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.

It’s too late to undo Freddie Mac’s settlement with BofA, and the IG’s report doesn’t argue otherwise. Instead, it calls for Freddie Mac to revise its mortage loan review process and to assure that senior managers respond quickly and sufficiently to staff concerns.

In fairness to Freddie Mac, there’s a good reason the agency focused its attention on mortgages that went into default quickly. Lenders are usually quicker to accept claims that material breaches in their reps and warranties led to the mortgage’s default if the loans fail right away. In other words, put-back claims on mortgages that went into default within a year or two are the low-hanging fruit of MBS put-back litigation. When homeowners default several years into their mortgage, mortgage issuers are likelier to assert that economic conditions — such as a homeowner losing a job or the decline in housing values — are responsible for the mortgage’s failure. Banks typically argue that they’re only liable to repurchase loans that failed as a direct result of their underwriting breaches. So forcing put-backs of later-defaulting loans is a tougher prospect.

But that doesn’t mean that bond insurers and MBS investors are ignoring those late defaults. To the contrary — they’re fully aware that it takes adjustable-rate mortgages longer to fail. My reporting indicates that if Freddie Mac truly didn’t assert put-back claims against BofA for mortgages that went bad after three years (there’s some doubt about that proposition), Freddie is an outlier. “I can guarantee that MBS investors and monolines aren’t limiting their review,” said one bond insurers’ lawyer. A lawyer for MBS investors added: “If a loan breached warranties on the day of closing and didn’t go into default until three years later, it’s no less in default.” This lawyer, like the monolines’ counsel, said no reasonable put-back claimant is limiting review to mortgages that defaulted within one or two years.

The proof is in the deals BofA has already struck with the bond insurer Assured Guaranty and with the investor group represented by Gibbs & Bruns. Under the Assured deal, BofA is continuing to pay the bond insurer for materially deficient mortgage loans issued in 2006 and 2007 — including loans that defaulted long after 2008 or 2009.

The embattled $8.5 billion BofA settlement with Countrywide MBS investors, meanwhile, explicitly accounted for late-defaulting mortgages, according to Kathy Patrick of Gibbs & Bruns. “The analysis the Inspector General claims FHFA should have done for recent defaults, we did,” Patrick told me. “We captured all loans that were 60 or more days delinquent and specifically analyzed [them].” The expert who opined on the fairness of the settlement amount for Bank of New York Mellon, the Countrywide securitization trustee, described his process of deriving a default rate in a filing BNY Mellon made public in the proceeding to win judicial approval of the proposed deal. The expert, Brian Lin of RRMS Advisors, said he accounted for defaults that occurred all along the timeline, including loans that hadn’t yet gone into default but were 60 days’ overdue. The default rate he used in reaching an estimate that BofA’s put-back exposure is about $9 to $11 billion specifically addressed loans that fell into trouble long after they were first issued.

Even Fannie Mae apparently didn’t limit its review of loan files to early defaults; the FHFA Inspector General was tasked with looking at both the Fannie and Freddie BofA settlements, but flagged only Freddie’s loan review methodology.

Freddie Mac has promised not to reach any additional settlements without considering the IG’s recommendations that it revamp its loan review process. And it shouldn’t. No reason the government shouldn’t do what everyone else already is.

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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.)

So, let’s take a look at what Fannie and Freddie are claiming and how the banks are likely to respond. As an initial matter, it’s important to distinguish between the two kinds of suits investors can bring against MBS issuers and originators of the underlying mortgage loans. One class of cases involves contract claims based on the representations and warranties issuers and originators made about the underlying mortgage loans. Under standard MBS securitization agreements, if investors can show that underlying mortgages don’t measure up to the stated standards, they can demand that issuers buy back those deficient loans. Those are straightforward breach of contract claims, but there’s a big catch: In order to bring a so-called put-back suit under standard securitization contracts, investors have to control 25 percent of the voting rights within an individual MBS trust. Gibbs & Bruns was able to negotiate the proposed $8.5 billion Bank of America MBS settlement, which would resolve investors’ representations and warranties claims, because its group of 22 large institutional investors had the requisite voting rights in more than 200 Countrywide trusts. Fannie and Freddie previously settled their own reps and warranties claims against BofA (for mortgages they bought directly from Countrywide) in a $3 billion deal last January. But generally, plaintiffs lawyers have struggled to piece together coalitions of investors to cross that 25 percent threshold and bring contract claims.

Most investors — including Fannie and Freddie in the suits filed Friday — have instead asserted securities law claims against MBS issuers under federal, state, and common law theories. The housing finance agency’s federal claims are based on the Securities Act of 1933. There are two key reasons why. The ’33 Act sections FHFA is asserting involve standards for offering documentation. Under those provisions, investors don’t have to show that issuers intended to deceive them or that they relied on the allegedly misleading documents. As I’ve previously explained, the ’33 Act holds issuers to a strict liability standard, meaning investors just have to show that an offering statement contained false representations about the securities. As alternative routes to the same damages they’re seeking under the ’33 Act, Fannie and Freddie are also making claims under Virginia and District of Columbia securities laws, and under common law fraud or negligent misrepresentation theories.

