This is the third in a series of five articles covering Bank of America's legal problems since the financial crisis.
Don't believe what the media says about Bank of America (NYSE:BAC) or its CEO Brian Moynihan. Is he a bit monotone in media appearances? Perhaps. A smidge boring? Sure. But inept? Certainly not.
Since taking the helm in 2010, Moynihan has adroitly navigated the bank through arguably the most treacherous legal battles ever waged against a company that wasn't in the throes of bankruptcy. He's overseen multi-billion-dollar settlements with the U.S. Justice Department, state attorney generals, banking regulators, the Securities and Exchange Commission, former shareholders of Merrill Lynch, Fannie Mae and Freddie Mac, and the Federal Trade Commission. Before Moynihan can declare victory in its ongoing legal war, however, he must first navigate the bank past a series of lawsuits by private investors in Countrywide Financial's mortgage-backed securities and a particularly litigious bunch of monoline insurance companies.
Putting the monoline claims into perspective
If the number of lawsuits filed against B of A resembles an unsolvable puzzle, here's a simple framework to keep in mind. The bank faces liability under three legal theories:
- Breach of contract
- Securities fraud
- 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 that insured particular tranches of the private-label MBSes.
What we're concerned about here are the claims in the third category -- the vast majority of which are tied up in a New York state court.
As a group, the monoline claims are the least alarming when it comes to monetary damages. To put them in perspective, between 2004 and 2008, Countrywide sold $846 billion worth of mortgages to Fannie Mae and Freddie Mac, $111 billion of which have since either defaulted or are severely delinquent -- that is, they're more than 180 days past due. Over the same time period, the mortgage originator packaged $716 billion worth of mortgages into hundreds of MBSes that were sold to private investors. A cool $190 billion of that group have defaulted or are severely delinquent. By comparison, according to B of A's third-quarter 10-Q filing, Countrywide sold only $184.5 billion of the loans originated between 2004 and 2008 into monoline-insured securitizations, $52.6 billion of which are now in default or severely delinquent.
As they say, a picture is worth a thousand words, and when we stack up the three groups, it's easy to see the disparity.
This isn't to say that monoline claims don't cause sleepless nights for B of A executives -- the damages will unquestionably amount to billions of dollars. Even more worrisome is the possibility that any of a number of critical legal issues in these cases will be decided against B of A. Those decisions could then go on to influence the outcome of parallel lawsuits, and even incentivize new counterparties to sue.
There are two issues that investors will want to keep a particularly close eye on in these cases. First and foremost is the question of "successor liability." This concerns whether B of A is even legally liable for Countrywide's pre-2008 misdeeds. If a court holds that it's not, then the bank could use the "nuclear option" of putting its Countrywide subsidiary into bankruptcy if damages become unmanageable. However, if a court holds that B of A is liable, then no such option exists, leaving the bank with significantly less leverage in settlement negotiations. Second, there's the issue of "loss causation," which concerns whether there must be a causal link between the monolines' losses and Countrywide's breach of contract.
Without wading into the details here, both issues are critical because they played central roles in B of A's $8.5 billion settlement with Bank of New York Mellon (NYSE:BNY), which is coincidentally awaiting judicial approval from the same court.
What are the damages here?
Arriving at an estimate of how much B of A ultimately owes the monolines is easier said than done, as even the bank admitted in its most recently quarterly filing that it's in the dark on this question:
It is not possible at this time to reasonably estimate probable future repurchase obligations with respect to those monolines with whom we have limited repurchase experience and, therefore, no representations and warranties liability has been recorded in connection with these monolines, other than a liability for repurchase claims where we have determined that there are valid loan defects and determined that there is a breach of a representation and warranty and that any other requirements for repurchase have been met.
What B of A is saying is that it can't estimate the potential exposure from monoline claims and, as a result, the bank hasn't fully provisioned for them. When settlements and/or judgments do come, the damages could hit B of A's bottom line close to dollar for dollar.
To get back to the issue of damages, we can draw certain conclusions from the settlement B of A reached with Syncora Guarantee, one of the smaller monoline insurers, in the middle of last year. In exchange for a payment of $375 million, Syncora agreed to resolve claims stemming from 14 private-label MBSes with an original principal balance of a combined $17.3 billion and of which $4.4 billion had either defaulted or were severely delinquent as of June 30, 2012. If you break this down, B of A paid $0.085 for every dollar of toxic mortgages.
If you then apply this figure to the $52.6 billion of defaulted or severely delinquent mortgages sold to all monolines, you get an estimate of aggregate damages of around $4.5 billion for the class as a whole. This is notably less than half of the total damages the bank has paid out to the GSEs and will similarly amount to a fraction of its liability to private-label investors.
But a word of warning is appropriate here, as there are at least two problems with this estimate. The first is that the monolines which have settled thus far -- Syncora and Assured Guaranty (NYSE:AGO) -- are by definition the most amenable to doing so. They're also two of the smallest players in that space. Meanwhile, the litigation that remains in court is backed by both the largest and the most litigious of the bunch, including MBIA (NYSE:MBI), Ambac Assurance, and Financial Guaranty.
The second problem is that recent court rulings have gone in the insurers' favor. Most recently, Judge Jed Rakoff of the U.S. District Court in New York awarded Assured Guaranty nearly all of the damages it sought in an analogous breach of contract case against Flagstar Bancorp (NYSE:FBC). This doesn't bode well for B of A because it effectively eliminates any incentive for the larger monoline companies to settle these matters out of court.
A final estimate on B of A's monoline liability
After taking all of this into consideration, these claims could end up costing B of A anywhere between $3 and $6 billion to resolve, equating to between one and two quarters worth of earnings. While this is an extremely rough estimate -- emphasis on both the "extremely" and "rough" qualifiers -- even the upper bound is digestible for a bank of B of A's size. What investors will want to watch for, however, is how these claims ultimately influence others, as that's where the real money is.
Continue reading this series:
- An overview of Bank of America’s legal predicament and its progress so far.
- One critical lawsuit that could cost B of A billions.
- The potential hit from securities fraud lawsuits against B of A is particularly murky.
- Conclusion: Should Bank of America investors be fearful, or hopeful?