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: