Is the Noose Tightening Around Countrywide?

One of the reasons for Bank of America to walk from the Countrywide deal is the rising tide of legal costs and potential for sizeable damages. Admittedly, at this juncture the prevailing view is that the Charlotte bank would renegotiate the acquisition rather than abandon it (particularly since it should be able to limit liability to the merger sub), but it still begs the question of why buy an operation that has the possibility of having zero financial value with considerable headache and embarrassment attached?

Some outstanding actions are moving forward. For instance, the US Bankruptcy trustee in three states have joined to accuse Countrywide of abusing the bankruptcy process. That's pretty unusual. There are also quite a few actions pending against the proposed merger; some have been halted as similar ones are litigated.

Established Countrywide hater Gretchen Morgenson provides an update on a class action suit alleging insider trading (!) and a failure to adequately supervise operations, as exhibited in lousy lending practices that (per the suit) simply cannot have gone unnoticed by management. While Morgenson has the mortgage lender in her crosshairs, she generally does an evenhanded job of reporting when working primarily from court filings, as in this case.

The significance of this suit, which can now proceed to the discovery phase, may be greater than it appears. Morgenson cites one level: this will be the few actions against the executives of a failed mortgage lender.

Another, less obvious impact: the suit will probe the bank's lending and management practices, and that will pave the way for further litigation. And it has the potential to confirm what are now only suspicions about abusive and misleading practices and thus further lower the value of the franchise.

Remember, once a suit is filed, testimony and exhibits filed in court become part of the public record unless sealed (unlikely in this instance). They can be used by subsequent plaintiffs at no cost, thus lowering the barriers for subsequent litigation.

Let me give you a mundane example. A recent Countrywide employee wrote me to describe many of the bank's bad practices. One was that the bank had launched a national campaign for a no-fee mortgage. He said he was certain not a single mortgage of the type promoted had ever been issued because the customer service people had all been given scripts to steer callers into other products (the no-fee loan had sufficiently high interest costs to make loans with fees look more attractive).

I called a litigator I know. She said the fact set would constitute advertising fraud and would indeed make for a good suit. However, most firms would wait for initial suits over more basic forms of fraud to proceed, since it would be easier to build the case for advertising fraud based on their causes of action and evidence.

That's a long winded way of saying that if Countrywide is indeed the serial miscreant many believe it to be, the lawsuits will build on themselves.

From the New York Times:

Directors and officers of Countrywide Financial, the beleaguered mortgage lender, must answer shareholder accusations of insider trading and an overall failure to monitor lending practices that led to the company’s collapse, a federal judge in California has ruled.

Rejecting the arguments of Countrywide executives and directors that they were unaware of lax loan operations that led to ballooning defaults, Judge Mariana R. Pfaelzer of Federal District Court in Los Angeles ruled Tuesday that she found confidential witness accounts in the shareholder complaint to be credible and that they suggested “a widespread company culture that encouraged employees to push mortgages through without regard to underwriting standards.”

Plaintiffs also identified “numerous red flags” that would have warned directors of increasingly risky loans made by Countrywide, according to the judge, who rejected a motion to dismiss the suit. “It defies reason, given the entirety of the allegations,” Judge Pfaelzer wrote, “that these committee members could be blind to widespread deviations from the underwriting policies and standards being committed by employees at all levels. At the same time, it does not appear that the committees took corrective action.”....

The plaintiffs in the case said they hoped to recover money for shareholders from Countrywide officials named in the case who sold $850 million in stock from 2004 to 2007. The plaintiffs contend that the directors and officers dumped shares even as the company spent $2.4 billion to repurchase its own stock in late 2006 and early 2007.

The chief executive of Countrywide, Angelo R. Mozilo, has argued that his $474 million in stock sales during the three-year period complied with securities laws under a planned selling program. But he revised the program, known as a 10b5-1 plan, several times, each time increasing the shares to be sold.

As a result, the judge wrote: “Mozilo’s actions appear to defeat the very purpose of 10b5-1 plans,” created to allow corporate insiders to sell stock regularly and without direct involvement.

Gerald H. Silk, who also represents the plaintiffs, said: “Corporate fiduciaries cannot expect to evade liability by blaming a general market downturn when there is specific and systematic misconduct taking place right beneath their noses.”

The suit names 14 current and former directors and officials as defendants; it is known as a derivative action because shareholders of Countrywide are suing its officers and directors on behalf of the company.

Microsoft Still Trying Evade the Rule of Law (EU Antitrust Edtion)

Someone needs to tell Microsoft to behave.

By way of background, in December 2004, Microsoft lost its final appeal on an EU antitrust case in which it was found guilty of tying its operating system to its media player, undermining competition and hurting consumer choice, and for failing to give rivals the information they needed to compete fairly in the market for server software, The Redmond company was fined a record $613 million.

To address the server complaint, Microsoft was ordered to license technical information to enable outside companies to design products that would run well on Windows (called API, the application program interface). Note that this isn't a particularly onerous request. Microsoft makes that sort of information available for free except in areas where it is trying to leverage its monopoly.

Microsoft acted in less than good faith through this entire exercise. It appeared to be delaying rather than complying. For example, Microsoft was asked to propose royalties for its API. Now consider Microsoft's response: up to 5.95% of revenues. The EU's technical expert, Neil Barrett, who was recommended by Microsoft, calculated that it would take software companies 7 years to recover their development costs. Now how many products last 7 years? And in particular, how many software products last for 7 years? Cost recovery looks like a fantasy. Barrett determined that even a 1% royalty would be too high, and 0% would be more appropriate.

In September 2007, the European Court of First Instance, in a starkly worded summary read to a courtroom of about 150 journalists and lawyers here, ordered Microsoft to obey a March 2004 commission order and upheld the €497.2 million, or $689.4 million, fine against the company.

In October, Microsoft negotiated a settlement of open items, giving every indication that it would submit to the court's ruling. As the Financial Times reported:

Microsoft finally admitted defeat in its three-year battle with the European Commission on Monday, as the US software giant agreed to comply with the regulator’s landmark finding that it was abusing its dominance of the market.

“I welcome the fact that Microsoft has finally undertaken concrete steps to ensure full compliance with the 2004 decision,” Neelie Kroes, competition commissioner, told a press conference in Brussels. “It is regrettable that Microsoft has only complied after a considerable delay, two court decisions and the imposition of daily penalty payments,” she said.

Under the deal reached between Ms Kroes and Steve Ballmer, the chief executive of Microsoft, early on Monday morning, the company will make it much easier for rivals to use its technology to develop their own programmes.

Microsoft also said it would not appeal the decisive September ruling by the European Court of First Instance, which upheld the Commission’s finding that Microsoft had broken EU competition rules. It ends three years of resistance that has cost €777.5m in fines.

