Top Five Reasons that MBS Lawsuits Are Just Beginning

Posted on May 5, 2011 by Isaac Gradman

After a few quiet months in the world of mortgage crisis litigation, we have seen a flurry of activity over the last six weeks that should put to rest speculation that mortgage derivative lawsuits are winding down.  To recap these developments, I bring you The Subprime Shakeout’s Top Five Reasons that MBS Lawsuits Are Just Beginning:

Number 5: Statistical Sampling Gains Widespread Acceptance in MBS Cases. I have reported previously on Judge Bransten’s decision in New York state court in the case of MBIA v. Countrywide/BofA to allow MBIA to use statistical sampling and extrapolation to prove its claims for breach of reps and warranties.  I also noted how, in subsequent litigation, Allstate cited those holdings in its complaint as a shortcut to proving widespread breaches in its MBS investments.

Now, United States District Court Judge Paul A. Crotty in the Southern District of New York has lent a new level of credibility to this line of reasoning, becoming the first federal judge to hold that a plaintiff could use statistical sampling to prove a generalized claim for breach, rather than being limited by the “sole remedy” language of the PSA to a loan-by-loan approach (opinion available here).  Though the analysis applied by Judge Crotty in Syncora v. EMC rested on the unique rights of Syncora as a bond insurer, and thus may not be entirely applicable to private investors seeking to employ the same remedy, judges in investor lawsuits may find the opinion’s common-sense approach to the complexities of MBS litigation persuasive.

In particular, Judge Crotty was highly skeptical that the loan-by-loan repurchase protocol was intended to be applied to situations where widespread breaches of reps and warranties were alleged.  This discussion, found in footnote 4 of the opinion, is worth reading in its entirety:

The repurchase protocol is a low-powered sanction for bad mortgages that slip through the cracks.  It is a narrow remedy (“onesies and twosies”) that is appropriate for individualized breaches and designed to facilitate an ongoing information exchange among the parties.  This is not what is alleged here.  Here, Syncora alleges massive misleading and disruption of any meaningful change by distorting the truth.  The futility of applying an individualized remedy to allegedly widespread misrepresentations is evident in the fact that, of the 1,300 loans actually submitted under the repurchase protocol, EMC has remedied only 20.  This .015% [sic] success rate does not bode well for the efficiency of employing the repurchase protocol for a generalized claim of breach.  Accordingly, EMC cannot reasonably expect the Court to examine each of the 9,871 transactions to determine whether there has been a breach, with the sole remedy of putting them back one by one.  This transaction was put together in days and months.  It is now in its second year of litigation.

You heard that right: of the 1,300 loans that Syncora has tried to put back to EMC to date under the repurchase protocol, EMC has agreed to repurchase only 20.  Again, given the evidence emerging about the conduct of that lender, I shouldn’t be surprised that it is ignoring its contractual repurchase obligations entirely.  Yet, somehow, this intransigence still makes my head spin.

Crotty’s language echoes the comments of Judge Bransten during the hearing on MBIA’s statistical sampling motion – that it is simply impractical to think that any court could adjudicate thousands of individual loans – but goes further, finding that the purpose of the repurchase protocol being to address “onesies” and “twosies.”  I believe that other jurists will find this analysis persuasive, thereby encouraging other MBS plaintiffs to come forward with claims of widespread breach, as the pathway to judgment will be significantly shorter and cheaper if sampling can be used.

Number 4: Bank of America Settles Repurchase Claims with AGO for $1.6 billion. On April 15, bond insurer Assured Guaranty, Ltd. (AGO) announced that it had reached a settlement with Bank of America, including Countrywide Financial and its subsidiaries, to resolve rep and warranty issues on 29 MBS deals that AGO had insured on a primary basis.  The settlement included $1.1 bn of cash up front and, according to Bank of America, up to another $500 million through a reinsurance agreement with BofA.  AGO is projecting its losses from first lien Countrywide deals to be $490 million and losses from its second lien deals with Countrywide to top out at $2.4 billion.  If BofA’s estimates of the value of this deal are correct, it could mean the bank is covering over 55% of AGO’s projected losses.

Though some would argue that the amount of this settlement was small compared to the number of breaches of reps and warranties that AGO was finding across all of its loan pools (88% of second liens and 93% of first liens according to AGO’s 2010 10-K), I see this as an out-and-out win for insurers and investors facing MBS losses.  This is the first time that a major bank has settled for any sizeable amount with a private party over rep and warranty liability, and it undermines the banks’ party line–repeated ad nauseum–that these claims were nothing more than sophisticated parties seeking to pass their losses onto somebody else.

Indeed, as commentators have begun to recognize, this settlement gives credence to the notion that monolines and private investors stand to recover a significant portion of their losses related to MBS from the banks that originated or packaged the loans into securities.  The accord may also embolden other plaintiffs to come forward with claims of their own, as it appears that BofA is making a concerted push to put its legacy issues from Countrywide’s portfolio behind it.

Number 3: AIG Jumps into the Fray. The sleeping giant has finally awoken.  Monolithic insurance company AIG, whose investments in the mortgage market forced Uncle Sam to swoop in to its rescue, has finally started taking legal action against some of the banks that induced it to insure mortgage products designed to fail and engaged in other underhanded conduct with respect to these investments.  Last Thursday, April 28, AIG sued two little-known CDO managers, saying they had conspired with affiliates to inflate the prices of these CDOs and create windfall profits and management fees for themselves.

As I’ve discussed before, AIG was forced to release its claims against the issuers of the mortgage securities it had insured through Credit Default Swaps and other derivatives when it accepted bailout money from the New York Fed.  However, AIG did not waive its claims as to the managers of those deals or as to the $40 billion of MBS that AIG purchased outright.  According to several people familiar with this matter, AIG is planning to bring additional lawsuits regarding those investments.  The insurer has hired Quinn Emmanuel, which also represents MBIA and several other bond insurers in MBS litigation, so it certainly looks like AIG is taking these issues seriously.

Notably, AIG’s first lawsuit draws on allegations made by the SEC last year when it accused the same money managers of securities fraud.  This creates a nice segue into the next item…

Number 2: Duetsche Bank and MortgageIT Sued by U.S. Department of Justice for Reckless Lending Practices. Nothing engenders more private follow-on litigation than when the government steps in and decides to sue somebody for fraud or negligence.  Similarly, the DOJ’s 48-page complaint against Deutsche Bank and its subsidiary, MortgageIT (available here), should give would-be plaintiffs substantial fodder upon which to base civil lawsuits against Deutsche for any harms stemming from MBS investments.

