If you have followed the saga surrounding Bank of America (NYSE:BAC) and the associated liabilities with its acquisition of Countrywide, you know that there has been plenty of hand-wringing that those liabilities would balloon into the range of tens to "hundreds of billions" of dollars. Were this to happen, the Bank's current reserves would be grossly inadequate. Here are some examples:
Joining this chorus are a group of investors who are bullish on MBIA Corporation (NYSE:MBI) and believe the threat of approval-failure at next month's Article 77 hearing for Bank of America's Gibbs & Bruns/Countrywide settlement is a catalyst for a settlement between Bank of America and MBIA. Most articulate of these are Mark Palmer of BTIG and Christian Herzeca. (As an aside, I give them both high marks for clearly articulating their position and I encourage everyone to pay attention to what they are saying, whether you agree or disagree. I have certainly benefited from each of them.) They believe that Bank of America CEO Brian Moynihan is engaging in a risky legal gambit, jeopardizing the Gibbs & Bruns settlement by not settling with MBIA. Their point is that rulings handed down in the MBIA litigation (a question of monoline bond insurance) could spill over into the Gibbs & Bruns case (a question of private-label securities and the contracts which govern them).
Rather than rely on opinions and second-hand sources, let's dig into the documents that govern the securities in question. Each trust is governed by a Pooling and Servicing Agreement ("PSA") which contains similar language to the following. This agreement basically creates a threshold requirement of 25% of the voting rights of the trust to direct the trustee. This one was pulled from a random Countrywide trust issued in 2005 (emphasis mine):
No Certificateholder shall have any right by virtue or by availing itself of any provisions of this Agreement to institute any suit, action or proceeding in equity or at law upon or under or with respect to this Agreement, unless such Holder previously shall have given to the Trustee a written notice of an Event of Default and of the continuance thereof, as hereinbefore provided, the Holders of Certificates evidencing not less than 25% of the Voting Rights shall also have made written request to the Trustee to institute such action, suit or proceeding in its own name as Trustee hereunder and shall have offered to the Trustee such reasonable indemnity as it may require against the costs, expenses, and liabilities to be incurred therein or thereby, and the Trustee, for 60 days after its receipt of such notice, request and offer of indemnity shall have neglected or refused to institute any such action, suit or proceeding; it being understood and intended, and being expressly covenanted by each Certificateholder with every other Certificateholder and the Trustee, that no one or more Holders of Certificates shall have any right in any manner whatever by virtue or by availing itself or themselves of any provisions of this Agreement to affect, disturb or prejudice the rights of the Holders of any other of the Certificates, or to obtain or seek to obtain priority over or preference to any other such Holder or to enforce any right under this Agreement, except in the manner herein provided and for the common benefit of all Certificateholders. For the protection and enforcement of the provisions of this Section 10.08, each and every Certificateholder and the Trustee shall be entitled to such relief as can be given either at law or in equity.
In other words, security holders need 25% of the pool to direct the trustee (Bank of New York Mellon (NYSE:BK)) to bring action against Countrywide.
Interestingly, a group of the world's largest investors (the "Investor Group") organized to do just that which resulted in the $8.5 billion settlement brokered by Gibbs & Bruns. Yet, in that settlement, the Investor Group could only achieve the 25% threshold for 189 of 530 Trusts. This despite the fact that the settlement group included:
BlackRock Financial Management Inc., Kore Advisors, L.P., Maiden Lane II, LLC, Maiden Lane III, LLC, Metropolitan Life Insurance Company, Trust Company of the West and affiliated companies controlled by the TCW Group, Inc., Neuberger Berman Europe Limited, Pacific Investment Management Company LLC (PIMCO), Goldman Sachs Asset Management, L.P., as adviser to its funds and accounts, Teachers Insurance and Annuity Associate of America, Invesco Advisers, Inc., Thrivent Financial for Lutherans, Landesbank Baden-Wuerttemberg, LBBW Asset Management (Ireland), plc, Dublin, ING Bank fsb, ING Capital LLC, ING Investment Management, New York Life Investment Management LLC, as investment manager, Nationwide Mutual Insurance Company and its affiliated companies, AEGON USA Investment Management, authorized signatory for Transamerica Life Insurance Company, AEGON Financial Assurance Ireland Limited, Transamerica Life International (Bermuda) Ltd., Monumental Life Insurance Company, Transamerica Advisors Life Insurance Company, AEGON Global Institutional Markets, plc, LIICA Re II, Inc. , Pine Falls Re, Inc., Transamerica Financial Life Insurance Company, Stonebridge Life Insurance Company, and Western Reserve Life Assurance Co. of Ohio, Federal Home Loan Bank of Atlanta, Bayerische Landesbank, Prudential Investment Management, Inc. and Western Asset Management.
