For MBIA and BofA, it’s just about high noon

April 13, 2012

Litigation is frequently likened to poker, but there’s actually a big difference. Poker ends with a winner and a loser. In litigation, there’s a third option: settlement. In the overwhelming majority of cases, lawyers and their clients eventually conclude that it’s more sensible to compromise than to test your hand with winner-take-all stakes.

Not Bank of America in its three-pronged litigation with the bond insurer MBIA.

MBIA has said publicly and repeatedly that it’s eager to make deals to resolve accusations that its 2009 restructuring, which split the bond insurer’s healthy muni-bond business from its ailing structured-finance division, was a $5 billion fraud. On Wednesday, the hedge fund Aurelius Capital became the latest plaintiff to reach a deal with MBIA. (Kudos to my colleague Karen Friefeld, who broke news of the settlement.) Aurelius had filed a purported class action in Manhattan federal court on behalf of MBIA policy holders, and its lawyers at Simpson Thacher & Bartlett were litigating that case alongside a group of banks that filed similar fraud claims — as well as a separate regulatory challenge to the restructuring — in New York State Supreme Court. Aurelius’s departure from the litigation means that the bank group, which began with 18 members but has dwindled to Bank of America and two French banks, loses a powerful, well-capitalized ally. (In fact, Aurelius was scheduled to depose MBIA CEO Jay Brown this week; now the banks will depose him next week.)

Meanwhile, in MBIA’s insurance fraud and mortgage-backed securities put-back case against Countrywide and BofA, New York State Supreme Court Justice Eileen Bransten on Wednesday denied the bank’s motion to bar MBIA from deposing BofA CEO Brian Moynihan. As I’ve explained, MBIA’s lawyers at Quinn Emanuel Urquhart & Sullivan want to question Moynihan to help establish Bank of America’s successor liability for Countrywide’s MBS failings. MBIA argued that Moynihan’s public statements about BofA assuming responsibility for Countrywide’s wrongdoing are key to the question of successor liability; Bank of America’s counsel at O’Melveny & Myers countered that MBIA was trying to harass Moynihan, who has no unique knowledge of BofA’s corporate structure or decision-making on Countrywide. Bransten said Moynihan’s public statements are “undoubtedly relevant,” and only the CEO can explain what he meant when he made them. Billions of dollars hang on how Bransten — the leading N.Y. judge on bond insurers’ claims against MBS issuers — decides the question of BofA’s successor liability.

I’m no poker player, but I don’t understand how Bank of America can tolerate the risk of continuing to litigate against MBIA, particularly because of looming capital reserve pressures if it wins the restructuring case. The bank’s leverage against the insurer decreases every time another member of the coalition challenging MBIA’s restructuring departs — and just about every time Bransten issues a major ruling in MBIA’s Countrywide case.

I get that BofA, Natixis, and Societe Generale believe they have a strong case that MBIA’s transformation was an improperly approved fraudulent conveyance. Just Monday, the bank group’s counsel at Sullivan & Cromwell filed the final brief in the regulatory case, submitting what the banks consider to be powerful evidence that MBIA deceived regulators about the health of its structured finance business in order to win approval of its restructuring and save the municipal bond insurance business.

I also understand their frustration with MBIA’s accounting. The bank group has long asserted that MBIA’s structured finance spin-off is insolvent, and that its settlements with more than a dozen former coalition members have only worsened MBIA’s dire straits. The insurer’s $1.1 billion loan from its muni-bond business, taken at the time MBIA announced its settlement with Morgan Stanley last fall, was perceived by its critics as proof of the insurer’s illiquidity. (The insurer and its lawyers at Kasowitz Benson Torres & Friedman always respond that MBIA has never failed to pay a policyholder what it owes, despite the banks’ assertions of insolvency.) No one’s disclosing terms of the Aurelius settlement, but it’s a good assumption that the tough-as-nails hedge fund insisted on a hefty payout. MBIA has not reported to the Securities and Exchange Commission where it’s getting the money for the Aurelius deal, nor, for that matter, for any commutation of UBS policies it agreed to when UBS dropped out of the bank group earlier this month.

But weigh the potential upside for BofA in the MBIA restructuring litigation against the potential downside for the bank in MBIA’s MBS case. Rulings by the judge in the case, Bransten, have generally favored MBIA and not the bank. She’s also been widely upheld by the intermediate state appeals court. I’ve said it before: If I were Bank of America, I would not want Bransten to set precedent on successor liability.

Even though the bank will surely appeal an adverse ruling, Bransten’s thinking in the meantime will affect every state-court judge overseeing an MBS case against Countrywide, and there are sure a lot of them. One of the ways BofA held the proposed global put-back settlement with Countrywide MBS investors to $8.5 billion was by citing uncertainty about successor liability. If Bransten removes some of that uncertainty, BofA’s $18 billion in MBS reserves could look puny.

The bank knows MBIA wants the cash it believes Countrywide owes the insurer for MBS deficiences. MBIA has said publicly that it has already paid out about $3 billion to policyholders with Countrywide MBS claims, all of which it believes Countrywide should be liable for. MBIA has also already booked $3.1 billion in put-back receivables from all MBS issuers. BofA’s leverage lies in MBIA’s need to fortify its balance sheet. That leverage will be considerably lessened if MBIA wins a major ruling from Bransten.

Bank of America, meanwhile has marked about $1.3 billion in MBIA “trades,” based on complex who-owes-who financial instruments. That number will go up if the banks win their challenge to MBIA’s transformation. But according to a very smart hedge fund friend of mine, the catch for BofA is that when the banking reforms enacted after the financial crisis take effect in 2014, BofA will have to hold more than what MBIA owes in capital reserves. Pressure on capital reserves was one of the reasons Morgan Stanley cited for settling with MBIA last fall.

The next critical date for MBIA and Bank of America is May 14, when the bank coalition’s regulatory suit against the insurer and the New York Department of Financial Services is scheduled to go to trial before New York State Supreme Court Justice Barbara Kapnick (who is, of course, also overseeing Bank of America’s proposed $8.5 billion Countrywide MBS settlement). Financial Service Superintendent Benjamin Lawsky, who’s been pushing hard behind the scenes, is widely thought to want a resolution between BofA and MBIA before then.

That’s going to depend, however, on how strong a hand BofA believes it’s holding.

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