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BofA v. MBIA and the Future of Private Label Securitization

posted by Adam Levitin

[Updated and corrected 11.15]

There's a fascinating and absolutely cut-throat fight going on between BofA and MBIA. There's been some good media coverage of how a litigation fight over MBS fraud has spilled over into a really nasty corporate finance battle. I think it shows yet another danger of too-big-to-fail firms:  they can adopt litigation tactics that others simply can't in order to avoid liability.  Put another way, the lesson I take from this fight is that if you get into bed with a too-big-to-fail firm on a business deal, don't expect the law to protect you if things go badly. Even if the law and the facts are on your side, that doesn't mean you can beat a too-big-to-fail firm in court. Contracting with a too-big-to-fail firm is not like contracting with a regular firm. It's more like contracting with a sovereign. If you put your head into the Leviathan's jaws, well, ask Siegfried & Roy how well that worked out...  

The rather long post below gives an overview of the litigation and corporate finance machinations, before a trio of bigger picture observations about inter-creditor duties, empty-creditors, and the private-label securitization market's denial of its lemons problem.  

OK, here's the story as I've pieced it together. You can get a lot of this from the press coverage, but I'm hoping that my presentation of the story, which has some surmises and fleshes out some points that aren't discussed in the media coverage, will be of interest to a legal audience.  For academics, I think this is a really neat case study for a corporate finance class.

During the bubble years MBIA insured lots of Countrywide MBS.  Not a good idea. MBIA has already paid out a lot of money on the policies, and there's a lot ($6B?) of liability left.  MBIA claims that it was duped into insuring the MBS:  it alleges material misrepresentations about the quality of the loans it was insuring. The insurance policies are irrevocable and MBIA is not trying to rescind coverage.  Instead, MBIA is suing Countrywide (BofA) for rescissory damages, meaning MBIA is looking for payment from BofA to put it in a position as if the policies had never been written. Essentially this means shifting the credit risk to BofA.  

MBIA's exposure on the MBS led to it being downgraded and unable to underwrite new municipal bonds because a poorly-rated insurer is hardly an attractive credit enhancement for a muni bond. MBIA's solution was to split its insurance business into two insurance companies:  a structured products insurer which retained the liability for the MBS and a municipal bond insurer with a common parent holding company. My impression is that these two units have an ultimate common parent, but are ring-fenced insurance companies; I do not think funds can be easily shifted from one unit to the other (and doing so would threaten the muni insurer's business). MBIA's regulator approved the move, but it's been challenged by BofA among others.  

It seems that BofA's basic strategy is to drag things out to force a settlement.  But this isn't just any delay strategy to increase the costs of litigation.  BofA seems determined to wait out MBIA's liquidity and threatens MBIA with collapse unless it settles. There are two parts to this strategy.

First is to litigate the spin-off of the muni bond unit. If MBIA isn't able to divide its muni bond business from its structured finance business, it will presumably be unable to write new business and go broke for lack of liquidity. Thus, threatening to unwind the division of the muni business from the structured finance business is a way of trying to force MBIA to settle the litigation over the Countrywide MBS on the cheap.

The second part of the strategy is to drag out the litigation for a long time, which has been draining MBIA's liquidity from the structured finance unit. If the structured finance unit runs too low on cash, it will end up in an insurance receivership. MBIA, however, isn't able to amputate this individual subsidary. There are cross-default clauses in the bonds issued by the parent holding company that would be triggered by a regulatory seizure of the structured finance unit.  So if the sub goes into receivership, there'd be an acceleration of the parent's debt and the parent would have a liquidity crisis that would probably result in the company's collapse.  

MBIA decided to make a consent solicitation on those bonds to try to free the parent from the cross-default clause risk:  MBIA is offering to pay 1% of the par value of the bonds in exchange for an amendment to the cross-default provision from a linkage to the structured products unti to a linkage to the municipal bond unit.  If MBIA could pull off the exchange offer, it would get some breathing room to continue its fight with BofA about the insurance on the Countrywide MBS.  

