A dizzying array of legal battles have and continue to be waged as a result of the financial crisis, but few approached the intensity of the recently concluded fight between Bank of America (NYSE: BAC ) and MBIA (NYSE: MBI ) . For the nation's second largest bank by assets, it was in many ways a matter of principle, as an unfavorable outcome could have induced new claimants to follow suit. And for MBIA, it amounted to nothing short of a death match. Had the mortgage-bond insurer failed to attain a considerable settlement, there was doubt about its ability to survive as an independent going concern.
At this point, of course, we'll never know whether these fears would have actually come to fruition or not, because the two parties reached an agreement at the beginning of last month to settle the cantankerous dispute. In exchange for MBIA's release of all outstanding representations and warranties claims against Bank of America, the latter agreed to pay $1.6 billion in cash, remit all of the insurer's outstanding debt that the bank had acquired in an effort to gain negotiating leverage, and release MBIA from billions of dollars in credit default swap protection that Merrill Lynch had purchased in the lead-up to the crisis. It was, in every sense of the word, a comprehensive settlement.
With the agreement now in the rearview mirror, it's possible to look back at the conflict as a whole. Why was it so contentious? Did its elongation cause irrevocable harm to either party? Are there lessons that investors can glean from it? These are just a few of the questions that I posed to Christian Herzeca, a veteran New York-based securities and finance attorney and author of the blog MBS Litigation Commentary for Speculators, a high-level conversation about, well, just what its title suggests.
John Maxfield: First of all, thank you for agreeing to shed light on this case. While many of our readers are experienced investors, it's safe to assume that few have an extensive knowledge of securities law in general, and this case in particular. Without further ado, I wonder if you would provide a high-level synopsis of MBIA's case against Bank of America. How did it come about? What were the principal legal issues involved?
Christian Herzeca: On its face, this was a relatively straightforward case involving MBIA's claims that Countrywide Financial breached a number of representations and warranties that it had made in connection with mortgage-backed securities that MBIA insured. MBIA claimed that Countrywide breached these representations both with respect to the manner in which it underwrote, or sourced and securitized, its mortgage loans, as well as with respect to the details of the individual loans themselves (e.g., whether the loans were subject to appraisals by a qualified appraiser).
Bank of America came into the picture in 2008 via is acquisition of Countrywide. Since the latter would not be able to pay any substantial judgment to MBIA, MBIA also claimed that Bank of America had succeeded to Countrywide's liabilities because of asset-stripping transactions Bank of America conducted following the acquisition. If true, this would have made Bank of America liable for any judgment against Countrywide as well.
Maxfield: As I noted in the introduction, this was one of the most contentious legal battles to spawn from the financial crisis. What made this case so much more acrimonious than, say, the lawsuits brought against Bank of America by other monolines such as Assured Guaranty (NYSE: AGO ) and Syncora Holdings? Given some of the adverse rulings that went against Bank of America toward the tail end, was it a mistake for the bank's attorneys to string the case along as opposed to settle it, and thereby avoid the potentially damaging legal precedent?
Herzeca: I believe MBIA locked itself into an expected recovery by recording an insurance receivable on its balance sheet equal to the amount that it expected to recover from suits like these against Bank of America and others. As a result, the case didn't settle earlier because Bank of America never offered MBIA an amount that was consistent with this recovery expectation until the very end of the litigation.
As I've posted in my blog, when Bank of America found itself subject to litigation from multiple parties, it had to defend against the actions not only on their individual merits, but also with an eye to whether decisions in one case would create disadvantageous precedents for all of the others. This is essentially a legal risk management issue, and I would give Bank of America an "F" with respect to the manner in which it managed this.
In the MBIA case in particular, legal decisions reached by the court just weeks before the case was settled stand as persuasive precedents that are adverse to the bank in other matters. Why Bank of America didn't settle this case earlier in order to avoid these adverse, and foreseeable, precedents is a question that its board of directors should be asking management.
