naked capitalism

I must confess I am surprised that Bank of America is close to settling a litigation threat by a group of investors headed by the New York Fed, Pimco, and Blackrock, which was discussed in the media quite a bit last fall for a reported $8.5 billion.

While most threatened litigation is settled out of court, this case in theory had to overcome procedural hurdles for any suit to be filed, and no group of investors had ever surmounted this impediment. Chris Whalen similarly noted that BofA could simply tell the investors to “pound sand.” However, we had noted that if it moved forward, that this type of case, a representation and warranties case, is always settled because they are too expensive to fight in court.

And representation and warranties cases of this type (which would demand that the servicer make the originator buy back dud loans) requires that the investors not merely prove that the seller lied, but that the lies were THE reason that the losses on specific mortgages took place (as opposed to normal “shit happens” loan losses, meaning due to unemployment or other loss of income, death, and disability). That means even if the judge approves the use of a sample that each side still will argue on the individual cases within that sample. Think how many loans that would involve across what as of the last sighting was reported to be 115 deals. Because these case are so costly to pursue, settlements historically have been 10% to 15% of the value of the loans alleged to have been misrepresented.

We had pencilled a settlement amount, if the case went that route as much lower, but that was also using the Wall Street Journal report that the amount of the bonds included in this action was $16.5 billion. The amount at issue ultimately was $58 billion, and 22 investors were involved, so we assume the much bigger amount is in large measure due to the increase in the number of participants and the much greater value of bonds). So if you gross up our estimate for the increased size and apply the same methodology we used earlier, you get to over $4 billion versus the $8.5 billion under discussion. While that’s a big disparity, the estimates by the litigation bulls were more off in the other direction.

But this begs the question: would BofA settle this case, and for this kind of number? It’s stance heretofore on these putback cases has been the banking equivalent of the Churchillian “We shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and in the streets, we shall fight in the hills; we shall never surrender.” And mortgage insurers, who have much better access to the underlying loan data, have not been able to prove widespread fraud, or even widespread breaches.

These are some factors that may have played into this change of heart:

The first reason may be that Bank of America has changed strategy and has decided it needs to put the matter behind them. Management or perhaps the board may have reacted to the damage to the stock price and concluded that it needed to fold. The dreaded “uncertainty” was taking too big a toll.

Second is the plaintiff’s lawyer may have convinced BofA that they had a way to overcome the procedural hurdle, which other investors had not been able to surmount on similar cases. As we had noted earlier:

The problem in suing is a bit circular: you need to be able to argue specifically what sort of breaches occured, but the investors lack access to the loan information to enable them to refer to specific breaches in a lawsuit. Or to put it in a bit more legalistically, unless the pooling and servicing agreement gives the certificateholders some rights to access to the loan files, you are likely to have an impediment: you may not be able to allege specific enough breaches to get to perform discovery.

And in that case, the issue would not just be Bank of America’s exposure to losses but the damage that could be done in discovery. And that damage comes on multiple fronts: the continuing bad press and resultant damage to the stock price of the sordid details of of how dreadful Countrywide was, and the revelations serving as grist for litigation by other investors. However, this settlement effectively proves that BofA can be shaken down with a threat of litigation that has never overcome certain procedural obstacles. The Wall Street Journal notes that any settlement may encourage other aggrieved parties to act:

The deal could embolden mutual-fund managers, insurance companies and investment partnerships to go after similar settlements with other major U.S. banks, arguing that billions in loans scooped up before the U.S. housing collapse didn’t meet sellers’ promises or were improperly managed. Most vulnerable would be Wells Fargo & Co and J.P. Morgan Chase & Co., which along with Bank of America collect loan payments on about half of all.

Third is that there may be evidence in other litigation underway (for instance, MBIA is suing Countrywide over similar issues, and mortgage insurer have much stronger contractual rights to putbacks than investors) that the bank knew might allow these investors to add more claims to their litigation that had additional economic value (as in the settlement might be broad and include any litigation related to these bonds, and BofA recognized that with this big an investor group united, it was exposed to other sorts of action.

More broadly, this development at a minimum shows that Bank of America to be running scared. I wonder what other shoes might be about to drop on the mortgage front.

