I set out with this aim in my last blog post Handicapping Bank of America's Article 77 (Spoiler Alert: Who the Hell Knows?) , but I was surprised at the outset to see so many important, unresolved procedural questions (What is the Standard of Review by the Article 77 Court? Which Litigant has the Burden of Proof?). I felt I had to pause to explain how indeterminate the Article 77 hearing process appears to me, with just a few months until the hearing is scheduled to begin, before beginning to address the merits.
An analysis of the reasonableness as to valuation of the $8.5 billion settlement requires a review of the opinion provided by RRMS Advisors, led by Mr. Brian Lin (Lin Report), to BNYM (Trustee) at the time the Trustee approved the settlement (a copy of the Lin Report is available here), in light of the settlement valuation reports of experts retained by the Intervenors (the Intervenors Report prepared by Mr. Charles Cowan, available here) and BAC (the BAC Report prepared by Mr. Philip Burnaman, available here). Additional expert opinions relating to the powers of the Trustee and the reasonableness of the investigation conducted by the Trustee were also filed, but their review will await a future blog post.
It is easy to get lost in the statistical and securitization weeds contained in the Intervenors and BAC Reports, but this is not the level where one needs to look for a meaningful understanding of these reports. God or the devil, depending on your persuasion, is in the assumptions made in these reports. If the Article 77 hearing becomes simply a contest among valuation experts, then I would suggest that the reason why Justice Kapnick should prefer one expert over another lies with the validity of the assumptions made in these reports, particularly as to the proper representation and warranty (R&W) breach rate (R&W Breach Rate) and putback success rate (Success Rate).
In particular, the Success Rate (40%) adopted in the Lin Report (which was identical to the Success Rate proposed by the BAC Report, as opposed to the 50%-75% Success Rate proposed in the Intervenors Report), is improperly low, because it is premised upon an mbs damage causation theory that, after Judge Rakoff's recent opinion in Assured Guaranty v. Flagstar, is no longer good law in New York.
This has the effect of applying an improper 60% haircut to BAC's repurchase liability, which (together with using a depressed R&W Breach Rate) results in a $20 billion to $40 billion understatement. This potential upward restatement of BAC's repurchase liability only highlights the importance BAC should place on settling with MBIA before Justice Bransten issues an adverse successor liability opinion.
The total actual and projected losses of the 530 BAC trusts covered by the settlement was estimated to be $108 billion (out of a total aggregate unpaid loan pool size of approximately $200 billion). Of course, not all losses can be expected to occur only with respect to loans that contained a R&W breach, so one needs to apply an appropriate R&W Breach Rate as a haircut to this anticipated aggregate loss amount. Moreover, mbs originators such as BAC have been resisting repurchases of loan putbacks upon breach, on the theory that the originators' R&W breach did not cause the loss incurred. Based upon this causation theory (which, as discussed below, is no longer good New York law), a further haircut represented by the Success Rate was applied to substantially reduce the originators' repurchase liability. This Success Rate reduction (a 40% Success Rate implies a 60% reduction) is no longer appropriate.
Before addressing the Success Rate haircut, it is necessary to examine briefly the Lin Report, which the Trustee has testified in a deposition was the sole basis relied upon by the Trustee for analyzing the fairness of the settlement amount, apart from considerations of counterparty credit risk and litigation risk.
The Lin Report examined different assumptions with respect to R&W Breach Rate and Success Rate presented by BAC and the settling institutional investors ("Settling Investors"). The Settling Investors presented a R&W Breach Rate of 60%, based upon research performed with respect to alternative analogous mbs pools (Analogous Pools) that, like the 530 BAC trusts in question, were composed of non-conforming loans. These non-conforming loans are typically larger and riskier loans than those loans bought by Fannie Mae and Freddie Mac (GSEs); indeed, these non-conforming loans are ineligible for sale to the GSEs. The Settling Investors applied a Success Rate of 50-75% based upon the actual repurchases made by mbs originators with respect to these Analogous Pools.
On the other hand, BAC presented a R&W Breach Rate of 36% and a Success Rate of 40%, based upon BAC's experience with pools of conforming loans that it sold to the GSEs.
Owing mostly to their differing R&W Breach Rates and Success Rates, the Settling Investors proposed that investors in the 530 trusts had repurchase claims in the range of $27 billion to $52.6 billion, while BAC proposed a repurchase claim of $4 billion.
Without explanation apart from referring to RRMS's "industry knowledge", the Lin Report adopted BAC's R&W Breach Rate and Success Rate, with minor adjustment resulting in a repurchase claim of $8.8 billion to $11 billion. In other words, the decision as to which R&W Breach Rate and Success Rate to apply is a $20 billion to $40 billion decision.