The DOJ’s suit accuses Deutsche of several violations of the federal False Claims Act, (carrying the potential for treble damages), as well as common law negligence and gross negligence based upon years of reckless lending.  Notably, though the complaint opens with the statements that, “This is a civil mortgage fraud lawsuit brought by the United States against Deutsche Bank and MortgageIT…[which] repeatedly lied to be included in a Government program to select mortgages for insurance by the Government,” it stops short of actually accusing the lenders of civil fraud.

Perhaps the DOJ, based on the heightened pleading standard for civil fraud, is awaiting the acquisition of better evidence through discovery before bringing any fraud claims (as Ambac recently did), or maybe it doesn’t feel it has a strong enough case to prove all of the elements of common law fraud (including knowledge of falsity, intent to deceive, and detrimental reliance).  Regardless, the allegations in the complaint suggest a strong basis for fraud, and the inclusion of such a claim would only add fuel to the fires of prospective plaintiffs.

Furthermore, Bloomberg reports that this may be only the beginning of U.S. suits against Deutsche and other lenders.  They note that the FHA and HUD are investigating existing loans for other potential claims to refer to the DOJ, and quote one commentator as saying that the Government may have filed this lawsuit as a “test case” before bringing more suit.  These cases, in turn, will beget many times that number of additional civil cases.

Number 1: Levin Report Referred to the SEC and DOJ for Potential Criminal Charges. Okay, remember when I just said that nothing brings about more private litigation than government lawsuits?  Well, I should rephrase that.  Nothing brings about more private litigation than government lawsuits, except for criminal charges.  Of course, as was illustrated most glaringly by Matt Taibbi in the article, “Why Isn’t Wall Street in Jail?” in Rolling Stone Magazine, not a single criminal indictment has been lodged, let alone any convictions obtained, against Wall Street bankers in the wake of the mortgage crisis that destroyed more than 40% of the world’s wealth.

However, it appears that this is about to change. First, Eric Holder testified before the House Judiciary Committee that more suits and prosecutions may follow the Deutsche Bank action discussed above.  In particular, Holder stated that, “we are in the process of looking at a whole variety of these matters, and it is possible that criminal prosecutions will result.”  Not exactly a guarantee, but it’s a start.

Then, just yesterday, the Levin report issued by the U.S. Senate, which finds that Goldman Sachs misled its clients about mortgage derivatives, was formally referred to the DOJ and SEC.  This puts the issue at the “top of the list” for the agencies and increases the likelihood that criminal actions will be brought.  Not only could charges be brought against Goldman and its executives for its actions leading up to the mortgage crisis, but additional charges of perjury could be levied against the executives that testified before Congress, as much of their testimony ran directly contrary to the ultimate findings of the Commission.

Though many were hopeful that all of the buzz surrounding the potential MBS litigation wave would fade with time, these five key developments over the last month or so send a strong signal that we haven’t seen the last of these lawsuits.  In fact, they’re likely just beginning.

[Many thanks to Manal Mehta from Branch Hill Capital for passing along several of the articles referenced in this post.

This updated post corrects some of the numbers with respect to the AGO/BofA settlement in the first and second paragraph of Reason Number 4 – IMG.]

Posted in AIG, allocation of loss, Allstate, Ambac, bailout, banks, BofA, bondholder actions, broader credit crisis, CDOs, CDSs, Complaints, contract rights, Countrywide, Deutsche Bank, discovery, emc, Federal Reserve, Goldman Sachs, incentives, investigations, investors, irresponsible lending, lawsuits, lenders, liabilities, litigation, loss estimates, MBIA, MBS, misrespresentation, monoline actions, mortgage fraud, mortgage insurers, negligence and recklessness, pooling agreements, private label MBS, putbacks, quinn emanuel, rep and warranty, repurchase, SEC, securities, securities fraud, securitization, settlements, sole remedy, statistical sampling, subprime, Uncategorized, waiver of rights to sue, Wall St. | 23 Comments

Pfaelzer Dismissal of Bank of America from Countrywide Suit Throws Investors for a Loop

Posted on April 27, 2011 by Isaac Gradman

Is Bank of America on the hook for Countrywide’s liabilities for defective loans?  Depends on which judge you ask.

With the recent decision by Judge Mariana Pfaelzer to dismiss BofA as a defendant in the case of Maine State Retirement System v. Countrywide Financial Corp., et al. (“Opinion,” link also provided at the end of this article), a difference of opinion has emerged among jurists over whether BofA should bear successor liability for the debts of its new lending subsidiary.  Judge Eileen Bransten in New York state court held that bond insurer MBIA could proceed with claims against BofA as the successor-in-interest to Countrywide under the theory that the bank’s purchase of the subprime originator constituted a de facto merger.  Judge Pfaelzer, on the other hand, has now ruled in California District Court that the plaintiff pension funds could not make such a claim, and has dismissed BofA from the lawsuit.

Two primary factors account for this difference of opinion.  First and foremost is the fact that each judge applied a different state’s law to the question of whether the plaintiffs had sufficiently alleged that Bank of America’s purchase of Countrywide’s assets should be treated as a de facto merger.  Judge Pfaelzer, turning to California choice of law principles under the federal Erie doctrine (as the forum state), applied Delaware law, which she found had historically used the doctrine of de facto merger “sparingly” and “only in very limited contexts” (Opinion at 6).  Delaware courts have held that this exception to the general rule that the purchasing corporation does not assume the liabilities of the selling corporation in an asset sale generally requires a showing of intent to defraud, such as an allegation that the sale was designed to disadvantage creditors or shareholders.

Over the objections of the plaintiffs in Maine State Retirement, who asked the judge to apply California law, Pfaelzer held that there was an actual conflict between the law of the two states and that Delaware (the state in which Countrywide was incorporated) had a greater interest in seeing its law applied than California (the state in which Countrywide had its principal place of business).  In particular, Pfaelzer found an actual conflict in that California law was much less restrictive than Delaware law in finding a de facto merger, the latter looking more to the substance of the transaction to see if it operated like a merger, notwithstanding its structure.  The Judge then relied on the Restatement (Second) of Conflict of Laws–which is a well-respected but non-binding treatise on conflict of laws principles–in finding that Delaware, as the state of incorporation, had a greater interest in having its law applied to the determination of this issue.  Certainly, this holding would have been stronger had Pfaelzer been able to cite to binding or persuasive case law to support her opinion.

By contrast, Judge Bransten applied New York law to the same question (opinion available here), which operates similarly to California law in looking more to the substance of the transaction than its form.  Bransten did not conduct a choice of law analysis, as the issue was not raised by the parties in the course of arguing the motion to dismiss (transcript available here), and thus simply assumed that New York law applied.  Of course, this did not stop BofA from challenging Bransten’s ruling on appeal, arguing that she should have applied Delaware law to the question of whether MBIA could state a claim for successor liability.  Though this issue is still up on appeal, my take is that BofA is unlike to prevail on an issue it did not appear to raise or properly preserve before the lower court.

