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New Ruling on Mortgage Putbacks a Potential Huge Win for Banks

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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.

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34 comments

  1. jake chase

    It is hard to argue with Judge King that loan quality is determined loan by loan. This makes me wonder once again why anyone ever bought MBS backed by non-govt insured loans? The only conclusion I can think of is that usury is so deeply imbedded in the thinking of so called financial institutions that they can only imagine an endless river of returns even from borrowers having no hope of servicing the loans. I recall reading somewhere (during the boom) droning reiterations of the montra, ‘home mortgage borrowers don’t default’.

    How long will it be before student loan investors find themselves in the same boat?

    1. ambrit

      Mr Chase;
      The mantra there is; “A college degree is your passport to the Big Time.” I’m already hearing University Graduate Students, who I work with in the DIY Boxxstore, openly questioning the value of the education they are purchasing.
      Since I’m guessing that the end game for the Student Debt Paradox is a massive Repudiation of the Debts, irrespective of the “Official” Tail Risk from such, the question arises: When will the State declare anti rentier social movements to be Terrorist Plots?

      1. harry

        Since the state is controlled by rentiers, it follows that anti-rentier movements are anti-government movements. Movements which attempt to wrest control of the State from its incumbent leaders are as a matter of course, described as terrorist or at the least revolutionary. So yes its a done deal.

        Time to set the police on the students again! Dont forget to video it.

      2. Jim A.

        It used to be that by and large a college degree was the dividing line between a comfortable white collar middle class job and blue collar work or retail drone. It’s becomming the dividing line between retail drone and marginally attatched fast food worker/part time no benefits worker.

        1. ambrit

          Dear Jim A.;
          The DIY Boxxstore I labour mightily in is rolling out new, part time, middle of the sale day, weekday, ‘seasonal’ employee positions. The joke going around the break room, where the ceiling speaker connected to the PA system has a sign attached to it saying “Do Not Touch”, is that the average length of employment of the ‘seasonal’ new hires will be determined by how long it takes them to pay off their bailbondsmen.

    2. curlydan

      Actually, I think a good lawyer could recommend that loan quality may be a widespread issue rather than loan-by-loan. If a company has high defaults and systemic procedures that create and approve bad loans, then I think an investor should be able to sue on bundled loans.

      This does not even mention the cultural practices that allowed crappy loans. We had a culture of creating a loan and selling it off as fast as possible. This culturally accepted practice (backed by the quick rev incentive) surely led to faulty underwriting and likely misrepresentations.

      Judge King appears to be extending the recent logic of the Supreme Court when it held that in many cases, customers may not be able to engage in class action suits and must go individually into arbitration. It’s a similar practice: raise the bar, increase the individual’s cost, limit the liability to the single entity.

      1. Yves Smith Post author

        A lot of “good lawyers” have been breaking their picks on this for a while. We’ve reported on this at some length. For the investors even to get the loan files to prove the underwriting failures has been a huge uphill battle, from a procedural standpoint. The investors cannot sue the servicer or originators directly, they have to sue the trustee for failure to do his duty (put back the loans). And the investors agreed to have their rights to litigate restricted, that was a condition of making the investment.

        1. Nathanael

          I would think that proof that the mortgages had *never been legally transferred to the trust* would be much more powerful as a legal tool.

          You should be able to file suit to replace the trustee for financial mismanagement, first; then you should be able to file suit to recoup phony losses caused by the payment of money for mortgages which were never transferred into the trust.

          Why has nobody taken this tack? It should be easy enough to prove failure to transfer if you can get a record of which loans were purportedly in the trust; just go to the local record offices and show that the transfer documents were not filed.

  2. jake chase

    Rather than trying to enforce putbacks, investors ought to be pursuing fraud claims, in which, presumably, the utter absence of underwiting standards ought to be both relevant and provable through sampling techniques. And if the banks complete disregard of underwriting standards, and contractual requirements like mortgage assignments and recording, etc., don’t amount to fraud, what does?

    1. Tyzao

      and how would such a sample be achieved? through discovery? additionally, how would you prove the sample followed a survey design without information about the population — possible, but perhaps difficult to defend in court (no idea how survey designs / samples occur in a legal setting)

      1. Yves Smith Post author

        Correct. Bond investors don’t have an easy path to getting to the loan files (I won’t bore you with details but procedurally it is hard). Monoline insurers have better putback rights and access to the loan files.

  3. Richard Davet

    The fact missed by Judge King is the fact that all the loans do have a common denominator called “The GSE Business Model”.

    Was counsel remiss in bringing this to the court’s attention?

    1. Enslavedlikeme

      Thanks Yves for your dedication. I read these from Alison, but not sure where it leads and not sure if it can help homeowners responsible for “Zombie Titles” like me. Thoughts anyone?

      http://newsandinsight.thomsonreuters.com/Legal/News/2012/04_-_April/Does_Pauley_s_BNYM_ruling_spell_new_liability_for_MBS_trustees_/

      http://newsandinsight.thomsonreuters.com/Legal/News/2012/12_-_December/MBS_industry_takes_a_hit_in_second_NY_ruling_on_trustee_liability/

      1. Susan the other

        If all the titles were cleared and each mortgage nullified because no party claiming to be the mortgagee can be identified and no note can be found with proper allonges then a case could be made for wrongful behavior and damages and restitution even if intent to defraud could never be proven. Misrepresentation, negligence and harm can be proven without a doubt.

        The easy way to clear all titles is to put the burden of proof on the claimant, each mortgagee, to prove they do hold an interest in the mortgages they are collecting money on. Give every mortgagee one year to prove their title claim with evidence, not robosignatures. If titles cannot be proven the property reverts to the homeowner and the mortgage is nullified, clearing the title. At which point investors have an easy case to make.