With Jeremy Lin having decamped from the New York Knicks to the Houston Rockets, one may conclude that a proper definition of Linsanity now should refer to the Trustee's decision to entrust such a monetarily significant analysis, with $20 billion to $40 billion up for grabs, to RRMS Advisors. RRMS Advisors is a firm which (i) comprises only three professionals, none of whom have any apparent experience in repurchase liability analysis (Mr. Lin was an mbs trader), (ii) does not have any disclosed assignments or clients other than the Trustee in this settlement, (iii) after an internet search, reveals no publicized mandates to advise on transactions other than the settlement, and (iv) which operates out of a walkup office next door to a psychic's storefront.
Even inspecting the Lin Report creates additional doubt. For example, when explaining in the Lin Report why he chose BAC's R&W Breach Rate and Success Rate, Mr. Lin is unacceptably opaque. Mr. Lin states "Given the lack of meaningful public information regarding this data, I feel it would be reasonable to use BofA's percentages for both [breach and success] rates since they were based on the performance of a mortgage pool representing actual repurchase experience."
Mr. Lin made this selection notwithstanding that i) the mortgage loan pool representing "actual repurchase experience" contained exclusively conforming GSE mortgages, while the mortgage loan pools subject to the settlement were non-confirming, riskier mortgages, and ii) the Settling Investors presented data from Analogous Pools that contained exactly the kind of public information Mr. Lin was searching for with respect to non-conforming mortgages, and which displayed much higher R&W Breach Rates and Success Rates.
Hence, the new definition of Linsanity.
As you would expect, the Intervenors Report disputes the Lin Report's selection of BAC's rather than the Settling Investors' R&W Breach Rates and Success Rates (or an interpolated median between them). Mr. Cowan states "It was not scientifically sound or reliable to attempt to estimate a settlement range in the manner attempted by Mr. Lin. If asked to do so, and restricted to the information Mr. Lin was given, at a minimum, I would have designed a statistically valid analysis that used both data sets presented to me in an effort to approximate the best result possible under the restrictive circumstances. I believe this is the approach that would have been taken under similar circumstances by a reasonable and qualified expert experienced in quantification of repurchase liability." Using this statistically valid analysis, Mr. Cowan estimated the repurchase liability would be $56 billion, before any haircuts for counterparty credit risk or litigation risk.
Mr. Cowan explains that this would not have been the preferred methodology under all instances, but simply the only acceptable methodology under the investigation and knowledge constraints imposed upon Mr. Lin, that of being restricted to the consideration of two sets of differing data, without recourse to actually inspecting the actual loan files or re-underwriting the loans contained in the mortgage pools. "To be clear, I reach my conclusion using only the limited information Mr. Lin had available to him. It is not my conclusion that such an exercise would represent an accurate estimate of the actual repurchase liability, only that had Mr. Lin pursued a scientifically sound approach to reconciling the two sets of data available to him, he would have calculated a repurchase liability in line with the results of my analysis."
Mr. Cowan emphasizes that if one is really seeking to know what the actual repurchase liability of BAC is, there is no substitute for performing a re-underwriting of the loans in a statistically significant sample of the mortgage pools: "If I were provided with loan files necessary to conduct a statistically valid sample of loans for the Covered Trusts, I could accurately determine the total repurchase liability...The question can be answered definitively by engaging in the appropriate re-underwriting analysis, which would have revealed the total repurchase liability....An analysis across the 530 trusts, but not for the trusts individually, could have been performed using a valid statistical sampling of 4,630-6,470 loan files...at an approximate cost of $200 to $300 per loan file."
This is a crucial point. Basically, Mr. Cowan in the Intervenors Report claims that anything short of a re-underwriting of a statistically significant sample of mortgage loans is simply a false endeavor at data manipulation, whether done in a scientifically supportable way suggested by Mr. Cowan or in an unscientific way performed by Mr. Lin. With a $20 billion to $40 billion variance at stake, how can the Article 77 court purport to arrive at a supportable result without availing itself of the facts that are readily at its disposable...the actual mortgage files in the mortgage pools that may be sampled and re-underwritten to determine an actual R&W Breach Rate. At the end of the day, isn't the Trustee's re-underwriting of the actual mortgage loans in question the only reasonable method to arrive at a valid R&W Breach Rate, after the Trustee is presented data sets from alternative mortgage pools which produce such massively divergent results?
The relevant analogy is if you went to a doctor for a check up, and instead of conducting a physical exam on you, the actual patient, the doctor looked on the internet for illnesses that you might have, based upon your age and gender. The doctor can either look at the person in front of him, or at data relating to other comparable people. Which process makes the most sense?
While Mr. Cowan points to the method to determine BAC's actual repurchase liability, Mr. Burnaman in the BAC Report argues that the settlement price negotiation process has the effect of disarming this conflcit between methodologies. Mr. Burnaman states "The record reveals that BANA, the Institutional Investors, each using their own proprietary modeling assumptions, and BNYM—which had the benefit of these competing reasonable views—entered into a protracted, arms-length negotiation, and ultimately agreed on a compensatory payment. In my opinion, this lends credence to the conclusion that the Settlement Amount was reasonable."
