$8.7 bln ResCap MBS deal takes a beating in new objections

February 4, 2013

Bank of America’s proposed $8.5 billion settlement with investors in Countrywide mortgage-backed securities gets all the attention, most recently in a column Sunday by Gretchen Morgenson of The New York Times, who cited new claims that echo old allegations of banks shortchanging MBS noteholders through modification of underlying investor-owned loans. Meanwhile, though, a similar global MBS deal between institutional investors and Residential Capital, the now bankrupt former mortgage lending arm of Ally Financial, has garnered much less outside attention, even though it permits MBS holders to assert an $8.7 billion claim in the bankruptcy, without opposition from ResCap. Friday was the deadline for objections in ResCap’s Chapter 11 to MBS investors’ $8.7 billion allowed claim. And the details that emerged in filings by ResCap bondholders, unsecured creditors and bond insurers that oppose the $8.7 billion deal add up to as compelling a story as the BofA saga, when it comes to assigning blame for and assessing victims of the mortgage crisis.

According to the new filings (especially those of the trustee for senior unsecured ResCap notes, the ad hoc committee of junior unsecured noteholders and the unsecured creditors committee), ResCap’s $8.7 billion allowed-claim settlement with MBS investors was engineered by Ally, which wanted to minimize its own liability to its mortgage unit. The filings point to emails and other evidence suggesting that Ally’s chief in-house litigation counsel, Timothy Devine, led negotiations with Kathy Patrick of Gibbs & Bruns, who represents the big institutional investor group that first notified ResCap of alleged breaches of its representations and warranties on underlying mortgages back in October 2011. (That group, like the BofA investor group, includes BlackRock and Pimco.)

The objectors claim that as ResCap approached Chapter 11, Ally executives estimated that Ally’s exposure to its ailing mortgage subsidiary could be as high as $2 billion. To minimize its own contribution to the ResCap estate, objectors assert, Ally supposedly agreed to back an unreasonably large estimate of ResCap’s put-back liability to MBS noteholders in exchange for support from MBS investors, who are ResCap’s primary creditors, for a $750 million settlement between Ally and ResCap. The supposed quid pro quo between Ally and the MBS investors group was a win for both of them but, objectors contend, only at the expense of monolines and ResCap’s other creditors. They argue that an $8.7 billion allowed claim for MBS investors would give holders of mortgage-backed notes an inflated share of the ResCap estate.

The new objections also assert that ResCap’s board hurriedly approved the $8.7 billion deal in May 2012 without really understanding its terms. In particular, the filings suggest that the board misunderstood, or was misinformed about, whether the settlement included MBS investors’ securities claims (it didn’t) and whether it resolved claims by monolines, a significant point considering that MBIA alone has asserted $2 billion in claims against ResCap. The board isn’t alone in its supposed confusion over how the settlement treats bond insurer claims against ResCap; MBIA’s objection says that point is “debatable.”

Filings by MBIA and its fellow bond insurer, Financial Guaranty, raise an interesting point, arguing that the investor group represented by Gibbs & Bruns (as well as a separate ResCap MBS investors group that is represented by Talcott Franklin and also supports the $8.7 billion allowed-claim settlement) doesn’t have standing to settle with ResCap, since put-back claims belong to MBS trustees, not investors. MBIA, Financial and Assured Guaranty also assert that bond insurers have stronger put-back claims than investors, since they can cite insurance law as well as contracts. MBS investors shouldn’t be permitted to resolve monoline claims as if they were the same as investor demands, the bond insurers argue.

Ally, ResCap and Gibbs & Bruns all filed briefs Friday that address objectors’ arguments. The Gibbs brief, for instance, lays out the statistical underpinning of ResCap’s liability to MBS investors to justify the size of the allowed claim. According to the firm, the $8.7 billion settlement isn’t too high at all; Gibbs argues that based on the breach rate calculated by an expert for the unsecured creditors, MBS investors would be entitled to demand the repurchase of fully $16 billion in underlying ResCap loans. Only if ResCap succeeded in all of its defense arguments, such as time bars and loss causation, would allowed put-back claims fall below $8.7 billion.

As for investors’ standing, the Gibbs brief points out that ResCap, and not its clients, filed the motion asking U.S. Bankruptcy Judge Martin Glenn of Manhattan to approve the $8.7 billion allowed claim, and the debtor certainly has standing to make that motion. MBS trustees have separately said they will abide by Glenn’s ruling on the fairness of the proposed settlement, according to Gibbs & Bruns.

Briefs by Ally and ResCap take great pains to minimize Ally’s involvement in the negotiations that produced ResCap’s proposed settlement with MBS investors, arguing that there was no quid pro quo between investors and Ally in which Ally agreed to back the investors’ too-high allowed claim in exchange for support for its own too-low contribution to the ResCap estate. The MBS allowed-claim deal, according to Ally’s and Rescap’s briefs, was the product of arm’s-length negotiations that met the standards established by the 2nd Circuit Court of Appeals in its 2007 decision in In re Iridium.

This case is generating billable hours for a wide swath of the bankruptcy bar. ResCap is represented byMorrison & Foerster; Ally has Kirkland & Ellis. The unsecured creditors have Kramer Levin Naftalis & Frankel; senior bondholders have Cleary Gottlieb Steen & Hamilton; and junior bondholders have White & Case and Milberg, Tweed, Hadley & McCloy. MBIA is represented by Cadwalader, Wickersham & Taft,Assured by Proskauer Rose and Financial Guaranty by Jones Day.

I called or emailed lawyers from all of the firms but heard back only from Gibbs & Bruns. “These are important issues,” said Gibbs partner Patrick. “In other significant bankruptcies (such as Lehman and Washington Mutual), RMBS investors have had to wait years to get their claims resolved. The evidence developed before and after the settlement in this case show this is a reasonable compromise and we are confident the settlement will be approved.”

Judge Glenn will hold a hearing next month on the fairness of the $8.7 billion allowed claim, two months before a similar hearing in New York State Supreme Court on Bank of America’s proposed $8.5 billion settlement with the same institutional MBS investors. Should be quite a show.

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