Monday, February 11, 2013

Sole Remedy v. Rescissionary Damages

In a little noticed decision by the 1st Appellate Division involving MBIA v Credit Suisse, the appeals court unanimously held that a waiver of jury trial contained in a mbs transaction document was not applicable where MBIA was alleging that there was fraud in the inducement to enter into the transaction document.  See 1st-Appellate-Division-Order.  This decision has important implications for the ability of MBIA to prove damages in its other actions against Bank of America (BAC) as well as other mbs originators.

As I discuss below, if MBIA can obtain rescissionary damages from BAC because the insurance contract is voidable due to BAC's breaches that induced MBIA to enter into the insurance contract, then all of the provisions in the insurance contract that might limit MBIA's recovery may similarly be avoided.  The most important such limitation, providing that the monoline's "sole recovery" for breach is to put back defective loans for repurchase, has the potential to limit a monoline's recovery in a way that rescissionary damages does not.  Even if the mbs originator's liability for breach is proven, a monoline will want to maximize its damage recovery by claiming rescissionary damages rather than damages for breach of a putback obligation.

For example, take the recently issued opinion by Judge Rakoff in the case of Assured Guaranty v. Flagstar.  When Judge Rakoff found that Flagstar had breached its transaction document representations and warranties (R&W) made to Assured Guaranty, Judge Rakoff analyzed damages payable by Flagstar in terms of the documents' provision that Assured Guaranty's "sole remedy" was to put back defective mortgage loans to Flagstar for repurchase.  When Judge Rakoff found further that Flagstar breached its repurchase obligation, Judge Rakoff then went into a "what if" analysis to determine whether Assured Guaranty would have incurred losses even if Flagstar had honored its repurchased obligation.

This "what if" analysis gave Flagstar a second bite of the apple, to show that even if it had repurchased all of the defective loans in the trust pools that Assured had guaranteed, Assured had no damages arising from Flagstar's breach because Assured would have incurred insurance losses in any event.  This might happen, for example, because there was insufficient credit support created by the securitization structure.  This is a causation argument made by mbs originators applied to the monolines' damages claim as opposed to their liability claim.

In the event, Judge Rakoff found that based upon Assured Guaranty's expert evidence as to the hypothetical outcome of the trusts' payment waterfalls where there was no putback breach, Assured Guaranty would have suffered no losses.  This proved that Flagstar's failure to honor its repurchase obligation, in fact, resulted in Assured Guaranty's losses, thereby entitling Assured Guaranty to the award of its damage claims almost in their entirety.

MBIA is pursuing put back claims against BAC and its other mbs defendants, similar to Assured Guaranty, and will have to prove its damage claim under this theory of the case in a similar manner.  If, for example, MBIA can't prove that it would have avoided losses if BAC repurchased all defective loans, then MBIA might be able to win on liability but lose on damages.

But importantly, MBIA is also seeking rescissionary damages for breach of insurance agreement.  Because the truth of BAC's R&Ws was a condition precedent to MBIA's entering into the insurance agreement, and NY insurance law provides that an insurer is entitled to void an insurance contract where the insured has misrepresented facts at the time the contract is entered into (see MBIA's primary liability claim), MBIA is seeking to be placed in the same position it would have been had it known the true state of affairs with respect to BAC's mortgage loan pools and, therefore, it declined to insure the pools.

Justice Bransten has already ruled in a preliminary motion that MBIA is entitled to rescissionary damages if it can show that it would not have insured the pools had it been aware of BAC's R&W breaches. BAC has appealed this decision.  An issue raised on appeal is whether MBIA is barred from receiving rescissionary damages from BAC where it will not rescind its insurance contracts.  MBIA will not rescind because of the resulting inequity to faultless insured noteholders.  BAC argues also that MBIA cannot rescind where MBIA has continued to receive insurance premiums.  There is NY insurance caselaw to the effect that an insurer cannot deny recovery for misrepresentation by the insured where the insurer becomes aware of the misrepresentation but continues to maintain the policy and collect premiums.

