s office to sign copies of the book and put together mailings to Washington, members of the media and other mortgage crisis thought leaders.

Way Too Big to Fail

A Hardback Copy of Way Too Big to Fail and its Accompanying Note Card

This was the first time I had held a hardback copy of the book (of which we printed a limited run), and it was truly a glorious feeling.  There’s something about the weight of a hardback, the cracking sound that it makes when you first open it, and the vibrancy of the dust jacket that instills a sense of pride and a feeling that you’ve really created something lasting see image on right).

 

Soon, however, euphoria once again gave way to a recognition of the work that lay ahead, as we were tasked with putting together a massive number of mailings.  Anyone who has ever had a wedding or a Bar Mitzvah knows that writing note cards is one of the most tedious tasks in the universe, and writing note cards for a book is no different.  It took up the remainder of the day.

That night, in the split second between when my head hit the pillow and when I passed out from exhaustion, the thought occurred to me that our greatest challenge in getting our ideas to take root would be pervasive pessimism.  Wherever we went, people seemed to be overwhelmed by the problems facing our government and our economy, and with good reason.  The gridlock in Washington, the financial fraud perpetuated by some on Wall St., and the and negligence and general sloppiness that characterized 2004-2008 mortgage lending have been the hallmark of our country over the past half decade and have caused many to despair at the possibility of ever reaching a solution.  I decided that WTBTF was an important work, not only for the ideas it presented, but because it presented a message of hope and optimism – that there is a way to fix the housing market if financial leaders and regulators could simply work together to make our suggested reforms a reality.

I will continue to blog on The Subprime Shakeout over the next week about my experiences during my first book tour (first post in the series available here). On tap for Tuesday: meetings with a publicist, a reporter, and a big-time financial blogger; a speech to NYU Law students about alternative career paths; and more books and note cards to sign…

[All names used with permission – IMG]

Posted in Attorneys General, bailout, Dan Rather, due diligence firms, Government bailout, hedge funds, mortgage market, Neil Barofsky, putbacks, re-underwriting, Regulators, RMBS, securities, securities laws, securitization, TARP, The Subprime Shakeout, Timothy Geithner, too big to fail, Treasury, Wall St., Way Too Big to Fail, William Frey | Leave a comment

Release of “Way Too Big to Fail” Simply Opening Salvo in Efforts to Reform Mortgage Finance

Posted on November 7, 2011 by igradman

It’s tempting when you have an enormous task before you to focus all of your attention on completing that task while blocking out any thoughts of what comes next.  For me, that enormous task has been the publication of a book with William (“Bill”) Frey to address the structural deficiencies in mortgage finance that brought about the subprime meltdown.  I must confess that with so much of my attention over the last several months dedicated to completing this book, I had little time to contemplate the even greater enormity of the task that lay ahead.  But with the publication by Greenwich Financial Press of Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System (WTBTF) on October 31, 2011 (official website here), and its release on CreateSpace and Amazon last week, it’s suddenly sinking in how much work remains to be done for the words on those pages to have any impact.

Let me start by saying that I am extremely proud of the final product that is WTBTF.  While many books have attempted to identify the causes or villains behind the mortgage crisis, Way Too Big to Fail is the first that examines why government-enacted fixes have failed and explains in detail what must, should, and can be done to right the ship.  It thus takes a positive and proactive approach to the problems plaguing our economy, providing a welcome ray of hope in an industry in dire need of some good news.  As much as I enjoy covering the ongoing mortgage litigation playing out in our courts as we speak (more on that later), which has the capacity to decide the fate of huge financial institutions and perhaps the future of the U.S. mortgage market, I am even more excited about turning my attention to helping to ensure that the U.S. housing market survives and thrives going forward.

I believe that Way Too Big to Fail is an important first step down that path.  With the combination of Bill’s expertise in mortgage finance and my expertise—cultivated in no small part through my work on The Subprime Shakeout—in communicating complex ideas regarding mortgage finance and litigation in straightforward ways, I think the book succeeds at providing an accessible blueprint to the mortgage finance machine of the past, present, and future.  I can say without hesitation that it has been one of the most productive and enjoyable collaborations of my professional career.

But as I sit here at the San Francisco Airport, waiting to board the redeye to New York, I realize that this is only the beginning.  To sit back and allow myself to revel in this accomplishment would be to miss the larger and more important opportunity—the opportunity for these words to have an impact in the current mortgage finance landscape.  And though the book has now taken on a life of its own, with its own website, Facebook page, and Twitter account, I know that it will not succeed in influencing the conversation without a lot more effort on our part.

Thus, I am heading off to spend the next week with Bill in New York and Washington, D.C. to meet with a full slate of lawmakers, academics, financiers, reporters and others in the industry with the desire and/or the capacity to influence where our nation goes from here.  My hope is that we can all start from the common understanding that the federal government should not and cannot support the entire mortgage market—and that private investors must step in to fill the void—and begin discussing concrete proposals for attracting private capital.