BofA is playing hardball, however.  BofA has launched a tender offer for the MBIA bonds, at 100% of par. I don't know where the bonds were trading previously, but I'd expect it would be less than par. If so, that's an offer that's going to be hard to resist.  I suspect BofA would actually be willing to pay more than par for the bonds, but in any case it, seems to show just how scared BofA is of going to trial with MBIA. If BofA is able to buy 50% +1 of the bonds, it will be able to block the amendment of the cross-default clause, which will also presumably cause the market value of the bonds themselves to drop. (N.B. I am assuming that nothing in the bond  indenture requires over 50%+1 for this type of amendment, but it's possible.) That will let BofA continue to put the squeeze of MBIA's liquidity.  

MBIA's stock has plunged in response to the BofA tender offer. I'm a bit confused by this since all that the tender offer will accomplish is to put MBIA in the liquidity position it had prior to its consent solicitation. It won't be in a worse position. I don't see a material change in MBIA's liquidity position (which doesn't seem to be an immediate issue) as a result of BofA's tender offer that would justify the stock sell-off. But maybe I've missed something.  

And the cherry on top?  There's speculation that BofA has taken out CDS protection on MBIA, so that not only will it avoid liability in the MBS litigation, but BofA might actually make some money if MBIA collapses.  Vicious stuff.  Financial law of the jungle.  

OK, now for some observations.

(1) What, if anything, can MBIA do to push back against BofA? Not clear to me. I don't think BofA owes any duty to MBIA or to MBIA's other bondholders currently, so I don't think the tender offer itself is a legal problem from a corporate law standpoint.  Once BofA becomes a bondholder, it is unlikely to be found to have duties vis-a-vis other bondholders, even though it is using its position to harm MBIA (and hence MBIA's other creditors, shareholders, and insureds) through litigation and the CDS.   But someone might think of a legal path for making such an argument. (Note how things might look different if this played out in bankruptcy...).  Maybe there's a contract or tort argument to be found--some sort of general unfair trade practice hook or perhaps tortious interference with contract. (Which contract? Take your pick--the muni bond insurance contracts, the other bondholders' contracts, etc.).  Maybe an enterprising attorney figures out how to pull a Joe Jamail on BofA. But I don't see an obvious legal parry here. Maybe others do. But it speaks to a potential problem in corporate law of inter-creditor relationships not being policed, even when they get really nasty.   

(2) This is an empty-creditor problem variant.  BofA is willing to pay perhaps 100x the market value of the bonds because overspending on the bonds may well save it a lot more money vis-a-vis its litigation interest with MBIA.  So BofA is willing to take a position that is way long on the bonds because it is really ultimately short on MBIA.  

This is a neat version of Black & Hu's empty-creditor problem.  Here we are able to see both BofA's long interest and its short interest.  But often we are only able to see half of the equation.  Imagine that this scenario were playing out in bankruptcy.  A hedge fund buys up a large position in the bankruptcy claims, and then pushes for liquidation, even though liquidation will result in less value for the hedge fund than a reorganization.  If it turns out that the hedge fund has another position on the debtor, say a bunch of total return swaps or an interest in the debtor's competitor--its short position outside of the bankruptcy might outweigh its creditor interest in the bankruptcy.  This is hardly new--we've seen this issue in Dish Network--but it's rare to see it tee'd up so starkly outside of bankruptcy.  

(3) Ending the Lemons Market.  The way this litigation is playing out is another indication of how poorly designed MBS were. MBS were designed with the assumption that everything worked out hunky-dory. These deals were not designed to deal with problems, be they borrower defaults or large scale non-compliance on underwriting. The monoline insurers like MBIA are actually in a better position than the MBS investors who have been generally screwed. 

A large part of the securitization industry still seems in deep denial that anything went wrong. Part of this is that the sell-side firms are completely implicated in causing the problems--they can't really admit them. Yes, there's some grudging admission that things didn't work out well, but there hasn't been acceptance that the industry is fundamentally tilted to protect the sell-side at the expense of the buy-side.  Deal design is really a function of the industry sell-side, but unless the sell-side is willing to redesign deals so that they provide credible protections for investors and insurers--the buy-side--I just don't see this market restarting beyond the rare Redwood deal. Maybe this speaks to the need for the buy-side to be much, much more involved in product design.  But the buy-side buys lots of things, not just MBS, so there's no reason to invest in MBS deal design.

