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Judge Rakoff Delivers Big Blow to Bank of America and JP Morgan in Flagstar Mortgage Putback Ruling

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Wow, one of my big assumptions about mortgage putback cases has been turned on its ear, much to the detriment of Bank of America and JP Morgan. If you thought there were pitched legal battles on this front, a key ruling by Judge Jed Rakoff means you ain’t seen nothing yet.

If you are late to this brawl, putback cases are also called representation and warranty cases, or rep and warranty. They occur when investors and bond guarantors who relied on the promises made by the originators and sponsors about the quality of the loans argue that the sellers broke those promises (“representations and warranties”). Their remedy is typically that they put dodgy loans back to the sponsor, and they either replace with a loan that was up to snuff or cash.

It also matters who is pursuing the case. Without getting into gory details, bond insurers have much better putback rights than mere garden variety investors (Fannie and Freddie as insurers similarly have good protection, hence the fear raised by the FHFA’s putback suits against 17 banks and servicers).

The assumption among many who’ve looked at these suits is that they might not be worth all that much in the end. In past putback litigation threats (which until the crisis were settled after some initial rounds of jousting) was that it would be too costly for the plaintiff to make his case. They’d have to prove that the loan defaults were due not to normal underwriting losses (death, disability, job loss) but to the misrepresentation of the loan. And ultimately, you’d have to examine a lot of loans individually to make the case, which would balloon the cost of proving your case.

The inclinations of the judiciary do reflect prevailing times, and both increasing comfort with statistical methods and the widespread evidence of underwriting lapses has led judges to approve the use of sampling, which is a really big break for bond insurer and investors. But Judge Rakoff’s ruling yesterday is a game-changer. On an admittedly small case, in dollar amount, Rakoff awarded bond insurer Assured $90.1 million of the $116 million it sought in damages against Flagstar over two home equity line of credit securitizations. That’s nearly 78%. Trust me, no big bank is reserving anything within hailing distance of those sort of numbers for bond insurer putback cases. Look at how underreserved Flagstar is proving to be, per Reuters:

Flagstar, which had net income of $223.7 million for 2012, said Jan. 23 that it had reserved $82.7 million for pending and threatened litigation, including Assured’s lawsuit.

The litigation reserves also cover another bondholder lawsuit launched earlier this month by MBIA, which sued after paying out $165 million on claims related to two mortgage-backed transactions it insured.

And this ruling is even worse for the big banks. Flagstar is a vastly more sympathetic plaintiff than Countrywide or Bear Stearns. Flagstar did mainly Fannie and Freddie deals; the HELOC securitization look to have been a byproduct of their bread and butter business. They didn’t have a pipeline to keep feeding or conflicts of interest due to providing warehouse line funding (this was a big deal with Bear: it was providing credit lines to mortgage originators to make loans. It would put back the really bad loans to the originator rather than try to stuff them into securitizations. But the point came when the proportion of bad loans coming through the pipeline was so high that putting them back to the originator would have bankrupted them, leaving Bear with big losses on its credit lines. So Bear passed on the toxic loans to investors instead). So if the loss level was 78% of the ask for a sponsor who was far from the worst actor in this space, what will the results look like when you factor in egregiously bad behavior?

The ruling is below. It will be seen as an important precedent not simply because Rakoff is a respected jurist, but also due to his thoroughness in considering the evidence and parsing, as he called it, the war of the experts. Assured constructed a sample of 800 loans across the trusts. Its expert found material defects in 606 of them. Flagstar argued that of the 606, only 126 had defaulted in the first 12 months, so there wasn’t any harm on the rest. And it (using multiple arguments) took issue Assured’s analysis and said of the 126, only 3 were materially defective. Over the course of the trial, there was detailed discussion of 20 of the loan.

