BREAKING NEWS: Judge Determines BofA $8.5 bn Settlement Belongs in Federal Court

Posted on October 20, 2011 by igradman

Though Bank of America (BofA) has taken its share of lumps over the past six months, this may be the one that leaves the biggest mark.  In an opinion issued today in the Southern District of New York (available here and hereinafter referred to as the “Order”), Judge William Pauley denied Bank of New York’s (BoNY) motion to send its Article 77 proceeding–seeking court approval for its decision to settle putback claims in 530 Countrywide trusts for $8.5 billion–back to state court.  This decision means that BoNY’s conduct will be evaluated under far less favorable standards for BoNY and BofA, and that disapproving bondholders may be permitted to “opt out” of the settlement.

If you will recall (and if you don’t, feel free to read my prior articles here and here for background), BoNY originally filed this action in New York state court in June of this year, seeking judicial approval under Article 77 for its decision to settle  potential repurchase claims or “putbacks” with respect to 530 Countrywide RMBS trusts.  Legal commentators hailed the use of Article 77 as “novel” and “creative” (it is usually reserved for garden variety family law trusts and other express trusts), citing the difficulty that investors would have in challenging the settlement under this special vehicle of New York law.

However, it soon became clear that numerous powerful parties were lining up in opposition to the settlement and were raising issues that would be difficult to ignore.  These included a challenge by the New York Attorney General, which accused BoNY of persistent illegality and fraud and raised the question of whether mortgages were properly transferred into Countrywide trusts at the outset.  At last count, 44 separate groups had filed petitions to intervene and challenge the settlement (or obtain more information) and one group had filed a petition to intervene in support of the accord.

In a surprise move, one such objector, Walnut Place, LLC, essentially hijacked the case–removing it to federal court and framing it as a “mass action” under the Class Action Fairness Act (CAFA).  This threatened to change the entire nature of the proceeding and prompted BoNY to file a motion to remand, in which it argued that Walnut Place’s efforts were unjustified and “frivolous” and urged Judge Pauley to send the case back to the friendlier confines of New York Supreme Court.

In hearings leading up to today’s Order, it appeared that Judge Pauley was skeptical about BoNY’s role and conduct in negotiating this settlement, and seemed inclined to keep the case.  In particular, His Honor seemed fixated on whether BoNY was subject to fiduciary duties derived from sources outside of the Pooling and Servicing Agreements (PSAs), which would weigh against finding that this case fell under the “securities exception” to CAFA.  This skepticism may have been exacerbated by revelations earlier this month that Gibbs & Bruns, the law firm representing the investors supporting the settlement, had urged its clients to withdraw from a parallel effort by Talcott Franklin’s Investor Clearinghouse to take more aggressive action against BoNY (you can read Alison Frankel’s astute coverage of these recent developments here).  But while the outcome of this motion may have been foreseeable, it was the tone of today’s opinion that I found most surprising.

In holding that CAFA provided the federal court with exclusive jurisdiction over this case, Judge Pauley found that Walnut Place had satisfied the elements for a mass action under CAFA, in that the case involved 1) monetary relief, 2) 100 or more persons, and 3) common questions of law and fact.  The Court did not seem to struggle with finding any of these elements or in dismissing BoNY’s claims that Walnut Place was not a proper party to remove the case.

The most robust discussion was reserved for the evaluation of whether the securities exception to CAFA applied, but even that thorny question was dealt with in relatively short order.  Repeatedly citing to Greenwich Financial v. Countrywide, 603 F.3d 23 (2d Cir. 2010), one of the earliest cases arising from the mortgage crisis (and discussed frequently on The Subprime Shakeout), Judge Pauley found that the “pivotal question” in reaching this determination was “whether a plaintiff’s claims arise under the terms of an instrument that creates or defines securities or plaintiff’s claims arise under an independent source of federal or state law.” (Order at 16)  His Honor noted that BoNY had conceded that New York trustees owe certain common law duties to trust beneficiaries that could not be waived, including the duty to avoid conflicts of interest.  In that regard, Pauley held that, “this duty–grounded in New York common law and not the terms of the PSAs–lies at the heart of the Article 77 Proceeding.” (Order at 17)

In disposing of BoNY’s counterarguments that the sources of its obligations were actually the governing PSAs, which had modified and superseded the Trustee’s common law duties, Judge Pauley noted wryly that, “PSAs are not talismans endowed with the power to ward off federal jurisdiction.  Because the Article 77 Proceeding necessarily involves New York common law, the securities exception does not bar removal.”  (Order at 19)  In other words, if the case involves common law questions not arising out of an agreement creating or defining a security, that’s enough for Pauley to find that the federal courts have jurisdiction.

Though Pauley appears unwavering and far from ambivalent in reaching this holding, the conclusion of his Order includes a remarkable appeal to the “core federal interests” implicated by this case, in what can only be described as a “belt and suspenders” approach to the determination of jurisdiction.  Rather than resting simply on the fact that the elements of CAFA were met and that the plaintiff did not carry its burden of proving any exception applied, Pauley recognizes the national implications of this case in an effort to bolster the decision to keep it in state court.  When reading the final paragraph of the Order, which I quote in full, consider whether this language will help Pauley’s opinion survive a potential appeal or suggest that he was swayed more by the case’s national prominence than an unemotional application of the relevant law:

The Settlement Agreement at issue here implicates core federal interests in the integrity of nationally chartered banks and the vitality of the national securities markets.  A controversy touching on these paramount federal interests should proceed in federal court.  And Congress enacted CAFA to provide a federal forum for such cases.  For the foregoing reasons, the Court denies BYNM’s motion to remand.  (Order at 21, citations omitted)

As much as I might agree with Pauley’s statements regarding the national implications of this case, I don’t believe issues such as the “integrity of nationally chartered banks and the vitality of the national securities markets” were actually before the Judge in this instance.  Instead, he was asked to rule on the narrow issue of whether remand of the Article 77 Proceeding was proper.  Because it’s tough to see how the vitality of the securities markets is directly implicated in adjudicating such a motion, I think this colorful flourish at the end of an otherwise well-reasoned opinion only weakens the credibility of the Order by suggesting that the Judge may have been influenced by the national attention this case has garnered.  Judge Pauley may have been well advised to end the discussion in his Order after the finding that the securities exception did not apply.  As Brad Pitt says in Moneyball in his role as Billy Beane, “when you get the answer you’re looking for, hang up.”