The second major factor that contributed to these divergent rulings is the level of detail included by the respective plaintiffs in their allegations regarding the transaction.  The primary inquiry for New York courts in this regard is whether the acquirer absorbed and continued the prior operations of the acquired corporation or dissolved the company’s management and general business operations.  In support of its allegations in this regard in MBIA, the plaintiff alleged facts showing that BofA retired the Countrywide brand, including its website; cited favorable New York case law holding that all-stock acquisitions, such as BofA’s acquisition of Countrywide, suggest that a de facto merger has occurred; and cited to BofA’s pursuit of a settlement of predatory lending suits with state Attorneys General immediately following its acquisition as evidence that BofA had taken over Countrywide’s business.  All of these facts led Bransten to conclude that MBIA had alleged a de facto merger in which BofA intended to absorb and continue the operations of Countrywide.

In Maine State Retirement, the Judge Pfaelzer found that the plaintiffs had not made allegations sufficient to satisfy any of the de facto merger factors under Delaware law.  Namely, the Judge found that the plaintiffs had failed to allege 1) that Countrywide did not receive valid consideration in the acquisition, 2) that the asset sale failed to comport with law, 3) that any creditors or stockholders were injured by way of the sale, or 4) that the sale was designed to disadvantage such creditors or stockholders (Opinion at 15).  Whether the plaintiffs were unprepared for Judge Pfaelzer to apply Delaware law or simply felt that there was little chance of satisfying these factors should Delaware law apply (and, indeed, it would be hard to say that Countrywide shareholders received insufficient consideration for the sale, knowing what we know now), the fact remains that the plaintiffs’ allegations in Maine State Retirement lacked the particularity or the detail of those in MBIA.  That being said, the Maine State plaintiffs had an uphill battle from the beginning, as Pfaelzer had already issued a conclusory ruling in a previous case, entitled Argent Classic Convertible Arbitrage Fund v. Countrywide, to the effect that BofA did not face successor liability for Countrywide because no bad faith had been alleged (the case eventually settled out of court).

All this does little to guide investors and other plaintiffs looking to hold BofA accountable for the fallout from Countrywide’s reckless lending spree leading up to the mortgage crisis.  Certainly, it will mean we’re more likely to see lawsuits against Countrywide brought in New York than California going forward.  But investors can’t be sure that there will be anything to fight for should they take Countrywide to court and secure a judgment.  Though there are no concrete signs that Countrywide is currently unable to satisfy its debts, commentators have speculated that BofA is holding onto a potential trump card–the option of throwing Countrywide into bankruptcy down the road in an attempt to cut off its liability, should the unit reach that point.  If nothing else, this recent decision provides yet another incentive for investors with valuable claims with respect to Countrywide mortgage backed securities and other derivatives to act quickly to enforce these claims.  Each additional day that they wait could mean a smaller pot at the end of the rainbow.

[Update: BofA ultimately dropped its appeal of Judge Bransten’s Order denying the bank’s motion to dismiss on the issue of successor liability — IMG]

Judge Pfaelzer Order Dismissing BofA in Maine State Retirement System v. Countrywide, et al.

Posted in acquisitions, allocation of loss, appeals, balance sheets, banks, BofA, Countrywide, investors, jurisdiction, lawsuits, lenders, liabilities, liquidity, litigation, MBIA, merger, monoline actions, motions to dismiss, private label MBS, responsibility, securities fraud, subprime, successor liability, vicarious liability | Tagged , , , , , | 6 Comments

Federal Regulators Pick Fight with Banks Over Collapsed Credit Unions

Posted on March 29, 2011 by Isaac Gradman

Just when you thought the hubbub surrounding mortgage backed securities (MBS) was starting to subside, federal regulators have taken their most aggressive stance yet against the banks that sold toxic loans as investment grade securities, according to an article in the Wall Street Journal (subscription required). The National Credit Union Administration (NCUA), the agency that oversees federal credit unions and guarantees the deposits of both federal and state-chartered credit unions, has threatened to sue Goldman Sachs, BofA’s Merrill Lynch, Citigroup, and JP Morgan if the banks refuse to refund over $50 billion in MBS purchased by five wholesale credit unions that have since collapsed.

With some minor differences, the NCUA is to credit unions as the FDIC is to banks, overseeing the safety and soundness of the member-owned credit unions that act like banks for groups of workers in the same field (e.g. firefighters, teachers, or military servicepeople). In its role as conservator, the NCUA seized wholesale credit unions WesCorp, U.S. Central, Southwest, Members United and Constitution between 2009 and 2010, which had collapsed under the weight of their investments in MBS. Now, in an effort to recover the losses on the bonds it inherited–currently priced at half their face value–the NCUA is accusing the banks that created them of misrepresenting the risks.

Though many other federal regulators, including the Fed, the FDIC and the Treasury, hold large amounts of distressed mortgage derivatives, none prior to the NCUA has seemed interested in confronting these issuer banks. Sure, the New York Fed, which holds $70 billion worth of these assets from its rescues of Bear Stearns and AIG, has said that it would be engaging in a broad effort to enforce its rights. However, the only public action we’ve seen the Fed take in this regard is to sign its name to the letter sent by Kathy Patrick to Countrywide and Bank of New York back in October 2010. According to several sources, this amounts to little more than an effort at striking a sweetheart deal for BofA that would preserve the bank’s financial strength while setting a low bar for future settlements. Notably, this effort has made very little noise since its opening salvo (with both sides saying that they are currently engaging in negotiations).

The most interesting thing about the NCUA’s efforts is their focus on misrepresentation. As I’ve noted, we’re seeing a trend away from putback lawsuits and towards claims based on misrepresentations by issuing banks, such as Securities Act, Blue Sky and tort claims. Though plaintiffs originally shied away from alleging fraud or misrepresentation because they had little hard evidence to support such claims, significant revelations from discovery in ongoing litigation and testimony in federal investigations have exposed shenanigans in the loan buying and packaging business during the boom years of 2005-2008. In addition, as the recent holding in the FHLB of Pittsburgh case against JPM (analysis here and full order here) makes clear, less evidence is needed than previously thought to ensure the survival of misrepresentation claims.

In the NCUA’s case, sources indicate that the reason the agency is banging the drum of misrepresentation rather than breach of rep and warranty is that it may not be able to overcome the significant procedural hurdles required to obtain standing. The NCUA, on its own, does not appear to hold at least 25% of the voting rights in many MBS trusts, meaning it would have to band together with other investors to pursue these claims. This is still a possibility, but until then, the NCUA is wise to pursue the more accessible Securities Act and Blue Sky claims.