Under both the state and federal claims, FHFA can demand that the banks repurchase securities issued under false offering documents. Here’s where MBS contract cases and securities cases intersect: Both types of suits rely on investors’ claims that issuers misrepresented the underlying mortgage loans. Fannie and Freddie’s complaints against the banks offer pages and pages of evidence that issuers fed investors false information about the quality of the underlying loans. On their face, the complaints make quite a compelling case for issuer liability.

Don’t underestimate the banks’ potential defenses, though. There’s reliance, for instance: Fannie Mae and Freddie Mac practically invented the business of securitizing mortgage loans, so they were among the most sophisticated MBS investors in the market. Did they really rely on issuers’ representations about the underlying mortgages? That’s not a defense the banks can assert against FHFA’s federal-law ’33 Act claims, which don’t depend on reliance. But it will come into play in the state and common-law causes of action. The banks will also point to disclaimers in their MBS offering documents , and they’ll argue that some of the allegedly-false statements, such as home appraisal values, are non-actionable opinions. Despite tolling agreements with FHFA, they may have statute-of-limitations defense as well; Los Angeles federal judge Mariana Pfaelzer, in the Countrywide MBS litigation now consolidated before her, has set a cut-off date for claims that will help Countrywide enormously.

The banks’ best defense, however, will be to question how much Fannie and Freddie actually lost as a result of the allegedly misleading offering documents. This is a two-pronged argument. First, the banks will assert that any value their mortgage-backed securities lost is due to the overall decline in the housing market and the general economy, not to problems with their MBS offerings. (We saw defendants use that argument, to varying degrees of success, in securities class actions alleging shareholders were deceived about subprime mortgage exposure.) Finally — and this is the banks’ last, best defense — they will argue that Fannie and Freddie haven’t lost much on their MBS investments.

Believe it or not, MBS notes haven’t been the total debacle you might think if you spent all your time reading investors’ complaints. Many trusts have been paying principal and interest more or less on schedule. Remember that $50 million in UBS mortgage-backed losses one bank defense firm calculated? The firm (which doesn’t represent UBS), analyzed the value of FHFA’s UBS investments using MBS trustee reports and Bloomberg data on already-paid principal, interest, and trading value of the securities the housing finance agency specified in the UBS complaint. By the defense firm’s calculation, Fannie and Freddie had lost about $48 million as of July, when the FHFA complaint was filed, and $50 million as of September 1.

So even if the notes are worth less today than they were at time they were issued, the banks will argue, Fannie and Freddie have already received billions in repaid principal and interest from their MBS investments, with billions more still to come from securities that continue to perform.

These are heady days for litigators, given the widespread theory that the economy can’t recover until banks resolve their liability for mortgage-backed securities. For the rest of us, here’s hoping for some clarity, the sooner the better, on the parameters of that liability.

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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.

The firm’s New York office was perfectly positioned for the new practice area. Quinn Emanuel New York lawyers represented the trustee in the Parmalat bankruptcy, so they’d already had some experience litigating against banks. And litigators Peter Calamari and Philippe Selendy had at least a glancing knowledge of structured finance from cases they’d handled against UBS and Bear Stearns. So when the housing bubble burst and mortgage-backed securities began to crater, Calamari, Selendy, and structured finance partner Jonathan Pickhardt hunkered down to learn all they could about the instruments — before Quinn Emanuel even had a single MBS client. “We invested an enormous amount of lawyer time to gain a deep, deep understanding of mortgage-backed securities,” Urquhart said.

“We had the expertise, and we had the horsepower,” added Calamari. “By the spring of 2008, it was apparent residential mortgage-backed securities were a disaster.”

The firm’s first MBS client was MBIA, the bond insurer. In October 2008, as the economic crisis worsened, Quinn Emanuel filed MBIA’s suit against Countrywide in New York state supreme court. That litigation produced some landmark MBS decisions from Judge Eileen Bransten, who refused to dismiss MBIA’s contract and fraud claims, ruled that MBIA can use statistical sampling to determine the percentage of deficient underlying mortgage loans, and granted the insurer access to discovery on the relationship between credit rating agencies and MBS issuers. Other businesses with MBS investments — including Mass Mutual, Allstate, and Assured Guranty — saw how the MBIA case was going and came to Quinn with their own claims. In October 2010 the FHFA disclosed that it had hired Quinn to analyze its potential MBS claims.

The work has already paid off big for Quinn Emanuel, even though MBS settlements are so far a rarity. (Two Quinn clients, Assured and the FHFA, have reached multibillion MBS settlements with BofA; the previous FHFA settlement involved mortgage loans Fannie Mae and Freddie Mac bought directly from Countrywide for their own securitizations; the expected new FHFA suit will center on mortgage-backed securities Fannie and Freddie invested in.) Unlike traditional plaintiffs firms, Quinn bills about 90 percent of its MBS cases at hourly rates, rather than on contingency. The volume of MBS litigation, in combination with the firm’s booming IP practice, has made Quinn Emanuel one of the three or four most profitable firms in the country.

Calamari told me that the MBS wave won’t last forever. New York has a six-year statute of limitations on fraud and contract claims; other states have narrower windows. The FHFA cases are reportedly being filed now to beat a three-year statute. “It’s clear that deadlines are coming,” Calamari said.

But the end is near only for new filings. When it comes to results of the MBS litigation, we’re just at the beginning.

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