Bottom line, the private-label residential mortgage securitization industry needs to recognize that it is a lemons market in a bunch of different dimensions:  underwriting, servicing, legal documentation, legal recourse. Lemons markets die. If this market is going to be resurrected--and I think it has social value and should be resurrected--it needs to really clean house and rebalance the interests of sellers and investors. 


What part of the analysis depends on BofA being too big to fail rather than just too big for MBIA to fight?

Fortunately, Uncle Sam has no need to concern itself with these pedestrian details about default risk or fraud, so the government buying spree of toxic MBS securities will continue unabated! Let the good times roll! Full speed ahead! Government mortgages for everybody!

You speak of a "lemon" problem with MBS.

The percentage of cars that are lemons -- that is, that have unintended manufacturing as opposed to design defects -- is at most a percentage point or two.

Here, the percentage of mortgages that failed underwriting standards was 60-80%.

Here, Countrywide employees passed around forms they could use to falsify borrowers' stated income.

Here, mortgages were often never even transferred into the ownership of the MBS trusts; the trusts often had legal title or recourse to nothing; the buyers of the MBS were often buying literally nothing.

Here, millions of assignments, notes, deeds were forged to cover up -- and are evidence of the banks' knowledge of -- the deficient or nonexistent chains of title and recourse.

Here, trustees of MBS trusts such as BoNY-Mellon have explicitly argued in court filings that they owed no fiduciary duty to the investors, the beneficiaries of the trusts. They argue -- contrary to hundreds of years of common law regarding the meaning of a trust and the role of a trustee -- that their duties to the beneificiaries were purely ministerial. Meanwhile, they seem to have a strong sense of duty toward the banks like BofA that bring them business.

In this context, the MBIA case is little more than one more instance where the federal judiciary and the regulatory/prosecutorial apparatus bend over backwards to protect a large bank and prevent an open and clear discussion about the fact that the MBS in question hold the record for the number of different frauds contained in the same security and are among the most fraudulent securities ever concocted.

And why is it so important that we avoid that discussion?

Because the federal Reserve has $1 trillion of those fraudulent MBS on its balance sheet as a backstop to the value of the US Dollar, securities that the Fed purchased in violation* of the Federal Reserve Act.

*The Fed's MBS purchases were and are illegal because MBS guaranteed by Fannie and Freddie are not federally-guaranteed. The US Treasury's support of Fannie and Freddie, which are private entities, only goes to the end of 2012 plus another $200 billion. MBS guaranteed by Fannie or Freddie are therefore not federally-guaranteed, not even close. At best, agency MBS maturing prior to, say, 2015 culd arguably be said to be somewhat guaranteed.

The Fed may only purchase securities that are guaranteed as to principal and interest by the United States. One could argue that the MBS purchased by the Fed at the height of the crisis in 2008 were puchased in a force majeure situation, but the subsequent purchases, now totaling about $1 trillion, were certainly purchased illegally in a plain violation of the Federal Reserve Act. These are facts that the Fed has effectively admitted in a footnote here and there but refuses to discuss -- and about which no one seems to ask...

Two partners in the "GSE Business Model" who businessman George Soros called "hoplessly conflicted".

Isn't what Mr. Lehrer described something like what a prosecutor would call a "theft by deception scheme", with the taxpayers as the funding source, albeit of a dimension that we have never seen before?

Knew or should have known. Too many patents describe the scheme, including how borrowers were targeted and how appraisals were secondary to credit scores and willingness to pay. It was all too obvious that borrowers were not vetted for the detonated interest rate hikes... And then there is LIBOR - MBIA didn't know the LIBOR rates were rigged...? C'mon.

The web site reports that Grover's "prior experience includes Visa International, GE Consumer Finance, Bank of America, NationsBank and Transamerica. Mr. Grover currently serves on the board of Nordstrom's credit card subsidiary." So Grover is part of the financial services industry

Jail time.

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