Can BofA and SocGen undo MBIA’s restructuring?

May 11, 2012

Of the 18 banks that challenged MBIA’s restructuring in 2009, only two – Bank of America and Société Générale – remain. On Monday, unless there’s a last-minute settlement this weekend, they will finally go to trial in New York State Supreme Court to argue that New York state insurance regulators should not have approved MBIA’s split, which stripped $5 billion in capital from MBIA’s crippled structured-finance insurance business.

But exactly what shape the trial will take – and what relief BofA and SocGen can ultimately obtain – remains unclear. Bank lawyers from Sullivan & Cromwell, MBIA counsel from Kasowitz Benson Torres & Friedman, and state lawyers from the office of New York Attorney General Eric Schneiderman are all preparing for a proceeding whose parameters have not been set. The banks call it a trial and continue to insist they are entitled to call expert witnesses such as former state insurance officials, who would opine on the adequacy of former Insurance Superintendent Eric Dinallo’s vetting of MBIA’s restructuring. MBIA and the state say the proceeding, brought under an expedited process known as Article 78, should be limited to a few witnesses with direct knowledge of the regulatory investigation. Justice Barbara Kapnick, who is overseeing the case, has called the trial “a glorified oral argument, with some testimony, the crucial testimony, to support it.”

Kapnick agreed at a hearing on Apr. 20 to permit witness testimony at the trial, but she didn’t specify who could be called as a witness. Nor did she set firm rules when she held a conference call this week with all of the parties. So the first order of business Monday will almost certainly be argument on motions to define the trial, though it’s just as likely that the lawyers will end up fighting over the witnesses one by one, as they are proposed. Kapnick has set aside 16 trial days over four weeks for the proceeding.

MBIA has spent more than $1 billion to settle with the 16 other banks that were part of the original coalition challenging its restructuring, including, most recently, Natixis, UBS, Morgan Stanley and Royal Bank of Scotland. According to MBIA’s quarterly filing with the Securities and Exchange Commission on May 10, the insurer has shed tens of billions of dollars of exposure through those deals. In just the first five months of 2012, MBIA commuted $11.5 billion of exposure.

But the insurer’s structured-finance arm, MBIA Insurance, has had to borrow from its better-capitalized municipal bond division, MBIA National, to fund those settlements. Last fall MBIA Insurance took out a $1.1 billion secured loan from MBIA National, at the time it announced a settlement with Morgan Stanley. According to its May 10 filing, MBIA Insurance has borrowed an additional $443 million from MBIA National in the last two months.

MBIA’s balance sheet is also a complicating factor in any global resolution of its disputes with Bank of America. These include a fraud case that parallels the challenge to MBIA’s restructuring, as well as MBIA’s claims against mortgage company Countrywide Financial, which is now part of Bank of America. MBIA claims Countrywide breached representations and warranties on mortgage loans underlying securities insured by MBIA. MBIA, as you surely know, has been in the vanguard of reps and warranties litigation with MBS issuers, and its case against Countrywide has broken important ground in what’s known as put-back litigation. MBIA may well eventually prevail in the case – as I’ve written many times, the judge overseeing the suit, New York State Supreme Court Justice Eileen Bransten, has sided with MBIA and against Countrywide and BofA on most of the big questions she’s confronted so far. But MBIA hasn’t waited for the final judgment to hatch before counting its put-back chickens. Even though the Countrywide case is still in prolonged discovery, MBIA has booked $3.2 billion of “expected recoveries,” according to its May 10 filing.

Bank of America and MBIA, in other words, both believe the other owes it enormous sums of money. MBIA wants Countrywide to pay billions to resolve its put-back claims. BofA wants corresponding billions to commute its MBIA credit default swaps and structured-finance policies through a settlement in the restructuring litigation. Global settlement talks promoted by Benjamin Lawsky, the superintendent of the New York Department of Financial Services, have apparently foundered because Bank of America has balked at the idea that its CDS claims are worth fewer cents on the dollar than MBIA’s put-back claims against Countrywide. BofA seems to be convinced that MBIA needs the bank’s money more than BofA needs MBIA’s.

The bank could well be right. MBIA’s May 10 filing concedes that the insurer “did not write a meaningful amount of U.S. public finance insurance” in the first quarter of 2012, and does not expect to write new muni bond policies unless and until it resolves the litigation challenging its restructuring. That means MBIA doesn’t have a business future as long as the banks keep litigating the propriety of its restructuring.

But BofA faces downside from the continued standoff with MBIA as well. In the case before Bransten, MBIA is poised to move for summary judgment on the bank’s liability for Countrywide’s representations and warranties on deficient mortgage loans. An adverse ruling for Bank of America in MBIA’s put-back case could hurt prospects for court approval of BofA’s proposed $8.5 billion global settlement with investors in Countrywide mortgage-backed securities, since that deal is based partly on the assumption investors won’t be able to establish BofA’s successor liability for Countrywide mortgage-backed securities. Moreover, as I’ve reported, the bank also runs the risk of going to the back of the line of MBIA’s creditors if, for any reason, the state decides to put the insurer into receivership.

Receivership is one possible outcome if Kapnick rules MBIA’s restructuring was improperly approved. The Department of Financial Services could decide that, to protect municipal bond policyholders, it must put MBIA into the insurance equivalent of Chapter 11. In the alternative, if the banks win, the state could appeal, triggering an automatic stay of Kapnick’s ruling.

The banks’ lead counsel, Robert Giuffra of Sullivan & Cromwell, has said in open court that if the banks prevail in the Article 78 proceeding over MBIA’s restructuring, MBIA can just reapply for approval “in open daylight.” But that seems the least likely result of the litigation, particularly with the parallel fraud case brought by the banks against MBIA scheduled for trial in 2013. Without a global settlement, it will take years for these cases to run through the trial and appeals process.

Hotly anticipated trials like the one starting Monday, at least in the early days, are weirdly festive, like a big horse race when the gate first opens. But it’s hard to see how either side wins this case, regardless of the trial’s outcome.

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