In theory, I’m a wee bit late to the item at hand, a suit by failed mortgage bond insurer MBIA against Morgan Stanley on a second mortgage deal. But in practice, I’ve not seen any commentary on it and the suit has some interesting wrinkles.
Before we get to the details, however, a general issue: looking at this case is like deciding which of Cinderella’s bad sisters is less ugly. While mortgage bond originators and sponsors did not cover themselves in glory in the later years of the subprime business, MBIA is no prize. Of all the monolines, MBIA was the most dubious. In addition to the general, and now well known problem with the industry business model, that they were running at such high leverage levels that they could not take on any real risks, MBIA has its own special cause for concern, namely a less-than-arms-length reinsurance operation. And management has major ‘tude. I’ve never read investor reports that were as haughty and obviously truth-stretching as MBIA, and thus any claims it makes about the merits of pending litigation need to be taken with a fistful of salt.
Here’s the lawsuit, courtesy Barry Ritholtz:
The first part of the case is pretty conventional as far as these monoline suits are concerned, focusing on breached representations and warranties and arguing that those breached reps and warrants are THE reason that MBIA lost big time (see our past discussion on this type of litigation, here, here, and here. Basically, these suits are not the slam dunk their promoters would lead you to think they are).
There are three interesting points about in this section:
1. The transaction, backed by Alt A, no doc, high LTV second liens, closed in June 2007. That’s awfully late in the year. The deal itself was not only risky, but this was the very last hurrah of the subprime market, when it was already hard to place deals because the big Wall Street firms were unloading inventory as fast as they could and many buyers had gotten cold feet. After all, we were at a point where market participants had woken up to the potential for a significant downturn in home prices and the mortgage market generally.
2. The bonds MBIA insured were rated AAA. Despite this, and the significant amount of credit enhancement required for this level (about 20%), MBIA has already paid about $70 million of claims, meaning all of the credit enhancement, including subordination is now gone. The fact that MBIA insured AAA bonds indicates that they were aware that risks for the bonds had increased, since they normally insured bonds rated BBB or A and, thus, in this case, they required more protection. At this late time, they probably got paid a lot more than normal to insure AAA risk, indicating that they were, or should have been, aware that investors thought these bonds had increased risk or didn’t believe the AAA rating.
3. MBIA claims that they had neither the right nor the ability to due their own loan file underwriting review prior to the close of the transaction. That is untrue. This right was available to bond insurers in most mortgage transactions. They are somehow implying they didn’t have the right (probably because there wasn’t enough time, but their analysis of this deal started in March. Three months was a long lead time in mortgage land, and ample time to do such a review).
Now on to their more viable claim. MBIA asserts that for large numbers of the loans, Saxon is failing to charge of the loans, despite a servicing requirement (and common sense) that such loans be charged off after 180 days. Because these are all second liens, they would not typically be foreclosed upon, but rather charged off like credit cards. This was standard practice (and typically required) so that the deal didn’t incur excess accrued interest charges on otherwise uncollectable loans. MBIA alleges that in some cases Saxon failed to charge off the seconds even after the underlying first mortgage lien had been foreclosed upon and liquidated.
I ran this by MBS Guy and got this back by e-mail:
That last point, on the failure to charge off the second liens, is truly appalling. It appears to provide strong support that Morgan Stanley is not writing down seconds in a realistic manner. While the bulk of the risk exposure to these second liens has been transferred to MBIA, it is possible that Morgan retained exposure to the residual portion of the transaction. I can’t see how this could, in any way, be seen to have any remaining value, given that MBIA is paying claims at the AAA level. But who knows how Morgan Stanley is carrying this potential exposure?
It is, however, likely evidence of how Saxon is treating other seconds owned and held by Morgan Stanley. It may also imply that this is how other servicers of second liens are treating such exposure.
By failing to charge off the loans even after it is clear that they are uncollectable, the servicer allows the illusion to be maintained that losses on the loans have not yet been realized.
What is fairly surprising is that no other bond insurer seems to have made this allegation in their second lien transactions – with exposure to EMC/Chase, GMAC, or Countrywide.
There are some open questions with this lawsuit. For instance, MBIA is silent on whether there was an explicit requirement for the loans to be charged off after 180 days or whether this was disclosed as a standard servicing practice. Similarly, in some cases, they discuss the problems with the loans not being charged off after 180 days, and in other cases with the loans not being charged off after 150 days. It isn’t clear why there is a difference.
The last curious item is that Morgan Stanley is not a bank with a major second lien book and hence has no obvious motivation for failing to write down second mortgages. It didn’t retain much of an ownership stake in this deal (if any), and the servicer is owned by them and used mostly for their first liens. I’d be curious to get any informed reader views as to why Morgan Stanley is acting in this manner.