Mortgage Meltdown

New Litigation Round-Up

New cases arising from the ashes of the mortgage meltdown continue a-plenty and take many forms.  A sampling of recent cases:

ERISA  According to an article here, on January 29 the ERISA retirement plan for a Minneapolis glass-ware manufacturer called Apogee sued State Street Bank alleging that State Street breached its fiduciary duties to the plan.  State Street is alleged to have been an investment adviser to the fund.  According to the suit, State Street touted the Daily Bond Market Fund as a conservative, stable, risk-controlled, well-diversified option for Apogee's 401(k) plan, but changed the fund's strategy during 2006 to take on significantly more risk. Apogee alleged that State Street applied leverage in making the investments in subprime mortgage-backed securities, which had the effect of adding greater risk to the fund.  The fund also alleged that State Street prevented it from exiting the bond fund, while it allowed others to get out.  The fund alleges it lost $5 million.

Title Insurer Sued Over 1031 Exchange Program.  When the large title insurance company LandAmerica Financial Group, Inc. filed for bankruptcy last November, people who sold real estate in the months prior to the bankruptcy intending to reinvest the proceeds of the sale into new real estate through an IRS 1031 exchange (the benefit is deferring capital gains) had their money tied up in the bankruptcy.  For some it appears the money was tied up too long, and they lost their ability to make the exchange.  Several lawsuits have been filed against LandAmerica related to these issues, including a $300 million class-action lawsuit claiming breach of contract, fraud and theft of property filed in LandAmerica's bankruptcy case in Virginia.  A separate class action, raising similar issues, was filed in federal court in California.  As reported here, the cases are similar, and allege that the 1031 Exchange customers were misled about the financial health of LandAmerica.

Hedge Fund Sues Over Mortgage Bond Investments.  As reported by Bloomberg (here), Ellington Management Group LLC, the hedge-fund firm focused on mortgage bonds, sued Ameriquest Mortgage Co. and other ACC Capital Holdings units over soured subprime home loans.  Ellington alleges that its $354 million investment in certain bonds backed by subprime loans was virtually lost in its entiretly.  Ellington claims it was misled about the risk and the loans' potential for default.

Another Securities Class Action Filed.  This time the company in the cross-hairs is mortgage insurer Triad Guaranty, Inc.  The plaintiff's lawyers press release (here and here) from earlier today states that they allege that Triad misled investors about its underwriting practices for insuring Alt-A and pay-option mortgage and failed to adequately disclose to investors its weakening financial position as the financial crisis deepened throughout 2008. 

Tranche Warfare

Although securitized residential mortgages have been at the forefront of the credit crisis, commercial real estate debt has also been securitized, sliced, diced and sold to investors.  Some estimate that over $700 billion in commercial mortgage-backed securities are held by investors.  Now it seems a new front may be opening in the mortgage meltdown litigation - legal battles among holders of different tranches of securities backed by troubled commercial real estate.  What some have dubbed "tranche warfare."

Last week several outlets reported on the dispute among holders of various tranches of debt secured by the John Hancock Tower in Boston.  In 2006, a real estate investment firm called Broadway Real Estate Partners bought the building and a portfolio of other commercial real estate for $3.3 billion.  Back then, the Hancock Tower was valued at $1.3 billion.  Almost all of the purchase price was funded with debt.  There is a $650 million senior loan, and then about $450 million in a "mezzanine" loan that was split up amongh 9 investors.  This mezzanine debt was essentially a bridge loan which had to be paid within two years. 

In times of easy credit and soaring real estate values, it would have been easy for Broadway to refinance the debt at the end of the two-year period.  But now credit has become scarce, and in the sagging economy the Tower has gone from fully occupied to only 85% full, causing cash flow problems.  Thus, Broadway recently defaulted on a payment for the mezzanine loan.

That has touched off a battle among the holders of the various tranches of the mezzanine debt secured by the Tower.  Some estimate that the building is now worth only $700 to $900 million.  The terms of the mezzanine agreement provide that the most junior creditor still in the money (i.e. it would be paid off in a liquidation) based on an appraisal of the property would become the "controlling holder" and determine whether to foreclose on the mortgage.  The current skirmish is over which investor is "still in the money" should therefore be in control of decisions about foreclosure.