Turning to the big picture, the WSJ article quotes Quinn Emanuel lawyer Jonathan Pickhardt as saying, “[t]here’s plenty more litigation yet to come,” and I tend to agree. The statute of limitations (“SOL”) for federal securities claims is five years, while the SOL for rep and warranty contract claims under New York law is six years, meaning that claims on securities backed by 2005- and 2006-vintage loans will expire en masse by the end of this year. Should institutional investors fail to take action on these assets, despite the emergence of substantial evidence that these assets were misrepresented or defective, they could be exposed to breach of fiduciary duty claims by the pensioners, retirees and ordinary Americans whose funds they oversee.

Thus, I expect to see a significant number of MBS-related lawsuits hit the courts this year, including action by the Investor Syndicate, which has been ominously silent over the last few months. When that 800-lb gorilla finally begins beating its chest, Wall Street and institutional investors alike will be forced to sit up and take notice.

Posted in BofA, bondholder actions, Citigroup, Credit Unions, FDIC, Goldman Sachs, JPMorgan, Kathy Patrick, litigation, Merrill Lynch, misrespresentation, NCUA, private label MBS, Regulators, securities fraud | Leave a comment

Midwinter Conference Sparks Lively Discourse, Focuses on Servicing Deficiencies

Posted on February 16, 2011 by Isaac Gradman

I just returned from my first Midwinter Housing Finance Conference in Park City, Utah.  Though the conference, organized by Brian Hershkowitz, has been an annual favorite of snow-loving housing professionals for decades, it tends to receive far less publicity than the American Securitization Forum (ASF), which takes place around the same time every year.  That will hopefully begin to change, as I found this year’s conference to be engaging and, ultimately, newsworthy, thanks to a keynote speech by Fed Reserve Board Gov. Sarah Raskin that placed the servicing industry directly in the cross hairs.

In fact, while a wide range of topics was discussed during the conference’s three days of presentations and panels, servicing deficiencies dominated the conversation.  Most conference participants agreed that the default servicing model was broken, and continued to be major drag on the recovery of the housing market.  There was also a consensus that servicer conflicts of interest and misaligned incentives played a large role in these deficiencies–stymieing loan modification programs and contributing to the latent foreclosure (aka “fraudclosure”) crisis.  However, it seemed that each participant had a different idea about what it would take to fix this important industry. 

This diversity of opinion can be attributed in part to the complexity of the issues, but also to the diversity of the conference participants themselves–something that I found to be one of the strengths of this conference.  The professionals in attendance were not limited to one segment of the housing industry, but included investors, regulators, bankers, academics, financiers, consultants and members of the press.  Indeed, the number of different opinions about the problems with the servicing industry seemed to outnumber even the participants.

I presented on a panel that served as a microcosm of this blend of viewpoints.  The session was called “Investor Putbacks, MERS & the Capital Markets,” and included a presentation on MERS by Christopher Peterson, a law professor at the University of Utah; a presentation on Trends in Investor RMBS Litigation by me, a blogger and litigation consultant; and a presentation on what investors are looking for these days by Neil Powers, a fixed income investor at Vectors Research Mgmt.  Though the topics and viewpoints differed, they combined nicely in my opinion to paint a multilayer picture of the current MBS landscape.  The lively Q&A that followed only enriched that perspective.  

Of course, another topic that arose frequently during conference sessions was the future of the GSEs, especially with the White House’s release on Friday of a white paper suggesting the gradual winding down of Freddie and Fannie.  Cal Professor Dwight M. Jaffee gave an reassuring presentation on why he believes a privatized US mortgage market will work–a refreshing viewpoint for those of us who believe in the future of private mortgage finance.  This was followed, appropriately enough, by a presentation by Fannie Mae’s Doug Duncan called “Economics and Mortgage Market Analysis,” in which he noted that while housing fundamentals were improving, homeownership rates will likely trend downward due to weakness in demand.

But the most surprising moment in the conference came with Fed Gov. Raskin’s speech, the full text of which is available here.  Striking a decidedly more direct tone than her Fed counterparts, Raskin noted that “widespread weaknesses exist in the servicing industry… [T]hese deficiencies pose significant risk to mortgage servicing and foreclosure processes, impair the functioning of mortgage markets, and diminish overall accountability to homeowners.”  She also called out the servicers that are affiliates of the larger banks, saying:

For those in the housing and mortgage fields, making needed changes will not be easy. In particular, for those in the mortgage servicing industry, it means difficult changes and significant investments to rectify broken systems. For those servicers who are subsidiaries or affiliates of a broader parent financial institution, the responsibility for change and further investment absolutely extends up to that parent company, many of which have enjoyed substantial profits while their servicing arms have been run on the cheap.

While Raskin’s speech was short on aggressive proposals to fix these problems, such as legislating a divestment of servicing arms by the major banks to avoid conflicts of interest, she can be commended for attacking head-on the current problems with default servicing and suggesting a variety of alternative business models that might ease some of the problems with this industry.  And though the Midwinter Conference participants could have had a lively debate about the merits of these various models, I think almost all of us could agree with Raskin’s statement that, “Until these operational problems are addressed once and for all, the foreclosure crisis will continue and the housing sector will languish.”

As I checked out of the St. Regis in Park City and headed home, I was left to marinate on these words and the fact that while responsible servicing might not have prevented the Mortgage Crisis, it certainly would have made the cleanup a whole lot easier.  Here’s hoping that the many intelligent folks I met at Midwinter and throughout this industry can reach a consensus on building a better servicing model going forward.

Posted in ASF, conflicts of interest, Fannie Mae, Freddie Mac, incentives, investors, litigation, Midwinter Conference, Presentations, Winding Down GSES | 1 Comment

Commentators Concur: Trustee Involvement Signals Shift in RMBS Litigation

Posted on February 2, 2011 by Isaac Gradman


A few weeks ago, I published an article suggesting that the increased cooperation of MBS trustees may signal the turning point in bondholder litigation.  It seems I’m not alone in reaching this conclusion.

The following week, on January 27, Adam Levitin, associate law professor at Georgetown University and vocal commentator on banks’ potential liabilities stemming from subprime lending, published a blog post entitled, “Clash of the Titans: RMBS Edition.” The post does a great job of summarizing the key early litigation in this space, including linking to some articles from The Subprime Shakeout, while also analyzing where this trend may be heading.

Levitin’s verdict?  That the storm we’ve long predicted is coming.  Levitin writes, “We’re about to witness the main event in financial institution internecine warefare: investment funds (MBS buyers) vs. banks (MBS sellers).”  The catalyst he identifies is that a group of large institutional investors has banded together and filed suit, in what Levintin calls the first “A-list litigation.”  This would be the case filed by Dexia, New York Life, and TIAA-CREF, among others, against Countrywide and BAC.

