Author Archives: David Reiss

Thrilla in Vanilla: Freddie v. Jumbo

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Kroll BondRatings issued an RMBS Commentary, Mortgage Credit Trends:  Freddie Mac vs. Prime Jumbo. This commentary is important because it offers some help in evaluating the proposed “risk sharing” securitizations that Fannie and Freddie are considering. It is also important because if compares plain vanilla agency issues with comparable private label jumbos as well as not-so-comparable limited doc jumbos.  The differences are revealing.

Kroll’s key findings are

  • Freddie Mac default and loss rates were much higher for vintages that experienced severe home price declines. The worst vintage was 2007, which experienced an estimated aggregate home price decline in excess of 18% with 12.3% of the original vintage balance liquidated to date.
  • A rapid and significant improvement in credit characteristics sharply curtailed Freddie Mac mortgage liquidation rates, which fell from 8.3% for the 2008 vintage to 0.9% for the 2009 vintage.
  • Current Freddie Mac originations continue to be of very high credit quality, with a weighted average (WA) FICO score of 767 and a WA loan-to-value ratio (LTV) of 70% for the 2012 vintage.
  • Credit performance of jumbo prime mortgages and Freddie Mac mortgages is highly comparable when controlling for characteristics such as FICO, LTV, balance, and income and asset documentation. (2)

I am most interested in the last finding. While Kroll controlled for many characteristics, the fact remained that Freddie, as a general rule, allows for fewer high risk characteristics like low doc loans and high CLTV [combined loan to value]. For instance, almost all of Freddie’s loans were full doc while about half of the private label loans were low doc. So, while Kroll appears to be correct in stating “that the credit analysis tools developed for analyzing jumbo prime loans can be productively applied to agency mortgages,” we should not take that to mean that the two products are effectively the same. (7)

 

State of the Nation’s Housing 2013: Build It and They Will Come

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The Joint Center for Housing Studies of Harvard University released The State of the Nation’s Housing 2013.  As always there is much of interest in this annual report. I was particularly intrigued by Figure 21 on page 20, “The Government Continues to Have an Outsized Footprint in the Mortgage Market.” The report states

Despite efforts to entice private capital into the mortgage market, the GSEs and FHA continue to back the vast majority of loans(Figure 21). In 2001, loans securitized into private-label securities or held in bank portfolios accounted for nearly half of loan originations. Their market share rose to about two-thirds at the height of the housing boom before retreating to the low single-digits. Beginning in 2009, government-backed loans have accounted for roughly 90 percent of all originations. While the private securities market was still moribund in 2012, portfolio lending by banks showed its first substantial increase in years (albeit to a modest level), bringing the government share down slightly. (20-21)

As Fannie and Freddie return to profitability, policymakers are acting as if only the government can provide credit to the residential mortgage market, but from Figure 21 we can see that over a relatively short time period, capital can meaningfully shift from the secondary market (private MBS) to the government (FHA, Fannie and Freddie) to the primary market (portfolio lenders). Instead of assuming that the present structure is the best of all possible worlds, we should design the system we want and incentivize capital to find it.

Build it and they will come.

BofA No Worm Ouroboros

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The Worm Ouroboros of myth was a gigantic serpent that encircled the earth only to bite its own tail. Judge Sweet (SDNY) has ruled that Bank of America is no modern-day Ouroboros that is so enormous that it must sue itself. In BNP Paribas Mortgage Corporation et al. v. Bank of America, N..A., No. 1:09-CV-09783 (June 6, 2013), Judge Sweet granted Bank of America’s motion to dismiss in its entirety (although this did not do away with all of the plaintiffs’ claims).

The Court noted that Bank of America served “in several distinct but related capacities for” what was a type of warehouse credit facility for Taylor, Bean & Whitaker Mortgage Corp. subsidiary, Ocala. (8) In particular, BoA served “as Indenture Trustee, Collateral Agent, Depositary and Custodian” for the transaction. (8) You may remember that the chairman of TBW was sentenced to 30 years in jail for running a massive fraud, from which this case ultimately springs.