Yet in February, the EU competition commission fined Microsoft $1.4 billion (€899m) for failing to adhere to the court decision:

The fine comes days after the world's biggest software group announced it would open parts of its software to rival companies in an attempt to assuage competition authorities.

But that move received a lukewarm reception in Brussels, where regulators have expressed scepticism about Microsoft's promise to make its Windows operating system and other big-selling software more open and transparent....

"The Commission has stuck to its guns," said John Pheasant, partner at Hogan & Hartson, an international law firm. "It also appears that the [European] Commission has not been swayed or deflected by the recent announcements by Microsoft."....

The Commission required Microsoft to offer such information on "reasonable terms," but subsequently complained that the royalty rates demanded by Microsoft over the next three years amounted to "unreasonable pricing". Microsoft fought the decision for several years but dropped its appeal after a top EU court ruled in favour of regulators last September

.
Now at the eleventh hour, right before the deadline for appeals is about to expire, Microsoft effectively repudiates the settlement and files an appeal. Yet incredibly, the press, even the usually reliable Financial Times, fails to note that this is a 180 degree change in its pretenses of being compliant. Again, from the Financial Times:

Microsoft said on Friday it would appeal against the record-breaking $1.4bn (€899m) fine imposed by Brussels two months ago because of the software group’s failure to comply with demands that it end anticompetitive business practices.

In a statement, the world’s biggest software group said that it was asking the European Court of First Instance to annul the European Commission’s February decision in which it imposed the penalty.

“We are filing this appeal in a constructive effort to seek clarity from the court,” Microsoft said in a statement....

Some independent competition specialists said openly that they believed there were grounds for an appeal – particularly since the Commission had never spelt out what it considered to be a reasonable charge for the patent licences. For example, Denis Waelbroeck, a partner at Ashurst, on Friday welcomed the move because he believed that there were “procedural inadequacies” in the approach taken by the Commission.

The Commission, however, responded on Friday by saying that it was “confident that the decision to impose the penalty was legally sound”.

The decision to file an appeal will also do nothing to ease the strained relations between the Commission and the company – which appear to have deteriorated again after failed efforts to reach some kind of “global settlement” late last year.

In January, the Commission announced that it was opening a fresh investigation into suspicions that Microsoft had abused market dominance of its Office software, and also whether it had illegally linked its Internet Explorer system to Windows. According to lawyers in Brussels, this probe is actively moving forward with information requests circulating.

It's too bad appeals courts can't increase fines. The one imposed on Microsoft was 60% of the maximum permitted; if I were a judge, I'd want to throw the book at them.

Why? The discussion about royalties is spurious; the Commission's expert said 1% was too high and zero might be appropriate. If Microsoft had had any good faith interest in putting this matter behind them, it would have proposed a royalty and put the onus on the EU to object.

I can't fathom what Microsoft thinks it will gain from this exercise, save delaying compliance with the EU's demands and annoying the regulator, which has issues far more important to Microsoft still before it. I am not a lawyer, but the issue of the level of royalties is not a basis for overturning the decision. The fine will stand and the interest will accrue. The most Microsoft can gain is to be able to charge a higher level within the 0% to 1% range. And this may be simply an artifact of the EU's drafting (the parameters were discussed in the trial, but the ruling itself indeed did not specify a level. Thus Microsoft at best will score a Phyrric victory.

Before readers assume Microsoft must have some advantage it can gain from this, consider: the coverage of Microsoft's antitrust trial in the US revealed that the company had an inept legal strategy. Some believed that Gates must have refused to listen to his advisors. Worse, the Redmond firm repeatedly showed its contempt for the court, repeatedly making statements that strained credulity.

Microsoft escaped tough penalties in the US only by a fluke. Judge Thomas Penfield Jackson was clearly disgusted by the Redmond's company's dissembling and was prepared to throw the book at them, but because he made the mistake of talking to the press substantively before the penalty phase was concluded, he was replaced by a cautious and clueless jurist, Colleen Kollar-Kotelly.

Microsoft just does not get it. The company seems not to understand that it is subject to the rule of law and has to comply when ordered to. Yes, Steve, there really are organizations out there that are bigger, tougher, and more determined than you are.

Will BofA-Countrywide Deal Get Done?

We've never been a fan of the pending acquisition of Countrywide by Bank of America. In fact, BofA's apparent eagerness to buy a company clearly on the ropes seemed odd: why not wait until it went bankrupt, or at least was on the courthouse steps with a filing? We're clearly old-fashioned, but in our day, not reputable company would risk its good name (and substantial litigation costs) by buying a large business that can only politely be described as ethically challenged.

The alleged reason for the deal was for BofA to get its hands on Countrywide's servicing business. People who deal with servicers tell us they are now hemorrhaging cash. I am advised that it is a standard feature of servicing agreements for the servicer to guaranteed to pay whatever interest is promised to the investors for at least 90 days after default. Some agreements also require them to pay principal during that period. Even after the 90 days, the servicer has to continue to pay real estate taxes and insurance. The servicer can use any late payment or other penalties from the borrower to offset these costs. The agreements had built in some margin to allow for these outflows, but no agreements contemplated defaults at the level we are seeing. Of course, the other reason the Charlotte bank may have stepped forward is if it were encouraged by banking regulators, or if a fire sale of Countrywide would directly have a negative impact on BofA's book.

So it looks like Countrywide is a walking mass of liabilities. Institutional Risk Analytics discusses why the deal may not go through (the article also contains a wonderful discussion of the oxymoron of business ethics):

First, it becomes clear, to us at least, that BAC is unable to close the CFC transaction due to uncertainty regarding the target's liabilities....in our view: BAC (and its lawyers and accountants) is not willing to do a deal that leaves BAC shareholders facing a potentially staggering loss....

Second, run the numbers. If you accept that none of the funds of CFC's $120 billion asset bank unit are available to repay parent company liabilities, except the $9 billion or so in book value representing the CFC equity in the sub, then the calculus comes down to about $50 billion in debt, vendors and other liabilities vs. the remaining assets of the parent, roughly a similar amount of loan servicing rights, conduit and investment assets, and whatever CFC can get for the bank unit.

Thus two billion dollar questions:

1) What is the estimated haircut for the ex-bank assets of CFC?

2) What is the estimated cost of settling all pending litigation?....

For BAC, a risky but better strategy than the course at hand may be to withdraw from the CFC merger, pay the $160 million breakup fee, and allow the entire company to slide into a managed default. As CFC's funding runs away, the OTS will be forced to invoke its statutory authority to appoint the FDIC as receiver of the insured bank subsidiary, thus precipitating a bankruptcy filing by CFC.

In the event, BAC and no doubt a crowd of other suitors will be standing by, waiting to bid for some or all of the bank's assets and liabilities in a competitive regulatory sale. But the claimants on the CFC bankruptcy estate would have to await the resolution of the bank receivership to see whether there were any net amounts from the sale of the bank that could be reclaimed.