Maxfield: One of the more interesting aspects of the case was the fact that it was fought on multiple fronts. MBIA sued Countrywide alleging breach of representation and warranties, yet it owed Merrill Lynch billions of dollars on CDS contracts. Meanwhile, Bank of America joined a contingent of other lenders in a case against MBIA to reverse the insurer's reorganization into two separate businesses -- cleaving off its comparatively healthy municipal bond unit from its sickly mortgage unit. And finally, at the end of last year, Bank of America sued MBIA for allegedly interfering with a tender offer to buy MBIA's bonds.
How did all of these pieces fit together? What's your view of the settlement terms? And what was your take on Bank of America's legal strategy throughout the case?
Herzeca: Bank of America's legal strategy was to starve MBIA into an advantageous settlement, inasmuch as the MBIA subsidiary plaintiff, MBIA Insurance, was seeing its liquidity suffer as the case dragged on. As well, by challenging the transaction approved by the New York Department of Financial Services that separated MBIA Insurance from National, the MBIA municipal insurer that was far more creditworthy, Bank of America was trying to improve the value of insured credit default swaps that MBIA Insurance had issued to Merrill Lynch.
Both strategies made sense, but the problem for Bank of America was that both its transformation transaction challenge and its defense in the representations and warranties case were ultimately losing cases on the merits. Strategy cannot trump the legal merits. So by playing the cases out as long as possible, the bank was unable to achieve litigation victories even as it was able to press MBIA Insurance to the point where it faced a real risk that it would be placed in rehabilitation by state regulators.
The problem for Bank of America was that the placement of MBIA Insurance into rehabilitation would have hurt the bank (by reducing the value of its CDS swaps that were insured by the insurance unit) as well as it would have hurt MBIA. As a result, once Bank of America lost the transformation transaction challenge, its legal strategy became self-defeating.
Maxfield: Many of the analyses that I read throughout the ordeal pitched it as a kind of David versus Goliath struggle -- with MBIA playing the role of David, and Bank of America serving as Goliath. And just like the parable, I always got the impression that the caricature was about more than just size -- that there was also an element of morality and social justice at play.
But given MBIA's history -- recounted, for instance, in the book Confidence Game by Christine Richard -- and the outsized profits and compensation awarded to its executives as a consequence of its CDO and MBS products, I wonder whether this caricature is fair. This is particularly true when you consider that Bank of America inherited the culpability by acquiring Countrywide Financial in 2008.
I know this is somewhat of an amorphous angle, but how did you view the controversy? Was MBIA being unjustly bullied by Bank of America? Or was the latter perhaps just as much, if not more, of a victim here?
Herzeca: This is both a very interesting question and one that is hard to answer with any resemblance of objectivity.
If you argue that Bank of America is unfairly being held to pay for Countrywide's sins, you are ignoring that the bank acquired the mortgage originator in order to become the preeminent mortgage banker in the nation, and then took out a corporate vacuum cleaner and sucked up all of Countrywide's mortgage business platform, leaving the company as a continuing litigation-defending shell. So there was an upside that Bank of America was seeking in its transactions with Countrywide, and I think it is hard for Bank of America to claim the high moral ground when it turns out that its profit-seeking bet turned out badly; unless you think too-big-to-fail banks should never be allowed to suffer from their mistakes.
On MBIA's side, it clearly wrote improvident insurance policies, but it was the beneficiary of representations and warranties about these transactions. If MBIA had not insisted on these contractual protections, it would have been foolhardy as well as improvident, and MBIA was no fool, motley or otherwise.
Maxfield: Last but not least, what if anything will be the legacy of the MBS litigation in general and the MBIA v. Bank of America case in particular? Has it changed the legal landscape? What about the investing landscape for those interested in monolines? And finally, are there any lasting lessons that investors can take away from this that would be helpful down the road?
Herzeca: I believe investors should give monolines a look, especially if investors believe that the U.S. housing market is on the road to recovery. This might generate some reserve reversals that will improve the monlines' financial positions over time. As well, there is the opportunity for some of these monolines to continue to achieve legal recoveries like the one MBIA got from Bank of America. Finally, if investors also believe that interest rates will rise, the municipal finance guaranty market should eventually recover. Having said that, this is an area that requires careful due diligence.
Maxfield: Christian, thank you very much for taking the time to answer these questions.