The Plaintiffs “allege that BoA had contractual duties as Collateral Agent (under the Security Agreement) and as Indenture Trustee (under the Base Indenture) to sue itself in its other capacities for breaches of the  Custodial and Depositary Agreements,  respectively, and that it breached those duties by failing to bring suit against itself for these alleged cIaims.” (15, citations omitted)

Relying on well-settled law, the Court held that the transaction documents did not require BoA to sue itself. While this case does not really cover new legal terrain, its logic brings to mind S&P’s motion to dismiss DoJ’s FIRREA case.  In that case, S&P argued that “the Complaint fails to allege that S&P possessed the requisite intent to defraud the investors in the CDOs at issue. It is more than ironic that two of the supposed ‘victims,’ Citibank and Bank of America—investors allegedly misled into buying securities by S&P’s fraudulent ratings—were the same huge financial institutions that were creating and selling the very CDOs at issue.” (3) The aftermath of the financial crisis laid much bare about the securitization process, but the utter incestuousness of it can still shock.

This is not to say that this complexity and self-dealing are per se bad. Just that it seems that the sophisticated business people who put the deals together did not think through at all what would happen if deals went south.  Will they during the next boom?  Probably not.

So what does that mean for regulators?

More Misrepresentations, More Litigation

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Judge Pfaelzer (C.D. Cal.) issued an order in American International Group Inc. v. Bank of America Corp., No. 2:11-CV-10549 (May 6, 2013), which allowed AIG to proceed with its claim that it was fraudulently induced to buy MBS by Countrywide (now a part of BoA). This case joins a long list of cases where judges have allowed fraud and misrepresentation allegations to proceed in the context of MBS issuances (for instance, here, here and here).  AIG claims that the deal documents for the MBS “fraudulently misrepresented and concealed the actual credit quality of the mortgages by providing false quantitative data about the loans, thus masking the true credit risk of AIG’s investments.” (5, quoting the Amended Complaint)

in allowing some of the claims to proceed, the Court notes that  AIG “plausibly alleges that the underwriting guidelines stated in the Offering Documents were false. The Amended Complaint describes a company-wide culture of abandonment of underwriting standards and wholesale use of ‘exceptions’ to the normal standards. This raises an inference, however strong, that the loans in AIG’s RMBS deviated from the underwriting standards.” (28, citations omitted)

Judge Pfaelzer notes that she has repeatedly issued similar rulings regarding Countrywide’s behavior in other cases, so this comes as no surprise.  But once all of these MBS cases alleging fraud misrepresentation are decided, it will be interesting to see just what the contours of this body of law will look like.  Clearly, issuers can’t avoid liability by means of general disclaimers in the offering documents.  Will they provide clearer, more explicit disclaimers and carve-outs in the hopes of  avoiding liability in future deals or will they ensure that future deals hew more closely to the deal documents?  Time will tell.

The Future of Foreclosure

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Professor Roger Bernhardt  (Golden Gate University School of Law) has posted The Future of Foreclosure to SSRN.  This short article is ostensibly about a few recent California foreclosure decisions but I was more intrigued by its “case for going back to the courthouses”  and its rejection of nonjudicial foreclosure. (2) Bernhardt makes the common argument that for debtors, “judicial foreclosure would give them the opportunity to have their defenses heard before their property is taken away by foreclosure . . ..” (3)  But he also argues that lenders would benefit from a judicial-foreclosure-only regime because it could “effectively eliminate the risks and consequences that a challenged conduct will later be determined to have amounted to a fatal error.” (3)

Bernhardt does note that

National reform movements have always gone in the opposite direction: attempting to improve the nonjudicial foreclosure procedure in ways to eliminate its deficiencies (e.g., the Uniform Land Transactions Act, the Uniform Land Security Interests Act, the Uniform Nonjudicial Foreclosure Act, and now the (draft) Residential Real Estate Mortgage Foreclosure and Protections Act). But those approaches all concede a premise that may no longer be tenable—that the foreclosure process can be safely or efficiently run without contemporaneous judicial supervision. After-the-fact oversight is too time consuming and too late. (3)

I have not heard any lenders advocate for such a solution and would be curious to hear what they would have to say.  My sense is that they would not agree that they would benefit from such a regime, but it would be interesting to know if I am wrong.