Besides including the usual slew of allegations regarding loosening guidelines, breaches of underwriting reps and warranties and misrepresentations regarding lending standards, Dexia and the other plaintiffs raise (for the first time I can recall in either bondholder or insurer litigation) chain of title issues regarding whether ownership of the note and deed was properly transferred through the securitization chain.  The Complaint discusses in detail the revelations of Linda DeMartini from Kemp v. Countrywide that Countrywide routinely did not transfer the mortgage note when it sold a loan into securitization.  Such errors became meaningful after the Massachusetts Supreme Court handed down the Ibanez decision, holding that the entity foreclosing had to able to show that they were the holder of the note and deed at the time they initiated foreclosure proceedings.  As Levitin points out, the Dexia complaint merely scratches the surface on chain of title issues, but it gives credibility to an argument that was long dismissed by the banks as a mere technicality.

Levitin also agrees that trustee intercession on behalf of bondholders could only mean the times are a-changin’. In that regard, Levitin writes, “It looks like the trustees see that it’s checkmate once the investors get to the collective action threshold and are finally squeezing the servicers… This ain’t gonna end pretty.”

One day after Levitin’s article came out, industry publication Debtwire reported a similar trend.  In an article entitled, “JPMorgan slowly loosens grip on loan files in bitter EMC, WaMu buyback disputes” (subscription only), reporter Allison Pyburn, whose writing has long reflected a strong handle on these issues, states:

This week, JPMorgan also agreed to relinquish 400 of the 902 loan files requested that serve as collateral for Bear Stearns Mortgage Funding Trust 2007-AR2, according to a letter filed Wednesday in Delaware Chancery Court in Wilmington. The case, Wells Fargo Bank v. EMC Mortgage Corp., has investor standing in 42% of the deal and loan level data alleged to prove a breach of the 902 loan files requested on 20 September.

Movements by the bank to turn over loan documents to trustees investigating buyback disputes could represent a shift of power between banks and investors seeking buybacks, said an RMBS investor and lawyer familiar with the disputes.  A JPMorgan Chase spokesman declined to comment.

Make no mistake about it, loan files are the key to unraveling this whole mess.  Once bondholders obtain possession of these critical documents–and eventually they will–they will be privy to a mountain of fodder for rep and warranty and misrepresentation claims, and losses will flow back to the originators and underwriters of these toxic loans.  The servicers (a.k.a. the originators and keepers of the files related to many of these loans) have been able to sit on their hands and refuse to turn over loan files thus far because passive trustees and arduous procedural hurdles have stood between the bondholders and loan access rights.  When this changes–and all evidence suggests that it already is–servicers will be left without a leg to stand on, and the files will be produced, either voluntarily, or by court order.  Brace yourself for the ruckus.

Posted in allocation of loss, bondholder actions, chain of title, emc, investors, loan files, servicers, TIAA-CREF, Trustees, Wells Fargo | 3 Comments

Ambac Drops Bombshell Proposed Amended Complaint on JP Morgan, EMC

Posted on January 25, 2011 by Isaac Gradman

In a pleading filled with allegations that can only be described as shocking, Ambac has accused Bear Stearns and its former subsidiary EMC Mortgage (both now owned by JP Morgan) of a parade of horribles in its proposed amended complaint in its case over defective residential mortgages in the Southern District of New York.  If only a fraction of these allegations are true–and the documentary evidence cited in support suggests that they are–it constitutes the most damning evidence thus far that securitizing banks engaged in out-and-out fraud in the race to churn out more RMBS and enhance their bottom lines.

Among the allegations are that Bear Stearns (now JP Morgan Securities) profited by obtaining settlements from certain lenders that sold the bank defective loans, while at the same time denying repurchase requests from investors and insurers based on the same loans and the same deficiencies (thereby “double-dipping” on these loans); that Bear Stearns was simultaneously selling short shares of banks holding Ambac-insured securities as it denied the bond insurer the benefit of its contractual right to have Bear repurchase defective loans; that Bear covertly cut the time allowed for early payment defaults without telling investors, allowing it to securitize more loans that had already gone bad; and that Bear ignored its own due diligence findings on loan deficiencies, lied to rating agencies about this data, and then went ahead and securitized these loans, anyway.

I first reported on this lawsuit back in November of 2008, and noted that while Ambac had accused EMC of originating mortgages it knew could not be repaid, it stopped short of alleging fraudulent or negligent misrepresentation on the part of the originator of loans or arranger of the securitizations it had agreed to insure.  Apparently, Ambac was simply waiting for better evidence of such misrepresentation to emerge during the discovery process.  It now looks like the strategy paid off in spades.

I can’t possibly do justice to this slew of new allegations against Bear, culled mostly from emails and testimony obtained by the bond insurer in discovery, so I will just recommend that you read the Proposed Amended Complaint (long but well worth it) or some of the excellent news articles that came out today.  I am quoted in this article by Jody Shenn at Bloomberg News about Ambac amending its complaint to allege that Bear Stearns was talking out of both sides of its mouth on the same deficient loans.  This is another great story from The Atlantic, which has been following the news of whistleblowers within EMC since May of 2010, discussing some of the colorful emails obtained from Bear Stearns execs, including one from Bear deal manager Nicolas Smith on August 11th, 2006 to Keith Lind, a Managing Director on the trading desk, referring to a particular bond, SACO 2006-8, as “SACK OF SHIT [2006-]8” and saying, “I hope your [sic] making a lot of money off this trade.”

Much more to come on this fascinating new development.  I shouldn’t be surprised anymore by the audacity and utter lack of principles shown by Wall Street execs over the last five years, but somehow, I still am.

Posted in accounting fraud, Ambac, bad faith, Bear Stearns, Complaints, discovery, due diligence firms, emc, JPMorgan, monoline actions, rep and warranty, repurchase, RMBS, securities fraud | 12 Comments

Wells Fargo Sues EMC as Trustees Start Playing Ball with RMBS Investors; Servicers Still Holding Out

Posted on January 21, 2011 by Isaac Gradman

Will we look back at this point in the mortgage crisis fallout as the turning point for RMBS investors?  With the news that Wells Fargo, as securitization trustee, has sued EMC Mortgage in Delaware Chancery Court over loan files, trustee cooperation with bondholders is starting to feel distinctly like a trend, and I can’t help but hear the words to Bob Dylan’s famous folk anthem in my head:

You better start swimming or you’ll sink like a stone/
For the times, they are a-changin’

According to Bloomberg, Wells Fargo is seeking over 2,000 loan files underlying mortgages in Bear Stearns Mortgage Funding Trust 2007-AR2, based on “serious” questions raised by investors in the trust regarding whether EMC, a wholly-owned subsidiary of JP Morgan, complied with its reps and warranties when originating the loans.  Wells Fargo further stated in the Delaware complaint that it had received a letter from attorney David Grais (who was the moving force behind Greenwich v. Countrywide, the FHLB SF case and the FHLB Seattle case) on behalf of an unnamed hedge fund purporting to hold 42% of the bonds in this deal.  In that letter, Grais stated that he had investigated 1,317 loans held by the trust on behalf of his client and found that 938 breached EMC’s reps and warranties–a whopping 71% deficiency rate!