Rakoff indicated he did his own analysis of a sample of the loans in order to help determine which of the wildly opposed expert reading was accurate. He first rejected the idea of excluding the ones that had not experienced an early default Assured had presented evidence of defects like fraud (!) and debt to income ratios way outside the underwriting standards. Rakoff said that made those loans riskier than they were supposed to be and Assured was harmed even if there had not been an early default. He also found the Flagstar reasoning for rejecting some of the Assured findings to be unsubstantiated and not persuasive, and similarly found most of their attacks on her approach to be overblown (he has a very detailed discussion of the conflicting arguments and the reasons for his conclusion).

As reader MBS Guy summed up:

Judge Rakoff came out with his long awaited opinion in the Assured Guaranty vs. Flagstar Bank case. This was a straight rep and warranty case – no fraud allegations. In short, Assured, the bond insurer on two Flagstar deals, got nearly everything they wanted, including legal fees. Assured was demanding $116 million for claims paid, Rakoff awarded them $90 million, plus legal fees. That is a remarkably high success rate – way higher, I suspect, than most people had been expecting from the bond insurer cases.

Rakoff allowed statistically sampling and believed that the insurer didn’t need to prove causation. He didn’t even believe the insurer needed to collect only on defaulted loans (he obligated Flagstar to also buy back loans which were breaches, but on which Assured hadn’t paid claims yet).

I think this will probably have implications for the litigation reserves that banks are holding on other bond insurer cases (especially BofA) and for the big BofA and Rescap rep and warranty proposed settlements. The banks have been fighting hard on the insurer cases and refusing to settle – I think that’s about to change. I wouldn’t want to be a holder of BofA stock right now. This is the first rep and warrant case to go to trial and it was a big, big win for the plaintiffs.

Here’s the ruling:

Assured Guaranty v. Flagstar Bank 2/5/13 Ruling by

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43 comments

  1. Greg R

    “Rakoff said that made those loans riskier than they were supposed to be and Assured was harmed even if there had not been an early default.”
    The 1% ain’t gonna let that stick.

    1. Jefemt

      Agreed, at first blush… Then, I remember that we have printed and handed the 1% an awful lot of cash, for contingencies,cocaine, coquettes, collusion… It will be fun to see if their greed gets the better of them, and they fight, or they just roll, realizing the hit was socialized onto the proles

    2. R Foreman

      It’s a misrepresentation, and this was after all about reps and warrantys.. no need to prove fraud.

      1. DeadlyClear

        IMHO – the only way the banks will even come close to saving their financial okole is to expose the fact that the investors’ finance managers and/or agents, governors, and CEOs knew that the only way to guaranty the liquidity (that is essential to allow pension and retirement fund investments) would be that these loans would default and/or turn and burn.  Either way, someone, somewhere in the chain of events had to know that in order to be as liquid as needed defaults would have to occur… And if they were still approved by their higher-ups as an acceptable investment – then, I’m sorry – if I were on a jury they’d be hard pressed to convince me that they knew nothing.

        I see nowhere, any bank standing up to these investors and questioning the purchasing agents, finance managers, etc. exactly what they were sold…and promised. And you know why? Because it would eat up the chain – all the way to the top. And my guess, in many cases there was a phone call coming from someone connected to or in Washington asking for help to prop up the banks and/or help pay for the wars in the name of Homeland Security.

        1. dolleymadison

          Why did they have to be defaulted in order to be liquid? YOu mean liquidate the collateral (the homes?). If that is the case, were there timelines for when certain loans had to be liquidated? Just wondering how this plays into “servicer manufactured” defaults and if it can be proven these defaults were planned. Also, why is it that servicers are accelerating loans yet still showing those loans are current – even when they fail to FC and lose in court? (I paid electronically on the fist of every month never missed a payment so I have been puzzled as the WHY of my foreclosure action, and why, 6 months they lost they put forced placed insurance on my home) Any insight would be appreciated…

          1. DeadlyClear

            The whole point here is that they (the banks) insured themselves so that they got paid when the homeowners defaulted. Defaults and refinances were the way that they maintained the liquidity – but when the credit stopped moving for the banks in 2007 they were hard pressed to continue to refinance as they had promised homeowners they would do.

