Interesting article on the Banks vs MBIA litigation:
MBIA and BofA: Thoughts on Litigation
Yesterday, 18 banks sued MBIA (MBI), seeking to block its transformation. This was written up capably by the WSJ and Bloomberg, so rather than duplicate their efforts I am going to focus on one aspect of the storm of litigation around MBIA – the role of Bank of America (BAC).
BAC emerges as a cynical and arrogant participant in the legal process. After acquiring Merrill Lynch and Countrywide, both of which are being sued for fraud by MBIA, BAC conveniently ignores that fact while suing MBIA over the transformation.
Of course, the amounts BAC, the successor to Merrill Lynch and Countrywide, owes to MBIA for their fraudulent conduct are material to MBIA's Insurance Corp's claim paying resources, which are the issue in the transformation litigation.
Warranties and Representations Liability
In following remediation efforts by MBIA and Ambac (ABK), I have done some research into the accounting treatment of warranties and representations liabilities by companies that sell their mortgages via securitizations. The paperwork supporting the sale of mortgages uniformly includes warranties and representations of the seller as to the quality of the collateral. Any collateral that does not meet the requirements calls for repurchase or indemnification of the buyer.
If the resulting liabilities of the seller become material to their financial statements, they are sometimes disclosed, typically in a note about contingent liabilities. In some cases, dollar amounts are revealed – in others, that information seems to slip between the cracks.
BAC's Warranties and Representations Disclosure
From their latest 10-Q:
The Corporation sells loans with various representations and warranties related to, among other things, the ownership of the loan, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, the process used in selecting the loans for inclusion in a transaction, the loan’s compliance with any applicable loan criteria established by the buyer, and the loan’s compliance with applicable local, state and federal laws. Under the Corporation’s representations and warranties, the Corporation may be required to either repurchase the mortgage loans with the identified defects or indemnify the investor or insurer. In such cases, the Corporation bears any subsequent credit loss on the mortgage loans. During the three months ended March 31, 2009, the Corporation repurchased $360 million of loans from securitization trusts as a result of the Corporation’s representations and warranties. The Corporation’s representations and warranties are generally not subject to stated limits. However, the Corporation’s contractual liability arises only when the representations and warranties are breached. The Corporation attempts to limit its risk of incurring these losses by structuring its operations to ensure consistent production of quality mortgages and servicing those mortgages at levels that meet secondary mortgage market standards. In addition, certain of the Corporation’s securitizations include a corporate guarantee, which are contracts written to protect purchasers of the loans from credit losses up to a specified amount. The losses to be absorbed by the guarantees are recorded when the Corporation sells the loans with guarantees. The Corporation records its liability for representations and warranties, and corporate guarantees in accrued expenses and other liabilities and records the related expense through mortgage banking income. In addition to the repurchases as a result of representations and warranties, the Corporation repurchased $760 million of loans from the securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls during the three months ended March 31, 2009.
Checking the balance sheet under accrued expenses and other liabilities, the amount increased from 37 billion as of 12/31/08 to 126 billion as of 3/30/2009. What portion of the increase arose from warranties and representations is not revealed, but it is probably substantial, and may very well exceed the amounts MBIA is seeking in litigation, approximately 2 billion from all parties. Certainly the timing of the increase, coming in the wake of the acquisition of Merrill Lynch, is food for thought.
Merrill Lynch's Warranties and Representations Disclosure
From their final 10-K:
In connection with residential mortgage loan and other securitization transactions, Merrill Lynch typically makes representations and warranties about the underlying assets. If there is a material breach of such representations and warranties, Merrill Lynch may have an obligation to repurchase the assets or indemnify the purchaser against any loss. For residential mortgage loan and other securitizations, the maximum potential amount that could be required to be repurchased is the current outstanding asset balance. Specifically related to First Franklin activities, there is currently approximately $36 billion (including loans serviced by others) of outstanding loans that First Franklin sold in various asset sales and securitization transactions where management believes we may have an obligation to repurchase the asset or indemnify the purchaser against the loss if claims are made and it is ultimately determined that there has been a material breach related to such loans. Merrill Lynch has recognized a repurchase reserve liability of approximately $560 million at December 26, 2008 arising from these First Franklin residential mortgage sales and securitization transactions.
Merrill Lynch seems to have been of the opinion that their exposure to this type of thing was limited to First Franklin, a toxic acquisition they bought from National City (NCC). Certainly their view that only 560 million of 36 billion had any problems seems optimistic. On the other hand, perhaps the remaining 35.4 billion was all pure as the wind driven snow.
Countrywide's Warranties and Representations Disclosure
In their final 10-Q, for the 2nd quarter of 2008, Countrywide disclosed a liability of 755 million, a 929% increase year over year. It is not possible to ascertain whether that trend of growth continued after BAC took over.
A Simple Solution
My take on this is fairly simple – BAC should accept the fact: they are a predator that ate toxic prey that in turn had eaten toxic prey, the toxins get concentrated as the morsel moves up through the feeding chain. You remember the cartoon, the big fish eating the little fish eating the minnow – just include the toxins into the picture. If BAC wants to buy outfits that book millions of dollars of liabilities to account for their own dishonesty then they have to take the consequences.
So BAC should step up to the plate, pay MBIA what they owe, and then watch in wonder as MBIA's credit ratings are restored and the paper they have wrapped begins to trade at much higher valuations.
BAC's fellow litigants could select a representative, somebody who is tactful and personable: he could approach Ken Lewis along these lines: “Ken, we got some problems here, all this stuff we own is trading at very low prices because people got these questions about MBIA. Seems like the problems at MBIA are mostly bogus stuff you sold into bonds they wrapped, we know you know you done it because its on your books and it was on the books of them bush league outfits you bought and you gotta just pay what you owe and then go to USG for more money.”
Then an even more personable and tactful representative could be dispatched to talk to Geithner, he could say something along these lines: “Tim, we got some problems here, all this stuff we own is trading at very low prices because people got these questions about MBIA. Now we know that you have a pretty good line of communication with those guys that own GMAC which owns ResCap which stuck a lot of bogus stuff into bonds MBIA wrapped and we are all in this together and we wouldn't need any more handouts from you if you would just tell those guys to stand up to the plate and have ResCap honor them warranties and representations, then MBIA's credit rating would go up and the crap they wrap would trade higher and our capital would look better, plus you are going to have to give GMAC more money anyway so they can prop up Chrysler so what's another billion?”
Finally an extremely humble and engaging person could be dispatched to see Sheila Bair about Indy Mac. I will leave it to the reader's imagination to develop that emissary's presentation.
Then the litigants who oppose the transformation could just give it up. But it is more likely they will prefer to have their day in court: after all, once you give ground on the warranties and representations issue then you have opened Pandora's box.
Moral Fulminations
Several years ago Bill Ackman asked the question: “who's holding the bag?” Bill Gross felt this would play out along the lines of a game of Old Maid, somebody has to wind up holding the bad card, its a game of wits to avoid being the one. The answer is fairly simple, those who furnished ineligible collateral in connection with securitizations will have to repurchase it. The whole securitization chain featured dishonesty and fraud at every link: every transaction should be pushed back along the chain to the responsible party, if they are still available.
Implications for Investors
I personally would not involve myself in trading BAC stock, either long or short. MBI has huge upside potential in the event our legal system can still dispense justice in the face of the massed might of the financial oligopoly. I wouldn't bet the farm on it.
Disclosure: long MBI, no position ABK or BAC
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