Opinion

Alison Frankel

As crisis litigation draws to close, lessons for investors

By Alison Frankel
July 16, 2014

We’re near the end. With the news Wednesday that Bank of America will pay AIG $650 million to settle their long-running and many-tentacled litigation over mortgage backed securities –along with a report in The Wall Street Journal that the credit rating agency Standard & Poor’s is contemplating a $1 billion settlement with the Justice Department for its MBS rating failures — it’s time to declare the twilight of financial crisis litigation.

Yes, there’s still some big work to be done, including BofA’s anticipated multibillion-dollar settlement with the Justice Department; the resolution of the Federal Housing Finance Agency’s last few cases on behalf of Fannie Mae and Freddie Mac; and dozens of private-investor breach-of-contract suits against the banks. But that’s the denouement, the last act.

So what have we learned, after six years of intense and expensive litigation? To me, the clearest lesson from financial crisis litigation is that investors cannot rely on anyone else’s assurances about complex securities.

Federal securities laws say otherwise, of course. Issuers and underwriters are supposed to disclose the risks built into the securities they’re selling. Credit rating agencies are supposed to provide realistic assessments of investment quality. State and federal regulators are supposed to make sure all of them are living up to their representations and to seek justice for investors if it turns out they’ve been deceived.

The first few years of MBS litigation, dominated by investor class actions and bond insurer suits against issuers, exposed the gap between bank representations about underlying mortgage loan pools and the pools’ actual risk profiles. After re-underwriting sample loans, MBS plaintiffs claimed breathtaking breach rates, asserting in case after case that 30, 50, 60 or even 70 percent of the mortgages underlying MBS trusts were deficient for one reason or another.

Discovery in the private cases also turned up reams of evidence that mortgage originators, bank securitizers and credit rating agencies knew — or at least should have known — that the underlying loans didn’t live up to their representations and warranties. The MBS sell side was either too greedy to tell the truth or too credulous that house prices would continue to rise, despite reports from the field about increasingly risky loans.

Regulators, meanwhile, just weren’t equipped to investigate allegations of fraud on an industry-wide scale. Even after the Obama administration and state enforcers teamed up to form an RMBS task force in 2012, the Justice Department and the Securities and Exchange Commission leaned heavily on evidence obtained in private MBS litigation. The government can afford to take its time, thanks to longer statutes of limitations than those that apply to private suits. But as Justice pursues a giant settlement with BofA, on top of the $20 billion it has already announced in settlements with JPMorgan Chase and Citigroup, it’s fair to wonder whether the government would have brought any MBS fraud cases at all if private investors and their lawyers hadn’t built a foundation for the feds’ claims.

We also learned that the MBS trust mechanism hinders accountability to investors. If AIG’s relentless opposition to Bank of America’s $8.5 billion settlement with Countrywide MBS investors proved nothing else (aside from AIG’s tenacity), it highlighted the awkward role of MBS trustees, who are paid (and indemnified) by issuers yet have the sole power to bring breach-of-contract claims for investors.

AIG failed to establish that Countrywide’s MBS trustee, Bank of New York Mellon, had a conflict of interest. But it’s no accident that some of the same gigantic institutions that negotiated the Countrywide MBS deal alongside BNY Mellon have just turned around and sued the bank for breaching its duties as a trustee.

For years after defaults began to erode MBS revenue streams, trustees declined to demand the repurchase of defective loans. Trustees began suing sponsors only after noteholders banded together to get past the 25 percent contractual ownership threshold to direct trustee action or when distressed debt funds acquired controlling stakes in faltering MBS trusts. And if noteholders couldn’t meet those procedural requirements by the end of 2013, they can pretty much forget about any recovery for contractual breaches (unless New York’s highest court raises the time bar for their claims).

No one, in other words — not issuers and underwriters, not rating agencies, not MBS trustees and not regulators — was ready, willing and able to backstop noteholders. So it shouldn’t be a surprise that the most consequential legacy of MBS litigation is investor wariness. Private capital hasn’t returned to the residential mortgage market (though other asset-backed securities are doing fine). Bondholder groups have argued in Congress and elsewhere that their members won’t invest again in mortgage-backed notes without safeguards they didn’t have the last time around.

I know what you’re thinking: MBS investors were generally sophisticated institutions with the resources to conduct their own due diligence. Investors such as Fannie Mae and Freddie Mac, for example, knew as much about chicanery in the mortgage market as any MBS issuer. You’re right, of course, and MBS defendants have made those points in court. Investors were arguably just as greed-blinded as issuers, underwriters and credit rating agencies in the MBS bubble. They could have and should have known better, though courts have generally held that MBS investors didn’t have access to enough specific, loan-level information to have known the full extent of issuers’ misrepresentations.

There’s a winner and a loser in every trade, but what years of MBS litigation has shown is that in MBS deals, noteholders were doomed to lose. Let’s hope they remember that lesson when the next securities bubble brews.

For more of my posts, please go to WestlawNext Practitioner Insights

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