MBIA is arguing on appeal with respect to this argument that one must distinguish its right to rescind its insurance agreement (one form of recovery), which MBIA is not pursuing because its insurance contract is unconditional, from its right to receive rescissionary damages from BAC (a different from of recovery).  By obtaining rescissionary damages, MBIA is seeking to be put in the position it would have been in if MBIA had been aware of BAC's misrepresentations and declined to insure, without resulting in the harm to faultless noteholders that would result from rescission.  See MBIA's appellate brief.  The NY insurance law regarding continued receipt of premiums is inapposite where, as MBIA argues, rescission is impracticable (inequitable to faultless noteholders to void insurance).

But another BAC argument on appeal is that where the insurance agreement stipulates that MBIA has a "sole remedy" for breach of R&W, MBIA cannot go outside that contractual limitation to obtain an alternative remedy.  This argument is really identical to the argument that was before the 1st Appellate Division, that a contractual bar to jury trial cannot be circumvented by the claim that the contract is voidable in the first instance.

We know now what the 1st Appellate Division thinks of that argument.

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.

Wednesday, February 6, 2013

Rakoff Makes Clear What Materiality and Risk of Loss Means

Tonight, Judge Rakoff issued the first opinion ever after trial, holding an mbs originator liable for breach of representations and warranties (R&W) made to a monoline insurer, in Assured Guaranty v. Flagstar.  See Rakoff-Trial-Opinion.  This is a significant holding for at least two reasons.

First, Judge Rakoff commands respect not only from the legal community as a whole, but also from the community of judges that have similar monoline R&W cases before them.  Judge Rakoff is not only the smartest guy in the room after you and I have walked in, he is the smartest guy in the room after those judges have walked in...and they know it.

But more importantly, second, Judge Rakoff soundly put to rest the main argument that mbs originators have presented to counter the monoline insurers' claim that the mbs originators' breach of R&Ws materially and adversely affected the monoline insurers' risk of loss (which is the key determination to be made under the transaction documents).

For example, in MBIA's motion for summary judgment (SJ) against Bank of America (BAC) for primary liability, you will recall that  BAC's primary defense with respect to materiality was to introduce expert testimony from Dean of Columbia Business School Glenn Hubbard to the effect that loans bearing such breaches of R&Ws do not give rise to a higher incidence of actual incurred losses, when compared to a population of loans that do not contain such breaches.  In other words, how can a breach be material if it doesn't create additional incurred losses?

This is just a backhanded way for mbs originators to argue that their R&W breaches did not cause monoline losses, and this argument was soundly dispatched by Judge Rakoff as immaterial to whether the R&W breaches materially increased the monoline insurers' risk of loss.

Quoting from Judge Rakoff's opinion:

"Furthermore, Flagstar, while repeatedly attacking Ms. Walzak’s [Assured Guaranty's underwriting expert] methodology, was notably unable to show actual instances where the loan files themselves did not contain material breaches of the guidelines. Thus, even though Flagstar’s expert, Griggs, agreed with Walzak as to material deficiency on only three loans,[citation omitted], he was unable to illustrate his conclusions with respect to specific loan files in a manner that the Court found convincing; and for the most part he did not even try. Indeed, the filters Griggs employed – not reviewing the 484 loans that had paid in full or are still performing [Flagstar argued that no misrepresentation could be deemed "material" if the loan was still current] and the 43 “life event” loans [loans deemed by Flagstar's underwriting expert to have resulted in nonpayment because of subsequent adverse developments occurring with respect to the borrower, such as loss of employment etc, rather than from borrower misrepresentation made to obtain loan], and deeming immaterial any breach of the representations and warranties if the borrower made his or her payments for twelve months – meant that Griggs failed to challenge the vast majority of Walzak’s findings. Assured is free to prove the fact of Flagstar’s breach, if not its damages from that breach, by demonstrative pervasive, materially defective underwriting equally for performing, delinquent and defaulted loans, as the “cure or repurchase” remedy in the Transaction Documents is not limited to defaulted or delinquent loans. Thus, the 484 loans that went unreviewed [out of a total 800 loans that were underwritten in connection with the trial] based on their payment status remain relevant to the Court’s determination of material breach.