            The banks were in trouble long before the homeowners began to default – it was the banks who could no longer perform on the “option” ARM loans, even though the homeowners had excellent credit. The property appraisals were inflated and the banks had no more investors knocking on their doors except to get out of these lousy trusts. If you haven’t read THE BIG SHORT by Michael Lewis or BAILOUT by Neil Barofsky – pick up a copy, they spotlight the flaws.

          2. Brooklin Bridge

            You paid ever month and they foreclosed on you???? If so, what a bummer! Are you fighting it?

            The latter part of your sentence, …(I paid electronically on the fist of every month never missed a payment so I have been puzzled as the WHY of my foreclosure action, and why, 6 months they lost they put forced placed insurance on my home), was a little unclear.

            When did they place insurance on your home? 6 months before they foreclosed? And therefore while you were paying electronically on time every month?

          3. DolleyMadison

            BB – they tried to FC when I was not in default, threatened every attorney I had into quitting and other nefarious threatening acts – then I beat them as a Pro Se (DWP – Lack of Standing) 6 months ago. So a few day ago I got a letter from them saying if I failed to provide proof of insurance they will force place insurance – “to protect our interest”! BTW they filed a notice appealed but have not asked to have it put on docket(the way it works here) The same day they filed Notice of appeal they sent me a “settlement” offer whereby I got to keep paying them in exchange for me indemnifying them! The “offer” Basically admitted they didn’t have standing and demanded I sign my deed over to them to rectify that and – oh yeah – keep paying them an interest-only loan for 30 years. The funniest part was the clause that read “Borrower will be responsible for any future claims” by unknown/actual holders of the note! Would have been hilarious if it were not so diabolical… (FYI Regulator saw no problem with this – said no harm since I didn’t sign it)You can’t make this stuff up. Still have possibility of appeal hanging over my head…but I am ready for them.

          4. James Cole

            I’m sorry DeadlyClear what you’re saying makes little sense. What are you trying to say with:
            “the investors’ finance managers and/or agents, governors, and CEOs knew that the only way to guaranty the liquidity (that is essential to allow pension and retirement fund investments) would be that these loans would default and/or turn and burn.”
            The pension and investment funds you refer to were relying on the AA and AAA ratings of the MBS they bought from bankers for liquidity; they did not need, expect or rely on any sort of default scenario.
            Also, in your follow up comment: “it was the banks who could no longer perform on the “option” ARM loans, even though the homeowners had excellent credit.” Huh? What was a banks performance obligation on a loan it originated and then sold to a MBS trust?

          5. Brooklin Bridge

            @DolleyMadison, So sorry to hear it. It’s terrific that you know what you are doing, but I imagine it’s a horror show anyway and it just seems so unbelievable. As you imply, for people less savey than yourself, this is the ultimate nightmare and the reaction of the Regulator, no problem here says it all.

    3. diptherio

      Might there be 1%ers on both sides? As some Wall Street lawyer said not too long ago, some very important people got defrauded and are wanting justice, so maybe the rest of us will get a little too, trickle-down style, you never know.

      That the 1% fraudsters couldn’t help themselves and decided to fleece some of their own peer group, along with all the schlubs down on Main Street, may prove to be their legal undoing. Will 1%er indignation succeed where the SEC, DOJ, et al. have failed? That would be ironic…

      1. David Petraitis

        Dip:

        It IS useful to see this as a potential for inter-one-percenter readjustment. You then need to ask: Which portion of the elite would you prefer to have a boot on your neck?

        There are always readjustments in capitalist elites. But… and this is key, they seem to reassert the capitalist values of accumulation toward the elites and suppression of rest.
        There is another scenario possible but the prevailing ethos is of an uncritical view of capitalism, and dissing the alternative futures which are NOT predicated on capital accumulation, endless growth and the resulting dysfunctions.