If the holders of the various tranches of the mezzanine funding cannot agree, one holder would likely file a foreclosure action and the other investors would then intervene to block the foreclosure or stay it pending a declaration from the court about who should be in charge.

To read more about the dispute, click here, here, and here.

One Step Forward; Two Steps Back For BofA-Merrill Lynch

One day after Bank of America received a second bailout from the federal government, which included stop-loss guarantees on assets BofA acquired through its January 1 acquisition of Merrill Lynch, the company announced that it was settling the subprime securities class action filed against Merrill Lynch last May for $475 million.  At the same time, it reached a separate $75 million settlement to resolve employee ERISA claims, for a whopping total of $550 million.  The complaint alleged that Merrill Lynch misled investors about its holdings of collateralized debt obligations and other securities backed by subprime mortgages.

The timing of the settlement suggests that  BofA had priced the cost of the settlement into the merger costs.  The settlement comes only about three weeks after the acquisition of Merrill closed on January 1, and comes before a motion to dismiss had even been filed in the case.  It seems that BofA wanted to put the securities litigation behind it and focus on getting Merrill integrated into its corporate structure.

Well throw that thinking out the window.  This week Bank of America has been hit with several new securities lawsuits related to the merger.  The class action filed today (here) against BofA, CEO Ken Lewis and Merrill Chief John Thain alleges that the proxy statement provided to BofA shareholders prior to the vote on the merger was false or misleading.  In addition, the complaint purports to represent a class of shareholders who bought BofA stock after the merger was completed on January 1.  Information about the other shareholder suits are available here and here.

The lawsuits follow BofA's January 16 announcement that Merrill suffered $15.3 billion in losses during the fourth quarter of 2008.  BofAs stock declined significantly following the announcement.  The discovery of these significant losses almost scuttled the acquisition.  BofA wanted to back out, but regulators pushed the company to conclude the deal.  The result was the second bail out discussed in yesterday's post.

Like Citi Before It, Bank Of America Gets Second Bailout

Late last week in a joint announcement by Treasury, Federal Reserve and the FDIC, it was revealed that Bank of America would receive another round of bailout money.  The structure of the new bailout is virtually identical to that received by Citigroup last November (my prior post on Citi is here).  $90 billion of the $191 billion spent in the Capital Purchase Program has been invested in these two banks.

Treasury will buy an additional $20 billion in preferred stock under the terms of the Capital Purchase Program on top of the $25 billion already invested in Bank of America.  Also, as with Citi, the Federal Reserve will enter a guarantee against losses of more than $10 billion on a $118 billion pool of asset backed securities held by Bank of America.  The term sheets are available here and here.

Like Citi, Bank of America was likely too big to fail, particularly after the government had already invested $25 billion.  Thus this new round of financing was provided under what has become known as the Targeted Investment Program, which to be eligible the Treasury must determine the institution "is sufficiently important to the nation’s financial and economic system that a loss of confidence in the firm’s financial position could potentially cause major disruptions to credit markets or payments and settlement systems, destabilize asset prices, significantly increase uncertainty, or lead to similar losses of confidence or financial market stability that could materially weaken overall economic performance."

Meanwhile, even with the trillions of dollars poured into the financial system, turmoil in the financial markets continues.  All financial stocks were pummelled yesterday after State Street announced bad financial results and disclosed a number of new risks and potential problems with its capital ratios.  Congress and the Obama administration are also considering establishing a federal "bad bank" that would do what TARP originally was supposed to do, take toxic assets off of bank balance sheets.  Some are estimating that the cost of this program could reach $2 to $3 trillion (or more) in additional federal government outlays (Forbes article, "A TARP In The Trillions?" here; Financial Times article here).

Citigroup Supports Bill Allowing Mortgage Modification In Bankruptcy

Last week, Citigroup broke ranks with the banking industry and publicly supported a bill being introduced by Senator Richard Durbin of Illinois which would allow bankruptcy judges to modify mortgages in the context of individuals' Chapter 13 bankruptcy cases (often referred to as a "cramdown").  Citigroup's CEO indicated it would support a bill allowing bankruptcy judges cramdown authority if the law was restricted to already existing mortgages, if it required borrowers to provide 10 days notice to their lender prior to filing bankruptcy, giving the lender an opportunity to offer a loan work-out; and if the law prevented the bankruptcy judge from rescinding mortgages that contained only minor violations of TILA.