Moreover, given the Court’s prior ruling that “the causation that must here be shown is that the alleged breaches caused plaintiff to incur an increased risk of loss,” [citation omitted], it is irrelevant to the Court’s determination of material breach what Flagstar believes ultimately caused the loans to default, whether it is a life event or if the underwriting defects could be deemed “immaterial” based on twelve months of payment. Risk of loss can be realized or not; it is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach. Thus, the Court concludes that Walzak’s [Assured] findings were largely unrebutted by Griggs [Flagstar]."

The importance of this finding cannot be overstated:  "Risk of loss can be realized or not; it is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach."

Remember for purposes of defending against primary liability, BAC used precisely this line of argument to claim that BAC's R&W breaches were not material.  Judge Rakoff has supplied not only the intellectual support for Justice Bransten to rule against BAC in MBIA's motion for summary judgment on primary liability; Judge Rakoff may have supplied some judicial backbone as well.

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.

Monday, February 4, 2013

Triaxx Turns Up the Heat in the Article 77

I have posted that any calculation (both in terms of likelihood and amount) as to whether Bank of America (BAC) settles with MBIA  before Justice Bransten issues her successor liability summary judgment opinion involves not only an analysis of the legal merits (which I believe favor MBIA-see Why BAC Will Lose on Successor Liability), but also the adverse effect such a holding would have upon BAC's obtaining judicial approval of its $8.5 billion settlement in the ongoing Article 77 proceeding (see Bank of America Successor Liability, the Article 77 Case, and Settlement Game Theory).

Now, Triaxx, an objecting investor in the Article 77 proceeding, and three Federal Home Loan Banks (collectively, Triaxx) have just turned up the heat in the Article 77 proceeding.  See Triaxx-Turns-Up-the-Heat-in-the-Article-77-Proceeding

Triaxx points out in a letter to the Trustee, BNYM, filed with the court in the Article 77 hearing on February 1, 2013, that prior to its settlement with BAC, BAC modified loans held in the investor trusts having a principal amount in excess of $32 billion.  Importantly, these modified loans were governed by Pooling and Servicing Agreements which require the Master Servicer (BAC) to repurchase such modified loans from the trusts.  The Trustee released claims obligating BAC to make such purchases, apparently without investigation or negotiation by the Trustee on behalf of the trust investors.

Typical PSA language regarding the Master Servicer's obligation to repurchase modified loans is set forth below:

"Section 3.11(b) The Master Servicer may agree to a modification of any Mortgage Loan (the "Modified Mortgage Loan") if (i) the modification is in lieu of a refinancing and (ii) the Mortgage Rate on the Modified Mortgage Loan is approximately a prevailing market rate for newly-originated mortgage loans having similar terms and (iii) the Master Servicer purchases the Modified Mortgage Loan from the Trust Fund as described below."

Triaxx goes on the point out that with respect to many of these modified loans, BAC owned second mortgages that were subordinated to the modified loans.  Therefore, BAC had a conflict of interest with the trust investors when BAC reduced the principal amount and interest rate of the modified loans owned by the investor trusts, causing losses incurred by the investor trusts, but maintained BAC's second loans in unmodified form.  Triaxx alleges that this impermissible conflict of interest resulted in massive value transfers from the investor trusts to BAC as second mortgagee.

Until this Triaxx filing, the Article 77 hearing was thought to bear only upon whether the Trustee settled too cheaply with BAC with respect to losses incurred by the investor trusts (over $25 billion at the time the Trustee settled for $8.5 billion).  Now the stakes have been raised to include BAC's obligation to repurchase over $32 billion of modified loans.

Remember, the core reasoning supporting the Trustee's settlement at $8.5 billion was that the Trustee believed that BAC would not have successor liability for Countrywide's liabilities.  If Justice Bransten issues an adverse successor liability holding, that core reasoning will come under intense scrutiny, and BAC's potential exposure for Countrywide liabilities will only be further magnified based upon Triaxx's allegations.

Just another reason not to believe the BAC CFO when he stated on BAC's most recent earnings conference call that Article 77 hearing is "completely independent from what's going on at MBIA."

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.