This assumes, of course, that it is appropriate for the Trustee to take a constrained view of its fiduciary duty to mbs investors other than the Settling Investors, by not undertaking an independent review of the settlement, under circumstances where an independent review might be especially prudent given that BAC is (i) paying the fee of Gibbs & Bruns, counsel for the Settling Investors, in an amount of $85 million, but only if the settlement is consummated, and (ii) indemnifying the Trustee against any liability incurred in connection with the settlement.
(The whole question of BAC's indemnifying the Trustee is worthy of a separate post. It is common for an issuer to indemnify a trustee in connection with the administration of a trust. However, once an event of default has occurred, the issuer and trustee become adverse parties, the trustee's fiduciary duty and duty of loyalty to trust beneficiaries is heightened, and it is highly questionable for a trustee, such as BNYM in the facts of the settlement, to confirm on two separate occasions that BAC, its adversary in a contested matter, is extending its indemnification of the trustee to events occurring after the event of default).
But the most troubling aspect of the BAC Report is that its 40% Success Rate (again, adopted whole cloth in the Lin Report) is based upon a discredited theory of causation, that was thought to require a showing that the mbs holder's loss was caused by the R&W breach (instead of some other event, such as the financial crisis or the borrower's "life event"). As Mr. Burnaham states, "In my experience, successful claims for a breach of representations and warranties were generally expected to arise from an underwriting defect that had a material and adverse effect on the performance of the loan."
This theory of damage causation is not good law in the State of New York. After Assured Guaranty v Flagstar, all that has to be shown for a mbs holder to recover damages for a R&W breach is that the breach materially and adversely affected the mbs holder's risk of loss. See my blog post, Rakoff Makes Clear What Materiality and Risk of Loss Means, with respect to the demise of mbs damage causation in New York. In the BAC Report, Mr. Burnaman acknowledges that "I am not aware of any significant rulings or disputes on this issue [of mbs damage causation] prior to 2009, and understand that it is now the center of much debate and legal interpretation." That's something of an understatement, Mr. Burnaman.
Incredibly, Mr. Burnaman fails to analyze the valuation work performed by RRMS Advisors at all in the BAC Report (at least in the unredacted portion). This is remarkable because the BAC Report is intended to support the repurchase liability valuation analysis that was contained in the Lin Report, which was the sole basis relating to settlement valuation upon which the Trustee agreed to the settlement amount.
So, one wonders what Justice Kapnick is to think about a settlement approval process in which the (i) actual R&W Breach Rate for the mortgage pools in question can be ascertained, but instead she is asked to approve the Trustee's selection of a low R&W Breach Rate derived from a non-analogous GSE pool, and (ii) Success Rate selected by the Trustee is based upon an improper interpretation of New York law relating to mbs damage causation.
Now, perhaps, you might sense that the answers to my questions regarding Article 77 procedure (What is the Standard of Review by the Article 77 Court? Which Litigant has the Burden of Proof?) may assume headline importance in presaging how Justice Kapnick will decide this case.
As the focus of this blog is to comment on litigation between MBIA and BAC, it is important to place the foregoing analysis of the Article 77 filings in the context of Justice Bransten's decision, expected to be rendered before the Article 77 hearing commences, on motion for summary judgment with respect to BAC's successor liability for Countrywide's legacy liabilities.
In a way, any lack of BAC successor liability acts as a "magic eraser" for BAC at the end of all of these analyses and calculations of repurchase liability, for even if the legacy Countrywide was found to have a repurchase liability of $40 billion, there is no way Countrywide can pay any more than a pittance of this liability. When viewed under this harsh reality, the $8.5 billion settlement can be argued by BAC to be generous. The only way the mbs holders can satisfy their judgment is to assert that BAC, the parent company, has successor liability for Countrywide's obligations.
When negotiating with a counterparty such as BAC which wields a magic eraser, it may be understandable for the Settling Investors to settle for what one can. But where does this leave BAC if Justice Bransten confiscates BAC's magic eraser? Isn't settling with MBIA before the issuance of an adverse decision on successor liability the only rational course of action for BAC?
A final thought. What if someone points out to you that the settlement should be approved because it was negotiated at a time when there was doubt with respect to causation under New York law, even though the settlement agreement makes clear that its provisions shall be unenforceable unless and until the settlement agreement is approved in the Article 77 hearing? The argument advanced is that it remains reasonable for the settlement agreement to be approved by a court, notwithstanding that the settlement agreement is contingent and unenforceable until approved by the court, and such court approval is at a time when an important legal underpinning to the settlement is no longer valid, if the committing to the settlement occurred prior to the demise of the legal underpinning.
Then, your reaction might be similar to that of Mr. Bumble in Oliver Twist. When Mr. Bumble, the unhappy spouse of a domineering wife, is told in court that "...the law supposes that your wife acts under your direction", replies:
"If the law supposes that," said Mr. Bumble, squeezing his hat emphatically in both hands, "the law is an ass..."
NB: this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice. Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.
Disclosure: long MBI. Follow me on twitter.