Opinion

Alison Frankel

Paulson bets (for now) on JPMorgan in $2.7 bln FDIC fight

By Alison Frankel
December 23, 2013

The relatively new industry of litigation funding, in which an investor otherwise uninvolved in a dispute agrees to front the money for one side or the other (almost always the plaintiffs) to litigate the case, has occasioned much soul searching about who has the right to bring a claim and control its prosecution. But there’s really nothing new about investors betting on litigation, albeit by acquiring a direct interest in a case. I’m speaking, of course, about hedge funds engaged in litigation arbitrage, in which they purchase a security in the hope that successful litigation will drive up its value. The phenomenon is best known in the distressed debt arena, where hedge funds have made heaps of money by buying up notes of bankrupt or near-bankrupt companies and then clawing for creditors’ rights by any means necessary. You also see trading in claims against receiverships, as in the brisk secondary market for claims belonging to Bernard Madoff’s investors, as well as trading in stock whose value is particularly driven by litigation developments, as, for instance, MBIA’s used to be. More recently, we’ve seen investors buying mortgage-backed notes with the intention of acquiring a big enough stake to force the MBS trustee to pursue repurchase claims. (Although, as I told you last week, that’s become a very low-odds bet, thanks to the New York state appellate court’s new ruling on the statute of limitations for put-back suits.)

The hedge funds that succeed in this game are, by definition, smarter than other investors about how litigation will impact the value of the securities they acquire. In that sense, Paulson & Co’s reported sale last week of its stake in Washington Mutual senior secured notes is a sign that JPMorgan is winning its years-long fight with the Federal Deposit Insurance Corporation over indemnification for WaMu MBS liability. As The Wall Street Journal reported Sunday, the hedge fund ditched its position in WaMu debt days after JPMorgan’s lawyers at Sullivan & Cromwell filed a complaint in federal court in Washington, demanding first dibs on the FDIC’s $2.7 billion WaMu receivership funds.

JPMorgan’s new suit repeats its long-running argument that when it took Washington Mutual off the FDIC’s hands in 2008, the acquisition contract required JPMorgan to assume only certain WaMu liabilities – and that liability based on deficient WaMu MBS remained with FDIC. The bank’s latest complaint does not assert a claim, at least for now, against the FDIC as a corporate entity, but demands more than $1 billion from the FDIC’s WaMu receivership fund, which contains about $2.75 billion (roughly $1.9 billion from JPMorgan purchase of WaMu plus another $800 million that the fund recovered through the Chapter 11 bankruptcy of WaMu’s holding company). JPMorgan’s complaint identifies 13 settled WaMu MBS investor cases and five that have yet to wrap up, and claims that the FDIC receivership is responsible for covering those deals, among other costs.

Interestingly, the bank is not demanding indemnification for the $1.53 billion it paid to resolve the Federal Housing Finance Agency’s claims that WaMu committed securities violations in its sale of MBS to Fannie Mae and Freddie Mac. FHFA did not require JPMorgan to give up its indemnification claim against the receivership as part of their deal, but the bank’s subsequent settlement with the Justice Department included that provision. JPMorgan’s new suit does demand payback from the FDIC for its previous mortgage repurchase (or put-back) settlement with FHFA’s wards, Fannie and Freddie.

JPMorgan’s rivals for the $2.75 billion in the FDIC receivership are WaMu’s creditors, chief among them the senior noteholders who hold some $6 billion in debt that WaMu issued before it failed. Those noteholders are a revolving cast of sophisticated investors represented by Dechert and Zuckerman Spaeder. Unfortunately for them, they’ve been pretty much shut out of the litigation over JPMorgan’s right to indemnification from the FDIC, in which the bank’s new suit is only the latest chapter. The main event is occurring in a put-back suit by Deutsche Bank as a WaMu MBS trustee. U.S. District Judge Rosemary Collyer of Washington, who is presiding over all of the litigation involving the FDIC, WaMu and JPMorgan, has said that she will rule in the Deutsche Bank trustee case whether JPMorgan or the FDIC is responsible for WaMu’s MBS liability, but such a ruling is a long way off; Collyer has asked for expert reports but hasn’t scheduled hearings. And meanwhile, the judge has rebuffed senior noteholders, including Monarch, Silver Point and York Capital, from intervening in the trustee litigation to defend their right to the money in the receivership. In July, the District of Columbia Court of Appeals upheld Judge Collyer’s decision on intervention, ruling that the noteholders don’t have standing in the trustee case.

Paulson’s reported sale of its position looks like an acknowledgement that the hedge fund believes it has squeezed all it can from its investment in WaMu secured notes, which will obviously decline in value if JPMorgan gets first crack at the money in the receivership. (Paulson & Co referred me to an outside spokesman, who didn’t respond to my email.)

There could, of course, be other explanations for Paulson’s sale that have nothing to do with JPMorgan’s new suit, and Paulson could certainly change its mind and repurchase WaMu debt after New Year. Moreover, the size and significance of Paulson’s WaMu stake is not publicly known, and Paulson was not publicly identified in the noteholders’ attempt to intervene in the Deutsche Bank case. And whoever bought the WaMu notes from the hedge fund is clearly betting that noteholders will end up with the lion’s share of the $2.75 billion receivership. But from what I’ve seen, Paulson’s litigation advisors make savvy bets. If I were JPMorgan, I’d be happy to have the hedge fund’s implicit endorsement.

JPMorgan counsel Robert Sacks of S&C and WaMu noteholder counsel Thomas Vartanian of Dechert declined to comment.

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