In other words, a veritable who's-who of the world's largest investors could only exceed the 25% threshold for 189 of 530 trusts, which demonstrates how difficult it is to bring collective action when ownership is widely dispersed.
On Wednesday, Bank of America's earnings announcement included this statement (emphasis mine):
Litigation expense was $881 million in the first quarter of 2013, compared to $916 million in the fourth quarter of 2012 and $793 million in the first quarter of 2012. Included in litigation expense for the first quarter of 2013 is a class action settlement in principle between certain Countrywide entities and various institutional and individual plaintiffs (collectively, the Luther, Maine State, and Western Teamsters plaintiffs) concerning residential mortgage-backed securities (RMBS) issued by subsidiaries of Countrywide Financial Corporation.
The first of these class action lawsuits was filed in November 2007, and they collectively concern the disclosures that were made in connection with 429 Countrywide RMBS offerings issued from 2005 through 2007. The original principal balance of the RMBS involved in these cases exceeded $350 billion, and the unpaid principal balance of these securities as of February 2013 (excluding securities that are the subject of individual or threatened actions) was $95 billion.
Under the settlement in principle, the lawsuits will be dismissed in their entirety, and defendants will receive a global release in exchange for a settlement payment of $500 million. The settlement will not affect investors' rights to receive trust distributions upon final court approval of the $8.5 billion settlement with Bank of New York Mellon as trustee.
The settlement is subject to final court approval. If approved, and all class members who have not already filed or threatened individual suits participate, the settlement is expected to resolve approximately 80 percent of the unpaid principal balance of the Countrywide-issued RMBS as to which securities disclosure claims have been filed or threatened, and approximately 70 percent of the unpaid principal balance of all RMBS as to which securities disclosure claims have been filed or threatened as to all Bank of America-related entities. The amounts to be paid in the settlement are covered by a combination of pre-existing litigation reserves and additional litigation reserves recorded in the quarter ended March 31, 2013.
On its face, the settlement is a good outcome - it resolves $95 billion of unpaid principal balance claims for $500 million. But, it may have broader implications which are even more important. Let's look at Mike Mayo's question and the response given from Wednesday's conference call (emphasis mine):
Mike Mayo - CLSA:
And the big question here is what happens if the $8.5 billion settlement doesn't go through. And I asked Bank of New York that question this morning, and the answer from Bank of New York is, well, it's up to the courts to decide. But what if the courts decide the $8.5 billion agreement does not go through? What would be the impact on your reserves?
Bruce Thompson - Chief Financial Officer:
The court is not opining on a number. They're either opining on approving or not approving. And obviously if they don't approve, we've set up reserves within the Countrywide securities, assuming that every trust gets to the 25% threshold. And so obviously, if it doesn't get approved, this will revert back to going individual trust by trust and working through it. But I don't think it's appropriate to comment on reserves on something that is not going to happen.
Bank of America has not specified the overlap between the 429 trusts in Wednesday's announced settlement and the 530 involved in the Gibbs & Bruns settlement, but given that Wednesday's settlement comprises 80% of Countrywide trusts, we can assume the overlap is significant. If Bank of America received a claims release with respect to 80% of disputed Countrywide-issued RMBS, the ability to assemble a 25% threshold for the remaining 20% -- an already Herculean task to begin with, as the Investor Group demonstrated - becomes highly improbable. Even in the event of an Article 77 approval failure, investors in these trusts will have little recourse (unless they find a way around the governing PSAs). In other words, "hundreds of billions" in liabilities are now a near-zero probability.
It should be noted that Wednesday's announced settlement is also subject to court approval. In addition, Countrywide liabilities related to federal entities (most notably FHFA) and monoline insurers (most notably MBIA) remain outstanding.
Special thanks to Kai Shih of Shih Investments whose comments and presentation from Value-X Vail have been helpful in my understanding of these matters.
Additional disclosure: THE ABOVE IS A STATEMENT OF MY PERSONAL OPINION, NOT FACT. PLEASE EXAMINE THE FACTS AS YOU SEE FIT AND FORM YOUR OWN OPINION. NOTHING IN THIS ARTICLE SHOULD BE CONSTRUED AS INVESTMENT ADVICE.