To that point, while retail depositors of Countrywide Bank FSB have little or no reason to be concerned in such a scenario, the jumbo depositors of CFC above the insured limit- if any remain - should take advice about their options. The jumbo deposit holders may or may not be paid immediately by the FDIC depending on their assessment of the bank's condition at the point of seizure.

Given the outline above, our view is that the equity of CFC is worth $0....if you are a fully cognizant bond holder of CFC... you... also understand that the equity holders are essentially toast....What are you waiting for?

If the BAC deal is not happening, then the only logical course is to pull the plug on the impossible dream of Ken Lewis, shoot the equity holders and get on with the CFC restructuring.

Bank of America May Not Guarantee Countrywide Debt

Some months ago, we had mentioned that Bank of America was keen to avoid taking on Countrywide's liabilities (who wouldn't be?). The possibility that the giant bank might not provide a guarantee for Countrywide's debt came to the fore again. Without BofA backing, the Countrywide paper is a pretty dodgy proposition. From Bloomberg:

Bank of America Corp., the second- biggest U.S. bank, said it may not guarantee $38.1 billion of Countrywide Financial Corp.'s debt after taking over the mortgage lender, fueling speculation that Countrywide's bondholders face renewed risk of default.

``There is no assurance that any such debt would be redeemed, assumed or guaranteed,'' the Charlotte, North Carolina- based bank said in an April 30 regulatory filing, adding that no decision has been reached....

Countrywide's $1 billion of 6.25 percent notes maturing in 2016 traded at 90.25 cents on the dollar yesterday with a yield of about 7.9 percent, according to Bloomberg data. The debt traded as low as 46 cents in January, with a yield of 20 percent, just before Bank of America announced the purchase.

``I'd be quite concerned if I was a bondholder if the intent of Bank of America is as it reads in the filing,'' said Gary Austin, founder of PDR Advisors LLC, an investment management firm in Charlotte. His firm, which manages about $600 million, doesn't hold Countrywide debt...

``This confirms how tenuous this transaction is,'' said Christopher Whalen, managing director at Institutional Risk Analytics, a banking research firm, from Torrance, California....

The wording in the bank's filing is new, Victoria Wagner, a credit analyst at Standard & Poor's Corp., said in an interview yesterday.

``If they let the debt fail, it would have implications for their other obligations,'' she said. ``They are still going to wholly own Countrywide.''.

DNA Turns Relatives Into Genetic Informants

A Washington Post article, "From DNA of Family, a Tool to Make Arrests," points to the increasing efforts to look for partial matches in DNA databases that might implicate close relatives.

This is a disturbing development, since DNA, like other forensic evidence, isn't as foolproof as its image in the popular imagination indicates. There have been cases of false matches of DNA, such as this one in England, this one in Germany, and one I recall in New Zealand. Worse, since US lab error rates (false positives and technician error, such as switching samples or miscataloguing someone in a database) are not captured, errors are almost certain to be higher than widely believed. Without this information, the public and defendants cannot know for certain whether this is a cause for concern. An article from the Observer on the UK's experience suggests the reservations are warranted:

The DNA database is not a perfect weapon. Last year 1,500 administrative mistakes were discovered and at least 100 inaccuracies pertaining to individuals. That means there is a real possibility of people being convicted of crimes they did not commit. Given the chaotic state of government databases, it must be obvious..... that administrative errors would be vastly increased if the database were to be expanded by a factor of about 13, from 4.5m to 60m.

Needless to say, expanding the scope of searches by looking for partial matches compounds the potential for false positives. However, at least for now, this procedure is sufficiently controversial that it doesn't have a green light everywhere. Yet. Welcome to our total surveillance society.

More troubling, I did not see a mention in this article of the issue of errors, so it unwittingly promotes the idea that DNA testing is infallible . From the Washington Post:

He was a church-going father of two, and for more than 30 years Dennis Rader eluded police in the Wichita area, killing 10 people and signing taunting letters with a self-styled monogram: BTK, for Bind Torture Kill. In the end, it was a DNA sample that tied BTK to his crimes. Not his own DNA. But his daughter's.

Investigators obtained a court order without the daughter's knowledge for a Pap smear specimen she had given five years earlier at a university medical clinic in Kansas. A DNA profile of the specimen almost perfectly matched the DNA evidence taken from several BTK crime scenes, leading detectives to conclude she was the child of the killer. That allowed police to secure an arrest warrant in February 2005 and end BTK's murderous career.

The BTK case was an early use of an emerging tool in law enforcement: analyzing the DNA of a suspect's relatives. In the BTK example, police had a suspect and were looking to tie him to the crime. But now, states are moving to conduct familial searches of criminal databases, looking for close-to-perfect matches with DNA from crime scenes. A partial match with a convicted criminal could implicate a brother or daughter or father of the convict. Such searches, advocates say, constitute a powerful law enforcement tool that, experts say, could increase by 40 percent the number of suspects identified through DNA.

As things stand in some states, lab analysts who discover a potential suspect in this way may not be permitted to share that information with investigators. Such a policy, said William Fitzpatrick, a New York state district attorney, "is insanity. It's disgraceful. If I've got something of scientific value that I can't share because of imaginary privacy concerns, it's crazy. That's how we solve crimes."

But the technique is arousing fierce objections from privacy advocates, who maintain that it turns family members into genetic informants without their knowledge or consent. They complain that it takes material collected for one purpose and uses it for another. And with the nation's DNA database disproportionately comprised of minority offenders, they say, it amounts to placing a class of Americans under greater scrutiny merely because their relatives have committed crimes.

"If practiced routinely, we would be subjecting hundreds of thousands of innocent people who happen to be relatives of individuals in the FBI database to lifelong genetic surveillance," said Tania Simoncelli, science adviser to the American Civil Liberties Union.

Nonetheless, California, which maintains the world's third-largest criminal DNA database with more than 1 million samples, will soon become the first state to adopt a protocol to allow for familial searches. Last week, Colorado performed a test run of familial search software on its criminal database. In Massachusetts, officials say they plan to develop a policy to allow familial searches.

The technique is being adopted as states and the federal government expand their databanks to include profiles of people who have been arrested but not convicted of certain crimes.

Only Maryland has expressly banned familial searching in a law adopted this month to expand its DNA database to include anyone charged with a violent crime. The FBI, which maintains the world's largest forensic DNA database with almost 6 million profiles, said it has so far refrained from adopting the technique because of concerns about constitutional challenges....

An advisory group to the FBI has proposed a final policy that goes further, recommending that partial matches be subjected to additional DNA testing and statistical analysis that would help investigators home in on relatives of people in the federal database.

The key is intent, Callaghan said. The bureau is "not deliberately trolling the database looking for relatives," he said.