Implications

So what does this all mean to BoNY and, more importantly, BofA?  On one hand, the precise procedural implications are yet to be decided.  Pauley included a section in the Order entitled “Remaining Issues,” in which he states that “This Court recognizes the procedural difficulty inherent in continuing this action in federal court” and orders the parties to submit a joint case management report by October 31 and appear before him on November 3 for a status conference. (Order at 20)  On the other hand, I can’t help but speculate that Pauley will not be forced (as Judge Kapnick would have been in state court) to defer to the standards and constraints of Article 77 in adjudicating this case.  Having found that the federal court has exclusive jurisdiction under CAFA, Pauley will likely handle the case along the lines of other “mass actions.”  Though mass actions are not governed by the identical procedural standards as ordinary class actions, I would expect that Judge Pauley will borrow certain aspects.  This will likely include the application of an “entire fairness” standard to evaluate the settlement rather than the more deferential “abuse of discretion” standard.  It will likely also mean that the Court will either require that a majority of potential claimants (i.e. bondholders) approve of the settlement, or allow disapproving bondholders to “opt out.”  This will completely undermine BofA’s strategy of settling uncertainty in the markets and resolving its legacy Countrywide liability in a rapid and favorable manner.  Now, the Court will likely be able to examine the inner workings of how this deal came about, learn that most bondholders were not consulted or notified, realize that BoNY’s experts based their loss estimates on inapplicable information provided to them by BofA, and evaluate whether BoNY was acting under a conflict of interest when agreeing to this settlement.  Disapproving bondholders may be able to extract themselves from this settlement, preserve their claims, and file separate lawsuits against Countrywide and BofA.  None of this is good for BofA.

Thus, the biggest question remaining in my mind is, can BoNY voluntarily withdraw this settlement without invoking the ire of Judge Pauley and startling the markets, or now that they’ve proceeded down this path, are they stuck with the monster they’ve created?  Only one thing’s for sure: BofA’s black eye will not be healing anytime soon.

Posted in Bank of New York, banks, BofA, bondholder actions, class actions, conflicts of interest, contract rights, Countrywide, damages, fiduciary duties, global settlement, Grais and Ellsworth, Greenwich Financial Services, investors, lawsuits, litigation, loss estimates, MBS, pooling agreements, private label MBS, putbacks, remand, removability, repurchase, RMBS, securities, securities laws, securitization, settlements, The Subprime Shakeout, Trustees, Uncategorized, William Frey | 4 Comments

Originator Business Models Led Inevitably to Housing Crash

Posted on October 14, 2011 by igradman

by Steve Ruterman, guest blogger

It has been four years since the onset of the epic economic and capital markets fiasco known as the housing crash, and this crisis is far from over.  Because the housing and mortgage finance industries are so important to the nation’s economy, we simply can’t afford to wait until we reach the endgame before we reach an understanding of what happened and why.

There are a lot of explanations out there already.  For example, Michael Lewis in The Big Short: Inside the Doomsday Machine says the crisis took place because the big banks ceased operating as private partnerships taking prudent risks with the partners’ money.  Instead, they became public companies, and began taking undue risks with public shareholders’ money.  Maybe this is so, but there were plenty of bubbles, crashes, panics and insolvent banks in the country’s history prior to the public ownership of banks.

Adam Levitin and Susan Wachter, in “Explaining the Housing Bubble,” argue that the market bubble and subsequent crash were due to an oversupply of housing finance, which was caused in turn by the explosive growth of the non-agency securitization market.  The oversupply occurred because the complexity and heterogeneity of private label mortgage securities permitted bankers to game investors, who were unable to price their risks correctly.  The authors identify the standardization of mortgages and securitizations as the means of avoiding future fiascos.  It would be interesting to see how the authors explain the current problems associated with GSE efforts to mitigate risks via standardized mortgages and securitizations, which they’ve had for over 30 years since Fannie issued its first pass-through in 1981.

Though neither of these explanations seems entirely satisfying on its own, there is no reason to expect the various explanations to be mutually exclusive.  Instead, each adds important detail to the complex phenomenon that was the housing crash.  No doubt, the crash had many fathers.

It is possible, however, that the causes of the crash are relatively simple to identify and understand, even though future remedies may not be.  One of the simplest explanations can be found in the business models of the big mortgage lenders.  Let’s take Countrywide to be our exemplar, and focus in on the 2005–2007 time period.  Remember that Countrywide concentrated on the refinance (“refi’) segment of the market.

Courtesy of Calculated Risk

MBA Mortgage Refi Index and Mortgage Rates - Sept. 2011

Taking note of the dramatic slowdown in refis after 2003 (see chart at right courtesy of Calculated Risk), Countrywide officers were quite vocal in airing their concerns about maintaining and growing their share of the stagnant mortgage market.  How was Countrywide, a publicly traded mortgage colossus with over a trillion dollars in existing mortgages, going to grow its earnings per share when the market was not growing?  Given its size and scale, the only way to do it was to market additional loans to its existing customers or to relax its credit underwriting standards for each of its loan product categories, so that it could lend to borrowers who would not have qualified for credit in years past.  Apparently, Countrywide did both.

The following is an excerpt from the complaint AIG filed against Countrywide, et al., on August 8, 2011:

In a conference call with analysts in 2003, [CEO Angelo] Mozilo made Countrywide’s market share objectives explicit, stating that his goal for Countrywide Financial was to “dominate” the mortgage market and “to get our overall market share to the ultimate 30% by 2006, 2007.” At the same time, Countrywide made public assurances that its growth in originations would not compromise its strict underwriting standards. Indeed, Mozilo publicly stated that Countrywide would target the safest borrowers in this market in order to maintain its commitment to quality.

 

To increase its market share, Countrywide instituted an aggressive “matching” program that effectively ceded its “theoretical” underwriting standards to the market and resulted in a proverbial race to the bottom. Under Countrywide’s “matching” policy, Countrywide would match any product that a competitor was willing to offer. A former finance executive at Countrywide explained: “To the extent more than 5 percent of the [mortgage] market was originating a particular product, any new alternative mortgage product, then Countrywide would originate it …

 

[Author’s Note:  Allegations made by plaintiff’s counsel in a complaint are what they are.]

