Banks beware: Time is ripe for MBS breach-of-contract suits

By Alison Frankel
September 19, 2011

Over the last couple of months Bank of America has taken a stock market and regulatory beating so brutal that it’s reportedly considering the previously unthinkable option of putting Countrywide into Chapter 11. BofA’s mortgage-backed securities exposure seems to have no upper limit; throughout BofA’s long hot summer, it felt like every week investors surfaced with new claims that BofA, Countrywide, or Merrill Lynch violated state and federal securities laws in MBS offerings.

Investors and bond insurers have, of course, made the same claims about Deutsche Bank, Credit Suisse, JPMorgan Chase, Morgan Stanley, Goldman Sachs, and a host of other MBS securitizers. Most notably, the Federal Housing Finance Agency ruined a lot of people’s Labor Day weekend when it filed 17 suits against just about every financial institution in the MBS game (except for Wells Fargo), asserting state and federal securities law claims.

But the difference, so far, between Bank of America and everyone else has been that BofA is facing litigation not just for securities claims but also for breaching contracts with MBS investors. Mortgage-backed securities, remember, were typically sold through trusts governed by pooling and servicing agreements. Those pooling and servicing contracts usually included provisions calling for the originator of the underlying mortgages to repurchase any loans found to violate the lender’s representations and warranties about their quality. Suits based on alleged breaches of reps and warranties are known as put-back claims — and there’s good reason to believe that banks’ put-back exposure may ultimately dwarf their securities law liability.

Consider the record to date. For all the turmoil in the stock market when an MBS investor like AIG or FHFA files a securities suit, there’s only been one public settlement of a claim that an MBS issuer violated securities laws: Wells Fargo’s $125 million class action deal in July. By contrast, BofA’s own estimation of its put-back exposure, according to its most recent presentation to analysts, is $18 billion, which includes the $3 billion it has already agreed to pay Fannie Mae and Freddie Mac for deficient mortgages the federal housing loan agencies bought directly from Countrywide; an estimated $2 billion BofA has agreed to pay the bond insurer Assured Guaranty; and the embattled $8.5 billion proposed settlement with Countrywide MBS investors for breaches in Countrywide’s reps and warranties. In addition, U.S. Bank, as the trustee in an offering backed by Countrywide mortgages, sued BofA in August, asserting that the bank is liable for breaches in Countrywide’s reps and warranties.

You may be thinking that put-back liability is only BofA’s problem. Put-back suits, after all, are not easy to bring. Investors can’t sue mortgage originators directly to demand compensation for deficient underlying loans. Those claims can be made only through the securitization trustee — and only after investors have jumped through a series of procedural hoops under the pooling and servicing agreements. Moreover, investors can’t take any meaningful action with regard to any individual trust unless they control 25 percent of the voting rights in the trust. Plaintiffs lawyers have spent the last three years trying to put together investor coalitions to get past that 25 percent threshold, but so far we’ve only seen those coalitions take action against Bank of America.

That’s going to change. I believe a combination of four factors is going to lead to an imminent rise in put-back claims against banks other than BofA.

The first consideration is mounting evidence of across-the-board breaches in mortgage originators’ representations and warranties about the mortgages underlying banks’ MBS offerings. The bond insurance industry and FHFA have been diligently combing through thousands of individual loan files, scrutinizing whether mortgage originators failed to live up to their promises about such things as loan-to-value ratios and homeowner occupancy rates. They’ve found that other mortgage originators — including the mortgage lending arms of Deutsche Bank and Credit Suisse — breached representations and warranties at least as often as Countrywide. Lawyers for bond insurers have also obtained key rulings from the New York state supreme court that permit them to use statistical sampling in put-back cases. Assuming those rulings extend to investors, put-back plaintiffs won’t have to look at every underlying loan file to assert breaches but can determine a breach rate by looking at a representative sample of loans.

Second, the clock is ticking on New York’s six-year statute of limitations for contract claims. Investors acted first against Countrywide because Countrywide was the biggest mortgage lender in the U.S. and because its October 2008 mortgage-refinancing settlement with 11 state attorneys general put investors on notice of deficiencies in Countrywide’s mortgage underwriting process. Since then, we’ve learned that Countrywide wasn’t the only one. Thanks to bond insurer litigation, securities suits, and Congressional investigations, the statute is running on investors’ breach-of-contract claims against other mortgage lenders and the banks that packaged their loans into MBS.

Third, securitization trustees are under pressure to act. Last week Wells Fargo, as trustee, filed a put-back suit against EMC (the erstwhile mortgage arm of Bear Stearns, now part of JPMorgan Chase). That was the third trustee put-back suit we’ve seen in just the last few weeks. Three isn’t a lot, but it’s a lot more than nothing.

Finally, there’s the most important consideration: the investors. Remember, investors don’t have standing to push trustees to bring reps and warranties claims unless they have the threshold 25 percent voting rights in an MBS trust. Throughout the MBS litigation investors have been reluctant to show themselves. But the controversy over BofA’s proposed $8.5 billion Countrywide MBS settlement has flushed investors into the open, beginning with the Gibbs & Bruns group of 22 major institutional investors that negotiated the deal and have steadfastly supported it. Subsequent intervention petitions in the case have disclosed the identity of dozens more Countrywide MBS holders, so presumably, they won’t be so reluctant to step up against other banks.

The Securities and Exchange Commission, meanwhile, has been warning financial institutions to brace for reps and warranties liability. Last October, in a letter from the SEC’s senior assistant chief accountant, the agency reminded MBS issuers and underwriters that they must disclose their exposure “relating to the various representations and warranties that you made in connection with your securitization activities and whole loan sales.” The letter called on banks to include in their public filings a discussion of their reps and warranties litigation risk and their MBS breach-of-contract reserves.

So far — and I know I keep using that phrase — big banks haven’t put a number on their reps and warranties exposure, which they’ve downplayed in public filings. Morgan Stanley’s most recent 10Q, for instance, said that the bank may “under some circumstances” face liability for “representations and warranties concerning approximately $46 billion of loans and the representations and warranties made by third-party sellers, many of which are now insolvent, on approximately $21 billion of loans.” It did not, however, report reserves for reps and warranties liability. Goldman Sach’s second-quarter 10Q reported that to date, mortgage repurchase claims against it “have not been significant,” and said it was “not in a position to make a meaningful estimate” of its ultimate exposure.” Credit Suisse reported only $1.6 billion in outstanding repurchase claims as of the end of the second quarter. JPMorgan Chase’s most recent report to the SEC addressed only the bond insurers’ put-back claims against EMC, and noted that its indemnifications by now-defunct mortgage issuers may not be worth much. It didn’t put any sort of number on its put-back exposure or reserves.

Will third-quarter filings have more to say about put-back exposure? Stay tuned.

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