I assume the reader has some familiarity with RESCU, its litigation program and the nature of the investment opportunity, all of which is likely to leave the reader uncertain as to whether RESCU is an investment long or short.
Let me add to this uncertainty by posing the following two questions.
1. The Piggyback Argument. Is RESCU able to use the favorable provisions of the client guide to claim that a correspondent bank's breach of loan-level representations and warranties (R/Ws) constitutes a breach of a transaction-level R/W, thereby substantially increasing the dollar amount of claims that RESCU can assert against such correspondent bank?
2. The No-Haircut Argument. Is RESCU able to recover the full amount of damages it incurred with respect to R/W breaches from each correspondent bank without any haircut applied to such recovery resulting from the haircut that RESCU's creditors experienced in the RESCU bankruptcy (understanding that RESCU's overall recovery from all correspondent banks may not exceed the total amount of allowed claims confirmed in the bankruptcy)?
The Piggyback Argument and the No-Haircut Argument, if pursued successfully, would afford RESCU the opportunity to assert claims and recover damages in an aggregate amount well above what many investors currently contemplate to be available to RESCU.
As to the Piggyback Argument, you will recall that the client guide contains not only various R/Ws that the correspondent banks made to RESCU, but also contains the strong-arm provision that RESCU is authorized to (i) determine in RESCU's sole discretion whether any R/W has been breached, thereby resulting in an event of default, and (ii) disclaim any requirement on RESCU's part to conduct due diligence or exercise reasonable reliance with respect to the R/Ws. The validity of this strong-arm provision was upheld by the federal circuit court of appeals in the Terrace case (discussed in my prior blog post), with the court stating that it would enforce the client guide strong-arm provision in accordance with its terms, subject only to the proviso that RESCU must proceed in good faith when using this provision as a basis for any damage claim.
This court authorization to use the client guide strong-arm provision makes RESCU's litigation program very likely to be successfully conducted, with most of the defendant correspondent bank defenses limited to pre-trial motions that are not likely to prevail.
But I wonder if investors and, indeed, RESCU itself is underestimating the potential reach of the client guide strong-arm provision.
Let's first distinguish between the following two types of R/W breaches: loan-level R/Ws and transaction-level R/Ws. If a loan-level R/W is breached with respect to a loan, RESCU is entitled to recover damages incurred in connection with that non-conforming loan. If a correspondent bank sold RESCU $1 billion of loans and had a loss rate of $500 million and a loan-level R/W breach rate of 50%, recovery on loan-level R/W breaches would imply a potential recovery of $250 million (since only half of the loans that incurred a loss can be said to have also been subject to a loan-level R/W breach).
If a transaction-level R/W is breached with respect to a loan, that loan may be considered to give rise to a damage recovery even if the individual loan-level R/Ws made with respect to that loan have not been breached. Indeed, if a transaction-level R/W can be asserted to be breached with respect to all loans, then the defect rate in respect of that transaction-level R/W can be said to be 100%. So, in the above example, RESCU would be entitled to recovery of $500 million.
Now, there are many loan-level R/Ws contained in the client guide, with each such R/W made individually with respect to each mortgage loan. For example, (i) “For each Loan for which an appraisal is required or obtained under this Client Guide, the appraisal was made by an appraiser who meets the minimum qualifications for appraisers as specified in this Client Guide," and (ii) “There is no default, breach, violation or event of acceleration existing under any Note or Security Instrument transferred to [RESCU], and no event exists which, with notice and the expiration of any grace or cure period, would constitute a default, breach, violation or event of acceleration, and no such default, breach, violation or event of acceleration has been waived by Client or any other entity involved in originating or servicing the Loan.”
But there is also this transaction-level R/W contained in the client guide: “Client’s origination and servicing of the Loans have been legal, proper, prudent, and customary and have conformed to the highest standards of the residential mortgage origination and servicing business.”
So, if RESCU brings an action against a correspondent bank in its litigation program that had a high defect rate with respect to loan-level R/Ws, RESCU should be able to claim that, in addition to the losses RESCU incurred in connection with loans that breached loan-level R/Ws, it is entitled to recover for losses incurred in connection with all other loans bought from the correspondent bank, inasmuch as all loans were originated by that correspondent bank in a manner that did not conform to the highest standards of the residential mortgage origination and servicing business.
Now, you might ask, RESCU can allege breach of this transaction-level R/W, but will a court allow it to recover on this claim? Here is where the strong-arm provision of the client guide comes to play with its full force.
RESCU need not prove in court that a correspondent bank's high loan-level R/W breach rate constitutes a breach of the high origination standard transaction-level R/W. RESCU need only prove in court that it has made a determination that the correspondent bank's high loan-level R/W breach rate constitutes a breach of the high origination standard transaction-level R/W, and that RESCU made such determination in good faith.