The point from this is that it’s not necessary to construct complex explanations of the mortgage market’s collapse.  It is sufficient to understand the relatively simple business models of the boom’s beneficiaries.

However, for a comprehensive analysis of business models and the many other factors which led to the collapse of the mortgage market, I would recommend Way Too Big To Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System from Greenwich Financial Press.  The book, written by William A. Frey and edited by The Subprime Shakeout’s Isaac Gradman, is now available on CreateSpace and Amazon.  Therein, Frey draws on 30 years of experience in structured finance to detail both the causes of the crisis and the reforms and steps to be taken to bring private investment back to the housing market.

Frey appears to share my belief that we can’t recover from this crisis until we fully understand its causes.  And at the end of the day, the main culprit he identifies is similar to the one I detail above–misaligned incentives for those creating mortgage securities.  I won’t give too much away, but having read an advance copy of this work, I can say that Frey’s analysis is fundamentally correct and that his recommendations are realistic and necessary.  I would highly encourage the read for anyone seeking to understand the flawed business models that got us into this mess and, more importantly, what we can do to dig ourselves out.

 

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

[Updated on 11/4 to reflect that Way Too Big to Fail has been released and is now available – IMG]

Posted in AIG, banks, broader credit crisis, causes of the crisis, Complaints, Countrywide, Fannie Mae, Freddie Mac, guest posts, incentives, interest rates, irresponsible lending, lawsuits, lenders, lending guidelines, MBIA, MBS, mortgage market, private label MBS, research, RMBS, securitization, The Subprime Shakeout, Uncategorized, Way Too Big to Fail, William Frey | Tagged , , , , , , | Leave a comment

The Government Giveth and It Taketh Away: The Significance of the Game Changing FHFA Lawsuits

Posted on September 15, 2011 by igradman

It is no stretch to say that Friday, September 2 was the most significant day for mortgage crisis litigation since the onset of the crisis in 2007.  That Friday, the Federal Housing Finance Agency (FHFA), as conservator for Fannie Mae and Freddie Mac, sued almost all of the world’s largest banks in 17 separate lawsuits, covering mortgage backed securities with original principal balances of roughly $200 billion.  Unless you’ve been hiking in the Andes over the last two weeks, you have probably heard about these suits in the mainstream media.  But here at the Subprime Shakeout, I like to dig a bit deeper.  The following is my take on the most interesting aspects of these voluminous complaints (all available here) from a mortgage litigation perspective.

Throwing the Book at U.S. Banks

The first thing that jumps out to me is the tenacity and aggressiveness with which FHFA presents its cases.  In my last post (Number 1 development), I noted that FHFA had just sued UBS over $4.5 billion in MBS.  While I noted that this signaled a shift in Washington’s “too-big-to-fail” attitude towards banks, my biggest question was whether the agency would show the same tenacity in going after major U.S. banks.  Well, it’s safe to say the agency has shown the same tenacity and then some.

FHFA has refrained from sugar coating the banks’ alleged conduct as mere inadvertence, negligence, or recklessness, as many plaintiffs have done thus far.  Instead, it has come right out and accused certain banks of out-and-out fraud.  In particular, FHFA has levied fraud claims against Countrywide (and BofA as successor-in-interest), Deutsche Bank, J.P. Morgan (including EMC, WaMu and Long Beach), Goldman Sachs, Merrill Lynch (including First Franklin as sponsor), and Morgan Stanley (including Credit Suisse as co-lead underwriter).  Besides showing that FHFA means business, these claims demonstrate that the agency has carefully reviewed the evidence before it and only wielded the sword of fraud against those banks that it felt actually were aware of their misrepresentations.

Further, FHFA has essentially used every bit of evidence at its disposal to paint an exhaustive picture of reckless lending and misleading conduct by the banks.  To support its claims, FHFA has drawn from such diverse sources as its own loan reviews, investigations by the SEC, congressional testimony, and the evidence presented in other lawsuits (including the bond insurer suits that were also brought by Quinn Emanuel).  Finally, where appropriate, FHFA has included successor-in-interest claims against banks such as Bank of America (as successor to Countrywide but, interestingly, not to Merrill Lynch) and J.P. Morgan (as successor to Bear Stearns and WaMu), which acquired potential liability based on its acquisition of other lenders or issuers and which have tried and may in the future try to avoid accepting those liabilities.    In short, FHFA has thrown the book at many of the nation’s largest banks.

FHFA has also taken the virtually unprecedented step of issuing a second press release after the filing of its lawsuits, in which it responds to the “media coverage” the suits have garnered.  In particular, FHFA seeks to dispel the notion that the sophistication of the investor has any bearing on the outcome of securities law claims – something that spokespersons for defendant banks have frequently argued in public statements about MBS lawsuits.  I tend to agree that this factor is not something that courts should or will take into account under the express language of the securities laws.

The agency’s press release also responds to suggestions that these suits will destabilize banks and disrupt economic recovery.  To this, FHFA responds, “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.”  Amen.

This response to the destabilization argument mirrors statements made by Rep. Brad Miller (D-N.C.), both in a letter urging these suits before they were filed and in a conference call praising the suits after their filing.  In particular, Miller has said that failing to pursue these claims would be “tantamount to another bailout” and akin to an “indirect subsidy” to the banking industry.  I agree with these statements – of paramount importance in restarting the U.S. housing market is restoring investor confidence, and this means respecting contract rights and the rule of law.   If investors are stuck with a bill for which they did not bargain, they will be reluctant to invest in U.S. housing securities in the future, increasing the costs of homeownership for prospective homeowners and/or taxpayers.

You can find my recent analysis of Rep. Miller’s initial letter to FHFA here under Challenge No. 3.  The letter, which was sent in response to the proposed BofA/BoNY settlement of Countrywide put-back claims, appears to have had some influence.

Are Securities Claims the New Put-Backs?

The second thing that jumps out to me about these suits is that FHFA has entirely eschewed put-backs, or contractual claims, in favor of securities law, blue sky law, and tort claims.  This continues a trend that began with the FHLB lawsuits and continued through the recent filing by AIG of its $10 billion lawsuit against BofA/Countrywide of plaintiffs focusing on securities law claims when available.  Why are plaintiffs such as FHFA increasingly turning to securities law claims when put-backs would seem to benefit from more concrete evidence of liability?

