Isaac Gradman is one of the nation’s leading experts on mortgage backed securities litigation. He is the author The Subprime Shakeout mortgage litigation blog, and the editor of the newly released book, “Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System,” by Bill Frey. Follow him on Twitter @isaacgradman
With all eyes in the mortgage litigation world glued to the pending decision on Partial Summary Judgment in MBIA v. Countrywide, et al., commentators are beginning to speculate that a settlement may be in the offing between the two MBS heavyweights. However, as we get closer to a decision on MBIA’s fully briefed motion with each passing day, and as BofA continues to suffer heavy casualties with each stroke of Judge Eileen Bransten’s pen, the nation’s largest bank by total deposits is running out of time to avoid another potentially disastrous result.
Indeed, rumors were already swirling as early as this past July that BofA had settled this lawsuit, sending the bond insurer’s stock soaring, but all gains were quickly erased as the market recognized the news as exactly that – just a rumor. Then, last month, another rumor emerged that again reported that a settlement was in the works, and this time the rumor revealed a purported price tag for this settlement – $5 billion.
Of course, every rumor contains a kernel of truth, and this one made sense – given the devastating precedent this lawsuit could set for BofA, it must be carefully considering, and is likely in the process of discussing, a settlement with MBIA. This past week, in fact, BofA reportedly settled a class action suit regarding Merrill Lynch securities to the tune of $315 million (interestingly, this settlement was first reported by Alison Frankel, who has also been suggesting that an MBIA settlement may be forthcoming). If this report is true, could a settlement with one of the most dogged and successful plaintiffs in the slew of MBS suits against BofA be far off?
Having already suffered tough-to-swallow losses on the issues of statistical sampling, scope of discovery, fraud claims and successor-in-interest liability, BofA is now facing an even more significant loss. At risk if BofA does not settle quickly is an adverse decision on the causation standard to be applied to putback claims – one of the key defenses cited by the bank (and by Bank of New York in justifying its settlement number on behalf of BofA) in maintaining that its obligations to repurchase defective subprime and Alt-A mortgages will be contained.
Aside from BofA’s string of losses before Judge Bransten, all signs from a legal perspective point to MBIA winning its Motion for Partial Summary Judgment on the issue of whether it can exclude BofA’s post-closing defenses (i.e., that the housing downturn, not Countrywide’s poor underwriting, caused MBIA’s losses) and focus on whether reps and warranties were breached at the time of the MBS Trusts’ closing. But with this motion having been fully briefed for over a month, it seems that if BofA was going to head off this loss with a settlement, it would have done so by now. So, assuming that this case does not settle in the next few weeks, I’m going to tell you why the next decision in this case – in one of the earliest-filed pieces of mortgage crisis-related litigation – will produce more bad news for the beleaguered Big Four Bank.
Loss Causation Background
For readers unfamiliar with the issues at stake, we’ll start with a little background. Countrywide, in conjunction with dozens of other subprime and Alt-A originators, sold trillions of dollars worth of loans to Wall Street during the 2000s and provided the purchasers with certain guarantees – known as reps and warranties – regarding the quality of the loan underwriting they would employ and the loan guidelines they would follow. The purchase and sale contracts for these loans specified that if any of these reps and warranties were breached with respect to a particular loan, and the breach materially and adversely impacted the value of the loan or the interest in the loan of the investor or bond insurer, the originating bank would have to buy back the loan at par (the original face value).
Though this description of banks’ so-called putback liability is noncontroversial, a major dispute has emerged over what is meant by “material and adverse impact.” Countrywide/BofA, along with many other banks with legacy loan origination liability, has argued since these MBS lawsuits were first initiated that the “material and adverse” language created essentially a loss causation standard. That is, plaintiffs were required to prove that each breach of reps and warranties identified actually caused the loan to go into default.
Plaintiffs like MBIA, on the other hand, have argued that the standard means what it says – that the breach has to simply impact the value of the loan by making it riskier and more likely to default. They point to several provisions of standard Pooling and Servicing Agreements (the contracts governing the creation of MBS) that provide specifically for situations in which performing loans are required to be bought back.
You would think that the presence of provisions allowing for the repurchase of current loans would end this discussion – but BofA and other banks with repurchase liability have continued to argue this point. I will run through each of these arguments in turn – as detailed in Countrywide’s Opposition to MBIA’s Motion for Partial Summary Judgment – and explain why none of them hold water.
Countrywide’s Loss Causation Arguments
Countrywide spends the first three-plus pages of the loss causation section of its memorandum making the unremarkable point that a breach of rep and warranty must have a material and adverse impact – that a breach alone is not enough. This amounts to the quintessential straw man argument: Countrywide sets up a flimsy characterization of MBIA’s argument only to batter it into the ground.