The Terrace case requires a court to rule in RESCU's favor based upon a much lower standard of proof. The court must find that the correspondent bank breached its high origination standards transaction-level R/W, whether or not the court agrees that the correspondent bank's particular loan-level R/W breach rate is not consistent with high originations standards, provided only that the court finds RESCU made this determination in good faith.
This is the Piggyback Argument that the client guide authorizes RESCU to assert, and it is not clear to me at the current complaint-stage of the litigation program whether or not RESCU is going to make it. It seems to me that the Piggyback Argument may be worth more than a billion dollars in potential enhanced recovery for RESCU.
The No-Haircut Argument can be illustrated by the following example: total losses experienced by RESCU creditors was reduced in the RESCU bankruptcy from approximately $47 billion to approximately $12.2 billion of allowed claims. Now, while it is clear that RESCU can recover from correspondent banks only for losses arising from R/W breaches, I have tried to point out in my Piggyback Argument discussion that RESCU should be able to attribute losses to R/W breaches by invoking the strong-arm provisions of the client guide in an aggregate amount far in excess of what one might otherwise expect.
But assume for sake of the No-Haircut Argument that there was a 40% R/W breach rate in all of the mortgage pools that incurred the $47 billion of losses (this 40% rate is approximately the defect rate set forth in the Sillman Examination in the RESCU bankruptcy). In the RESCU bankruptcy, a further haircut of about 40% was also applied as a settlement factor, in order to reach a fair recovery expectation, as if RESCU's creditors had been able to proceed in litigation against a solvent RESCU.
This raises the following important questions to answer: do the defect rate and settlement rate haircuts imposed by the bankruptcy court on RESCU's creditors benefit the correspondent banks? Were the correspondent banks parties to the RESCU bankruptcy? Are the correspondent banks intended third-party beneficiaries of the RESCU bankruptcy? Did the confirmation plan in the RESCU bankruptcy contain any provision that, by its terms, applied any haircut to the losses that could be asserted by RESCU against the correspondent banks arising out of the sale of loans by the correspondent banks to RESCU (as opposed to claims that might by asserted by RESCU's creditors against RESCU in respect of losses arising out of subsequent securitizations)? If a correspondent bank sold loans to RESCU that incurred $1 billion of losses, assuming that RESCU can prove that all of these losses arise from R/W breaches under the strong-arm provisions of the client guide, is RESCU required by any provision of law to seek less than the entire $1 billion amount as a damage recovery?
It seems to be an article of faith among followers of RESCU that I have talked to that RESCU must haircut what it seeks in recovery from each correspondent bank simply because RESCU's creditors suffered a haircut in getting their claims against RESCU allowed in the RESCU confirmation plan in bankruptcy. Under this ideology (I dare not call it a thesis, since I would think a thesis requires an underlying principle or articulable rationale), each correspondent bank's "share" of RESCU losses must be ratcheted down from the actual loss amount to a lesser amount proportionate to the haircut suffered by RESCU's creditors.
I am not aware of any legal provision that would require this result. If one looks for an analogy to the common law, one notices that the law allows a tort victim to proceed for the full amount of its recovery against any single tortfeasor among multiple responsible tortfeasors, even if the full amount is in excess of that tortfeasor's proportionate responsibility for the tort victim's damages. The law permits the overpaying tortfeasor to proceed against the other tortfeasors for contribution, rather than requiring the tort victim to ratchet down its damage recovery to a proportionate amount against the first tortfeasor.
In terms of bankruptcy law, I am unaware of any provision which requires the bankruptcy debtor to limit its recovery, as a plaintiff in proceedings against defendants that caused the losses incurred by the debtor, in a manner that conforms to the recovery schema imposed upon the debtor's creditors. Indeed, one would think that in a post-bankruptcy collection proceeding, the shoe would be on the other foot, and bankruptcy law would seek to promote the debtor's ability to obtain full recovery in favor of the bankruptcy creditors (up to the aggregate amount of their allowed claims).
Put another way, the bankruptcy case benefits the debtor at the expense of the debtor's creditors, but I am not aware that it benefits firms, which were not parties to the bankruptcy, against which the debtor has a cause of action at the expense of the debtor.
Now, I will concede that RESCU would not be able to recover more than its full damage amount of $12.2 billion, because I do think that is the aggregate ceiling on the amount that the debtor can recover in respect of its $12.2 billion allowed claims that were confirmed in bankruptcy. But I don't know of any legal provision that would prevent RESCU from recovering this $12.2 billion maximum amount in whatever manner that RESCU is able to obtain recovery among the correspondent banks.
Put another way, it seems to me that each correspondent bank's "share" of the RESCU losses is post-bankruptcy the same as it was pre-bankruptcy, or 100% of the pre-bankruptcy losses arising from such correspondent bank's breaching loans (subject to an overall maximum recovery cap for the RESCU litigation program of $12.2 billion).
It seems to me that the No-Haircut Argument may also be worth more than a billion dollars in potential enhanced recovery for RESCU.
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.