Of course, as most people have now come to understand, private investors will not put any more money into private mortgage securities until the litigation raging over the mortgage backed securities (MBS) created from 2004 to 2007 is resolved.  As the FHFA stated in a press release in connection with its slew of recent lawsuits,

the long-term stability and resilience of the nation’s financial system depends on investors being able to trust that the securities sold in this country adhere to applicable laws. We cannot overlook compliance with such requirements during periods of economic difficulty as they form the foundation for our nation’s financial system.

In this regard, several major decisions are anticipated in the coming weeks.  The first is the decision in MBIA v. Countrywide on MBIA’s Motion for Partial Summary Judgment.  This decision, expected sometime this month, will determine the viability of Countrywide/BofA’s so-called “loss causation argument,” which maintains that an underwriting breach must actually cause a loan to go into default to constitute grounds for a putback.  All signs point to Countrywide/BofA losing this motion, as they find little support for their position in the contract language or the small amount of existing MBS putback precedent.  The “materially adverse” standard found in most pooling and servicing agreements mirrors closely the materiality standard used in the insurance context, and I see no reason why some proximate cause standard should be read into these contracts that would alter the ordinary understanding of a materially adverse impact on the value of a loan—i.e., something that increases the loan’s risk.

Moreover, with Judge Eileen Bransten having ruled against BofA in a recent motion to sever MBIA’s successor-in-interest claims from the rest of the case and try them separately with such claims from the other monoline cases, Bransten has now ruled against Countrywide/BofA in nearly every major decision thus far (see, e.g., her adverse rulings on discovery issues, statistical sampling, and the viability of MBIA’s successor-in-interest claims).  As Bransten has long appeared fed up with the heel-dragging and hide-the-ball tactics of Countrywide’s attorneys (entertaining transcript on motion to dismiss available here), there’s no reason to believe she’ll be any friendlier to their arguments this time around.

And the impact of a ruling against Countrywide/BofA on this motion will not be limited to this case alone; the opinion will almost certainly be cited in every ongoing putback case in the country.  Already, after Bransten’s most recent decision allowing MBIA to move forward with depositions on successor liability, we know that this case will be the country’s bellwether on the question of whether BofA engaged in a de facto merger with Countrywide.  The crowds that gathered inside the overflowing courtroom for the October 5 hearing on Partial Summary Judgment (see transcript part I and part II) illustrate just how closely the markets are watching this legal proceeding.

The other major decision that will be coming down the pike in the next few months is a ruling on Bank of New York’s appeal of Judge William Pauley’s order denying remand.  The significance of this ruling cannot be understated.  If this proposed settlement remains in federal court, Bank of America and/or Bank of New York will likely attempt to withdraw (as discussed by the astute Alison Frankel at Reuters) and the settlement will fall apart, creating even more chaos for the embattled lender.  Should the settlement go back to state court and breeze through to approval under the favorable standards of Article 77, you can expect every other major lender with subprime exposure to try the same tactic to resolve its outstanding putback liabilities.

I will certainly be watching these and other developments closely over the coming months.  But, I’m also going to be doing something a little different on The Subprime Shakeout.  I’m going to start making it a little more personal, by updating readers on the successes and failures of my efforts with Bill to push the needle on reforming the country’s mortgage finance system.

I’m going to start by blogging my East Coast trip this week, as we reach out to policymakers and industry leaders about the book and begin discussing our ideas for reform.  If you have an interest in seeing change in the way this country finances mortgages in the future, I invite you to participate by reading this blog and responding to me via the comments section or Twitter (@isaacgradman); interacting with WTBTF on Facebook and Twitter; and, of course, reading Way Too Big to Fail (you’ll notice this site’s first and only banner ad on the right sidebar, which links to the WTBTF’s CreateSpace page)and sharing your feedback and reviews with us, on Amazon, and with anyone else who you think could benefit from the ideas we present.  While I do not expect that our ideas will please everyone all of the time, I do think that the book initiates a conversation that has been a long time coming.

Way Too Big to Fail, authored by Bill Frey and edited by Isaac Gradman, was published by Greenwich Financial Press on October 31, 2011.  Please visit www.waytoobigtofail.com for information about the book, its author, and its editor; news and reviews on the book; and to view actual excerpts and illustrations.  The paperback edition is available on CreateSpace and Amazon; a limited edition hardback was also printed, some copies of which may be available through Amazon later this year.  If you feel so inclined, please like WTBTF on Facebook and follow @WTBTF on Twitter.

Posted in allocation of loss, appeals, Bank of New York, banks, BofA, bondholder actions, causes of the crisis, contract rights, Countrywide, discovery, FHFA, global settlement, investors, irresponsible lending, lawsuits, liabilities, litigation, lobbying, loss causation, MBIA, monoline actions, mortgage market, pooling agreements, private label MBS, putbacks, regulation, Regulators, remand, repurchase, RMBS, securitization, settlements, statistical sampling, successor liability, The Subprime Shakeout, Uncategorized, Way Too Big to Fail, William Frey | 1 Comment