The rest of the Mortgage Banking industry continues to oppose the legislation (here).  They were able to keep a similar provision out of the EESA legislation passed last Fall.

I think this is an interesting development and a possible reflection of the explicit or implicit influence the federal government is having or will have on private business as a result of its unprecedented direct investment in the financial sector.  Citi has been the largest beneficiary of direct Government investment, save for perhaps AIG.  As this blog noted previously (here), the Government has purchased $45 billion in preferred stock from Citi as well as providing a "backstop" on losses related to a $306 billion pool of mortgage-backed securities held on Citi's balance sheet.

I suspect that this may have bought some ability to influence decisions at the company.  Others in the financial press have speculated that Citi's support for the bill is not the result of Government influence, but rather because it is in Citi's own self-interest.  Because its losses on billions of mortgage-related assets are capped under the second bailout, Businessweek speculates (here) that the bill would drive down the price of mortgage-back assets further, hurting Citi's competition (who does not have the benefit of the Government's backstop).  NYT article, containing similar reference, here.

Citi's more innocuous party line is set forth in a letter from its CEO, Vikrit Pandit, to lawmakers.  He writes that the law "will serve as an additional tool" to help homeowners at risk of foreclosure. "Given today's exception economic environment, we support its swift passage."

SEC's Report On Mark-To-Market Under EESA Says FAS 157 Not A Major Factor In Financial Crisis Or Bank Failures

Section 133 of the EESA required the SEC to study mark-to-market accounting under FAS 157, and, in particular, whether to suspend or eliminate the rule.  The SEC staff issued the mandated  at the end of 2008.  The report clocks in at over 259 pages, and touches on all aspects of FAS 157.  My prior post on the FAS 157 issues is here.

Despite widely held belief that problems applying fair value accounting to illiquid assets was an important factor in spawning the financial crisis that led to the voluminous report, the Staff concluded that mark-to-market accounting did not play a major role in either the bank failures or the crisis at other financial institutions, including specifically Bear Stearns, Lehman and AIG.  The Staff concluded that liquidity pressures brought on by poor risk management and "concerns about asset quality" were the primary drivers of the financial crisis.  It seems to me, however, that these concerns about asset quality may have been concerns by investors as to whether banks and other financial institutions were properly valuing these illiquid mortgage-backed assets on their balance sheet.

The Staff reached itsconclusion that FAS 157 was not a major contributing factor primarily by looking at the recent financial statements of banks that failed and were taken over by the FDIC in 2008.  However, by focusing solely on those banks that were taken over by the FDIC and not considering other banks and financial institutions -- Wachovia and Citigroup come to mind -- that were either acquired before being taken over by the FDIC (Wachovia) or where the government injected sizeable capital to keepthem "healthy" (Citigroup,AIG, and others participating in the Capital Purchase Program), the study seems to have overlooked a large piece of the analysis.  As the report admits, the larger and more complex the financial institution, the more likely fair value accounting would have on the company's reported financial condition.  Therefore, it was these largest and most complex financial institutions that were both most impacted by fair value accounting and whose ailing financial health cascaded through the rest of the financial sector.

The staff also concluded, based "upon Staff observation through its prudential oversight function," that FAS 157 issues were not the "primarydriver" of the crisis; rather the Staff's "observations indicate that the liquidity positions of some financial institutions, concerns about asset quality, lending practices, risk management practice, and a failure of other financial institutions to extend credit appear to be the primary drivers."  The Staff specifically concluded that liquidity and a crisis in confidence in counter-parties, hedge funds, and traders led to the demise of Bear Stearns and Lehman Brothers.  The Staff stated that it believes "liquidity pressures" were the root cause of problems at other financial institutions, investment banks and AIG.

Finding that fair value accounting did not cause much of the problem, the Staff not surprisingly suggested only tweaking the current rules.  It made eight recommendations:

1) FAS No. 157 should be improved and not suspended;

2) Existing fair value and mark-to-market requirements should not be suspended;

3) Additional measures should be taken to improve the application and practice related to existing fair value requirements;

4) The accounting for financial asset impairments should be readdressed;

5) Further guidance is needed to foster the use of sound judgment in this area;

6) Accounting standards should continue to be established to meet the needs of investors;

7) Additional formal measures to address the operation of existing accounting standards in practice should be established; and

8) There is a need to simplify the accounting for investments in financial assets.