This is the second major battle currently being fought by a RMBS trustee to pursue bondholder interests.  In the District Court of Washington, D.C., Deutsche Bank is suing JP Morgan and the FDIC over loan repurchase responsibilities for mortgages in at least 159 WaMu-sponsored securitizations.   Though a major issue in that case is who should be left holding the bag for WaMu’s bad loans between the FDIC, the conservator of WaMu, and JPM, the purchaser of the failed bank, the issue of loan files is also at the forefront.  Just last week, Deutsche Bank filed a response to the Motions to Dismiss filed by JPM and the FDIC, and the Partial Motion for Summary Judgment filed by JPM, arguing that JPM is in continuing breach of its obligations to turn over loan files to the Trustee upon “reasonable notice.”  Deutsche Bank maintains that it should not be punished for failing to identify specific loans that are subject to repurchase in its Complaint when JPM is withholding that information in violation of its obligations in the relevant Pooling and Servicing Agreements.

So that’s two major trustees who are taking very aggressive approaches towards JP Morgan and its affiliates regarding their refusal to turn over loan files.  Could it be that the trustees are starting to realize that bondholders will eventually mobilize, and they don’t want to be caught in the crosshairs?

For he that gets hurt will be he who has stalled/
There’s a battle outside and it is ragin’/
It’ll soon shake your windows and rattle your walls/
For the times they are a-changin’

This passage could apply to EMC and other servicers who have thrown up road block after road block to investor attempts to get the loan files underlying their investments.  Colorfully, Wells Fargo states in its complaint against EMC that it had repeatedly asked the servicer for these documents, but, “EMC has played proverbial ‘rope a dope’ and otherwise continued to drag its feet, and has produced nothing.”  These loan files are expected to be treasure troves for putback claims, rife with evidence of poor underwriting and defective origination.

But Dylan’s lyrics about the costs of stalling could also apply to the pension funds, insurance companies and other institutional investors who are sitting on their hands while the statute of limitations clock ticks on billions of dollars worth of distressed RMBS in their portfolios.  In fact, these investors may have already blown the chance to raise securities fraud claims as to 2005-vintage MBS, while the window for rep and warranty claims as to the ’05 collateral will slam shut by the end of this year.

Your old road is rapidly agin’/
Please get out of the new one if you can’t lend your hand/
For the times they are a-changin’

Though servicers and trustees are both contractually obligated to act in the interests of the trust and the ultimate bondholders, as the owners of the trust, neither group had responded to repeated bondholder calls for action, let alone gone out of their way to find out how so many poor candidates for mortgage credit slipped through the cracks from 2005 to 2008.  Until recently.  The word on the street is that the same investors who were getting stonewalled by their trustees one year ago are now finding the trustees more receptive to their requests for investigations, loan files, and the initiation of repurchase requests.

This could have something to do with the anticipation building around the Investor Syndicate, which, according to this Bloomberg article, now boasts that it represents 1,325 trusts with at least a 50% ownership stake (and over 3,200 trusts with a 25% ownership stake).  This 50% magic number means that investors could fire and replace trustees and servicers that the bondholders feel have breached their contractual obligations.  The trustees seem to be recognizing that while they were willing to drag their heels at first in the name of industry solidarity, this isn’t their battle, and they don’t want to find themselves on the hook for the errors and omissions of subprime lenders.

Come senators, congressmen, please heed the call/
Don’t stand in the doorway, don’t block up the hall

Which brings us to the servicers like EMC who are still refusing to cooperate with demands for loan files.  Though their contractual obligations require them to act in the interest of bondholders, even at the expense of their own interests, the major servicers are all affiliates of major subprime lenders, and are thus far too interested to let a little thing like a contract stand in their way.  That is, if EMC begins turning over files, it would open the floodgates to putback claims against its parent, JP Morgan Chase.

This is the reason that congressmen like Brad Miller have begun urging federal regulators to use their authority under the Frank-Dodd Act to force large financial institutions to divest their loan servicing arms.  Though this recognition by Washington comes late in the game–and after many failed efforts to induce servicers to modify loans without understanding their conflicts of interest (see, e.g., my series of articles about the Servicer Safe Harbor)–letters like Miller’s are an encouraging sign that even the politicians are beginning to see the writing on the wall.  This battle will eventually be brought to the door of the major subprime lenders, or the Big Four banks foolish enough to have taken on their liabilities, and you don’t want to be caught standing in the way of that tidal wave.  To quote another great Dylan track, for subprime and Alt-A lenders, it’s a hard rain’s a-gonna fall.

Now that trustees appear to be giving in to the momentum building around loan putbacks, a major procedural hurdle that has been hampering prior bondholder efforts will be swept aside.  Now, so long as investors can pull together 25% or more of the Voting Rights in a particular deal, and offer the trustee some credible evidence of shenanigans in the servicing or underwriting of the loans in the trust, they should be able to convince the trustee to act on their behalf, making it significantly easier to get loan files and initiate repurchase requests.  So, while only time will tell, this moment could indeed be the point we look back upon in private label putback efforts and say “that’s when everything changed.”

The order is rapidly fadin’/
And the first one now will later be last/
For the times they are a-changin’

[Lyrics to “The Times They Are A-Changing” courtesy of bobdylan.com.  Copyright © 1963, 1964 by Warner Bros. Inc.; renewed 1991, 1992 by Special Rider Music.  Special thanks to Manal Mehta for passing along news of the Wells Fargo suit against EMC.  The case is Bear Stearns Mortgage Funding Trust 2007-AR2 by Wells Fargo Bank N.A. as Trustee v. EMC Mortgage Corp., CA6132, Delaware Chancery Court (Wilmington). – IMG]
Posted in Bear Stearns, Deutsche Bank, emc, FDIC, Investor Syndicate, loan files, private label MBS, procedural hurdles, putbacks, rep and warranty, repurchase, Trustees, WaMu, Wells Fargo | 3 Comments

Massachusetts Supreme Court Hands Down Ruling in Ibanez, Invalidates Postforeclosure Assignments and Assignments in Blank

Posted on January 8, 2011 by Isaac Gradman
The Massachusetts Supreme Court has issued its highly-anticipated opinion in the case of US Bank National Association v. Ibanez (and the related case of Wells Fargo Bank v. LaRace), bringing with it more bad news for the lending industry.  The unanimous opinion, authored by Justice Ralph Gants (available here and embedded below), upholds the prior decision in Massachusetts Land Court that foreclosure sales conducted as to properties inhabited by borrowers Antonio Ibanez and Mark and Tammy LaRacemakes were invalid because the Trustees attempting to foreclose were not the holders of the mortgages at the time they initiated foreclosure proceedings.