        But MERS is being shielded and the litigation against MERS that prevails does not make a difference to the owners of MERS, the banks. Titles are not being cleared. Nothing will ever be resolved. And now the Fed has added an extra layer of bank protection by buying up 80 Bn MBS per month, making the chain of proof even more complex. i wouldn’t put it past the Fed to simply claim indisputable standing because they represent all possible parties of interest. Enriching the banks beyond imagination, as usual.

        1. Mark P.

          No surprises. The Obama administration has made clear in word and deed that it views the real estate industry and, in particular, the monster of the mortgage bond securitization industrial complex as being central to the U.S. economy, so it’s committed to reviving those things.

          It seems crazy to us. But the mortgage industry has been the primary artifact by which most Americans’ lifetime debt-indenture is established. In large areas of the world, like the Middle East and Africa, housing is relatively cheap and food costs consume 40-80 percent of the average person’s income; by contrast, in the U.S. (and much of the West) food is cheap but housing eats up 30-65 percent of most peoples’ incomes.

          One of the things that’s apparent here in the continuing aftermath of the 2008 collapse is that, just as the system has been absolutely rigged to favor the financial elite — to the extent, if necessary, of suspending all the rules of the game and just printing new money to give to the banks — so, too, the U.S. housing industry has been effectively structured to siphon off as much of peoples’ earnings as possible.

          Arguably, an effect of the market. Yet a market structurally manipulated — as here, with the government’s shielding of MERS and the banks — to favor the extraction of money from the masses by the financial industry. Because we now see see substantial numbers of houses sitting empty and degrading quickly; whole ghost sub-divisions exist if you go through some towns in California and Florida.

          How much would the average American home — outside of places like New York and San Francisco — cost absent the government/financial industry’s structural manipulation? What would the actual worth of the land be, given that the U.S. is, for God’s sake, continent-sized? What would the actual building and material costs be?

          1. Tyzao

            and infrastructure and public services are poor to bad in most places anyways — i.e. public transportation, public health, public safety, public education etc…

          2. different clue

            Well . . . popsicle sticks, shitrock, and fallaparticle board can’t be worth very much or cost very much in and of themselves.

    2. Anon

      this can only be the result of very poor pleading by the plaintiffs lawyers.

      It is a well recognized theory of liability that negligence or breach of contract can be based on the result of systematic failure (lack of policies, supervision, improper incentives, etc.)

      Beyond that, to have filed these cases in federal court was super stupid, given the cost. If you have a misrepresentation case, then you have an individual whom you can sue to defeat diversity.

      1. Yves Smith Post author

        No, you don’t understand the structure of these securitizations. Rep and warranty cases get into very hairy procedural issues.

          1. Nathanael

            So why aren’t the fraud cases being filed?

            I mean, we’ve shown that a whole bunch of the MBSes were actually not backed by anything because the mortgages were never legally transferred into the trust. This is easy to prove if you can get the addresses of the supposedly mortgaged properties — you need nothing more, because all you have to do is go to the local land offices and show that they weren’t transferred.

            This is a violation of the trustee’s obligation as trustee, so it should be trivial to remove the trustee at that point. Once the trustee is replaced, a whole lot of options open up.

  4. Eric Zuesse

    Yves, will you please explain to me here: Lehman sued the mortgage-originator, Universal American Mortgage Company, because Lehman wanted to transfer the blame to UAMC after being sued itself by Lehman’s investors.

    So: How does the judge’s action in this case reduce accountability at the top, which is to say at the level of the bank that was creating this financial hamburger with rotten meat? How is this judge’s decision not, instead, a focus of blame at the institutional top of the economic food chain — the mega-banks, instead of the mortgage-originators?

    Did not the mega-banks incentivize the mortgage-originators to do this? When you call this decision “a potential huge win for banks,” is that false? Please explain.

  5. redleg

    I am afraid that the inevitible outcome of this will be a France 1793 scenario. When the rule of law only applies to little people, the little people will eventually establish their own form of justice.
    Thing just keep getting worse.

    1. different clue

      Could that be why the “establishment” is pursuing “gun control” with such earnest intensity at this moment?

      1. Nathanael

        No. Handguns are of relatively little use in a France 1789 scenario.

        Surface-to-air missiles would be of substantially more use, as the Syrian freedom fighters are discovering. Those are already heavily controlled, however.

  6. JGordon

    This is a very positive development. The more people come to realize that we live under a criminal regime, the more the official markets will grind to a halt (with their inevitable collapse)and the more that “black” markets which are not subject to tax confiscation by the criminal regime will thrive. All the parasites are doing is sowing thier own graves with these kinds of laws/judgements, and thankfully they are too insanely delusional to see it.

    1. will nadauld

      I wish I could believe JGordons analysis of this becoming a teaching moment. I have been telling otherwise intelligent people about these issues for the last four years. By and large, non nc readers do not understand what is happening to our society. Some like my inlaws have the intelligence to grasp the situation, and the implications, but refuse to believe that their president,basically their entire govt, serves the interest of rich criminals. Their eyes get glassy and they talk about how tough congress is making it on obama. Hope for the future lies in our ability to somehow have the next batch of young elites survive the scum of their organizations and have at least some morality left when they get elected/appointed.

  7. John Doe

    A must read Georgia Lawsuit on Scribd Sonya Shuler vs. Bank of America. Homeowner being foreclosed on because she refused to do a Home Mod.

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  9. Pete

    I think you’re vastly underestimating the settlement leverage of winning even one loan putback claim; the precedent will be extremely influential on the business question of whether or not to settle.

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