        1. James Cole

          Speaking of boots, for what it’s worth, bond insurers are in a much better position than are banks to directly force adjustments of public employee benefit contracts (pensions, health care) in Chapter 9 municipal bankruptcy proceedings by using their position as major municipal creditors. Watch Stockton and, eventually, Detroit.

        2. Nathanael

          For future reference, if it’s a fight between elites, *you want the industrialists to be on top*.

          If the financiers are on top, you get nothing. If the industrialists are on top, you get industrial production.

          Unfortunately it’s not clear that industrialists have a dog in this fight.

          1. different clue

            Unless the long-term existence of a critical massload of people jusssst non-poor enough to keep buying the products of industrial production is their “dog in this fight”.

          2. Nathanael

            different clue: good point; that would be nice.

            Sadly, I’m seeing a remarkable lack of “Henry Ford” thinking (“I pay my workers enough to buy my product”) among the elites right now.

            Instead, the worst predictions of Veblen in _Theory of the Leisure Class_ seem to have come true: the elite is dominated by idiots who don’t understand anything about the businesses they own, and whose sole motivation is cheating people.

  2. jake chase

    So, the banks have to swallow the loans, but the banks can pass them on the Fed, where they disappear as an addition to the Fed balance sheet. Does it matter how large this fictional balance sheet becomes? I haven’t yet heard anyone talk about this.

    1. Kokuanani

      Yeah, I’d really like to see some focus on what’s going to happen now that Bernanke has moved so many of those crap loans from the banks’ balance sheets to the Fed, thanks to “quantitative easing.”

      Was Mr. B. “fully informed” as to just how crappy these purchased “toxic assets” were, or does it even matter.

      Taxpayers screwed again.

      1. Susan the other

        The fact that these cases are now coming to court, like somebody finally opened the floodgates, explains why Bernanke is in such rush to buy up all the MBS. I’d like to hear the discussion on just how this loss is going to be resolved too. Especially in view of the fact that evidence of fraud was looked at by Rakoff, an apparently considered convincing.

        1. dolleymadison

          EXACTLY – Uncle Ben began buying up these worthless MBS within weeks of the first judge giving suits like this one the green light. There is no end to the the amount of soft batting Old Ben will lay down to ensure a cushy landing for his beloved banksters.

          1. Nathanael

            Breach of fiduciary responsibility by the Federal Reserve?

            But who would have standing? Only the Fed stockholders, I think, which are all banks.

  3. Hayek's Heelbiter

    What are the chances this will be overturned on appeal? Does anyone know Rakoff’s track record on appeals?

    1. Thisson

      The odds are very slim on appeal. I have followed this case extensively, reading all of the trial transcripts, and I was confident that this was a winning case from the beginning. The risks to the plaintiffs were that: (1) some of their expert testimony could have been found unreliable; (2) they should have introduced the full set of underwriting guidelines into evidence.

      1. Hayek's Heelbiter

        Dear Thisson,

        Thanks for the informative update.

        I can rest a little easier, knowing that it will be harder for them to weasel out on a procedural technicality.

  4. financial matters

    Great precedences. Finding abundant fraud with these sampling techniques shouldn’t prove too difficult. Keep the ball rolling.

  5. chris herzeca

    in my opinion, the biggest takeaway from rakoff’s ruling is how he eviscerated the bank’s argument on materiality. this is all of the banks’ only real argument (since the loans are demonstrably deficient), and it is blown away.

    1. weinerdog43

      Chris, that is certainly a big takeaway. I think another big one is that contrary to most Ma & Pa plaintiffs, insurers are a 900lbs gorilla at the courthouse. Go to any court docket and you’ll see an insurance company involved in a larger percentage of lawsuits than virtually any other entity. My takeaway to add to yours is that you have a plaintiff that is very familiar with the legal system (and judges) and is also not afraid to take it to the mat. (and has the bankroll to go up against the banksters)

  6. GDC707

    Well, let’s hope. I’ve been hearing these “bankers are about to finally get their come-uppance” stories for years now and they never seem to pan out.

