naked capitalism

Bloomberg reports that Countrywide took a major setback in a suit against it by bond insurer MBIA. MBIA has alleged (quelle surprise!) that Country misrepresented the quality of loans it had MBIA guarantee. From Bloomberg:

Bank of America Corp. (BAC) lost a court fight against MBIA Inc. (MBI) over the hurdles the bond insurer will have to clear in a lawsuit seeking to force the bank to buy back faulty home loans made by its Countrywide Financial unit.

MBIA, which says it was duped into guaranteeing payment on Countrywide mortgage bonds, need only show the lender made misrepresentations about the loans backing the bonds, instead of having to prove they caused the losses the insurer is seeking to recover, New York state Judge Eileen Bransten said in a decision.

“No basis in law exists to mandate that MBIA establish a direct causal link between the misrepresentations allegedly made by Countrywide and claims made under the policy,” she wrote.

I’m no lawyer, but I find this ruling puzzling, and I expect Bank of America to appeal it. If you are suing someone, you not only have to establish that you did something wrong, but you also need to establish that you were damaged and come up with some sort of basis for arguing how badly you were damaged. If your dry cleaner destroyed a suit, you can’t assert, “This was a custom made Saville Row suit that cost me $5000 and would now cost $7500 to replace,” you need to produce some evidence that you really were damaged to that degree. How otherwise do you have a basis for determining damages? Perhaps this MBIA agreement has some language that provides for specified damages in the event of rep and warranty breaches, but if so, you’d think the matter would not take a judicial ruling.

Our colleague and former monoline executive Tom Adams drafted the claim for one of the very early rep and warranty suits (he sees his language picked up in most of the current suits) and has deemed the need to prove that the rep breach actually led to a loss to be a major hurdle (as it imposed very serious costs on the party suing to prove that the losses resulted from the loan being less than it was promised to be, as opposed to normal underwriting losses, such as the borrower losing his job). The judge may be trying to reduce that buredn, but I am not sure this approach would withstand an appeal. And the language of her ruling also implies that her logic applies only to monolines, and may not be generalizable to rep and warranty suits brought by investors. But if my doubts prove to be ill informed, that means the so called Bank of America settlement, in which investors were to get $8.5 billion to settle claims against 530 Countrywide trusts, looks even more wildly underpriced that we said it was when it was announced.

And this illustrates, yet again, that the legal liabilities facing Bank of America are putting in on a terminal path, unless it can successfully put Countrywide into bankruptcy. We’ve heard some pretty persuasive arguments as to why it probably can’t (the AIG objection to the $8.5 billion settlement makes a very persuasive case). And given how the liability is weighing on the stock, we imagine BofA would have put Countrywide in bankruptcy by now if it thought that was a workable solution.

Update: I will be getting more information when I get my hands on the decision, but an opposite ruling was issued today on a Countrywide case in New York on a case filed by another bond insurer, Syncora, that the claimant (Syncora) has not established as a matter of law that there does not have to be a direct causal link between a rep breach and a loss. So this MBIA ruling may not be as significant as the initial media reactions suggest.

MBS Guy also tells me that the language of the monoline agreements is clear, that the language of the monoline contracts is that the breach has to be material and adverse. He wonders if the breach did not lead to the loss, then how is the breach material?

Update 6:40 PM: Reader MBS Guy has read both rulings, and I will turn the mike over to him:

Have read this through finally, and I would conclude it is not the victory it is made out to be. Unfortunately, I can’t cut and paste language from the decision because the pdf is locked. However, here’s how I see it:

with respect to MBIA’s common law and NY State Insurance Law fraud claims, the judge rules that MBIA does not need to prove that a direct causal link between the alleged misrepresentations and the loss MBIA suffered. However, the judge notes that MBIA’s burden remains quite high: (1) MBIA must prove that the misrepresentations were material to MBIA’s decision to enter the policies (and that the misrepresentations occurred), (2) that MBIA relied on the information misrepresented, (3) that it would not have issued the policy if not for the alleged misrepresentations, (4) that the alleged misrepresentations materially increased MBIA’s risk, and (5) that MBIA was damaged as a direct result of the material misrepresentations. Then MBIA must prove the amount of its damages.

Here’s a quote from this part of the decision:

”
MBIA must then prove that it was damaged as a direct result of the material misrepresentations. As has been aptly pointed out by Countrywide, this will not be an easy task.”

To some degree, this seems like a rather fine parsing of distinctions: MBIA doesn’t have to prove a direct causal link between misrepresentations and loss incurred, but must still prove that it was damaged by misrepresentations that were material.

The court did lower the standard from what Countrywide wanted for the proof of damages – but not in any way that I think is important.

With respect to breach of reps and warrants portion of MBIA’s motion, the court denied MBIA’s motion. This means the court denied MBIA’s motion that (1) it does not have to prove that the alleged breach of reps and warrants caused the non-performance of the loans and (2) that it is not limited to non-performing loans.

Put another way, the court did not agree that, as a matter of law, MBIA had proved its case on these issues. This is, I think, the real causation issue that people were concerned about: Do allegations of breaches of reps and warrants have have to prove that the breach caused the loss?

Countrywide argued that the plain language of the contracts states that no breach occurs unless the breach materially and adversely affects the interest of the insurer. MBIA disagreed. The court ruled that MBIA was not entitled to a summary judgment on this issue. Therefore, MBIA has the burden of proof to show that this is the case in arguments down the road, including issues of interpretation of what the contract means.

The Syncora decision argues basically the same thing, but in a different order. In this decision, the judge holds on the rep and warrant issue first, and denies Syncora’s motion for summary judgment.

On the rep and warrant issue, Syncora sought to prove that it only needed to prove that a rep breach was material and adverse, but it did not need to prove that the loan was non-performing or the cause of the loan’s non-performance.

The court denied Syncora’s motion because it said that the contract was open to different interpretations. The court noted that it was not holding that Syncora must show that a breach caused the loss or must be for a loan that defaulted. Rather, the court was only holding that Syncora had the burden of proof to make this argument more fully, based on the facts and terms of the contracts (i.e. it is not a “matter of law” issue when there are facts or terms open to interpretation).

With respect to Syncora’s fraud claims (that, under NY State Insurance Law and common law, Syncora was fraudulently induced to enter the insurance policies based on misrepresentations by Countrywide), the court basically reaches the same conclusion as in the MBIA case – Syncora does not have to prove a direct causal link between the alleged misrepresentation and the loss, but it still has a high burden of proof to prove the misrepresentation occurred, that it relied on the misrepresentation, and that it was damaged as a result.

Note – it was the same judge on both cases.