Heightening privacy concerns are the growing number of local jurisdictions that maintain DNA databases not restricted to criminals. Some include the DNA of victims, suspects or even lab workers. Such collections, which critics call "rogue databases," are barred from inclusion in state and national databases, but rules about their use by law enforcement agencies are unclear.

The Supreme Court has repeatedly held that authorities may not conduct searches for general law enforcement purposes without suspicion about individuals. Although convicted criminals have a diminished expectation of privacy, searching a database for unknown relatives might violate that principle, said Jeffrey Rosen, a George Washington University law professor.

"The idea of holding people responsible for who they are rather than what they've done could challenge deep American principles of privacy and equality," he said. "Although the legal issues aren't clear, the moral ones are vexing."....

Other states and localities maintain "offline" DNA databanks of samples taken from victims or suspects never charged with a crime. Such databases, which also exist in New York, are a violation of the constitutional ban on unreasonable search and seizure, said Barry Scheck, a commissioner on New York state's Forensic Science Review Board. "If I get a sample from you and I don't tell you I want to put it in the database, that violates the scope of the Fourth Amendment," he said.

Prince George's County, for example, maintains a database with DNA profiles of both victims and suspects. Such local databases "have literally no oversight and regulation and yet are pushing the boundaries farther than anyone could imagine," said Patrick Kent, chief of the Maryland public defender's forensic division. "I do not think that victims of crime would be pleased to know that in addition to having been a victim, their DNA profile has been surreptitiously placed into a DNA database."

A Possible Approach to the Mortgage Mess

On a post yesterday on how well (or more accurately, how badly) various state efforts to rescue homeowners were faring, reader Richard Kline offered a suggestion.

Note that while I still favor the apparently destined-never-to-see-the-light-of-day idea of permitting bankruptcy judges to write down mortgages to the current market value of the collateral (the rest becomes unsecured), Kline's idea is elegant. One change I'd recommend is to have his markdown from the index vary by either state of MSA.

Hoisted from Kine's comments:

I don't mean to frown any excessive frowns on the issue, but there is simply NO solution to the bad mortgage problems that exist as they are presently constituted. The problems are too diverse; there are too many lenders, and worse diffused standing with respect to the actual mortgates; the volume of property is, well, vast. That's just on the lender side. Borrowers have many and various problems so there is no one-size or even middle-of-the-curve solution to implement. These mortgages need to be, literally, re-negotiated one at a time. But it gets worse: with asset values plunging to well south of the face value of many loans there is no sane way to 'save the loan' as written. You want the lender to eat 40% of the loan? It might be easier for them to walk away---or there may be no 'lender' to walk away, they're dead. For troubled mortgage holders, it's a big blot on their credit, a life-changing event. For lenders, it's often going to be a blot on an x-ray; a life-ending event.

Don't expect a fast resolution to this issue; three years from now, we'll still be unwinding it, in my view. Federal legislation does nothing to solve the problems. 'The guvmint buys all notes?' They don't got that kind of dough.

The government can't solve the problem---but the government just might be able to change the problem. Here is the outline of a coherent solution process; it won't happen, and I'm not going to propose offhand the means to get there, but since this all is a mess, and we'll have some time to kick arouond issues, here is one way to go about it.

Take the market or appraised value of the property as of a set, market top date; oh, March, '07 for an index. Now take 60% of that: this is the new value of the property. Take the loss, and apportion it between mortgage holder and lender based on their equity shares as of today; this means most, but not all of the writedown goes to the lender. Many mortgage holders will end up with negative equity, but at much lower total dollar value; the property is worth less, but by the same token the amount which will have to spend to pay it off and own it clear is much less, too. That's a situation which may keep an owner willing to stay in the property and pay off that smaller negative equity; they take some loss, but they can end up with whole credit and a home, not a bad outcome. Refi the loan into a traditional loan structure. If the owner can't meet that payment, well the loan is dead anyway, we've done all we can. The advantage to the lender is that they now have an asset again, rather than a rotting, unoccupied structure against which they owe taxes after foreclosure costs in a horrible property market without viable mortgage lenders and huge inventory overhangs.

No one forces this solution on either party to a locked up, upside down squat, but it's a package deal, go/no-go, with little or no side dickering over terms: you go to court and say, "We both agree to this change in our pre-existing contract by the terms of the Somebody Help Me Jesus Act of '09," judge raps the gavel, ever'body clap hands, and walk out the door with chins up and best foot forward. Once a mortgage holder at a viable payment is signed on, the lender can sell the package or hold it to term, but the mortgage is a tradable instrument again at known value. This is for first liens only. I have no solution to propose for second and third mortgage situations other than the Darwinian solution: stupidity means your equity dies stillborn without reproducing.

Rather than a total loss-loss, cut cards and do a re-deal, but 'automate' the process with shared pain.

Don't like it? Let's hear your plan.

He also offered an addendum for borrowers in severe negative equity land but able to service the debt, but I figured we'd stick with the base case for now.

Maryland Greatly Lengthens Foreclosure Process

Housing Wire provides this report:

Maryland governor Martin O’Malley joined with local elected officials and consumer advocates last week to sign emergency legislation that targets troubled borrowers in the state.

Perhaps the most immediate industry impact will be felt by just one of the three bills passed last week — the obscenely-long-named Real Property–Recordation of Instruments Securing Mortgage Loans and Foreclosure of Mortgages and Deeds of Trust on Residential Property bill. (Yes, that’s the actual name).

The legislation significantly lengthens the foreclosure process from 15 days to approximately 150 days, by requiring a lender to wait 90 days after default before filing the foreclosure action and to send a uniform Notice of Intent to Foreclose to the homeowner 45 days prior to filing an action.

It also requires personal service to notify a homeowner of impending foreclosure action, and requires that a sale may not occur for 45 days after service. A lender must also produce “proof of ownership” when filing a foreclosure action, according to a press statement put out by the governor’s office.

“Proof of ownership” has been a hotly contested issue in many courts as the number of borrower defaults have surged. Many judges are now requiring the actual mortgage note to be produced, when such requirements did not exist in the past and when such requirements may actually be contrary to existing law.

Nonetheless, it’s unclear what Maryland’s definition of “proof of ownership” is; calls to a few industry sources in the state were not returned by the time this story was published.

Programs like this, intended to help homeowners, have the potential to wind up in the Land of Unintended Consequences. Consider: there's ample evidence that lenders are already dragging their feet on foreclosing, choosing to defer the costs of getting the owner out and managing the property. So the problem of servicers eagerly petitioning courts to seize property is a tad overstated.

But more important, what is eventually going to restore local real estate markets to some semblance of health is when investors start to put a floor on housing by either buying property or mortgages. Having the state push out the timetable for when foreclosed inventory will hit the market discourages real estate bottom fishers; having it reduce lenders rights in foreclosure (and increase costs, per the personal service requirement) will deter potential buyers of Maryland mortgages (and in other states) by raising the specter that the creditor's standing will be weakened even further down the road.