Empire State Bidding War?

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I was quoted in a Law360 Story on the ongoing Empire State Building saga, Empire State Bids Soar Over Approaching REIT Deal (behind a paywall).  It reads in part:

the bidders that have come out of the woodwork since Schron’s left-field offer may be banking on the assumption that Malkin and its shareholders could be willing to part with the iconic skyscraper in an all-cash deal that would avoid some of the drama associated with the REIT proposal.

“The owners … may lose the prestige by losing control of the Empire State Building, but they may end up making more money,” said David Reiss, a professor of real estate law at Brooklyn Law School, on Friday. “They may be more than happy to sell to the highest bidder if they’re going to get more than what the REIT would get them for it.”

The bidders appeared to think the unhappy shareholders would find value in their offers as well.

In connection with his bid, Schron agreed to enter into a contract with Malkin with a $50 million nonrefundable deposit immediately and to close the all-cash deal in 90 days. As part of the deal, investors would be able to choose to remain invested in the building and receive a membership interest in Schron’s Cammeby’s International Group in lieu of cash, according to an offer letter revealed last week.

The offers that followed — one from Thor Equities that was “north of $2.1 billion,” one from a group of investors including Phil Pilevsky and Joseph Tabak, and another from an unnamed bidder — reportedly offered similar assurances.

In addition to the chance to own one of the most famous buildings in the world, experts say those who have thrown their hats into the sudden bidding war for the skyscraper are also keen to take advantage of its retail potential.

“I think there’s a belief that this is a valuable property, and that particularly the retail portion of it — and to some extent the office portion too — is undervalued,” Israel said. “I think they feel they could do a major upgrade.”

Those who may have been previously interested in the building also now have the assurance, after a May court ruling in one of the lawsuits over the proposed deal, that verified the legality of a controversial $100-per-share buyout provision, according to Reiss.

Potential buyers now know “that the buyout provision is valid and … that a good bid can get the requisite votes,” he said.

An appeal of the ruling on the buyout provision remains pending.

BoA Claws Back Clawback

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New York County Supreme Court Justice Bransten held, in U.S. Bank National v. Countrywide Home Loans, Inc., no. 652388-2011 (May 29, 2013), that a trustee cannot succeed in getting the defendants (Countrywide entities among others) to repurchase all of the mortgages in a securities pool based on a theory of “pervasive breach.” Rather, she holds that the repurchase obligations are determined by the terms of the agreements governing this MBS transaction.

The trustee asserted that the loans breached the reps and warranties.  The deal documents, however, limited the trustee’s remedy for such a breach to repurchase. The Court writes that

Plaintiff invites this Court to look past the absence of contractual language supporting its claim, asserting that it is entitled to the  benefit of every inference on a motion to dismiss.  While the Trustee is entitled to all favorable inferences with regard to its factual claims on a motion to dismiss, its bare legal conclusion that the Servicing Agreement accommodates its pervasive breach theory is not entitled to deference. (8)

Justice Bransten has ruled on a number of MBS cases involving alleged breaches of reps and warranties and is developing a coherent body of law on this topic. In the Bransten Trio of cases, she rejects the idea that vague disclosures are sufficient to immunize securitizers from liability for endemic misrepresentation. And here, she rejects the idea that vague theories of liability can replace the clear language agreed to by the parties.  In good judicial fashion, she is letting parties know that they should pay attention to the text of their agreements and be ready to face the consequences of those agreements.