The decision confirms what many legal commentators had feared: that the common industry practice of assigning a mortgage “in blank” – meaning without specifying to whom the mortgage would be assigned until after the fact – does not constitute a proper assignment.  The Supreme Court further held that, without proof of a proper assignment to the party attempting to foreclose prior to the initiation of foreclosure proceedings (and proof that the party from whom the mortgage was assigned was a holder of the mortgage at the time of such assignment), the trustees could not rely on assignments after the fact to cure this deficiency.  The majority opinion was careful to distinguish between proper assignment in advance of foreclosure and proper recording of that assignment, holding that the latter could be effectuated after the fact.  The Court also found that being the holder of the promissory note was not enough to foreclose, if that entity did not also hold the mortgage.

Wells Fargo and US Bank, who are acting as the Trustees for the securitizations purporting to hold the mortgages at issue, each argued that, aside from having been assigned the mortgages via assignments in blank, they had been assigned the mortgages under their respective pooling and servicing agreements.   The Court rejected both arguments.  First, the Court found that, “We have long held that a conveyance of real property, such as a mortgage, that does not name the assignee conveys nothing and is void; we do not regard an assignment of land in blank as giving legal title in land to the bearer of the assignment” (Order p. 11).  The Court went on to find that poolwide assignments of “all right, title and interest” in the mortgages contained in the trust agreements were also ineffective because the trustees did not provide any proof that the loans at issue were included in any schedules attached as exhibits to those agreements.
Further – and this is important for investors considering possible legal action with respect to private label MBS – the Court held that there was no evidence that the Trusts, the entities that purportedly assigned the mortgages to Wells and US Bank, ever held the mortgages to be assigned. This suggests that many mortgages were never properly transferred into the securitizing trusts in the first place, meaning that investors may be holding unsecured debt instruments.  As two of the four biggest Trustees of mortgage backed securitizations, Wells Fargo and US Bank could experience increased liability as a result of this decision, as they had certain obligations to confirm that the mortgages were properly transferred into the trusts and that all relevant paperwork was in order.  Both banks’ stock prices took a hit immediately following the release of the Mass. Order.
Notably, the Court also explicitly rejected the Trustees’ request that the ruling be held to be only prospective in application, and not retroactive (see Order p. 12).  The Court noted that its opinion had not changed settled case law, but was simply enforcing well established legal principles and requirements.  Thus, there was no need to restrict the opinion only to future foreclosure cases.  This opens the door for borrowers who were previously foreclosed-upon on the basis of an assignment-in-blank to come back and challenge the foreclosure as invalid.  Chaotic times, indeed.

Even if foreclosing banks can cobble together the necessary paperwork to prove valid assignment prior to initiating proceedings going forward, the Ibanez decision means that private investors will take an even greater loss on their MBS investments than they have already, as this ruling will certainly lead to longer foreclosure timelines, higher legal costs coming out of securitization trusts, and higher loss severities for delinquent loans.  And the costs will be even higher if banks have lost paperwork or are unable to cure their assignment problems, as many suspect.  Of course, the allocation of this loss could change if bondholders mobilize and take legal action against the arrangers of the securtizations in which they invested.  Indeed, if the debt instruments they purchased were held out to be backed by collateral (i.e. mortgages) that the trusts never really held, investors will have some potent legal arguments that they can return these instruments to Wall Street for a full refund.
[For additional solid analysis of this opinion, check out this article on Felix Salmon’s Reuters blog and the comments at the end from Adam Levitin – IMG.]

Posted in allocation of loss, assignment in blank, bondholder actions, chain of title, foreclosure crisis, investors, massachusetts, mortgage market, securitization, standing, Trustees, US Bank, Wells Fargo | 8 Comments

Streaming Audio of Bloomberg Radio’s Hays Advantage Segment Featuring Isaac Gradman Now Available

Posted on January 4, 2011 by Isaac Gradman

On October 22, 2010, I appeared Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays to discuss issues facing RMBS investors in litigation against originators and underwriters.  A number of readers have asked me if a recording of the interview was available.  Below, please find links to that interview, split up into two segments.  Select “Open With” to hear them in your preferred media player.  Many thanks to Kathleen Hays and producer Kendall Kulper for inviting me onto the show and for providing me with these recordings.

Click here to play streaming audio of Segment 1 of Hays Advantage Bloomberg Radio spot featuring Isaac Gradman.
Click here to play streaming audio of Segment 2 of Hays Advantage Bloomberg Radio spot featuring Isaac Gradman.

Posted in Bloomberg Radio, foreclosure crisis, investors, lawsuits, media coverage, putbacks, rep and warranty, repurchase, RMBS | 1 Comment

MBIA Sampling Order Signals Shorter Path to RMBS Putbacks

Posted on December 30, 2010 by Isaac Gradman

The news gets worse for Bank of America.  Not only will it have to eat massive numbers of Countrywide-originated loans, but the bank may have to complete repurchases sooner than previously thought.  Judge Eileen Bransten’s long-awaited evidentiary ruling in the New York state court makes it clear – MBIA can use statistical sampling to prove its claims against Countrywide/BofA.  The ruling provides the bond insurer–and other insurers and private label investors–with a short cut to proving claims against lenders and originators of defective mortgage loans.

Bransten’s Order has already had an impact in newly-filed litigation over the losses associated with private label residential mortgage backed securities (RMBS).  A $700 million lawsuit filed by Allstate Inusurance Co. against Bank of America this past week refers directly to language from Bransten’s Order (available here and embedded below).

In her 15-page Order, Bransten found that MBIA will “be allowed to use and present evidence for its case through statistical sampling” (p. 15).  This means that MBIA will not have to present evidence of fraud or breach of contract for each of the 300,000-plus loans at issue in its case to a judge or jury; instead, MBIA will be able to evaluate a much smaller but statistically significant sample of loans and extrapolate the findings to the rest of the loans in the challenged securitizations.

In the course of making her ruling and rejecting the vigorous arguments made by Countrywide in opposition to MBIA’s motion, Judge Bransten found that the use of statistical sampling of large populations was not novel, was generally accepted in the scientific community, and was appropriate in the case at bar.  Bransten also explicitly held that her decision, “has the possibility of saving the parties and the court from significant litigation time and may significantly streamline the action without compromising either party from proving its case” (p. 13).