One reason may be the procedural hurdles that investors face when pursuing rep and warranty put-backs or repurchases.  In general, they must have 25% of the voting rights for each deal on which they want to take action.  If they don’t have those rights on their own, they must band together with other bondholders to reach critical mass.  They must then petition the Trustee to take action.  If the Trustee refuses to help, the investor may then present repurchase demands on individual loans to the originator or issuer, but must provide that party with sufficient time to cure the defect or repurchase each loan before taking action.  Only if the investor overcomes these steps and the breaching party fails to cure or repurchase will the investor finally have standing to sue.

All of those steps notwithstanding, I have long argued that put-back claims are strong and valuable because once you overcome the initial procedural hurdles, it is a fairly straightforward task to prove whether an individual loan met or breached the proper underwriting guidelines and representations.  Recent statistical sampling rulings have also provided investors with a shortcut to establishing liability – instead of having to go loan-by-loan to prove that each challenged loan breached reps and warranties, investors may now use a statistically significant sample to establish the breach rate in an entire pool.

So, what led FHFA to abandon the put-back route in favor of filing securities law claims?  For one, the agency may not have 25% of the voting rights in all or even a majority of the deals in which it holds an interest.  And due to the unique status of the agency as conservator and the complex politics surrounding these lawsuits, it may not have wanted to band together with private investors to pursue its claims.

Another reason may be that the FHFA has had trouble obtaining loan files, as has been the case for many investors.  These files are usually necessary before even starting down the procedural path outlined above, and servicers have thus far been reluctant to turn these files over to investors.  But this is even less likely to be the limiting factor for FHFA.  With subpoena power that extends above and beyond that of the ordinary investor, the government agency may go directly to the servicers and demand these critical documents.  This they’ve already done, having sent 64 subpoenas to various market participants over a year ago.  While it’s not clear how much cooperation FHFA has received in this regard, the numerous references in its complaints to loan level reviews suggest that the agency has obtained a large number of loan files.  In fact, FHFA has stated that these lawsuits were the product of the subpoenas, so they must have uncovered a fair amount of valuable information.

Thus, the most likely reason for this shift in strategy is the advantage offered by the federal securities laws in terms of the available remedies.  With the put-back remedy, monetary damages are not available.  Instead, most Pooling and Servicing Agreements (PSAs) stipulate that the sole remedy for an incurable breach of reps and warranties is the repurchase or substitution of that defective loan.  Thus, any money shelled out by offending banks would flow into the Trust waterfall, to be divided amongst the bondholders based on seniority, rather than directly into the coffers of FHFA (and taxpayers).  Further, a plaintiff can only receive this remedy on the portion of loans it proves to be defective.  Thus, it cannot recover its losses on defaulted loans for which no defect can be shown.

In contrast, the securities law remedy provides the opportunity for a much broader recovery – and one that goes exclusively to the plaintiff (thus removing any potential freerider problems).  Should FHFA be able to prove that there was a material misrepresentation in a particular oral statement, offering document, or registration statement issued in connection with a Trust, it may be able to recover all of its losses on securities from that Trust.  Since a misrepresentation as to one Trust was likely repeated as to all of an issuers’ MBS offerings, that one misrepresentation can entitle FHFA to recover all of its losses on all certificates issued by that particular issuer.

The defendant may, however, reduce those damages by the amount of any loss that it can prove was caused by some factor other than its misrepresentation, but the burden of proof for this loss causation defense is on the defendant.  It is much more difficult for the defendant to prove that a loss was caused by some factor apart from its misrepresentation than to argue that the plaintiff hasn’t adequately proved causation, as it can with most tort claims.

Finally, any recovery is paid directly to the bondholder and not into the credit waterfall, meaning that it is not shared with other investors and not impacted by the class of certificate held by that bondholder.  This aspect alone makes these claims far more attractive for the party funding the litigation.  Though FHFA has not said exactly how much of the $200 billion in original principal balance of these notes it is seeking in its suits, one broker-dealer’s analysis has reached a best case scenario for FHFA of $60 billion flowing directly into its pockets.

There are other reasons, of course, that FHFA may have chosen this strategy.  Though the remedy appears to be the most important factor, securities law claims are also attractive because they may not require the plaintiff to present an in-depth review of loan-level information.  Such evidence would certainly bolster FHFA’s claims of misrepresentations with respect to loan-level representations in the offering materials (for example, as to LTV, owner occupancy or underwriting guidelines), but other claims may not require such proof.  For example, FHFA may be able to make out its claim that the ratings provided in the prospectus were misrepresented simply by showing that the issuer provided rating agencies with false data or did not provide rating agencies with its due diligence reports showing problems with the loans.  One state law judge has already bought this argument in an early securities law suit by the FHLB of Pittsburgh.  Being able to make out these claims without loan-level data reduces the plaintiff’s burden significantly.

Finally, keep in mind that simply because FHFA did not allege put-back claims does not foreclose it from doing so down the road.  Much as Ambac amended its complaint to include fraud claims against JP Morgan and EMC, FHFA could amend its claims later to include causes of action for contractual breach.  FHFA’s initial complaints were apparently filed at this time to ensure that they fell within the shorter statute of limitations for securities law and tort claims.  Contractual claims tend to have a longer statute of limitations and can be brought down the road without fear of them being time-barred (see interesting Subprime Shakeout guest post on statute of limitations concerns.

Predictions

Since everyone is eager to hear how all this will play out, I will leave you with a few predictions.  First, as I’ve predicted in the past, the involvement of the U.S. Government in mortgage litigation will certainly embolden other private litigants to file suit, both by providing political cover and by providing plaintiffs with a roadmap to recovery.  It also may spark shareholder suits based on the drop in stock prices suffered by many of these banks after statements in the media downplaying their mortgage exposure.