And it also confirms our initial take on the Countrywide deal, which we disapproved of merely when BofA made an investment in the struggling subprime lender:

…even though the financial press has almost universally hailed Bank of America’s investment in Countrywide as a bold and savvy stroke, the market has remained singularly unimpressed.

I will confess I haven’t studied the details of the deal for a simple reason: I’m appalled that B of A would even consider it. The two banks had reportedly been talking for six years. That means B of A knew, or ought to have known, Countrywide very well. An article by Gretchen Morgenson in Sunday’s New York Times paints Countrywide is, at least in spirit if not the letter of the law, a criminal enterprise, aggressively targeting misrepresenting its products and pushing customers into unnecessarily costly mortgages.
…. I know lawyers who have Countrywide in their crosshairs, and I am certain they have plenty of company.

To put it another way: there’s enough fraudulent selling in the the subprime market in general, and smoke around Countrywide in particular, to deter anyone investor who takes litigation or reputation risk seriously.

In my day, no respectable institution would make a high-profile equity investment or otherwise closely link its name with an organization that had the whiff of serious liability about it (except in liquidation or some other scenario which got rid of the incumbent management team).

So even though underestimated Bank of America’s anxiety to settle a specific action that would be costly to prove in court, this move would be consistent with the risks we identified back in 2007.

Update: An attorney who is a card-carrying Countrywide hater pinged me to express skepticism about this news item. He said that the plaintiff’s attorney has been trying to move this action forward via press releases, and he can’t fathom any reason for BofA to settle ex having the other side overcome the heretofore unbeaten procedural hurdle. So he thinks this will prove to be more bluster.

Update, 12:00 AM: As details come in, this is more consistent with our initial views. I pinged MBS Guy. His response:

I can’t find any news confirming that the lawsuits were ever filed. Just a threatening letter to the trustees that the clock was ticking and they had 60 days to respond (starting from back in October, 2010, by the way).

http://www.bloomberg.com/news/2010-10-19/pimco-new-york-fed-said-to-seek-bank-of-america-repurchase-of-mortgages.html

Back in March, they were still discussing the terms of the letter. http://www.gibbsbruns.com/countrywide-rmbs-effort-gibbs–bruns-llp-issues-statement-03-31-2011/

In addition, the Sub-prime Shakeout website suggests that the bonds affected by the settlement actually have a current amount of $84 billion according to Bloomberg, compared to the $56 billion cited by the WSJ. In addition, the original amount of these bonds is, again according to Bloomberg, $182 billion. http://www.subprimeshakeout.com/2011/06/breaking-news-bofa-close-to-reaching-8-5-bn-settlement-with-blackrock-pimco-100th-post.html

Loans are repurchased at the stated principal amount, plus accrued interest – which is the original principal less any amortization that has occurred.

If the bonds affected are $84 billion, this sounds like it would be the best number for comparison, which means the $8.5 billion settlement would be equal to 10.1% of outstanding par of the deals. If true, then this isn’t a bad settlement for BofA and probably about at the same level as they are settling the Fannie and Freddie claims.

Also, as suggested by Subprime Shakeout – can these investors and the trustee really settle on behalf of all of the investors? Can BofA really get a release from all potential litigation relating to reps and warrants for their deals from this type of action? It seems awfully suspect to me, but if true, then maybe it really would be a good deal for BofA.

Ultimately, I remain skeptical that BofA would settle for such a large amount without even the filing of a lawsuit when the have lawsuits pending against them which they have fought tooth and nail from MBIA, Ambac, FGIC, Syncora and MGIC for an aggregate amount in excess of $20 billion worth of losses on approximately $60 billion worth of deals.

Where did this information come from (hint – Kathy Patrick) and why are the press accounts so varied on the details? I’m fairly certain there is more to this story.

And this comment from reader Pelican:

“The settlement goes beyond just the $56 billion of securities owned by these investors, however. It covers nearly all of $424 billion in mortgages that Countrywide issued, which were then packaged into mortgage bonds. That means that a broader group of investors will share in the proceeds, according to the people who were briefed on the proposed settlement, but were not allowed to speak publicly.”

http://www.nytimes.com/2011/06/29/business/29mortgage.html?partner=yahoofinance

If BofA can settle on $424 billion of bonds for $8.5 billon, that’s 2%, which is a screaming bargain, particularly if they get a broad waiver.