Bear: Did the Fed and Treasury Push Too Hard?

Andrew Ross Sorkin in the New York Times provides some important background on how the Bear deal wound up being retraded today. But he does his readers and the greater public a huge disservice by telling the story so as to flatter Wall Street.

According to Sorkin, the $2 price for Bear was the Fed's and Treasury's idea; JP Morgan was prepared to pay more, but they nixed the idea, saying they did not like the "optics" of the deal. The implication is that the officials overstepped their bounds. That is a pretty outrageous spin when the government is putting up taxpayer money.

Had it been an option, the Fed should have nationalized Bear. It was going to declare bankruptcy Monday if there was no deal; its shareholders would have been wiped out. Why am I so confident of this view? If bondholders, as rumored, were buying shares to make sure the JPM deal went through (and thus would take losses on their stock purchases when the deal closed), that meant that they thought their bonds were worth well under 100 cents on the dollar in a bankruptcy. Shareholders are subordinate to bondholders, so equity owners would have gotten zilch.

I can think of a host of reasons, however, why the Fed did not go the nationalization route, the biggest being that it lacked clear authority (it couldn't declare Bear to be insolvent, as it could a member bank). And letting Bear fail (and having acsounts frozen) was what the Fed was trying to avoid, so letting it fail and then seizing control (even assuming it could do that) was never an option. No doubt, the central bank also did not want to assume administrative control of an entity that it had never regulated (ie, its supervisors had never kicked its tires) that dealt actively in markets in which the Fed has little expertise. Even in an orderly liquidation scenario, that it a lot to take on.

Sorkin nevertheless argues that the Fed did Bear a dirty because:

.....the night that Bear signed the original bid, the Fed opened what’s known as the discount window to companies like Goldman Sachs and Lehman Brothers — oh, yes, and to Bear, too. Except that the Fed didn’t tell Bear that it planned to open the window when it was signing its deal with JPMorgan.

This verges on being revisionist history. First and most important, the discount window was opened to keep the panic about Bear from spreading to other firms, most notably Lehman. It almost certainly would not have happened then if Bear was not on the verge of imploding. Remember, a mere week and a day ago, there was pervasive fear that the wheels were about to come off the financial system, particularly if counterparties started getting leery of dealing with Lehman.

Moreover, usage of the new discount window the first week was light due to worries about stigma. If Bear had gone and used it aggressively, it may well have reinforced rather than allayed fears about the trading firm's health. If other firms continued to refuse to deal with Bear, its collapse was assured. There was a very real possibility that even if Bear had remained independent and used the window, its bankruptcy merely would have been delayed a day or two. And it would have been well nigh impossible to put together a three party takeover deal between the close of business in New York and market opening in Asia on a weekday.

But the most appalling aspect of Sorkin's account: he acts as if Bear had the right to be informed of the Fed's plans. Sorkin seems to have forgotten the golden rule: he who has the gold makes the rules. The Fed had every right to be calling the shots. They were taking the biggest risk in this transaction. The notion that a firm about to fail is entitled to be treated as a being on an equal footing with its rescuers is absurd. And the fact that Sorkin (and presumably others on Wall Street) sympathize with this view says the industry badly needs to be leashed and collared.

Finally, a series of posts at Dealbreaker suggest that JPM knew full well that it was guaranteeing Bear's trades (the supposed mistake in the contract):

As we pointed out this morning, we don’t think it was an oversight. On the conference call on the Sunday night the deal was announced there was a lot of discussion of the guarantee. Some of it was confusing, as much of what happens on public conference calls is often confusing. But it seems pretty clear that JP Morgan fully understood that it’s guarantee would cover Bear liabilities even if the deal was rejected.

After the jump, we present an excerpt from the transcript of the Sunday night conference call. In the excerpt, Steve Black, the co-head of JP Morgan’s investment banking division, is asked by an analyst about the guarantee. He clearly says that it will cover Bear liabilities already entered into and those entered into prior to closing or rejection, but not those entered into after the rejection.

Sorkin also makes clear that Dimon was unhappy paying so little for Bear and was concerned about a revolt among those employees he wanted to keep. That then raises the question of whether the supposed fits thrown by Dimon over the trading guarantees really were a bad case of buyer's regret. After all, at a price of $2, JPM was paying more than a billion less than than it eventually offered. Was that exposure really so awful that the economic value of getting out of it was worth a billion plus?

It thus seems more plausible that the alleged contract defects gave Dimon the excuse to pay the price he wanted to pay to keep peace in the family. And I will go further: knowing a bit about one of the attorneys involved (Rodgin Cohen of Sullivan & Cromwell, who represented Bear), I consider it quite possible that the lawyers contrived to have glitches in the deal to allow it to be reopened. (On a deal I was involved in, Cohen pulled a huge ruse with the Fed that my client to this day is unaware of, according to Gene Ludwig, who was later my attorney). Their loyalties are to the Street, not the Fed or the public at large.

Even the Times' news reporting (a story by Lanodn Thomas and Eric Dash) falls for the Wall Street party line:

Mr. Dimon’s about-face illustrates the deep complexity and political sensitivity of a deal with participants who reached into the highest corners of Washington, from the Treasury to the Federal Reserve System. It also underscores the extent to which JPMorgan and government officials underestimated the wave of anger and opposition that would flow from irate Bear employees and shareholders who saw the original $236 million that JPMorgan agreed to pay just a week earlier as far too cheap....

And finally, the low-ball offer cast Mr. Dimon as an unscrupulous negotiator in the eyes of envious rivals, who felt no compunction in raiding Bear for its talent, with many employees only too happy to leave. The new terms, he hopes, will show him to be a more pragmatic deal maker, willing to seek compromise to save a deal that for the time being at least, brought a jolt of confidence to Wall Street.

Bear was going to fail as of Monday. Bye bye equity and many if not most jobs. How hard is this to understand? I thought anyone who was remotely financially literate understood what bankruptcy means. The employees should be grateful to get anything. But no, the media slavishly accepts their sense of entitlement.

So I don't buy Sorkin's theory that the Fed overreached. In fact, I'm deeply offended that he is presenting this idea at all. It's part of the conspiracy to foist the losses of a reckless securities industry onto the public at large.

Update 1:40 AM: A post by Steve Davidoff at the New York Times' Dealbook argues that the revised deal could be more susceptible to being upended by the Delaware courts. While most Bear shareholders have reportedly thrown in the towel, billionaire Joe Lewis has the funds and motivation to keep fighting.

Some Subprime Debt Valued at 5 Cents on the Dollar

Gillian Tett has an intriguing little piece in today's Financial Times, in which she reports on the first public valuation of particular structured credit instruments.