Second, as to these particular suits, many of the defendants likely will seek to escape the harsh glare of the litigation spotlight by settling quickly, especially if they have relatively little at stake (the one exception may be GE, which has stated that it will vigorously oppose the suit, though this may be little more than posturing).  The FHFA, in turn, is likely also eager to get some of these suits settled quickly, both so that it can show that the suits have merit with benchmark settlements and also so that it does not have to fight legal battles on 18 fronts simultaneously.  It will likely be willing to offer defendants a substantial discount against potential damages if they come to the table in short order.

Meanwhile, the banks with larger liability and a more precarious capital situation will be forced to fight these suits and hope to win some early battles to reduce the cost of settlement.  Due to the plaintiff-friendly nature of these claims, I doubt many will succeed in winning motions to dismiss that dispose entirely of any case, but they may obtain favorable evidentiary rulings or dismissals on successor-in-interest claims.  Still, they may not be able to settle quickly because the price tag, even with a substantial discount, will be too high.

On the other hand, trial on these cases would be a publicity nightmare for the big banks, not to mention putting them at risk a massive financial wallop from the jury (fraud claims carry with them the potential for punitive damages).  Thus, these cases will likely end up settling at some point down the road.  Whether that’s one year or four years from now is hard to say, but from what I’ve seen in mortgage litigation, I’d err on the side of assuming a longer time horizon for the largest banks with the most at stake.

Posted in acquisitions, Ambac, bailout, banks, Bear Stearns, BofA, bondholder actions, Complaints, contract rights, Countrywide, damages, Deutsche Bank, emc, Fannie Mae, Federal Home Loan Banks, FHFA, Freddie Mac, freeriders, Goldman Sachs, Government bailout, investors, irresponsible lending, JPMorgan, jury trials, lawsuits, lending guidelines, liabilities, litigation, litigation costs, loan files, loss causation, loss estimates, LTV, MBS, media coverage, Merrill Lynch, misrespresentation, monoline actions, mortgage fraud, motions to dismiss, negligence and recklessness, private label MBS, procedural hurdles, putbacks, quinn emanuel, ratings agencies, rep and warranty, repurchase, RMBS, securities, securities laws, securitization, shareholder lawsuits, sole remedy, sophistication, stability, standing, statistical sampling, statutes of limitations, subpoenas, successor liability, too big to fail, Trustees, underwriting practices, Wall St., WaMu | 6 Comments

RMBS Legal Roundup: The Top Five Developments You Might Have Missed While Obsessing Over the BoNY/BofA Settlement

Posted on August 25, 2011 by igradman

With interesting developments occurring almost daily in the proposed Bofa/Countrywide settlement with Bank of New York, it has been hard to focus on anything else.  Indeed, since the last time I posted on the settlement (discussing New York AG Eric Schneiderman’s momentous challenge), AIG and the Delaware Attorney General have filed petitions to intervene and BoNY and the 22 investor group have filed oppositions to the New York AG’s petition that matched the prosecutor in ferocity.

But that’s not what I want to talk about today.  Instead, I’d like to take a few minutes to cover some of the most important developments in RMBS litigation aside from the BofA settlement and Death Watch (courtesy of Naked Capitalism).  There are many from which to choose, but these five were, to me, the most interesting non-Countrywide RMBS developments.

Number 5 – JP Mogan Settles Charges over Magnetar CDO

On June 21, the SEC announced that it had entered into a $154 million settlement with JP Morgan over civil fraud charges associated with the Squared CDO, which the bank set up for a hedge fund named Magnetar.  The SEC asserted that JPM misled investors regarding the synthetic securities and stuck these unsuspecting investors with some of the world’s ugliest mortgages just before the market tanked. Helpful infographic here.

Maybe it has something to do with the fact that I had just watched X-Men: First Class, but whenever I heard discussion about Magnetar, I couldn’t help but picture Magneto, the mutant arch-villain that could manipulate magnetic fields with his mind.  In fact, there were a lot of parallels.  Just like Magneto, hedge fund Magnetar weakened the architecture of Squared to profit from the structure’s collapse.  It succeeded in shorting subprime mortgages by constructing Squared CDO with the worst mortgage securities it could find.  We’ll call this “Magnetaring” a deal.

Just as Magneto was allowed to walk by authorities once he lost his powers, Magnetar has also escaped legal prosecution (as did hedge fund Paulson & Co., which played a similar role in selecting the mortgage derivatives to stuff into Goldman Sachs’ Abacus deals).  It’s not technically illegal if there’s a sucker on the other side of the deal.

Instead, the SEC decided to go after JP Morgan for failing to disclose to its investors that the collateral for the CDO had been adversely selected by a party that would profit should the CDO fail.   All I know is, if I were a CDO investor, I would certainly consider it material if a prospective deal had been Magnetared.

Though the SEC has not done much to address the glaring irregularities in the creation of MBS, it has at least taken a stab at addressing the underhanded behavior by investment banks surrounding the black boxes that were CDOs (often comprised of the leftover pieces of mortgage backed securitizations the bank couldn’t sell directly).  Yet, I wonder whether this is really the best use of the SEC’s time and taxpayer dollars.  Though the amount of these settlements sounds large to the average layperson, $154 million is a drop in the bucket to JP Morgan (JPM’s stock actually rose 18 cents to $41.09 on the news) and is less than one-third the size of the settlement Goldman Sachs paid as part of the Abacus deal.  And while commentators speculate that the SEC will bring more such actions against other banks, my guess is that they won’t go after Goldman or JP Morgan for any other CDO transactions, including the Hudson-Mezzanine deal that garnered so much attention during the Levin Commission’s investigations.

So, while the SEC touts the fact in its press release that “harmed investors will receive all of their money back,” and provides a colorful infographic to illustrate how Squared CDO was “a bad deal for investors,” it is doing nothing to recover the monies lost by investors in the scores of other similar deals orchestrated by these banks.  As with so many other problems arising out of the mortgage crisis, we’ll have to rely on private litigants to take remedial steps on this front.  At least the SEC settlement might provide these plaintiffs with enough encouragement to come forward, sparking class action lawsuits like those that followed Goldman’s Abacus deal.