The outcome of MBIA’s evidentiary motion (also known as a motion in limine) was not entirely unexpected based on Judge Bransten’s prior comments.  In a June 16, 2010 hearing (transcript available here), Bransten said,

I think that it makes all the sense in the world that you can use a sample to prove the case because otherwise I can’t imagine a jury listening to 386 thousand cases.  Even if you have that available, nevertheless you are not going to present that to a jury or even a judge.  I’m patient but not that patient.  So, therefore it is going to be a sample in the end…

Yet the fact that an order in this regard has officially been put to paper–and in a closely-watched case such as this one–is already having a major impact in the MBS litigation world.  On Monday, Countrywide and Bank of America were sued by Allstate Insurance Co. and its affiliates over $700 million of RMBS purchased by the insurer (complaint available here).  In that suit, Allstate proposed to use samples of 1600 loans (800 defaulted loans and 800 randomly-sampled loans) from each of 14 securitizations (there are 61 securitizations at issue) to prove its claims.  In support of this methodology, Allstate asserted that,

Allstate‘s sample sizes of Mortgage Loans are more than sufficient to provide statistically-significant data to demonstrate the degree of misrepresentation of the Mortgage Loan characteristics. Analyzing data for each Mortgage Loan in each Offering would have been cost-prohibitive and unnecessary. Statistical sampling is an accepted method of establishing reliable conclusions about broader data sets, and is routinely used by courts, government agencies, and private business. As the sample size increases, the reliability of its estimations of the total population increase as well. Experts in RMBS cases have found that a sample size of just 400 loans can provide statistically significant data, regardless the size of the actual loan pool, because it is unlikely that so large a sample would yield results vastly different from results for the entire population. (Allstate Complaint, p. 38)

Filed by Quinn Emanuel, the same law firm representing MBIA and other monolines, the Allstate Complaint is novel for its assertion of a “matching strategy” by Countrywide–that is, that Countrywide was willing to approve any mortgage feature offered by its competitors, resulting in Countrywide “mixing and matching the worst features of mortgage products from different competitors,” and creating a product that was “very aggressive within the industry” (Allstate Complaint, p. 2).  Such a strategy required Countrywide to systematically abandon its guidelines and resort to the widespread use of unsupported exceptions, according to the Complaint.

As the Allstate Complaint shows, Bransten’s decision in the MBIA case has already dealt a blow to banks trying to defend themselves against mortgage putback liability, as it significantly reduces the prospective litigation costs, as well as the projected timeline, for investors seeking to compel originators to buy back defective loans with the help of the courts.  However, the decision is particularly harmful for BofA’s financial outlook and the credibility of its executives.  In addition to shorting the path to court-mandated repurchases by the bank, which has the most potential putback liability of any of its peers based on its acquisitions of Countrywide and Merrill Lynch, the decision undermines several statements made by BofA’s CEO, Brian Moynihan, regarding his strategy for the battle over rep and warranty liability.  For example, during BofA’s 2010 Q3 earnings call, Moynihan stated that, “This really gets down to a loan-by-loan determination and we have, we believe, the resources to deploy against that kind of a review… we will go in and fight this.  It’s worked to our benefit to–we have thousands of people willing to stand and look at every one of these loans.”

Moynihan has also stated that BofA would approach this type of litigation like “hand-to-hand combat,” disputing individual putbacks and dragging out litigation as long as possible to allow the bank’s earnings to offset these contingent liabilities.  Bransten’s Order presents a significant roadblock to the execution of that strategy.  Now, instead of going loan-by-loan, MBIA will be able to use a surprisingly small sample–less than 1.6% of the total loan population in dispute–to prove incidences of breach or fraud in the entire pool.

In its motion in limine, MBIA proposed using a statistical sampling methodology that included sampling 400 loans from each of the 15 securitizations at issue; stratifying the samples into mutually exclusive subgroups based on the characteristics of the borrower’s credit score, combined loan to value ratio (CLTV) and Countrywide’s documentation program; and then dividing each of these subgroups into further subgroups to ensu
re that important loan characteristics were adequately represented in the samples.  The monoline also proposed using delinquency status to stratify the samples used to prove its servicing contract and implied covenant claims.  MBIA asserted that this methodology would provide a confidence level of approximately 95% with a 5% margin of error.  Though Bransten ruled that MBIA could use this methodology to present evidence at trial, she stopped short of rejecting Countrywide’s arguments that this methodology was flawed and subject to challenge, arguments that she conceded “are not without merit” (p. 11). Instead, she ruled that those challenges were “premature,” and that “Defendant’s cited issues will be decided by the trier of fact as pertaining to the weight, rather than the acceptability, of the evidence” (p. 12).

Bransten’s commentary signals that MBIA may not be out of the woods yet in proving its case against Countrywide.  As an initial matter, the sample size seems exceedingly small compared to the overall loan population.  Due diligence firms like Clayton, who were often hired by investment banks to perform due diligence checks on loan pools before the bank would buy them, often took a 10-20% sample to ensure adequacy.  As recounted above, Allstate has chosen a sample size of 1600 loans–four times the sample size chosen by MBIA. With the cost of hiring a third party firm to review a loan file averaging around $300-350, meaning that it would cost MBIA over $5 million more to review a sample of 1,600 loans across its 15 securitizations, it’s easy to see why MBIA is trying to keep its sample size small.  Still, while I’m no statistician, it seems like cutting corners in this way could open MBIA’s data up to a number of technical challenges.

Furthermore, it’s not at all clear how the representative sample would be applied to the overall loan population, even if it was established to be representative by the trier of fact.  The contractual remedy for proving that Countrywide breached a rep and warranty with respect to a loan is the repurchase of that particular loan.  How would that remedy be applied to the overall loan population if MBIA’s sample showed, for example, that 60% of loans breached at least one rep and warranty?  In other words, which loans would Countrywide be forced to repurchase, and how would the court ensure that size and the loss severity of those loans lined up with those found to be defective in the sample?

Still, this decision is a definitive win for MBIA and all RMBS investors hoping to recoup some portion of their losses.  Now that MBIA has received the loan files underlying the securities at issue, it’s only a matter of time before it will be able to find significant percentages of loans with (often multiple) material deficiencies.  By enabling the insurer to project findings on such a small sample to the rest of the pool, this decision provides MBIA with a monumental shortcut to establishing Countrywide’s repurchase liability.  Only time will tell if this changes BofA’s strategy of hand-to-hand combat and brings the bank to the negotiating table, or simply provides the bank with one more issue on which to put up a fight.

[Thank you, as always, to Manal Mehta for sharing his perspective and real time updates on this case – IMG]
Bransten Sampling Order (MBIA v. Countrywide) http://d1.scribdassets.com/ScribdViewer.swf?document_id=46008294&access_key=key-2bvsg4dsfur86xdm5ujv&page=1&viewMode=list

Posted in Allstate, BofA, bondholder actions, Countrywide, due diligence firms, investors, litigation costs, MBIA, monoline actions, quinn emanuel, rep and warranty, repurchase, RMBS, statistical sampling | 5 Comments