The odd bit (and theories by those that may have insight are welcome) is that JP Morgan apparently elected to make these prices public. JPM needed to value the securities for a court filing; perhaps it decided it had nothing to lose by sharing its pricing and thought it might encourage other banks to similarly disclose value estimates in legal cases in the hopes of encouraging more transparency.

But as the article makes clear, the markdowns from face value, even of the top rated instruments, were considerable.

From the Financial Times:

The first public price estimates for specific structured credit securities to have emerged since the start of the credit crisis show that values have fallen sharply.

Some securities have lost almost a third of their value – even though many were considered to be so safe that they carried top-notch ratings from the credit ratings agencies.

Meanwhile, some subprime mortgage-linked securities issued by groups such as UBS have lost almost 95 per cent of their value.

The price estimates were made in a legal filing following a decision by JPMorgan Chase to ­publish detailed securities valuations in a Canadian court. The securities are linked to commercial loans and medium-grade mortgages.

The estimates are likely to be scrutinised by auditors and regulators since they come at a time when the issue of security pricing has become controversial.

Banks are under pressure from regulators to book losses they have incurred on such instruments. However, trading has virtually dried up in many corners of the credit markets, and it is hard to compare prices for these instruments between banks.

Many regulators and investors fear that banks are still varying in the degree to which they have booked losses on their credit instruments in recent months – not least because it is hard for auditors to compare internal estimates with external benchmarks.

The figures have emerged because the US bank is leading an effort to restructure a group of 20 Canadian structured investment vehicles that issued $32bn of asset-backed commercial paper.

Does Bear Have JP Morgan Over a Barrel?

This is the nuttiest situation I can recall in some time in deal land, assuming the rumor in the New York Times is true. The Grey Lady reports that JPM is working to increase its offer for Bear from $2 (well, roughly $2 since it is a stock-for-stock deal) to $10.

Yes, Bear's stock price is trading above the JPM's offer price; that normally would produce pressure to sweeten terms. But this deal was about as far from normal as you can get. JPM has an option on Bear's headquarters building, an option to buy 19.9% of Bear's shares at the deal conversion price (admittedly, some limitations exist) and most important, it has the Fed's backing in the form of its $30 billion first loss position (in the form of a secured loan, with JPM permitted to pony up "illiquid securities" which reads like an invitation to let the Fed carry the worst non-derivatives positions JPM can find).

Why is JPM offering to pay more? The New York Times story suggests JPM is negotiating with Bear, the Fed is not keen to reopen the deal, and for good reason. There are already House and Senate hearing scheduled on the deal. The Fed can defend its role if Bear goes for a fire sale price (if the firm was toast, the shareholders should have been wiped out entirely as a condition of a government rescue, but the $2 price can be presented as an unfortunate necessity).

But JPM raising its offer makes the Fed look like a chump to have agreed to the initial backstop. That will vastly increase criticism of the deal. And if JPM knew enough to offer $10 a mere week later, why didn't it put that on the table last Sunday? This looks like JPM took advantage of the Fed (ie, Bear is not in as awful shape as JPM portrayed; the price still should have been $2 given the imminent bankruptcy, but with a smaller loan facility from the Fed).

The only thing I can fathom:

One, that the apparent economics of the deal will support JPM paying more (duh, but it needs to be said)

Two, someone has the 5 x 7 glossies. I can only presume that a Bear ally has information (perhaps about why the deal was advantageous to JPM in terms of how their positions would be netted and/or how badly JPM needed the deal to happen) that would be hugely embarrassing if released. A raise from $2 to $10 is huge and appears unwarranted for (from what I can tell, the stock didn't get above $8 this week and has traded mainly around $6. It closed the week just below that level). This price talk suggests JPM is panicked. The facts in the open say that Dimon ought to be able to stare this challenge down.

Three, as the NYT claims, there were contractual errors in the deal that require JPM to go back to Bear to get waivers, putting Bear management in the catbird seat. Eeek, but highly plausible given the haste with which the deal came together.

Although item three sounds persuasive, it does not seem sufficient to warrant as large an increase as is on the table. I suspect there are other embarrassing revelations that JPM is keen not to have come to light. But the fact it can (as well as may) increase its bid by such a large degree does not pass the smell test. It suggests it negotiated in bad faith with the Fed.

One other factor that the NYT article mentions is that customers are still reluctant to trade with Bear since they perceive the deal to be at risk. That no doubt makes the economics of the deal less attractive to JPM (there will be less revenues, hence either lower profits or greater losses, between the time of signing and closing than anticipated earlier). The longer the uncertainty, the greater the risk that trading accounts will shift their business entirely away from Bear. That does create an economic incentive to pay more. However, even if that factor alone were sufficient to justify the higher price, it will not go down well in the court of public opinion. Possible revenue losses between now and closing will go over the heads of most newspaper readers, and more important, most Congressmen.

The face saving reason justification would have been that Bear's management can sell 39.5% of the company without shareholder approval. Thus using the trumped-up excuse that the deal might not get done (baloney if there hadn't been a screw up), JPM can raise its offer to the upset shareholders and dispel the misguided uncertainty that the deal is at risk. Had the deal been done along the lines presented in public, a mere PR salvo should have been sufficient to clear any doubts up.

If JPM does increase the price beyond a token amount, like a dollar, expect there to be a firestorm of criticism of the Fed allowing a payout to a failed firm. Either JPM should buy Bear free and clear, with no government support, or the shareholders should be wiped out, or as close to that as the practical constraints allow. Bear really should have been nationalized, but there are reasons why the JPM route, although in theory less than ideal, was a necessary evil. It could be executed on a short timetable and kept the Fed from assuming operational control of an entity it did not know and certainly did not understand.

Improving the payout to Bear's shareholders is a terrible precedent and deserves to be lambasted.

And now we have the complicating factor of this leak. This makes Dimon (well, his own staff and attorneys) look bad, it may precipitate a backlash against Bear management (before they and the employees got sympathy in some quarters for their extreme fall in fortune) and it may also make it even harder for the Fed to back an increase in price for Bear (and it was already going to be hard). And this embarrassment will make it much harder for the Fed to do any more salvage operations, at least until any blowback from this development settles down.

Note I predicted that even with the Fed's first loss position in the deal, JPM would come to regret it. Increasing its exposure to the credit market mess, particularly to a firm that was heavily involved in the riskiest activities (lending to hedge funds, mortgage backed securities trading, writing protection on credit default swaps) so far before the end of the cycle will turn out to be a bad move. And at a higher price, even a modestly higher price makes the economics worse.

Update 8:50 AM: An ambiguous comment on the WSJ Deal Blog:

Bear Stearns shares surged Monday following a report in The New York Times that J.P. Morgan Chase is nearing an agreement to quintuple the price that it agreed last week to pay for Bear to $10 a share..... Other terms of the new deal are expected to be substantially different than the original pact. In particular, the role of the Federal Reserve, which played a critical role in the week-old deal, is expected to change, a person familiar with the situation told The Wall Street Journal.