  7. kaj

    I am having a heck of a time reading your blog because an MFS ad keeps popping up. Yves, what is going on and how do I avoid this nonsense

    1. Enraged

      Same problem here. It’s been going on for about a week. It forces open and redirects me automatically to a site I close once, twice, three times before if finally quits. What is that?

    2. different clue

      I too have seen this MFS ad. I assume that MFS pays to place this ad. With that in mind, I sit there and watch the whole ad. How is NaCap to pay for its activities if not with paying ads? Are donations enough all by themselves? And if we don’t watch the ads, will anyone pay to place the ads? Given that, I sit there and watch the MFS ad.

  8. Rob Harrington

    The fraud was in the underwriting and appraisals – 2011 Florida Statutes – (felony)
    Title XLVI CRIMES Chapter 817 FRAUDULENT PRACTICES View Entire Chapter

     817.545 Mortgage fraud.—
     (1)For the purposes of the section, the term “mortgage lending process” means the process through which a person seeks or obtains a residential mortgage loan, including, but not limited to, the solicitation, application or origination, negotiation of terms, third-party provider services, underwriting, signing and closing, and funding of the loan. Documents involved in the mortgage lending process include, but are not limited to, mortgages, deeds, surveys, inspection reports, uniform residential loan applications, or other loan applications; appraisal reports; HUD-1 settlement statements; supporting personal documentation for loan applications such as W-2 forms, verifications of income and employment, credit reports, bank statements, tax returns, and payroll stubs; and any required disclosures.
     (2)A person commits the offense of mortgage fraud if, with the intent to defraud, the person knowingly:
     (a)Makes any material misstatement, misrepresentation, or omission during the mortgage lending process with the intention that the misstatement, misrepresentation, or omission will be relied on by a mortgage lender, borrower, or any other person or entity involved in the mortgage lending process; however, omissions on a loan application regarding employment, income, or assets for a loan which does not require this information are not considered a material omission for purposes of this subsection.
     (b)Uses or facilitates the use of any material misstatement, misrepresentation, or omission during the mortgage lending process with the intention that the material misstatement, misrepresentation, or omission will be relied on by a mortgage lender, borrower, or any other person or entity involved in the mortgage lending process; however, omissions on a loan application regarding employment, income, or assets for a loan which does not require this information are not considered a material omission for purposes of this subsection.
     (c)Receives any proceeds or any other funds in connection with the mortgage lending process that the person knew resulted from a violation of paragraph (a) or paragraph (b).
     (d)Files or causes to be filed with the clerk of the circuit court for any county of this state a document involved in the mortgage lending process which contains a material misstatement, misrepresentation, or omission.
     (3)An offense of mortgage fraud may not be predicated solely upon information lawfully disclosed under federal disclosure laws, regulations, or interpretations related to the mortgage lending process.
     (4)For the purpose of venue under this section, any violation of this section is considered to have been committed:
     (a)In the county in which the real property is located; or
     (b)In any county in which a material act was performed in furtherance of the violation.
     (5)(a)Any person who violates subsection (2) commits a felony of the third degree, punishable as provided in s. 775.082, s. 775.083, or s. 775.084.
     (b)Any person who violates subsection (2), and the loan value stated on documents used in the mortgage lending process exceeds $100,000, commits a felony of the second degree, punishable as provided in s. 775.082, s. 775.083, or s. 775.084.
    History.—s. 13, ch. 2007-182; s. 2, ch. 2008-80.

  9. Sanctuary

    I’m grateful for this ruling, but will it establish precedence that will actually be used against these filthy banksters? I remember the Bank of NY Mellon v. Silverberg ruling which I thought would blow away the banksters but which seems to have not been applied anywhere else.

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