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The Biggest Unknown Threat to Bank of America

This is the fourth 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. 

Since its fateful decision to purchase Countrywide Financial in 2008, Bank of America (NYSE: BAC  ) has faced a multitude of existential threats. But while an estimated $35 billion dollars in losses has already been realized by the nation's second largest bank in its effort to combat these, a considerable amount of exposure remains. The biggest wild card in this regard concerns a series of multibillion-dollar securities fraud lawsuits brought by investors against B of A and its now-reviled subsidiary.

Putting the securities fraud claims into perspective
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:

  1. Breach of contract
  2. Securities fraud 
  3. Malfeasance in mortgage servicing

The breach of contract claims can be further broken down into:

  • Those involving mortgages sold by Countrywide to government-sponsored agencies Fannie Mae and Freddie Mac. 
  • Those involving private institutions which invested in Countrywide's mortgage-backed securities (MBS). 
  • And, those involving monoline insurance companies which insured particular tranches of the private-label MBSes. 

In this article, I'm focusing on the large number of lawsuits that allege Countrywide committed securities fraud in the marketing and sale of MBSes to investors, the vast majority of which are being litigated in a federal court in California.

The Securities Act of 1933 gives the purchaser of a security the right to recover damages when a registration statement or prospectus contains untrue statements or omissions of material fact. At issue here are Countrywide's assertions in MBS offering documents about the credit quality of mortgages packaged into securities, as well as Countrywide's declarations that it adhered to strict underwriting guidelines.

The allegations made by AIG (NYSE: AIG  ) against the mortgage originator provide a textbook example. After reviewing 262,000 loans in various Countrywide MBSes, AIG found that 34% had loan-to-value ratios that were more than 10 percentage points higher than represented in the registration statements. It also found that an average of 17% of the mortgages sampled had LTVs in excess of 100% despite Countrywide's claims in the same statements that none did.

Although the damages in these cases overlap potential recoveries in the breach-of-contract actions against B of A, securities fraud claims offer aggrieved investors a number of advantages. To file a breach-of-contract claim, an investor must typically own 25% of the underlying MBS. This is a threshold few investors meet. Alternatively, no such threshold exists in an action for securities fraud. Investors also don't have to show that Countrywide intended to defraud them. The federal securities laws hold issuers to a strict liability standard, meaning that investors only have to show that an offering statement contained false representations about the securities in order to recover damages.

On the other hand, the one distinct disadvantage is that federal securities fraud claims must be filed within a certain period of time. Any claims related to securities sold more than five years ago are barred -- plain and simple. In addition, this time period shrinks to only three years from when investors were on notice about the alleged fraud, which the judge has ruled occurred no later than Feb. 14, 2008. As a result, any federal securities fraud actions that weren't filed by Feb. 14, 2011 are no longer viable.

To say that this has been a coup for B of A would be an understatement, as it's led to the dismissal of multiple lawsuits and claims against Countrywide.

How bad are the potential damages?
Let me start out by saying that estimating B of A's liability for Countrywide's securities fraud is an inexact science at best. Making it worse is the fact that B of A has been tight-lipped about these actions in particular.

Roughly two years ago, the SEC sent a letter "reminding" banks that they must disclose exposure "relating to various representations and warranties that you made in connection with your securitization activities and whole loan sales" -- by "representations and warranties" it's referring to the breach-of-contract cases. But it notably didn't require banks to disclose exposure to securities fraud claims, and they similarly aren't obligated to publish litigation reserves, which could be used to back into estimates. Consequently, as Reuters' Alison Frankel has pointed out, "Damages have been an open question in the MBS securities litigation."

Given the uncertainty, the range of potential damages in these cases is extremely broad. In an analogous case brought by the Federal Housing Finance Agency against UBS (NYSE: UBS  ) , the overseer of Fannie Mae and Freddie Mac claims that the government-sponsored agencies "lost in excess of 20%" of their investment in $4.5 billion worth of the Swiss bank's MBSes. If you apply this multiple to the $716 billion of mortgages packaged into MBSes by Countrywide, you arrive at an astounding $143 billion in potential liability -- a patently absurd figure that's far more than enough to bring B of A down. Of course, the claim against UBS is also just that, a claim. If it settles with the FHFA, the settlement amount would likely be a fraction of the purported losses.

Fortunately, a number of settlements in other cases moderate this considerably. In July of 2011, Wells Fargo (NYSE: WFC  ) paid a group of investors $125 million to settle securities fraud actions related to $35 billion in MBSes. Four months later, Citigroup (NYSE: C  ) and Deutsche Bank (NYSE: DB  ) paid the National Credit Union Agency a combined $165.5 million to settle claims related to an estimated $30 billion in MBSes sold to five now-defunct credit unions. Using these multiples, B of A's potential exposure reduces to a much more reasonable range of $2.6 billion to $3.9 billion.

So what is it, $2.6 billion or $143 billion? The answer is that It'll likely fall somewhere in between these figures, though I believe much closer to the former than the latter. One reason for this is that B of A has a number of viable defenses. In addition to the statute of limitations, which has already knocked multiple claims out of court, there's "reliance" -- that is, did these sophisticated institutional investors really rely on Countrywide's statements in the offering documents? If it can be shown they didn't, B of A will be off the hook for at least the state and common law portions of the securities fraud cases. And if they did rely on the documents, then there were disclaimers in the offering documents -- with typical rear-end covering for the issuer -- that would have presumably been relied upon as well. Finally, B of A can argue that the true source of the damages suffered by MBS investors was the financial crisis and not false representations made by Countrywide.

On the other hand, there are a number of factors that work in the MBS investors' favor. For one, if the facts asserted by the plaintiffs in all of these lawsuits are true, then the underlying fraud at Countrywide was both rampant and provable. This matters because it could sway judges and/or juries. Additionally, the mortgages originated by Countrywide between 2004 and 2008 were among the worst, if not the worst, in the industry.

A wide range of potential damages
Given the comparatively early stages of the securities fraud litigation and the lack of precedent, any estimate of potential damages here must necessarily include a wide margin of error. With this in mind, my estimate (and that's all it is, an estimate) is that B of A will end up paying between $5 billion and $15 billion to resolve these claims.

To learn more about B of A, I encourage you to check out the premium report from Motley Fool senior analyst Anand Chokkavelu. Claim your copy by clicking here now.

Continue reading this series:

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