BofA’s legal predicament

By Felix Salmon
October 20, 2010
Nelson Schwartz links the big lawsuit against BofA/Countrywide directly to the mortgage bond scandal I've been banging on about:

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Nelson Schwartz links the big lawsuit against BofA/Countrywide directly to the mortgage bond scandal I’ve been banging on about:

The legal battle turns on the question of whether the banks properly represented the loans they put together into mortgage-backed securities when they sold them to investors. If the banks ignored evidence that the underlying mortgages did not conform to underwriting standards or they lacked the proper paperwork, the banks could be obligated to buy the troubled mortgages back.

Schwartz also reports that this legal trade is attractive enough that vultures are circling:

Hedge funds like York Capital and Moore Capital have been jumping into the game recently, buying up bad debt in the hopes it will eventually be bought back…

“Any hedge fund with a distressed desk is contemplating this trade,” said one analyst.

There’s a whole bunch of different things going on here, but the key development is that bondholders have managed to get organized, and they’re taking the battle not only to otiose trustees, but also to loan servicers.

The key number here comes right at the top of the letter sent to BofA/Countrywide:

The undersigned are the Holders of not less than 25% of the Voting Rights in Certificates issued by the Trusts listed on the enclosed Exhibit A.

Once that 25% level is reached, bondholders have all manner of rights, which are now being put to good use. For one thing, they’re allowed to file exactly this letter: a notice of nonperformance, telling the servicer in pretty strong language to buck up and start doing its job, or face a massive legal action.

Isaac Gradman says there might be a problem here:

These efforts may well fail for an additional reason that was cited as a basis for Bank of New York’s refusal to comply with Patrick’s earlier request – the failure to provide evidence of a specific breach.

But I’ve also heard that the 25% number is crucial on this front, too. If you own 25% of a securitized issue, I’m told, you can force the custodian to hand over the underlying, individual loan documents — exactly the same documents that Clayton and other due diligence companies examined before the bonds were issued. At that point, it becomes a lot easier to find specific breaches and to make BofA’s life a legal nightmare.

The position of BofA here is hilariously complex and conflicted. BofA owns 34% of BlackRock, which is a lead plaintiff in this case. (BlackRock manages the mortgage bonds which the Federal Reserve inherited as part of the Bear Stearns bailout.) BlackRock, in turn, is suing Countrywide (owned by BofA), the loan servicer which has clearly not been doing its job:

Although there are tens of thousands of loans in the RMBS pools that secure the Certificates, the Trustee has advised the Holders that the Master Servicer has never notified it of the discovery of even one mortgage that violated applicable representations and warranties at the time it was purchased by the Trusts.

In other words, Countrywide has an obligation to tell the bond trustee whenever a loan turns out to be in violation of the bond’s representations and warranties. But Countrywide has never done that. Why? The answer is obvious: the minute that it did so, the trustee would force the servicer to put the loan in question back to the originator. And the originator is — you guessed it. Countrywide.

Essentially, BofA is suing BofA so that BofA can be forced to put bad mortgage loans back to BofA.

Yves Smith reckons that the winner here is likely to be BofA — that the lawsuits (which, remember, haven’t even been filed yet, and won’t be for at least 60 days) will probably be settled for a relatively modest sum. But I’m less sanguine.

For one thing, Smith says that the plaintiffs will only be able to collect on loans which have gone bad and where they can show damages. But the bondholders might want to force BofA to buy back even performing loans, if they got thrown into the pool without conforming to the relevant standards. Calculating BofA’s loss on such things won’t be easy: after all, if those loans continue to perform, then BofA would ultimately make a profit on them. But given the ongoing foreclosuregate mess, there’s a very real chance that even performing loans will end up in strategic default.

The big picture I think is that a lot of the risk embedded in mortgage bonds could shift from bondholders back to the investment banks which underwrote them. In a just world, the bond trustees would be leading this charge, but they’re not, so the cause has been taken up by the bondholders themselves, who are only now beginning to organize and to become familiar with all the legal avenues that the various players can explore.

It’s entirely possible, of course, that obstructionist lawyers for BofA and the trustees will manage to block these suits and keep all those toxic bonds in the hands of bondholders. But mortgage-bond owners are becoming increasingly aggressive and activist, and they’re comparing notes with bond insurers who are also in a very similar situation. The investment banks, BofA foremost among them, might win. But the fight is going to be long and hard and expensive, and is going to make them look very bad indeed. They might well find it more attractive, all things considered, to negotiate a settlement, write a ten-figure check, and move on.

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