Number 4 – HUD Inspector General Accuses BofA of Obstructing Investigation

On June 13, the Huffington Post reported that Bank of America had “significantly hindered” a federal investigation into the firm’s foreclosure practices, according to William W. Nixon, the federal fraud examiner and assistant regional inspector general for HUD’s inspector general office.  Nixon accused BofA of withholding key documents and data and preventing the agency from interviewing key employees with knowledge of BofA’s foreclosure practices.  Nixon also stated that the bank prevented his team from conducting a walkthrough of the bank’s documents unit and failed to comply with subpoenas issued by Nixon’s team.  Though Nixon’s investigation has been completed, news of these allegations just recently became public when documents created by Nixon and his team were filed in a lawsuit brought by the State of Arizona against the bank.

According to Nixon, BofA’s intransigence forced him to ask the DOJ to issue civil investigative demands to compel testimony, a much less effective means of carrying out his investigation.  Ultimately, Nixon’s final report found that the nation’s five largest servicers defrauded taxpayers and violated the FCA by submitting false claims for FHA insurance coverage to the government.  These investigation results have been turned over to the DOJ for possible prosecution. 

Aside from putting the banks at risk of criminal prosecution, the government’s recent scrutiny of FHA claims submitted by the big banks could create significant legal exposure.  A report issued on June 13, 2011 by Bernstein Research estimates that, since inception of BofA’s relationship with the FHA, BofA originated $800 billion worth of FHA loans.  The report notes that, “[e]arlier in the year, our discussions with the company left us with the impression that FHA loans were not a material risk for BofA. However, during our recent Strategic Decisions Conference, CEO Brian Moynihan said that the FHA loans and BofA’s servicing activities are ‘a risk that [the company] continues to monitor.'”  Though the report does not provide a specific estimate of losses related to false claims for FHA insurance – including stemming from lawsuits such as the one the DOJ has already filed against Deutsche Bank for this type of conduct – it does estimate that BofA will face another $27 billion of housing-related losses between 2Q11-2013.  That’s on top of the $46 billion BofA has already lost.

With the Treasury having cut off HAMP payments to several servicers, including BofA, and the AGs still hot on extracting a $20+ billion settlement from servicers, it’s not surprising that many banks want out of the servicing business entirely.  This will open the doors for independent servicers to fill the void – ideally those without prior origination activities or section lien holdings.

Number 3 – Class Actions Alive and Well

Much has been made about the fact that class actions on behalf of RMBS investors have not fared well in courts around the nation.  This article discusses how this trend resulted in 85% of the RMBS originally included in the suits being dismissed.  This guest post by Josh Silverman in The Subprime Shakeout discusses some of the consequences of that trend and the specter of additional RMBS litigation.

Earlier this week, Judge Jed Rakoff in the Southern District of New York issued the explanation for his June 16 opinion granting class certification in the case of Public Employees’ Retirement System of Mississippi, et al. v. Merrill Lynch & Co., et al. (08-CV-10841), and sent a strong signal to banks and investors that the class action vehicle was alive and well.  Whereas many earlier opinions on RMBS class cert had limited the scope of the class to those investors who bought the same securities as the named plaintiffs (that is, they had to own securities in the same tranche as the named plaintiffs, not just securities from the same offering), Judge Rakoff certified a class that included all investors that purchased any Merrill Lynch-issued mortgage backed securities from 18 separate offerings between 2006 and 2007.

Rakoff’s opinion may be found here.  Therein, Rakoff found that Plaintiffs had “satisfied all of the requirements for class certification under Rules 23(a) and 23(b)(3). As courts have
repeatedly found, suits alleging violations of the securities laws, particularly those brought pursuant to Sections 11 and 12(a)(2), are especially amenable to class action resolution.” (Rakoff Opinion at 3)  This is a far cry from the earlier decision of Judge Harold Baer, Jr. in the Southern District of New York (yes, the same court on which Rakoff sits), who found that investors varied in sophistication to such an extent that individual questions predominated. I think “risk?” is a question that most investors know how to ask.

Likewise, Rakoff held that the action before him depended primarily on “establishing that certain statements and omissions common to all the offerings were material misrepresentations: a classic basis for a class action.” (Id. at 3-4)  Because the class action approach would result in an “enormous savings in judicial resources,” Rakoff affirmed his June 15, 2011 Order granting class cert in all respects. (Id. at 4)

Rakoff’s opinion comes on the heels of another momentous decision, handed down last week by Judge Paul Crotty, also from the Southern District of New York.  In the 15-pager, Crotty approved class certification for a group of 103 RMBS investors who had purchased Credit Suisse securities.  In doing so, he made clear that he wasn’t buying the argument that the disparity of sophistication among RMBS investors destroyed the commonality of the class.  Colorfully, Crotty noted that, “Defendants’ view is apparently that, in order for a class to be certified, it must be like Baby Bear’s porridge in the story of Goldilocks: just right. This suggestion is untenable.” (Crotty Opinion at 11 n.1)

These two judicial opinions confirm what many of us following RMBS legal developments have known for some time: underwriting deficiencies and misleading prospectuses were not isolated occurrences – they were par for the course.  By 2005, the abandonment of sound underwriting practices and the packaging of defective loans without proper disclosure had become part of the industry standard on Wall St., and this conduct harmed investors at every level of seniority and sophistication.  Permitting class actions allows investors to overcome many of the procedural hurdles that banks have been hiding behind in recent years while discounting their potential put-back liabilities on their earnings statements.  Namely, if a few investors can bring class actions on behalf of all other affected investors, they can overcome the difficulties that bondholders have had in finding one another and banding together.  They all ate the same porridge, and it had been Magnetared in the microwave too long.  Larger global settlements now become more likely.  Already, a reputable law firm has re-filed a massive class action against several underwriters that purports to cover $350 billion worth of RMBS.  And that’s far too hot for even the biggest banks.

Number 2 – NCUA Opens Fire On Behalf of Failed Credit Unions

This agency is racking up the lawyer points.  I thought it was pretty bold when the National Credit Union Administration (NCUA) threatened to sue some of Wall Street’s biggest banks over MBS losses.  But then, the NCUA actually backs it up with four separate lawsuits, seeking a total of $2 billion in damages?  It’s safe to say somebody over there is fired up.

