Even though, for most people, the housing crisis is a thing of the past, the fight over who should bear the cost of sloppy and openly fraudulent mortgage origination and securities sales continues to grind through the courts.
We’ve written now and again about mortgage putback cases, which are also called representation and warranty, or “rep and warranty” litigation. Investors in mortgage-backed securities were not quite as dumb as the crisis aftermath had made them look. The sponsors of the securitizations made promises in the offering documents (called representations and warranties) about the quality of the loans. It turns out they lied.
Normally, when a loan is found to be worse than the sponsors promised, the remedy is a putback. The originator is required to take the bad loan back and replace it, either with cash or buy replacing it with a loan that was of the quality that the investors were promised. However, the mortgage securitizations put hurdles in front of the investors: it took a minimum level of investors (usually 25%) to demand putbacks and it was hard for any investor to know who else had bought a particular deal. Even then, the trustee (who was the party who was responsible for putting back the loan) almost always ignored and fought investor putback requests. They have ongoing relationships with the sponsors, so they don’t want to ruffle big meal tickets, plus the margins for acting as a mortgage securitization trustee are thin, so they don’t lift a finger unless they absolutely have to.
Investors have thus been going to court to enforce their putback rights. We haven’t been enthusiastic about these suits. It isn’t that the investors weren’t harmed or that the banks really didn’t lie about their wares. But we have always been of the view that ultimately, if these suits get anywhere, the plaintiff would have to show on a loan by loan basis that the default was due not to normal underwriting losses (as in death, disability, job loss) but specifically because the loan was bad (as the loan was so badly underwritten that default was highly likely). That is, the plaintiffs don’t just have to show that their contracts were breached (the loans were worse than they were supposed to be) but that the breach was what caused damages.
What makes these cases potential duds, or at best unlikely to produce damages within hailing distance of investor losses is the fact that they will likely require a loan by loan fight. Imagine the cost of each side doing discovery on a loan, and telling its version of the story as to why the borrower defaulted. Multiply that by thousands of loans and the cost of proving how much you are owed becomes very costly relative to what the plaintiff might recoup. That’s why the people we know who have experience in rep and warranty litigation have expected these cases to settle for comparatively small percentages of likely losses suffered (now having said that, in an important ruling last year in Syncora v. EMC, the judge agreed that misrepresentations about loan quality would increase the risk of an insured loan pools, meaning Syncora would not need to get into a huge analysis of how many loans defaulted and why. But that ruling was based on insurance statues, so that doesn’t help mortgage bond investors).
The cases that are furthest along are those involved monoline insurers, since they had stronger putback rights in their contracts than bond investors. In MBIA v Countrywide, the judge agreed to allow MBIA to construct a sample of the loans (the two sides will now fight over what is an adequate sample) but even within that sample, we’d expect both sides to do a loan level analysis, which would probably include loan level discovery. Ugh.
Alison Frankel of Reuters points to a new ruling which could make this investor-unfriendly picture even uglier. A new ruling has told bond investors to file separate cases on each loan they think was misrepresented. No, I am not making that up. From her post:
I did a double take Wednesday, when I noticed a pair of new suits by Lehman Brothers Holdings in federal court in Colorado. The complaints, which are almost identical, claim that the mortgage originator Universal American Mortgage breached representations and warranties about loans it sold to Lehman, which subsequently suffered losses as a result of those breaches. But here’s the thing: Each suit addresses only one supposedly deficient loan! Lehman’s lawyers at Akerman Senterfitt allege that Lehman sustained about $100,000 in damages on one of the loans and $120,000 on the other — numbers that are light years apart from the multibillion-dollar claims we’ve seen from groups of mortgage-backed securities investors who band together to assert contract breaches in thousands of loans at a time.
The Lehman complaints each also contained a curious paragraph, noting that the claims at issue were previously asserted as counts in an eight-loan put-back case Lehman was litigating in federal court in Miami. The judge in that case, Lehman said, had decided after a pretrial conference last week that “each loan must be filed separately, rather than joined within one action.”
That notation sent me to the docket in the Florida case, and to the order entered by U.S. District Judge James King on Jan. 9. It’s true: King ruled that every allegedly deficient loan has to be addressed in its own suit, not in a block case. “The lack of commonality among the various factual circumstances pertinent to each of the eight individual loans makes them all but impossible to be adjudicated together,” King wrote. “That lack of commonality flows from, among other things, the facts that each of these loans was made at a different time, to different borrowers, in different locations involving different purchases of different real properties; most fundamentally, each loan requires separate proof as to whether a breach occurred, what damages, if any, flowed from any such breach, and what the amounts of any such damages are.”
To add insult to injury, the eight loan case was far enough along that it was scheduled to go to trial in March. And even though this conclusion may seem barmy to some readers, it may have precedential value since few investor putback cases have gotten very far:
Universal American’s lawyer, Philip Stein of Bilzin Sumberg Baena Price & Axelrod, told me Wednesday that if other judges
following King’s lead, the ruling could have profound implications for put-back litigation, since it significantly increases the cost of asserting breach-of-contract claims. (Stein also blogged about the order at Bilzin’s Mortgage Crisis Watch site.) Few put-back cases, Stein said, have reached final pretrial conferences, so few judges have considered the kind of commonality challenges he raised back in 2011 in Universal American’smotion to dismiss the Lehman suit. The judge denied the dismissal motion in order to permit discovery, Stein said, but was receptive when Universal American revived its argument at a pretrial hearing on Jan. 4.
If this ruling does establish what Frankel correctly calls “a new paradigm”, you’d need your head examined to ever invest in anything other than government guaranteed mortgage bonds. And of more immediate import, investors who had hoped they would recover some of their losses will find, yet again, that they’ve spent a lot on lawyers to find out that they don’t have much protection under the law.