Can MBS investors block national mortgage deal via litigation?

By Alison Frankel
March 21, 2012

Mortgage-backed securities investors who are convinced that banks intend to shift the cost of the $25 billion national mortgage settlement onto their shoulders are “evaluating their legal options,” according to Chris Katopis, executive director of the Association of Mortgage Investors (and a former clerk on the Federal Circuit Court of Appeals). The private investors, as I’ve reported, are outraged at the terms of the settlement, which sets no limit on the percentage of securitized mortgages the settling banks — Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, and Ally Financial — are permitted to modify to reach their $17 billion target for reducing the principal balance owed by struggling borrowers. Mortgage-backed noteholders believe the deal terms encourage banks to write down investor-owned first liens, rather than second lien mortgages in bank-owned portfolios. That incentive, they say, shifts the cost of the deal from the banks to mortgage-backed bondholders.

Their argument is gaining traction. The New York Times editorialized Sunday on the bank-friendly details of the national settlement, and both Zero Hedge and American Banker have picked up on the MBS investors’ cost-shifting theme. The U.S. Department of Housing and Urban Development, which has denied assertions that Secretary Shaun Donovan promised MBS investors a cap on modification of securitized mortgages, has been put on the defensive, issuing a “Myth vs. Fact” blog post to present its case for the settlement. The bond investors are doing a great job of whipping up outrage about the deal, which must be approved by a U.S. District Judge in federal court in Washington.

Unfortunately for the bond investors, outrage is not a cause of action.

Katopis told me he doesn’t want to give away any clues about the strategy MBS investors may pursue. There are certainly some very smart, creative lawyers who’ve counseled mortgage-backed noteholders over the last three years, including David Frederick of Kellogg, Huber, Hansen, Todd, Evans & Figel, who represents the National Credit Union Administration in MBS securities suits and also happens to be one of the most prominent U.S. Supreme Court litigators around. (I tried to reach Frederick but he was arguing a case in Chicago and unavailable.)

As best I can determine, bondholders have two potential grounds on which to attempt to block the deal (aside from an amicus brief outlining their concerns with the terms of the settlement). They could argue that the settlement interferes with their contractual relationships with the banks that sponsored mortgage-backed securities, or they could make a way-out-of-the-box argument that the proposed settlement violates the Fifth Amendment’s takings clause, which prohibits the government from snatching private property without just compensation.

Neither argument looks very promising to me. The settlement contains a specific (albeit incredibly convoluted) clause deferring to the pooling and servicing agreements that govern MBS trusts. The banks are not supposed to be permitted to take any action to satisfy their obligations under the national settlement in violatation of their underlying contracts with investors. So even though they weren’t included in the negotiation of the national settlement, noteholders shouldn’t be any worse off contractually than they were under the terms of contracts they agreed to. Any judge weighing an objection to the national settlement on contract grounds would probably tell MBS investors to wait and see if any bank actually breaches an underlying contract, and then sue the bank. (That’s not so easy, of course; most pooling and servicing agreements require that noteholders pass a 25 percent voting-rights threshold even to begin the process that leads to contract litigation.)

The more exotic takings argument rests on the idea that because the United States has a financial interest in the solvency of the banks in the mortgage settlement, the government indirectly benefits from the banks’ alleged cost-shifting. It’s a pretty nifty idea, but bondholders in both the Chrysler and GM bailouts tried to float it and it sank like the proverbial lead balloon. The Chrysler bondholders represented by Thomas Lauria of White & Case didn’t even make a Fifth Amendment argument to the Supreme Court, and the government had a much more direct role in damaging debtholders in the auto bailout than it does in the mortgage settlement.

The bondholders, however, may simply want the time and leverage litigation buys to force the banks and the state and federal officials who negotiated the settlement to give them the loan modification cap they believe they were promised. I can’t wait to see what their lawyers come up with.

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