One of the straightest paths this country could take toward Bank Bailout 2, the Sequel, would be through forcing financial institutions to buy back the lousy mortgage-backed securities they sold before the meltdown. Large-scale buybacks could open gaping wounds on bank balance sheets, a risk Bank of America (BAC) is particularly vulnerable to because it swallowed Countrywide's gigantic -- and now infamously fraudulent -- mortgage machine. Regardless of that risk, banks should have to follow the rules of their contracts, and the law. But getting BofA to buy back its mortgage junk won't be easy.
As of June 30, 2010, BofA faced some $11 billion in requests for repurchase of such securities. Most of those requests came from government-sponsored entities such as Fannie Mae, from bond insurers, and from major investors. Less than a third of a percent -- $33 million -- were from so called "private label" buyers.
But those securities-holders are now beginning to make their demands, too. Investors in more than $1 billion of securities backed by 2006 vintage Countrywide mortgages have filed an unusual lawsuit to try to get many of those mortgages repurchased. That case, filed Wednesday in New York state court, is Walnut Place LLC v. Countrywide Home Loans Inc, and is one of the first investor putback efforts. Unsurprisingly, Bank of America told Reuters the suit was "meritless."
Investors Act Because Trustee Won't
Beyond the fact that the suit is one of the first investor attempts to force a large quantity of putbacks, it's unusual because the investors shouldn't have had to file it -- for two reasons. First, if the claims in the complaint are true, BofA is contractually required to buy back the mortgages. But also, Bank of New York Mellon, which is the trustee for the securities, is supposed to do the suing on the investors' behalf. BNYM's duty is to ensure the right mortgages are backing the securities. But it hasn't, so the investors have filed suit against BNYM as well as BofA, seeking to stand in BNYM's shoes and force the buy back.
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BNYM spokesman Kevin Heine had no comment on the suit, but if the allegations in the complaint are true, it's hard to see what grounds BNYM has to refuse to sue. Interestingly, the key allegations in this suit are unlikely to be the ones related to the mortgages, because the evidence that Countrywide loans generally weren't of the promised quality has already been shown to be quite strong.
No, the key will be demonstrating that the litigating investors had in fact crossed all the t's and dotted all the i's necessary to get the trustee to act. Unsurprisingly, plaintiffs attorney Leanne Wilson believes all procedural hurdles have been crossed, and that their case is strong. So I'm betting any explanation about why BNYM's not suing will key off of one of those procedural requirements. Either that, or BNYM will get off the couch and sue.
Trustees are generally loathe to act, because taking the wrong action could leave them open to suits from other investors. That said, it's hard to see why any investor would object to forcing BofA to buy back Countrywide's garbage mortgages. And it's not as if BNYM's taken no action requested by the investors. After the investors gave their evidence of contract violations to BNYM, the bank did ask BofA to buy the mortgages back. It was only when the issue reached the stage where it became clear that BofA would have to be compelled to honor the contract that BNYM balked.
Loans Weren't What Countrywide Claimed
As to the mortgages, all the loans in the $2.8 billion issuance were pay-option adjustable-rate mortgages, a type of loan that's performing particularly poorly. Option ARMs are notoriously shaky, because the pay-what-you-want feature meant most borrowers paid so little they didn't even cover the interest due, much less the principal, which meant that every month their loan debt grew instead of shrank. Worse, the borrowers faced payment resets that would suddenly jack up their payments.
Of course, if Countrywide had complied with the terms of its contracts with investors, lousy performance wouldn't give the investors the right to sue. But as the SEC and multiple state attorneys general suits discovered, Countrywide routinely violated its official underwriting standards, and the investors' research indicates that this securitization was classic Countrywide in that regard.
The investors investigated about a third of the 6,500 mortgages backing the securities, and found that two-thirds of them appear to violate the contracts. The violations include mortgages that didn't meet Countrywide's official underwriting standards -- no surprise there -- and mortgages that were supposed to be on primary residences but weren't. The investors have evidence suggesting that the remaining, as yet unreviewed, mortgages would also have a high rate of problems.
BoA's potential liability depends on how many mortgages violate the securities contracts, as every put back is priced at the outstanding principal on the mortgage at that time, plus any unpaid but due interest. Wilson had no estimate of the stakes at this time.
The most common way Countrywide allegedly violated its contracts was by selling into securities mortgages in cases when borrowers had less than 5% equity in their houses. Borrowers with little equity are at especially high risk of default. The suit also alleges Countrywide relied on inflated appraisals and made loans that it knew wouldn't be repaid, as evidenced in part by loans that defaulted within the first few months of the mortgage.
One Suit Among Many
The plaintiff's firm in this case, Grais & Ellsworth, has filed many other mortgage-backed securities cases. Its clients include the federal home loan banks of San Francisco and Seattle, and Charles Schwab. The defendants include essentially all the big banks: BofA/Merrill Lynch/Countrywide, JPMorgan Chase/Bear Stearns, UBS, Credit Suisse, Deutsche Bank, Morgan Stanley, and a handful of smaller institutions. Those cases also allege securitized mortgages were not what was promised, however they are slightly different.
The putback case is a breach of contract claim; either the mortgages violated the terms of the contract or they didn't, and the contract specifies the remedy: buyback. The others are state securities law challenges, and involve proving the securities' selling documents were materially misleading, investors relied on the bad information, and were harmed by it. Nonetheless the suits involve similar methods of identifying bad mortgages and make similar claims about the mortgages' quality. Not one of the other cases has advanced very far yet. Some procedural rulings have been made, but no motions to dismiss have been ruled on, much less has discovery started.
Crawling to Toward Resolution
The buyback suit too is a long way from won, and at this stage, it's hard to tell how it will ultimately play out. But no matter the result, these cases are painful reminders that the whole financial crisis is really a slow-motion disaster. Yes, we had our speedy crash, our flash-frozen markets and our period of government bailouts. But several years on, the true damage isn't yet known.
The mortgage-backed securities lawsuits and the risk they represent to the financial system continue to crawl toward a resolution. Likewise, the multiple aspects of the foreclosure mess are only incrementally being clarified.
For those who wonder how long will it be before we have a clear perspective on the damage wrought by Wall Street's recklessness and regulators' inaction, the only answer is Yogi Berra's: It ain't over till it's over.
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