In the first batch of suits, filed on June 20 in Kansas City federal court, the NCUA sued J.P. Morgan Chase & Co. and Royal Bank of Scotland (RBS) for $278 million and $565 million, respectively, in damages from purchases of RMBS by the five failed corporate credit unions.  The suits allege that the banks “systematically disregarded the underwriting guidelines stated in the offering documents,” resulting in securities that “were destined from inception to perform poorly.” According to the suits, at the time of filing, nearly half of the mortgage loans underlying the securities were delinquent, in bankruptcy or tied up in foreclosure.  This was exactly what I used to see all day when reviewing subprime due diligence reports, and trust me, you get pissed.

On July 18, the NCUA struck again, firing off another lawsuit against RBS, this time in Los Angeles federal court with a demand for $629 million in damages based on violations of federal and state securities laws.  This lawsuit was filed on behalf of WesCorp, which failed and was taken over by the NCUA on March 20, 2009. In a press release issued by the NCUA contemporaneously with this filing, the regulator stated that RBS’s misrepresentations “caused WesCorp to believe the risk of loss associated with the investment was minimal, when in fact the risk was substantial.”  A subtle, but important difference.

Most recently, on August 9, the NCUA sued Wall St. paragon Goldman Sachs in federal court in Los Angeles, seeking over $491 million in damages.   This lawsuit likewise alleges misrepresentations relating to 22 separate securities offerings, stating that, “a material percentage of the borrowers whose mortgages comprised the RMBS were all but certain to become delinquent or default shortly after origination. As a result the RMBS were destined from inception to perform poorly.”  Aka, Magnetared.

So, who is behind this aggressive federal action? Maybe it’s NCUA Chairman Debbie Matz, who issued a statement saying that, “NCUA continues to carry out our responsibility to do everything reasonable in our power to seek maximum recoveries.  Those who caused the problems in the wholesale credit unions should pay for the losses now being paid by retail credit unions.” Matz is just saying what every institutional investor should be saying right now – “these deals are totally Magnetared, and I want my money back.”

By the way, the NCUA has stated that it anticipates filing a total of 5 to 10 lawsuits in this space before all is said and done. Since, of the banks mentioned in its initial threats, only Merrill Lynch and Citigroup have not yet been sued, I’d bet dollars to donuts that these guys are also racking up the lawyer points.

Number 1 – FHFA Subpoenas Bear Fruit

Over a year ago, I wrote an article about how the Federal Housing Finance Agency (FHFA), as conservator for Freddie and Fannie, had issued 64 subpoenas to various participants in mortgage securitization, seeking underwriting documents for the RMBS the GSEs had purchased.  Since then, I have received many inquiries regarding the status of those subpoenas.  Until recently, I had little to offer, as it was all quiet over at FHFA.

Then, on July 27, FHFA finally pounced, filing a lawsuit against various UBS entities and executives in the Southern District of New York to recover losses on $4.5 billion worth of private label mortgage backed securities. The 102-page Complaint alleges violations of the federal securities laws based on misrepresentations regarding borrower creditworthiness and underwriting standards, yadda-yadda.

In a press release, the federal agency stated that it expects additional lawsuits to follow.  “FHFA is taking this action consistent with our responsibilities as conservator of each Enterprise,” said FHFA Acting Director Edward J. DeMarco. “From the issuance of 64 subpoenas last year to the filing of this lawsuit and further actions to come, we continue to seek redress for the losses suffered by the Enterprises.”

The big question that remains for me is whether the FHFA will show the same aggression toward U.S. banks that it has toward the Swiss banking giant.  For political reasons (e.g. “too big to fail” protectionism), they may not, which would mean leaving a lot of money on the table for the GSEs (and thus taxpayers).  Remember that FHFA inherited over $250 billion in private label MBS garbage when it took over the failed institutions as conservator.

While the claims asserted in the cases filed by the FHFA and NCUA may not be novel, they are significant because of their size and the fact that they are being driven by federal regulators.  This hints at a subtle shift in the “too big to fail” political climate since the outset of the crisis, and banks are no longer being viewed or treated as off-limits.  Instead, investors of all sorts (even Treasury-owned AIG, which recently sued BofA for over $10 billion in damages) are looking to recover their losses however they can, and in particular from the banks that make for ready villains.

As the last dominoes fall for many hulking financial institutions, they will be forced to admit that their “past experience” with private label put-backs no longer applies, and they will continue to blow through each successive round of loss reserves.   Indeed, the size of this country’s subprime shakeout seems only to expand as investors – and courts – come to fully understand the true villainy that was involved in putting mortgage securities together.

Posted in AIG, Attorneys General, Bank of New York, banks, BofA, bondholder actions, CDOs, class actions, Complaints, contract rights, costs of the crisis, Credit Unions, damages, Deutsche Bank, Fannie Mae, FHFA, Freddie Mac, global settlement, Goldman Sachs, investigations, investors, JPMorgan, lawsuits, litigation, loss causation, MBS, misrespresentation, mortgage market, motions to dismiss, NCUA, Paulson and Co., private label MBS, probes, procedural hurdles, research, reserve reporting, responsibility, RMBS, SEC, securities fraud, securitization, settlements, sophistication, standing, subpoenas, subprime, too big to fail, Treasury, Trustees, Uncategorized, Wall St. | 2 Comments

New York AG Schneiderman Comes out Swinging at BofA, BoNY

Posted on August 5, 2011 by igradman

The nation's most outspoken financial copThis is big.  Though we’ve seen leading indicators over the last few weeks that New York Attorney General Eric Schneiderman might get involved in the proposed Bank of America settlement over Countrywide bonds, few expected a response that might dynamite the entire deal.  But that’s exactly what yesterday’s filing before Judge Kapnick could do.

Stating that he has both a common law and a statutory interest “in protecting the economic health and well-being of all investors who reside or transact business within the State of New York,” Schneiderman’s petition to intervene takes a stance that’s more aggressive than that of any of the other investor groups asking for a seat at the table.  Rather than simply requesting a chance to conduct discovery or questioning the methodology that was used to arrive at the settlement, the AG’s petition seeks to intervene to assert counterclaims against Bank of New York Mellon for persistent fraud, securities fraud and breach of fiduciary duty.