If this retrade of the deal enables the Fed to lower its commitment, JPM is considerably worse off. If I were a JPM shareholder, I'd be very unhappy.

Update 9:20 AM: More detail on JPM's legal problem from the New York Times' Dealbook:

Did JPMorgan Chase get snagged in a legal loophole? A careful read of its guarantee agreement with Bear Stearns, part of its deal to acquire the troubled investment bank, suggests that the agreement may be much broader than JPMorgan might have intended it to be. This apparent oversight likely played a role in JPMorgan’s decision over the weekend to consider raising its offer for Bear.

Under the merger agreement, if Bear’s shareholders vote down the takeover deal for a year, Bear can terminate the agreement. This we already knew. But it also appears that, in such circumstances, JPMorgan’s guarantee to backstop Bear’s liabilities stays in place — forever.

That is, even after the rejection from Bear’s shareholders, JPMorgan’s guarantee would continue to apply to any liabilities Bear accrued up to the termination of the agreement. This provision could allow Bear’s shareholders to seek a higher bid while still forcing JPMorgan to honor its guarantee.

The post contains the relevant sections of the contract.

From the New York Times:

JPMorgan Chase was in talks on Sunday night for a deal that would quintuple its offer for Bear Stearns, the beleaguered investment bank, in an effort to pacify angry Bear shareholders, according to people involved in the negotiations.

The sweetened offer is intended to win over stockholders who vowed to fight the original fire-sale deal, struck only a week ago at the behest of the Federal Reserve and Treasury Department.

Under the terms being discussed, JPMorgan would pay $10 a share in stock for Bear, up from its initial offer of $2 a share — a figure that represented a mere one-fifteenth of Bear’s going market price.

The Fed, which must approve any new deal, was balking at the new offer price on Sunday night after several days of frantic, secret negotiations, these people said. As a result, it was still possible the renegotiated deal might be postponed or collapse entirely, said these people, who were granted anonymity because of their confidentiality agreements.

If the Fed were to reject the new proposal, it could set off a furor among shareholders of both firms that the government was preventing them from making a fair deal.

In an unusual move, Bear’s board was seeking to authorize the sale of 39.5 percent of the firm to JPMorgan in an effort to move closer to majority shareholder approval. Under state law in Delaware, where the companies are incorporated, a company can sell up to 40 percent without shareholder approval.

The renegotiation, which would set a sale price of more than $1 billion, comes after a tumultuous week on Wall Street and in Washington because of the near collapse of Bear and the hastily devised deal to save it.

While the initial agreement appeared to have defused the financial crisis of confidence that undid Bear, the initial terms of the deal — and the government’s controversial role in reaching them — drew criticism from those who say the takeover amounts to a government bailout of Bear, a firm at the center of the mortgage meltdown.

A new deal could raise even more questions about the Fed’s involvement in the negotiations. As part of the original deal, the Fed guaranteed to take on $30 billion of Bear’s most toxic assets. The central bank also directed JPMorgan to pay no more than $2 a share for Bear to assure that it would not appear that the Bear shareholders were being rescued, according to people involved in the negotiations.

In television interviews last week, the Treasury secretary, Henry M. Paulson Jr., who has been closely involved in the negotiations, sought to portray the agreement not as a rescue effort but as a way to provide stability for the entire financial markets.

“Let me say that the Bear Stearns situation has been very painful for the Bear Stearns shareholders,” Mr. Paulson said on Monday on the NBC “Today” show, referring to the $2 a share price. “So I don’t think that they think that they’ve been bailed out here.”

If the price is increased, however, some critics could have more ammunition to complain that taxpayers are helping to bail out a Wall Street firm that should be responsible for its own risky behavior. That is one reason the Fed was hesitant on Sunday night to approve the transaction at $10 a share, people briefed on the talks said....

Some shareholders could seek to file lawsuits to block the deal, claiming that the unusual board vote was an act of coercion.

JPMorgan was also in negotiations with the Fed on Sunday to assume the first $1 billion in losses on Bear assets before the Fed’s $30 billion cushion kicks in. However, the Fed may now be seeking to raise that number.

A major aim of a new agreement would be to provide assurances to investors who trade with Bear that it will continue to be open for business. Even with JPMorgan’s original agreement in place last week, some of Bear’s largest customers would not trade with it, still nervous that the deal might unravel.

JPMorgan and Bear were prompted to renegotiate after shareholders began threatening to block the deal and it emerged that several “mistakes” were included in the original, hastily written contract, according to people involved in the talks.

One sentence was “inadvertently included,” according to a person briefed on the talks, which requires JPMorgan to guarantee Bear’s trades even if shareholders voted down the deal. That provision could allow Bear’s shareholders to seek a higher bid while still forcing JPMorgan to honor its guarantee, these people said.

When the error was discovered, James Dimon, JPMorgan’s chief executive, who was described by one participant as “apoplectic,” began calling his lawyers at Wachtell, Lipton, Rosen & Katz to seek a way to have the sentence modified, these people said. Finger pointing over the mistakes in the contracts began as bankers blamed the lawyers and vice versa.

As it began to look more possible late last week that the deal might be struck down, JPMorgan approached Bear in earnest on Friday about renegotiating the sale price to guarantee its completion and brought the Federal Reserve into the talks as well, people involved in the negotiations said.

Mr. Dimon became increasingly desperate in recent days. He offered certain employees cash and stock incentives to stay on and made calls to his rival chief executives on Wall Street — John J. Mack at Morgan Stanley and John A. Thain at Merrill Lynch, among them — pleading with them not to recruit Bear employees during the transition.

Mr. Dimon had became convinced that the deal was in jeopardy after spending much of last week taking angry calls from Bear’s largest shareholders, including Mr. Lewis, these people said. Moreover, Mr. Dimon, who had indignantly told associates that he would “send Bear back into bankruptcy” if the deal was struck down, was persuaded by his advisers that he had less leverage than he thought, according to people briefed on the conversation. Such vindictive behavior, they told him, would turn into a legal and public relations nightmare.

CDOs: Murky Deal Documents Compound Woes

An article in the Financial Times, "Credit crisis lurches from bad numbers to bad writing," by Arturo Cifuentes, contains a stunning revelation: the deal documents governing CDOs are in many cases so badly written that, for instance, it isn't clear how to handle a default.

To give readers a sense of proportion, the contracts governing transactions involving large amounts of money are typically the focus of a great deal of legal attention. Negotiation of definitive agreements in M&A transactions are done on a line-by-line basis. For financings, law firms usually have standard forms that give them boilerplate for major elements of the transaction. For CDOs, which had been done in high volumes in 2003, it seems inconceivable that a good deal of contractual language wasn't largely pre set (firms and investment banks have different stylistic preferences, but the general framework and key terms ought to fall within certain well accepted parameters).

