This is the second in a series of five articles covering Bank of America's legal problems since the financial crisis. Links to the rest of the series are at the bottom of this article.
Although it may not seem like it, Bank of America (NYSE: BAC ) has made considerable progress at putting its 2008 acquisition of Countrywide Financial in the rearview mirror.
To date, the bank has paid more than $35 billion, excluding legal fees, to resolve claims related to Countrywide's arguably criminal practices before, during, and after the financial crisis. Yet, by my count, somewhere between $15 billion and $25 billion in liability beyond stated reserves remains outstanding.
Where the ultimate payout falls within this range rests in part on a case that's making its way through a New York state court.
Mapping out B of A's legal labyrinth
If the number of lawsuits filed against B of A resembles an unsolvable puzzle, here's a framework to keep in mind. The bank faces liability under three legal theories:
- Breach of contract,
- securities fraud, and
- malfeasance in mortgage servicing.
The breach of contract claims can be further broken down into:
- Mortgages sold by Countrywide to the government-sponsored agencies Fannie Mae and Freddie Mac.
- Private institutions that invested in Countrywide's mortgage-backed securities.
- Monoline insurance companies that insured particular tranches of the private-label MBSes.
In this article I'm going to be focusing on the second sub-category, the claims asserted by investors in Countrywide's private-label MBSes.
The scale of exposure stemming from this category is breathtaking. Between 2004 and 2008, Countrywide originated $1.562 trillion in residential mortgages. Of these, it sold $846 billion to the GSEs and packaged $716 billion worth into securities which were marketed to institutional investors like insurance companies, university endowments, and pension funds. The problem is that large swaths of these mortgages have since either defaulted or are now severely delinquent -- that is, more than 180 days past due. A full 13% of the loans sold to the GSEs, or $111 billion, fit into these categories. A staggering 27% of securitized loans, or $190 billion, are similarly classified.
The Bank of New York Mellon settlement
The good news is that B of A has reached a settlement that extinguishes more than half of its liability to private investors. On June 28, 2011, the bank agreed to pay $8.5 billion to settle claims brought by the Bank of New York Mellon (NYSE: BK ) , acting in its capacity as the trustee of 530 MBSes, and a group of 22 institutional investors including bond giants BlackRock (NYSE: BLK ) and Pimco.
If the settlement is approved by a judge, which remains far from certain, it will be a massive victory for the nation's second largest bank by assets. In one fell swoop, it resolves contract claims related to $409 billion, or 57%, of the mortgages packaged into private-label MBSes. Additionally, $113 billion of the mortgages covered by the settlement have either already defaulted or are now severely delinquent. That equates to 60% of toxic private-label mortgages.
The catch is that many of the remaining stakeholders in the MBSes at issue are now challenging the settlement, as the 22 institutional investors that participated held somewhere north of only a quarter of the voting interests in only 225 of the trusts within the settlement's scope. The list of objectors includes hedge funds, pension funds, Goldman Sachs (NYSE: GS ) and other investment banks, insurance companies such as AIG (NYSE: AIG ) , and even the attorney generals from New York and Delaware. These parties are asserting that both the specific terms of the settlement are inadequate and that BNY Mellon violated the fiduciary duty it owes to them by entering into it.
Despite the nature and magnitude of these allegations, B of A has a critical advantage in court stemming from the fact that the objections are being made in the context of an Article 77 proceeding. This gives a trustee -- in this case, BNY Mellon -- the right to seek a judicial endorsement of trust-related decisions.
As Reuters' Alison Frankel has pointed out, while the Article 77 vehicle is typically invoked in "garden-variety" trust disputes and not multibillion-dollar deals affecting hundreds of beneficiaries, its advantage to B of A is clear:
Under trust law, the bar for blocking a decision by the trustee is incredibly high. Anyone with an interest in the trust has a right to challenge the trustee's decision. But unless objectors can show that the trustee, in this case [BNY Mellon], abused its discretion, acted unreasonably, or otherwise breached its fiduciary duty to the trusts' beneficiaries, the court is not supposed to interfere with the trustee's power.
Thus, the onus is not on the settling parties -- B of A and BNY Mellon -- to prove the agreement was reasonable. Instead, the burden is on the opposing investors to prove that the Bank of New York Mellon acted inappropriately in one form or another. And while this may appear to be just a semantic difference, it's a powerful, often times definitive, distinction.
What if the challenging parties nevertheless prevail and the settlement is set aside? While this is a valid question, it's almost unfathomable for one reason: None of the individual investors appear to have viable claims on their own.
On March 29, 2012, the judge overseeing the settlement dismissed one of the most ardent challenger's separate lawsuits for breach of contract, ruling that only the Bank of New York Mellon, in its capacity as the trustee of the underlying MBSes, has the authority to sue on the investors' behalf. This ruling was upheld two months later on appeal. And a month after that, the challenger dropped its opposition to the $8.5 billion settlement altogether. At most, in turn, it seems like the judge would simply force the existing parties back to the negotiating table for a higher figure. It's worth noting here that the expert opinion that BNY Mellon received prior to entering into the $8.5 billion settlement put B of A's range of liability at $8.8 billion to $11 billion.
That being said, if B of A's public statements are any indication, then there's at least reason for the bank's shareholders to be optimistic. In the midst of an exchange with an analyst on its fourth-quarter conference call, B of A's CEO Brian Moynihan -- who, notably, is also a lawyer -- predicted that this litigation will wrap up "sometime in the second quarter or early in the third quarter" of this year, and that he was "comfortable with our legal positions across the board."
Take that for what it's worth. However, if it does end favorably, B of A's remaining liability from contract actions related to private-label MBSes will drop to an estimated $4 billion in excess of current accruals -- a highly digestible figure.
The many fronts in B of A's legal war
As I noted at the beginning, there are multiple fronts in B of A's war to atone for the sins of Countrywide. While the struggle to consummate the settlement with BNY Mellon is only one such battle, it's one of the larger skirmishes remaining outside of a constellation of securities fraud actions that are making their way through a federal court in California.
Continue reading this series:
- Part 1: An overview of Bank of America’s legal predicament and its progress so far.
- Part 3: The bank needs the cards to fall in its favor to overcome lawsuits from major mortgage insurers.
- Part 4: The potential hit from securities fraud lawsuits against B of A is particularly murky.
- Part 5: Conclusion: Should Bank of America investors be fearful, or hopeful?