Did you say F-f-f-fraud?  That’s right.  The elephant in the room during the putback debates of the last three years has been the specter of fraud.  Sure, mortgage bonds are performing abysmally and the underlying loans appears largely defective when investors are able to peek under the hood, but did the banks really knowingly mislead investors or willfully obstruct their efforts to remedy these problems?  Schneiderman thinks so.  He accuses BoNY of violating:

Executive Law § 63(12)’s prohibition on persistent fraud or illegality in the conduct of business: the Trustee failed to safeguard the mortgage files entrusted to its care under the Governing Agreements, failed to take any steps to notify affected parties despite its knowledge of violations of representations and warranties, and did so repeatedly across 530 Trusts. (Petition to Intervene at 9)

By calling out BoNY for failing to enforce investors’ repurchase rights or help investors enforce those rights themselves, the AG has turned a spotlight on the most notoriously uncooperative of the four major RMBS Trustees.  Of course, all of the Trustees have engaged in this type of heel-dragging obstructionism to some degree, but many have softened their stances since investors started getting more aggressive in threatening legal action against them.  BoNY, in addition to remaining resolute in refusing to aid investors, has now gone further in trying to negotiate a sweetheart deal for Bank of America without allowing all affected investors a chance to participate.  This has drawn the ire of the nation’s most outspoken financial cop.

And lest you think that the NYAG focuses all of his vitriol on BoNY, Schneiderman says that BofA may also be on the hook for its conduct, both before and after the issuance of the relevant securities.  The Petition to Intervene states that:

Countrywide and BoA face liability for persistent illegality in:
(1) repeatedly breaching representations and warranties concerning loan quality;
(2) repeatedly failing to provide complete mortgage files as it was required to do under the Governing Agreements; and
(3) repeatedly acting pursuant to self-interest, rather than
investors’ interests, in servicing, in violation of the Governing Agreements. (Petition to Intervene at 9)

Though Countrywide may have been the culprit for breaching reps and warranties in originating these loans, the failure to provide loan files and the failure to service properly post-origination almost certainly implicates the nation’s largest bank.  And lest any doubts remain in that regard, the AG’s Petition also provides, “given that BoA negotiated the settlement with BNYM despite BNYM’s obvious conflicts of interest, BoA may be liable for aiding and abetting BNYM’s breach of fiduciary duty.” (Petition at 7) So much for Bank of America’s characterization of these problems as simply “pay[ing] for the things that Countrywide did.”

As they say on late night infomercials, “but wait, there’s more!”  In a step that is perhaps even more controversial than accusing Countrywide’s favorite Trustee of fraud, the AG has blown the cover off of the issue of improper transfer of mortgage loans into RMBS Trusts.  This has truly been the third rail of RMBS problems, which few plaintiffs have dared touch, and yet the AG has now seized it with a vice grip.

In the AG’s Verified Pleading in Intervention (hereinafter referred to as the “Pleading,” and well worth reading), Schneiderman pulls no punches in calling the participating banks to task over improper mortgage transfers.  First, he notes that the Trustee had a duty to ensure proper transfer of loans from Countrywide to the Trust.  (Pleading ¶23).  Next, he states that, “the ultimate failure of Countrywide to transfer complete mortgage loan documentation to the Trusts hampered the Trusts’ ability to foreclose on delinquent mortgages, thereby impairing the value of the notes secured by those mortgages. These circumstances apparently triggered widespread fraud, including BoA’s fabrication of missing documentation.”  (Id.)  Now that’s calling a spade a spade, in probably the most concise summary of the robosigning crisis that I’ve seen.

The AG goes on to note that, since BoNY issued numerous “exception reports” detailing loan documentation deficiencies, it knew of these problems and yet failed to notify investors that the loans underlying their investments and their rights to foreclose were impaired.  In so doing, the Trustee failed to comply with the “prudent man” standard to which it is subject under New York law.  (Pleading ¶¶28-29)

The AG raises all of this in an effort to show that BoNY was operating under serious conflicts of interest, calling into question the fairness of the proposed settlement.  Namely, while the Trustee had a duty to negotiate the settlement in the best interests of investors, it could not do so because it stood to receive “direct financial benefits” from the deal in the form of indemnification against claims of misconduct.  (Petition ¶¶15-16) And though Countrywide had already agreed to indemnify the Trustee against many such claims, Schneiderman states that, “Countrywide has inadequate resources” to provide such indemnification, leading BoNY to seek and obtain a side-letter agreement from BofA expressly guaranteeing the indemnification obligations of Countrywide and expanding that indemnity to cover BoNY’s conduct in negotiating and implementing the settlement.  (Petition ¶16)  That can’t be good for BofA’s arguments that it is not Countrywide’s successor-in-interest.

I applaud the NYAG for having the courage to call this conflict as he sees it, and not allowing this deal to derail his separate investigations or succumbing to the political pressure to water down his allegations or bypass “third rail” issues.  Whether Judge Kapnick will ultimately permit the AG to intervene is another question, but at the very least, this filing raises some uncomfortable issues for the banks involved and provides the investors seeking to challenge the deal with some much-needed backup.  In addition, Schneiderman has taken pressure off of the investors who have not yet opted to challenge the accord, by purporting to represent their interests and speak on their behalf.  In that regard, he notes that, “[m]any of these investors have not intervened in this litigation and, indeed, may not even be aware of it.” (Pleading ¶12).

As for the investors who are speaking up, many could take a lesson from the no-nonsense language Schneiderman uses in challenging the settlement.  Rather than dancing around the issue of the fairness of the deal and politely asking for more information, the AG has reached a firm conclusion based on the information the Trustee has already made available: “THE PROPOSED SETTLEMENT IS UNFAIR AND INADEQUATE.” (Pleading at II.A)  Tell us how you really feel.

[Author’s Note: Though the proposed BofA settlement is certainly a landmark legal proceeding, there is plenty going on in the world of RMBS litigation aside from this case. While I have been repeatedly waylaid in my efforts to turn to these issues by successive major developments in the BofA case, I promise a roundup of recent RMBS legal action in the near future.  Stay tuned…]

Posted in Attorneys General, bad faith, Bank of New York, banks, BofA, chain of title, conflicts of interest, contract rights, Countrywide, discovery, fiduciary duties, global settlement, improper documentation, investigations, investors, litigation, loan files, LPS, MBS, mortgage fraud, private label MBS, RMBS, robo-signers, servicer defaults, servicers, settlements, standing, successor liability, Trustees, Uncategorized, underwriting practices, Wall St. | 11 Comments