It accomplishes this by seizing on one admittedly imprecise line in MBIA’s Motion, that “MBIA may invoke the repurchase provisions upon showing that the characteristics of a loan was [sic] not as represented by Countrywide” (Motion at 22), to suggest that MBIA is denying the existence of a materiality requirement. Yet Countrywide ignores that in the very next sentence of its brief, MBIA states that Countrywide’s repurchase obligation is triggered “if MBIA’s interest in the loans is ‘materially and adversely’ affected by Countrywide’s breach…[meaning there is a] material increase in the risk profile.” Id. I doubt that Judge Bransten will have much patience for the creation of a dispute where none exists.
Assuming that both sides agree that the contract says what it says, and that it includes the “materially and adversely impacts” language, Countrywide is left with three arguments that are far flimsier than any straw man it set up for MBIA. First, it attempts to counter MBIA’s argument that other provisions of the PSA expressly provide that non-defaulted loans may be put back to the originator. To this, Countrywide responds that nothing in those provisions undermines the fact that a breach must “materially and adversely impact” the insurer’s interest in the loans. (Countrywide Opp. at 20) Of course, this is true, but not if Countrywide’s interpretation of the materiality provision is that the breach must cause the loan to go into default.
Countrywide states that the PSA does contemplate the repurchase of performing loans, but only in “very limited circumstances… which are not at issue here.” (Countrywide Opp. at 20) Again, that’s not the point. The point is that if the PSA contemplates the repurchase of performing loans, then the “materially and adversely impacts” language cannot possibly mean that the breach must cause the loan to go into default, because that would create a contradiction, which courts are expressly instructed to avoid in interpreting contracts. Thus, even if the circumstances under which performing loans can be put back are not present here, the presence of that language authorizing repurchase of performing loans undermines Countrywide’s interpretation of the governing contract.
Countrywide follows up this red herring with an argument that couldn’t beat its way out of a wet paper bag. Essentially, it argues that MBIA’s insistence that a materially adverse impact could consist of an increase in the risk profile of the loan ignores the “plain meaning” of the contract language. It then launches into an etymological exploration of the word “affects” that would have made Webster proud. Because, according to Countrywide, “affects” means “to produce a change in,” then the breach must have actually caused harm to MBIA. (Opp. at 21) A breach that makes the loan riskier is simply a potential adverse impact, and not an actual one, according to Countrywide.
This argument ignores the concept of risk entirely. I’ll illustrate with a brief hypothetical. Say we’re playing a card game where we’re betting on whether the next card you draw will be black or red. You put up even money that the next card will be red. When you’re not looking, I remove 5 red cards from the deck. Now, I present you with the deck and ask you to pick a card.
Let’s freeze it at the moment before you draw. Now, have I caused any direct harm to you? Well, you haven’t actually lost any money yet, so technically there’s no “loss” and under Countrywide’s argument, no direct harm. But, I have certainly adversely impacted your interest in our transaction, as I have made it more likely that you would draw a black card. In this case, you would be justified in arguing that I harmed you by making it more likely that you would suffer a loss. It makes no difference whether you end up drawing a red card or a black card once the game resumes.
In my mind, the argument over reps and warranties is identical to this scenario (or, if you don’t like that analogy, try the one often used by MBS plaintiffs attorneys – if the brakes on your car are defective, you don’t need to wait to get into a car accident to return the car to the dealer). Countrywide has (allegedly) ignored its underwriting guidelines and issued loans without screening for certain risk factors (such as excessive debt-to-income ratios, inflated appraisals, inflated borrower incomes, etc.). Now, even if Countrywide “got lucky” on these loans and some are still performing, the fact that nobody checked the borrower’s characteristics or ignored red flags means that those loans are more likely to default sometime in the future.
MBIA is essentially drawing from a stacked deck and will be forced to pay insurance claims based on how many black cards it draws going forward. This certainly constitutes a material and adverse impact on the loans, notwithstanding whether or not it has actually resulted in a loss. In other words, this argument conflates actual loss with actual adverse impact, and thus it is Countrywide, not MBIA, that is seeking to change the plain meaning of the pooling and servicing agreements.
Moreover, as MBIA is quick to point out, it is a familiar understanding of materiality in the insurance context that a misrepresentation that decreases the insurer’s willingness to insure the risk, or insure the risk at a particular price, constitutes a material misrepresentation. Insurers, in other words, are entitled to know the nature of the risks they are assuming, and may avoid a policy based on a misrepresentation as to a risk, even if that particular risk does not materialize.