But no, the Financial Times tells us quite the reverse:

Understandably, the rating agencies have embarked on an effort to restore their shattered reputations. But, surprisingly, the risk management profession has not received the same criticism the rating agencies have.

That is odd. The fundamental assumptions of this discipline should be, if not trashed, at least re-examined critically. After all, most recent subprime-related losses were suffered by institutions that took pride in the sophistication of their risk management systems.

To summarize: the crisis so far has been an unfortunate sequence of bad decisions related to models, default probabilities, correlations, real estate valuations, expected losses, etc. In short, a massive failure of numbers.

These bad decisions, in turn, have resulted in the collapse of many investment vehicles: more than 100 collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) have already entered the murky post-event of default (EOD) state. This number will grow in the coming weeks.

Unfortunately, the legal documents that govern these transactions are so poorly written – full of ambiguities, inconsistencies, “circular references” and worse, contradictions – that many investors, trustees and respective legal advisors do not know how to interpret them.

For instance, in a number of cases it is not clear whether the assets should be sold (liquidation) or let to run off (acceleration). Moreover, even the rules to distribute the money post-EOD (who gets what) are unclear.

In essence, we have gone from bad models to bad writing. From a failure of numbers to a failure of words. Which brings us to another issue: maybe the “quants” who ran the models and interpreted the results were incompetent. But what about the structured finance lawyers who drafted these legal documents? Did they read them? More relevant perhaps, did they understand what they wrote?

Rating Agency Conflicts in Munis Coming Under Fire

In "States and Cities Start Rebelling on Bond Ratings," the New York Times attempts to make the case that municipalities can lead a revolt against Wall Street:

Does Wall Street underrate Main Street?

A growing number of states and cities say yes. If they are right, billions of taxpayers’ dollars — money that could be used to build schools, pave roads and repair bridges — are being siphoned off in the financial markets, where the recent tumult has driven up borrowing costs for many communities.....

States and cities have begun to fight back, saying they can no longer afford the status quo given the slackening economy and recent market turmoil.

It's a bit late to come to that realization. The horse hasn't just left the barn, it's in another county by now. As Bloomberg tells us in "Auction Supply `Tsunami' Foreshadows Deeper Municipal Losses," issuers of auction rate securities, already hosed by market failures and the resulting spike-up in rates, are going to take a second beating when they try to secure longer-term funding due to a massive supply/demand imbalance:

U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities....The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989....

``It's a supply tsunami,'' said Robert Fuller, principal of Capital Markets Management LLC in Hopewell, New Jersey, a financial adviser to municipalities. ``All of that is going to be redone and it's going to be redone fast,'' he said of auction-rate bonds.

Now the New York Times piece, on page one, is no doubt intended for a broad audience, so it explains (without giving comparative default rates, which would have been useful), that rating agencies grade muni bonds more harshly than corporates:

At every rating, municipal bonds default less often than similarly rated corporate bonds, according to Moody’s. In fact, since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings. Furthermore, when municipalities do default, investors usually receive some — or even all — of their money back, unlike in most corporate bankruptcies..... Moody’s estimates that more than half of the market would be rated triple A or double A using the corporate scale. Triple-A securities are considered nearly as safe as Treasury bonds issued by the federal government.

However, the piece notes rather blandly the central conflict of interest: that rating agencies have good reason to have established and perpetuated this double standard. When less than AAA municipalities go to buy bond insurance, they are paid again to issue the second rating.

Despite noting this large economic incentive, the Times makes no attempt to obtain or develop estimates of what these second ratings might be worth in financial terms to the rating agencies. One has to assume that these second ratings are highly profitable; there's just about no effort involved in rubber-stamping a bond insurer policy.

While journalists can't be as pointed as commentators, the lack of critical thinking, as exhibited in failure to question the pablum fed the author, is striking. Consider this section:

Moreover, some bond specialists caution that this is the wrong time to rerate municipal bonds. The slowing economy and faltering housing market are squeezing state and city tax revenue. At the same time, public pension liabilities keep rising. Facing budget shortfalls, states like California, New Jersey and Arizona are cutting services.

And pray tell, who assumed that the municipalities should pay for new ratings? All that these hapless issuers (and allied state attorney generals) are asking for is for their self-serving grading scales to be recalibrated. They can do that using their existing data. The notion that they'd extract another fee for this is preposterous.

And the rating agencies are resorting to bald-face lies to defend their practices:

Ratings firms, bond insurance companies and some bond investors defend the separate ratings scales, arguing that it allows investors to make distinctions among various debt and, ultimately, set appropriate interest rates. Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things.

Gail Sussman, the Moody’s executive in charge of public finance ratings, likened the firm’s dual ratings scale to a ruler that measures in inches on one side and centimeters on the other.

“The distance between point A and point B is the same” whether it is measured in inches of centimeters, Ms. Sussman said.

Well, of course the rating agencies and bond insurers defend the system; it's a meal ticket. And some investors might like it because it creates market inefficiencies.

But contrary to their sudden protestations otherwise, ratings were always supposed to mean the same thing, in terms of default risk, not matter what was being rated. That was the rating agencies' own position on the matter. From Joshua Rosner and Joseph. Mason's "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions":

Credit rating agencies (CRAs) have long argued that the ratings scales they employed were consistent across assets and markets. Not long ago Moody’s stated “The need for a unified rating system is also reflected in the growing importance of modern portfolio management techniques, which require consistent quantitative inputs across a wide range of financial instruments, and the increased use of specific rating thresholds in financial market regulation, which are applied uniformly without regard to the bond market sector.” In a similar pronouncement in 2001 Standard & Poor’s stated their “approach, in both policy and practice, is intended to provide a consistent framework for risk assessment that builds reasonable ratings consistency within and across sectors and geographies”.

However, the willingness of ratings agencies to lie in public should come as no surprise. Moody's, in testimony before the Senate Banking Committee last September, maintained that it played not role in structuring or designing structured securities. They dare make statements like that despite the fact that numerous industry textbooks, as well as documents at the SEC, describe the process of creating structured finance instruments, and frequently describe, in some detail, the active participation of the rating agencies. If this practice is so well known that it shows up in textbooks, it would be trivial to get industry participants to confirm it.

But of course, the rating agencies have a huge incentive to try to snooker anyone who can't be bothered to dig deeper. Admitting to their well-known role in structured finance transactions could open them to liability by virtue of being an underwriter (now they are suit-proof by virtue of being able to hide successfully behind the First Amendment). So in keeping with their fierce attention to their bottom line, they'll also defend their municipal bond sham as long as they can get away with it.

US Bankruptcy Trustees Ask for Sanctions Against Countrywide

We have said that Countrywide is an institution that has deliberately operated on the edge of the law. Apparently we've been far too charitable in our views.
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