naked capitalism

The meltdown in the financial markets obscured an important development on the mortgage front, namely, that New York state attorney general Eric Schneiderman filed a motion to intervene in the proposed $8.5 billion settlement between Bank of America and the Bank of New York acting as trustee of 530 Countrywide residential mortgage securitizations.

We said when the deal was announced that it was not a done deal and it stank to high heaven, so we are glad to see confirmation of our dim view. In keeping, the motion charges Bank of New York with “fraudulent and deceptive conduct”. As we will see, the allegations that Schneiderman has made against Bank of New York opens up a whole new front of mortgage securitization liability, that of the trustees failing to live up to their contractual duties and worse, making ongoing certifications that they had. This is an area we’ve discussed at some length before and have been surprised hasn’t been taken up until now.

By way of background, the proposed settlement purportedly had Bank of New York acting on behalf of investors, although it conferred with only 22 and did not even go through the motions of consultation with the rest. In addition, we indicated, many of that 22, such as the New York Fed, had reason to support Bank of America getting a sweetheart deal if it alleviated questions about the bank’s solvency. Moreover, as we pointed out, Bank of New York itself had substantial conflicts of interest in entering into this deal. BofA represented nearly 2/3s of Bank of New York’s trustee business, and as Adam Levitin had noted prior to the settlement being filed that Bank of New York would “inevitably have to be deferential” to Bank of America.

But the biggest problem with the deal were the broad releases that went well beyond the matter at hand, which were breaches of representations and warranties (in simple terms, that investors were promised that the mortgages would meet certain standards and those promises were violated). One was effectively a payoff: that Bank of America gave Bank of New York indemnification that looked to be too good an offer to refuse. As we noted in an earlier post:

[T]he side letter also indemnifies the trustee broadly against liability in the pooling and servicing agreements, the contracts that govern these deals. Since trustees like Bank of New York provided multiple certifications that the trusts held the assets (and that would include observing the chain of title niceties) when lawsuits all over the country have established that that did NOT happen. In addition, a senior Countrywide employee in testimony in Kemp v. Countrywide said Countrywide had retained the notes (the borrower promissory note) when the trust was supposed to have them. Whoops!

So the trustees have a ton of liability the are eager to escape. And that means that the indemnification in the Bank of America side letter is tantamount to a very big bribe to Bank of NY to go along with this deal.

The motion objects to the settlement on multiple grounds:

1. The amount to be paid appears to be too low given the damages suffered

2. The other consideration (the undertakings by BofA) are pretty meaningless and don’t make up for the insufficient dough. Per the motion:

Given the steeply discounted cash payment, the value of any nonmonetary consideration is a crucial element in evaluating the Proposed Settlement’s fairness. Here, the Attorney General believes that the proposed settlement’s purported servicing improvements are too vague and ill-defined to provide any concrete value to investors.

3. The trustee failed to perform key duties it had promised to carry out in the contracts that govern these deals (the pooling and servicing agreement, or PSA), and made false certifications about its actions:

One of BNYM’s primary obligations as trustee under these PSAs was to ensure the proper transfer of loans from Countrywide to the Trusts. 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.

This is the first time I have ever seen a court filing discuss widespread document fabrication by a servicer. This of the proper transfers is germane for the BofA deal because BofA gives Bank of New York indemnification for this liability. And it’s even juicier: Bank of New York’s self dealing works to the disadvantage of the investors to whom it owes a fiduciary duty:

But as BNYM concedes in its petition here (Petition ¶¶ 78-81), Countrywide has inadequate resources. A side-letter agreement appended to the Proposed Settlement expands the benefit of the PSAs’ indemnification provisions by having BoA, now Countrywide’s parent company, expressly guarantee the indemnification obligations of Countrywide. In addition, the Proposed Settlement expands the indemnification to cover BNYM’s negotiation and implementation of the terms of the settlement, thus shielding the trustee from significant forms of liability in connection with the formation and implementation of a settlement which seeks to compromise the claims of the investors to whom BNYM owes fiduciary duties.

Although the motion discusses the constrained financial capacity of Countrywide, let us not forget that Bank of America has limited resources as well, so any valuable indemnification to Bank of New York comes out of what otherwise might have been available to pay the investors.

New York Attorney General Pleading in Bank of America Intervention 8-4-11

You can find the other filings made in connection with the motion here, here, here and here.

The motion goes into some detail as to how Bank of New York breached its duties to investors and the consequences of its failures:

Any action to foreclose requires proof of ownership of the mortgage. This must be demonstrated by actual possession of the note and mortgage, together with proof of any chain of assignments leading to the alleged ownership. Moreover, complete mortgage files give borrowers assurance that their properties are properly foreclosed upon. The failure to properly transfer possession of complete mortgage files has hindered numerous foreclosure proceedings and resulted in fraudulent activities including, for example, “robo signing.” These fraudulent activities have burdened borrowers as well as the courts with flawed foreclosure proceedings.

BNYM knew the scope of the loan documentation deficiencies because it issued detailed exception reports for the Trusts. These deficiencies impaired the value of the securities by compromising the collateral and imposing additional servicing costs.

The motion discusses how Bank of New York had a duty to notify investors and to try to stop Countrywide’s “widespread fraud in improperly prosecuting foreclosure actions” yet failed to do so.

In other words, this motion is significant not simply because it throws a very large spanner into the works of the BofA settlement and the misguided hopes that it would serve as a template for other miscreant banks. It also describes very clearly the substantial liability of trustees like Bank of New York thanks to their failure to make sure notes were transferred to the trusts as stipulated in the pooling and servicing agreements.

Although Schneiderman has chosen to use the Martin Act and other New York statutes as his basis of action, trustee like Bank of New York provide annual certifications in SEC filings that say (in very crude terms) that the trust had good title to its assets.

Given the widespread failure to convey notes to trusts as stipulated in the PSAs and the resulting train wreck in courtrooms around the US, many if not all of these certifications were false. All trustees did at least one annual certification after the deal closed; if a deal has less than 50 investors, they can seek an exemption from the SEC filing requirement. This means, unlike other areas of the mortgage mess, where damaged parties can sue only based contractual breaches, they can also sue trustees for securities fraud for making materially misleading SEC filings. And since the major trustees are too big to fail institutions by virtue the critical roles they play in custody, clearing, and settlement, it is going to be interesting to see how the officialdom will try to stuff this genie back in the bottle.