In further support of its “plain language” argument, Countrywide states that the First Department of the New York State Appellate Courts has already rejected MBIA’s risk profile argument in an appeal related to this very case. (Opp. at 21) If true, this would certainly be an important fact, but alas, it’s yet another creative presentation of the truth by Countrywide’s attorneys. You see, what the First Department actually did was affirm the lower court’s denial of Countrywide’s motion to dismiss MBIA’s fraud claim. Countrywide had argued that the housing downturn was an intervening cause of MBIA’s loss, and thus MBIA could not as a matter of law make out its fraud claim, which requires a showing that its losses were caused by Countrywide’s fraud. The appellate court simply held that it could not establish as a matter of law that the housing downturn was an intervening cause – that this would be a factual determination for the trial court. How this translates into support for Countrywide’s argument that the contract language requires that actionable breaches must actually cause loan defaults is beyond me.
Finally, Countrywide adopts the familiar contract dispute refrain that adopting MBIA’s interpretation would render certain contract language “meaningless.” (Opp. at 22) The argument goes that a breach that adversely impacts the loan’s risk profile is nothing more than a “material breach,” thus rendering the language “adversely impacts” meaningless. Yet, if the language simply stated a “material breach,” it could refer to a breach that was material to any number of participants or factors, such as material to the originator’s ability to sell the loan, the issuer’s ability to securitize the loan, or the servicer’s ability to service or modify the loan. Instead, the language specifies that the breach must materially adversely affect the investor’s or the bond insurer’s interest in the loan. The language thus specifies that the breach must impact the risk that the loan will not be repaid. Thus, MBIA’s interpretation gives meaning to the entire clause, and would not render any language in that clause meaningless.
Countrywide goes on to cite a number of cases that employ a “materially adversely impacts” standard to the breach of a rep and warranty. None of these holds that a breach that causes a loan default is required to satisfy this standard. For example, Countrywide cites LaSalle Bank, N.A. v. Citicorp, 2002 WL 181703, at *3 (S.D.N.Y.) for the proposition that “a plaintiff states a claim for breach of a repurchase agreement when it has alleged a causal link between the breach of a representation and warranty and the defaulted loan.” (Opp. at 23) Essentially, that case said that if a breach causes a default, it constitutes a material adverse effect. It did not say that a default was the only material adverse effect that would qualify. Instead, just one paragraph later, when addressing a separate breach of reps and warranties, the court in LaSalle held that:
a determination of materiality is a fact-intensive matter. These factual issues relate to whether the breach was material and whether any breach had a material adverse effect on the value of the mortgage loan. (Id. (emphasis added))
Need I go on? At this point, I feel like I’m just piling on. Suffice it to say that none of Countrywide’s cases hold that a default is the only permissible evidence of a material adverse impact. It’s not that Countrywide’s attorneys are doing anything wrong by making these arguments – it’s just that they have been asked by their clients to defend a position that is not supported by the documents or the law. In fact, the best thing that Countrywide has going for it is that there is very little case law directly on point. The best case that MBIA can offer is Wells Fargo Bank v. LaSalle National Association, 08-CV-1125, a case governed by Oklahoma law, rather than New York law. This does not mean that Judge Bransten will be unable to interpret the plain meaning of the governing contracts – this is something that judges do quite often and with competence, even when the case law is unsettled.
MBIA’s Loss Causation Counterarguments
At the end of the day, MBIA’s best argument – other than the plain language argument – is that other provisions of the contracts provide expressly for the repurchase of performing loans. Though they could have done a better job of hammering this point home in their briefs, MBIA’s attorneys made the argument a central point during the hearing before Judge Bransten, which is worth quoting at length:
So the important point here is [Section 2.10 of the Sales and Servicing Agreement] says that with respect to any mortgage loan that is not in default, so it is performing, no repurchase pursuant to Sections 2.02, 2.03 and 2.04 shall be made unless you get that tax agreement. Now, Section 2.04, which you’ve also just been shown, is the law that contains the material and adverse language. What 2.04 says, in order to have a breach of this section, this section is not breached unless there is a showing of material and adverse affect.
So if you put these two clauses together, by referring to 2.04 and 2.10, what they are saying is that… you can put-back a performing loan that is in breach of 2.04 if you get this tax opinion, and in order to put-back the performing loan under 2.04, you have to show that it had a material and adverse affect.
