Bond insurers v. banks: MBS loss causation teed up for ruling

October 10, 2011

Last week a rumor made the rounds of hedge funds that trade in Bank of America and MBIA shares: The bank had reputedly agreed to settle the bond insurer’s mortgage-backed securities fraud and put-back claims for $5 billion. The rumor turned out to be false, or at least premature, since no settlement is in the offing at the moment. But the size of the rumored deal gives you a sense of the magnitude of the litigation between the banks that packaged and sold mortgage-backed securities and the bond insurers that wrote policies protecting MBS investors. We are talking about billions of dollars — perhaps tens of billions — at stake in suits by MBIA, Syncora, Ambac, and Financial Guaranty against Countrywide, Credit Suisse, GMAC, Morgan Stanley, and other MBS defendants.

Last week, Manhattan state supreme court judge Eileen Bransten, who has been the leading jurist in the bond insurer cases against MBS issuers, heard oral arguments on the issue that will determine the magnitude of the banks’ liability: Can bond insurers demand damages based on banks’ misrepresentations on the day deals were signed? Or can MBS issuers point to the housing bust, and not their deficient underwriting, as the reason so many loans have gone bad in the years after the MBS were sold? The case argued Wednesday before Judge Bransten concerned summary judgment motions in the MBIA and Syncora suits against Countrywide, but as the judge noted in her introductory remarks to the overflow crowd in her courtroom, “I understand that this [argument] has a major impact on lots of people.”

For everyone who couldn’t squeeze into Judge Bransten’s courtroom, I’ve gotten hold of transcripts of the day-long hearing. I’m going to focus on the morning session on the loss causation issue, but here’s a link to the afternoon session on consolidating the issue of Bank of America’s successor liability for Countrywide MBS, which is specific to BofA.

The loss causation question is central to two of the bond insurers’ categories of claims. The insurers assert they never would have agreed to cover Countrywide mortgage-backed securities offerings if Countrywide hadn’t misrepresented the quality of the underlying mortgages. They claim Countrywide fraudulently induced them to enter those contracts, so it must pay what they call “recissionary damages” in compensation. The insurers also assert that Countrywide must agree to buy back any underlying loans that breach the representations and warranties it made about them, regardless of whether the loans subsequently went into default or not. The monolines want Judge Bransten to keep things simple: If Countrywide lied in order to obtain insurance on MBS offerings, it’s liable to the insurers.

As MBIA counsel Philippe Selendy of Quinn Emanuel Urquhart & Sullivan told Judge Bransten: “It is immaterial that there is no causal or other relationship between the actual loss which is sustained under the policy and the falsity of the representation.The insurer has to be able to elect what risks to insure, and its assessment of whether to issue the policy at all is based on Day One risk attributes,” he said. Debevoise & Plimpton partner Donald Hawthorne, who represents Syncora, followed Selendy. “In order to prove our entitlement to rescission for breach of contract, rescission for fraud, and in order to show our entitlement to put-backs,” he said, “all we have to show is that these provisions were breached at the time of the transaction, and there is no need to provide any evidence of whether loans defaulted or what might have caused them to default.”

Both Selendy and Hawthorne pointed Judge Bransten to an April 2011 ruling from Oklahoma City federal judge Robin Cauthron, who held in Wells Fargo Bank v. LaSalle Bank that Wells Fargo, as securitization trustee in a commercial mortgage-backed securities offering, only had to show that LaSalle had committed material and adverse breaches as of the closing date of the offering. “Evidence regarding the post-securitization market conditions is inadmissible,” she wrote.

If Judge Bransten followed Judge Cauthron’s reasoning, a main line of defense for Countrywide and the other MBS issuers would be knocked out. Countrywide counsel Mark Holland and Paul Ware of Goodwin Procter, however, argued that Judge Bransten must consider the meltdown in the U.S. housing market. That’s been the banks’ defense in every MBS case, in which they assert that the real reason underlying mortgages soured isn’t because pieces of paper were missed from loan files or because underwriters didn’t check whether mortgaged houses were primary residences but because the recession hit, people lost their jobs, and housing prices fell. That was a risk, Holland argued, that the bond insurers assumed when they agreed to write MBS policies.

“The insurance companies are trying to make Countrywide pay for risks that they assumed by asking you to exclude all evidence of the mortgage market meltdown,” he told Judge Bransten. “It is our position that before the monolines can recover any damages, they have to show that their losses were caused by something Countrywide did and not by a risk that they agreed to insure.” (The Goodwin lawyers also distinguished between the LaSalle ruling and their case because LaSalle didn’t involve New York law.)

But Judge Bransten’s repeated questions for Holland showed that the bond insurers’ arguments made an impression. “My problem, Mr. Holland, is that can’t we agree that is this not a case concerning the decline of the housing market, but rather a case involving claims for fraud and breach of contract?” the judge said. “So, therefore, when does the issue — at what point does Countrywide say it should be [that] fraud and breach of contract should be shown?” The judge went on to ask virtually the same question twice again, with Holland never exactly answering. Instead, he continued to try to reframe the questions, arguing that Countrywide didn’t commit fraud, but suffered from the mortgage meltdown.

Countrywide’s argument did prompt one question from Judge Bransten for the bond insurance lawyers. (“There was one thing that I think Mr. Holland pointed out that interested me,” she said.) The insurers had argued that they can seek so-called recessionary damages under an old insurance law. Countrywide countered that the law was actually passed to protect policyholders from insurers attempting to cancel policies. The bond insurers were now “overreaching” in asking Judge Bransten “to use a statute designed to protect consumers from the sharp practice of insurance companies to somehow expand the right of insurance companies to seek damages,” Holland said.

The judge asked MBIA counsel Selendy to respond. He said that the insurance law “simply clarified that rescissionary relief can be awarded provided there is this threshold showing, either a material increase in risk in the event that it is a breach of conditions precedent, warranties, and the insurance agreement, or a material misrepresentation but for which the insurer wouldn’t have written the policy on the same terms.”

The judge didn’t give any clear indication of how she was leaning or even when she’ll rule. But if I were Countrywide, I’d be thinking hard about the power and appeal of Philippe Selendy’s words to Judge Bransten. “The housing crisis does not give Countrywide a defense to its Day One misconduct and its misconduct leading into these transactions. There would be no insurance policies and no losses but for that fraud,” he said. “When you think about it, what Countrywide is trying to do here, having first caused the housing crisis, together with other reckless loan originators and underwriters, they want to turn around and profit from it again. They want you to rule that the crisis is in effect a Get Out of Jail Free card that allows them to escape liability for their fraud and shift the costs to innocent parties. Well, luckily we’re in a country governed by the rule of law, and the law doesn’t work that way.”

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