Alison Frankel

When I first read the Federal Housing Finance Agency Inspector General’s report criticizing Freddie Mac’s $1.35 billion MBS put-back settlement with Bank of America, I wondered if the FHFA IG had just exposed billions of dollars in untapped bank liability. The IG report notes, after all, that Freddie’s deal with BofA (unlike Fannie Mae’s simultaneous $1.52 billion BofA settlement) resolves not only pending breach of contract claims, but also any future claims that Countrywide breached representations and warranties on the mortgages it sold Freddie. Those are exactly the kinds of global settlements banks are going to have to reach if they have any hope of resolving their MBS put-back liability.

So if the FHFA Inspector General is castigating Freddie for overlooking BofA’s liability for mortgages that defaulted four or five years after they were issued — and FHFA is generally reckoned to be the most experienced evaluator of reps and warranties claims there is — have other put-back claimants underestimated potential bank liability? Are bond insurers and MBS investors making the same supposed mistake as Freddie Mac?

The short answer is no.

The IG report faults Freddie for failing to account for the exotic mortgage loans that proliferated in the housing bubble. Homeowners with interest-only or adjustable-rate mortgages often made it through the early teaser-rate years, only to default when they had to begin making higher payments. The FHFA IG report indicates that Freddie Mac has seen tens of thousands of these mortgages go into default three to five years after they were issued.

That changed the traditional default bell curve, in which deficient mortgages went sour within a year or two and default rates slowed thereafter. But according to the FHFA IG, Freddie never adjusted its process of reviewing defaulted loan files to reflect the changed default model. The government agency continued looking for breaches of reps and warranties in loans that went bad within the first two years after they were issued, even though the exotic mortgages of the housing boom frequently took longer to sour. As a result, the report said, Freddie may have severely underestimated its put-back claims against Countrywide.

“By choosing to review intensively only those loans that defaulted within two years of origination,” the IG report asserts, “Freddie Mac did not examine close to 100,000 2006 vintage loans.Those loans that were not reviewed have a combined unpaid principal balance exceeding $50 billion.” The report cited a senior FHFA examiner who estimated that BofA’s liability for those unreviewed loans could run to billions of dollars, although in a footnote deep in the report the IG quoted a more moderate estimate of $500 million to $1 billion in total additional revenue (not just from BofA) for Freddie if it changed its loan review process to account for later-defaulting mortgages.

Last Friday evening, after the Federal Housing Finance Agency filed 17 blockbuster suits against just about every major issuer of mortgage-backed securities, the buzz was about the staggering size of Fannie Mae and Freddie Mac’s investments in mortgage-backed notes and certificates. The suits, 13 filed by Quinn Emanuel Urquhart & Sullivan and four by Kasowitz Benson Torres & Friedman, cite about $196 billion in MBS holdings by Fannie and Freddie. Under both state and federal damages theories, the suits demand rescission, or a buyback of the notes by their issuers. Does that mean we should we assume that FHFA has $196 billion in claims?

Nope. Not even close. FHFA doesn’t specify any damages numbers in the complaints filed Friday, but in the agency’s previously-filed $4.5 billion MBS suit against UBS, FHFA asserted that Fannie and Freddie had “lost in excess of 20 percent” of their investment in UBS notes, including unrealized losses. Apply that rough logic to the FHFA’s new suits, and the agency’s claims are knocked down to $40 billion — a huge number, to be sure, but not a heart-stopping one. The banks, meanwhile, are cranking up defenses to shrink even that reduced estimate of FHFA losses. One bank defense lawyer told me Tuesday that by his firm’s calculation, which I’ll explain later, Fannie and Freddie have actually realized losses of no more than about $50 million on their $4.5 billion investment in UBS mortgage-backed certificates. Do the math: if FHFA’s losses are similar across the board, that would put Fannie and Freddie’s recoverable damages on MBS securities claims in the universe of a few billion dollars.

That is, of course, a lot of supposition. But any estimate of banks’ MBS liability, by necessity, involves supposition. MBS investor litigation is so new that there’s not much precedent to guide predictions of how FHFA’s suits, or those of any other MBS investor, will fare in court or in settlement talks. So far, there’s only been one public settlement of an MBS securities case — Wells Fargo’s $125 million deal in a class action involving investors in 28 MBS offerings. Lots of other MBS investors have filed federal court cases, including several class actions, but the litigation hasn’t progressed very far. (Late Tuesday FHFA put out a press release that clarified its damages theories and claims, spelling out some of the same points I make below.)

The Federal Housing Finance Agency’s reported mortgage-backed securities suits against a slew of major banks haven’t yet been filed. But if you want to know what they’re likely to look like, check out Mass Mutual’s 168-page MBS complaint against Bank of America, Merrill Lynch, Bear Stearns, and J.P. Morgan, filed Thursday. (It’s so big the Massachusetts federal court docket split it into four parts: here, here, here and here.) Or you could look at AIG’s $10 billion megasuit against BofA, Countrywide, and Merrill, filed on Aug. 8, or Allstate’s 114-page complaint against Goldman Sachs on Aug. 15, or U.S. Bank’s MBS breach of contract suit against BofA, which came at the beginning of this week.

All of those complaints — and many, many more raising allegations that big banks misrepresented the quality of the mortgages underlying the asset-backed securities they packaged and sold — were filed by the law firm representing FHFA in its MBS investigation: Quinn Emanuel Urquhart & Sullivan. And that’s no accident. Quinn Emanuel, a 450-lawyer firm whose partners take home an average of more than $3 million a year, made a conscious decision more than three years ago to push into structured finance litigation against money-center banks, at a time when most litigators didn’t know the first thing about these instruments. In a way, the anticipated FHFA suits are the culmination of Quinn Emanuel’s four-year investment in MBS litigation.

Before 2007, Quinn Emanuel was usually competing for a seat on the banks’ side of the table. Then name partner John Quinn, a onetime Cravath, Swaine & Moore lawyer, had a revolutionary thought. Quinn Emanuel doesn’t have a big corporate practice, he reasoned, so there were no conflicts to keep the firm from suing financial institutions. Rather than vie with a pack of premier law firms for bank business, he decided the firm should give up its relationships with banks and accounting firms and start representing corporate clients with claims against big banks. “We deduced there weren’t very many prestigious law firms willing to be adverse to financial institutions,” name partner William Urquhart told me Friday.