Opinion

Alison Frankel

What are Fannie and Freddie’s MBS cases really worth?

By Alison Frankel
September 6, 2011

Last Friday evening, after the Federal Housing Finance Agency filed 17 blockbuster suits against just about every major issuer of mortgage-backed securities, the buzz was about the staggering size of Fannie Mae and Freddie Mac’s investments in mortgage-backed notes and certificates. The suits, 13 filed by Quinn Emanuel Urquhart & Sullivan and four by Kasowitz Benson Torres & Friedman, cite about $196 billion in MBS holdings by Fannie and Freddie. Under both state and federal damages theories, the suits demand rescission, or a buyback of the notes by their issuers. Does that mean we should we assume that FHFA has $196 billion in claims?

Nope. Not even close. FHFA doesn’t specify any damages numbers in the complaints filed Friday, but in the agency’s previously-filed $4.5 billion MBS suit against UBS, FHFA asserted that Fannie and Freddie had “lost in excess of 20 percent” of their investment in UBS notes, including unrealized losses. Apply that rough logic to the FHFA’s new suits, and the agency’s claims are knocked down to $40 billion — a huge number, to be sure, but not a heart-stopping one. The banks, meanwhile, are cranking up defenses to shrink even that reduced estimate of FHFA losses. One bank defense lawyer told me Tuesday that by his firm’s calculation, which I’ll explain later, Fannie and Freddie have actually realized losses of no more than about $50 million on their $4.5 billion investment in UBS mortgage-backed certificates. Do the math: if FHFA’s losses are similar across the board, that would put Fannie and Freddie’s recoverable damages on MBS securities claims in the universe of a few billion dollars.

That is, of course, a lot of supposition. But any estimate of banks’ MBS liability, by necessity, involves supposition. MBS investor litigation is so new that there’s not much precedent to guide predictions of how FHFA’s suits, or those of any other MBS investor, will fare in court or in settlement talks. So far, there’s only been one public settlement of an MBS securities case — Wells Fargo’s $125 million deal in a class action involving investors in 28 MBS offerings. Lots of other MBS investors have filed federal court cases, including several class actions, but the litigation hasn’t progressed very far. (Late Tuesday FHFA put out a press release that clarified its damages theories and claims, spelling out some of the same points I make below.)

So, let’s take a look at what Fannie and Freddie are claiming and how the banks are likely to respond. As an initial matter, it’s important to distinguish between the two kinds of suits investors can bring against MBS issuers and originators of the underlying mortgage loans. One class of cases involves contract claims based on the representations and warranties issuers and originators made about the underlying mortgage loans. Under standard MBS securitization agreements, if investors can show that underlying mortgages don’t measure up to the stated standards, they can demand that issuers buy back those deficient loans. Those are straightforward breach of contract claims, but there’s a big catch: In order to bring a so-called put-back suit under standard securitization contracts, investors have to control 25 percent of the voting rights within an individual MBS trust. Gibbs & Bruns was able to negotiate the proposed $8.5 billion Bank of America MBS settlement, which would resolve investors’ representations and warranties claims, because its group of 22 large institutional investors had the requisite voting rights in more than 200 Countrywide trusts. Fannie and Freddie previously settled their own reps and warranties claims against BofA (for mortgages they bought directly from Countrywide) in a $3 billion deal last January. But generally, plaintiffs lawyers have struggled to piece together coalitions of investors to cross that 25 percent threshold and bring contract claims.

Most investors — including Fannie and Freddie in the suits filed Friday — have instead asserted securities law claims against MBS issuers under federal, state, and common law theories. The housing finance agency’s federal claims are based on the Securities Act of 1933. There are two key reasons why. The ’33 Act sections FHFA is asserting involve standards for offering documentation. Under those provisions, investors don’t have to show that issuers intended to deceive them or that they relied on the allegedly misleading documents. As I’ve previously explained, the ’33 Act holds issuers to a strict liability standard, meaning investors just have to show that an offering statement contained false representations about the securities. As alternative routes to the same damages they’re seeking under the ’33 Act, Fannie and Freddie are also making claims under Virginia and District of Columbia securities laws, and under common law fraud or negligent misrepresentation theories.

Under both the state and federal claims, FHFA can demand that the banks repurchase securities issued under false offering documents. Here’s where MBS contract cases and securities cases intersect: Both types of suits rely on investors’ claims that issuers misrepresented the underlying mortgage loans. Fannie and Freddie’s complaints against the banks offer pages and pages of evidence that issuers fed investors false information about the quality of the underlying loans. On their face, the complaints make quite a compelling case for issuer liability.

Don’t underestimate the banks’ potential defenses, though. There’s reliance, for instance: Fannie Mae and Freddie Mac practically invented the business of securitizing mortgage loans, so they were among the most sophisticated MBS investors in the market. Did they really rely on issuers’ representations about the underlying mortgages? That’s not a defense the banks can assert against FHFA’s federal-law ’33 Act claims, which don’t depend on reliance. But it will come into play in the state and common-law causes of action. The banks will also point to disclaimers in their MBS offering documents , and they’ll argue that some of the allegedly-false statements, such as home appraisal values, are non-actionable opinions. Despite tolling agreements with FHFA, they may have statute-of-limitations defense as well; Los Angeles federal judge Mariana Pfaelzer, in the Countrywide MBS litigation now consolidated before her, has set a cut-off date for claims that will help Countrywide enormously.

The banks’ best defense, however, will be to question how much Fannie and Freddie actually lost as a result of the allegedly misleading offering documents. This is a two-pronged argument. First, the banks will assert that any value their mortgage-backed securities lost is due to the overall decline in the housing market and the general economy, not to problems with their MBS offerings. (We saw defendants use that argument, to varying degrees of success, in securities class actions alleging shareholders were deceived about subprime mortgage exposure.) Finally — and this is the banks’ last, best defense — they will argue that Fannie and Freddie haven’t lost much on their MBS investments.

Believe it or not, MBS notes haven’t been the total debacle you might think if you spent all your time reading investors’ complaints. Many trusts have been paying principal and interest more or less on schedule. Remember that $50 million in UBS mortgage-backed losses one bank defense firm calculated? The firm (which doesn’t represent UBS), analyzed the value of FHFA’s UBS investments using MBS trustee reports and Bloomberg data on already-paid principal, interest, and trading value of the securities the housing finance agency specified in the UBS complaint. By the defense firm’s calculation, Fannie and Freddie had lost about $48 million as of July, when the FHFA complaint was filed, and $50 million as of September 1.

So even if the notes are worth less today than they were at time they were issued, the banks will argue, Fannie and Freddie have already received billions in repaid principal and interest from their MBS investments, with billions more still to come from securities that continue to perform.

These are heady days for litigators, given the widespread theory that the economy can’t recover until banks resolve their liability for mortgage-backed securities. For the rest of us, here’s hoping for some clarity, the sooner the better, on the parameters of that liability.

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