When you put those two things together, your Honor, you have to come to the conclusion that what this contract necessarily says is that material and adverse is measured at the time that the transaction occurred. It cannot be measured based on whether a loan defaulted or not because, of course, performing loans which you can put-back and which could have a material and adverse affect, performing loans are never defaulted, and therefore the contract cannot as a matter of logic mean what Countrywide says it means. (October 5, 2011 Transcript at 40:7-41:6)
What MBIA also has going for it is the logical appeal of its interpretation. As illustrated by the stacked deck and the faulty brake hypotheticals, it can’t be the case that Countrywide could engage in the shoddiest underwriting in history, but get away with it if the loan still somehow performed. There are plenty of examples in the law of scenarios in which parties are found liable for dangerous, illegal, or improper conduct pursuant to a contract, even if such conduct does not result in direct harm (think about attempted robbery, possession of a machine gun or driving under the influence, to name a few).
I could go on, but I think Philippe Selendy, MBIA’s lead attorney from Quinn Emanuel, said it as well as anyone, so I will just end this section with a quote from his oral argument before Judge Bransten:
The housing crisis does not give Countrywide a defense to its Day One misconduct and its misconduct leading into these transactions. There would be no insurance policies and no losses but for that fraud… When you think about it, what Countrywide is trying to do here, having first caused the housing crisis, together with other reckless loan originators and underwriters, they want to turn around and profit from it again. They want you to rule that the crisis is in effect a Get Out of Jail Free card that allows them to escape liability for their fraud and shift the costs to innocent parties. Well, luckily we’re in a country governed by the rule of law, and the law doesn’t work that way. (October 5, 2011 Transcript at 35:4-25)
Loss Causation Fallout
I don’t mean to belabor the point here, but I want to make it crystal clear what a bad position BofA has backed itself into. For years, it has been telling its shareholders and regulators that its exposure to private label putback liability will be circumscribed, based in large part on this loss causation argument. Take CFO Chuck Noski’s statement on BofA’s earnings call back in Q3 2010:
We believe many of the losses observed in these [private label] deals have been, and continue to be, driven by external factors, like the substantial depreciation in [home] prices, persistently high unemployment and other economic trends, diminishing the likelihood that any loan defect should one exist at all, was the cause of the loan’s default.
Or take the statement of Bank of New York’s “independent expert” in substantiating the $8.5 billion settlement amount for Countrywide putback claims in part with the finding (which Countrywide cites in its Opposition, in a classic lesson in bootstrapping) that, “based solely on general contract principles, and taking the language of the provision at face value, it appears to be a reasonable position that a determination of whether a breach materially and adversely affects the interests of Certificateholders should turn on the harm caused by the breach.”
Now, we all know that there are no guarantees in litigation, and there is always some chance that BofA will will this motion (or at least Judge Bransten will find that there is a genuine issue as to whether BofA’s post-closing defenses are relevant). Indeed, if BofA’s permitted to put forth these defenses in MBIA v. Countrywide and in other cases across the country, it could be an enormous boon for originating banks. Suddenly, it would open the case up to arguments of intervening causes – that it wasn’t our shoddy underwriting at issue but the global credit crisis, the collapse of the housing market, the soaring unemployment rates and a whole host of other factors that caused these loans to go into default. It would also place the burden on MBS plaintiffs to prove not only a breach of reps and warranties but that such breach was the actual and proximate reason that the borrower stopped making his or her mortgage payments. You don’t have to be a lawyer to understand what a monumental task that would be in cases like MBIA v. Countrywide, where hundreds of thousands of loans are potentially at issue.
On the other hand, if BofA loses this motion, it could cause a hugely detrimental chain reaction. Proving that a breach simply made the loan riskier is not all that difficult. Most reps and warranties are designed to control the risk of the loans, and plenty of extrinsic evidence is available to show that breaches of these reps result in a decrease of the price that purchasers were willing to pay for the loans.
In fact, back in August, San Francisco hedge fund Branch Hill Capital estimated that a loss on this materiality interpretation could cost Bank of America as much as $9 billion. And that estimate was made before bondholders managed to move the settlement with Bank of New York to federal court, where Judge Pauley will have far more freedom to evaluate the settlement number and methodology proffered by Bank of New York than Judge Kapnick would have had in state court under Article 77. If Pauley has an opinion from Judge Bransten before him holding that the housing downturn is not a valid defense to putback claims, it could undermine that entire settlement.
So you can see why BofA might have wanted to settle this case before such a potentially devastating decision could be rendered. But with a decision expected to be handed down by Judge Bransten any day now, the window of opportunity for Bank of America to side step this potential train wreck is rapidly closing. I would imagine that BofA’s attorneys can hear that train whistle blowing as we speak.
[Many thanks to The Subprime Shakeout’s new intern, India Autry, for her meaningful contributions to this article – IMG]