MBIA and BofA: Thoughts on Litigation

Yesterday, 18 banks sued MBIA (MBI), seeking to block its transformation. This was written up capably by the WSJ and Bloomberg, so rather than duplicate their efforts I am going to focus on one aspect of the storm of litigation around MBIA – the role of Bank of America (BAC).

BAC emerges as a cynical and arrogant participant in the legal process. After acquiring Merrill Lynch and Countrywide, both of which are being sued for fraud by MBIA, BAC conveniently ignores that fact while suing MBIA over the transformation.

Of course, the amounts BAC, the successor to Merrill Lynch and Countrywide, owes to MBIA for their fraudulent conduct are material to MBIA's Insurance Corp's claim paying resources, which are the issue in the transformation litigation.

Warranties and Representations Liability

In following remediation efforts by MBIA and Ambac (ABK), I have done some research into the accounting treatment of warranties and representations liabilities by companies that sell their mortgages via securitizations. The paperwork supporting the sale of mortgages uniformly includes warranties and representations of the seller as to the quality of the collateral. Any collateral that does not meet the requirements calls for repurchase or indemnification of the buyer.

If the resulting liabilities of the seller become material to their financial statements, they are sometimes disclosed, typically in a note about contingent liabilities. In some cases, dollar amounts are revealed – in others, that information seems to slip between the cracks.

BAC's Warranties and Representations Disclosure

From their latest 10-Q:

The Corporation sells loans with various representations and warranties related to, among other things, the ownership of the loan, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, the process used in selecting the loans for inclusion in a transaction, the loan’s compliance with any applicable loan criteria established by the buyer, and the loan’s compliance with applicable local, state and federal laws. Under the Corporation’s representations and warranties, the Corporation may be required to either repurchase the mortgage loans with the identified defects or indemnify the investor or insurer. In such cases, the Corporation bears any subsequent credit loss on the mortgage loans. During the three months ended March 31, 2009, the Corporation repurchased $360 million of loans from securitization trusts as a result of the Corporation’s representations and warranties. The Corporation’s representations and warranties are generally not subject to stated limits. However, the Corporation’s contractual liability arises only when the representations and warranties are breached. The Corporation attempts to limit its risk of incurring these losses by structuring its operations to ensure consistent production of quality mortgages and servicing those mortgages at levels that meet secondary mortgage market standards. In addition, certain of the Corporation’s securitizations include a corporate guarantee, which are contracts written to protect purchasers of the loans from credit losses up to a specified amount. The losses to be absorbed by the guarantees are recorded when the Corporation sells the loans with guarantees. The Corporation records its liability for representations and warranties, and corporate guarantees in accrued expenses and other liabilities and records the related expense through mortgage banking income. In addition to the repurchases as a result of representations and warranties, the Corporation repurchased $760 million of loans from the securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls during the three months ended March 31, 2009.

Checking the balance sheet under accrued expenses and other liabilities, the amount increased from 37 billion as of 12/31/08 to 126 billion as of 3/30/2009. What portion of the increase arose from warranties and representations is not revealed, but it is probably substantial, and may very well exceed the amounts MBIA is seeking in litigation, approximately 2 billion from all parties. Certainly the timing of the increase, coming in the wake of the acquisition of Merrill Lynch, is food for thought.

Merrill Lynch's Warranties and Representations Disclosure

From their final 10-K:

In connection with residential mortgage loan and other securitization transactions, Merrill Lynch typically makes representations and warranties about the underlying assets. If there is a material breach of such representations and warranties, Merrill Lynch may have an obligation to repurchase the assets or indemnify the purchaser against any loss. For residential mortgage loan and other securitizations, the maximum potential amount that could be required to be repurchased is the current outstanding asset balance. Specifically related to First Franklin activities, there is currently approximately $36 billion (including loans serviced by others) of outstanding loans that First Franklin sold in various asset sales and securitization transactions where management believes we may have an obligation to repurchase the asset or indemnify the purchaser against the loss if claims are made and it is ultimately determined that there has been a material breach related to such loans. Merrill Lynch has recognized a repurchase reserve liability of approximately $560 million at December 26, 2008 arising from these First Franklin residential mortgage sales and securitization transactions.

Merrill Lynch seems to have been of the opinion that their exposure to this type of thing was limited to First Franklin, a toxic acquisition they bought from National City (NCC). Certainly their view that only 560 million of 36 billion had any problems seems optimistic. On the other hand, perhaps the remaining 35.4 billion was all pure as the wind driven snow.

Countrywide's Warranties and Representations Disclosure

In their final 10-Q, for the 2^nd quarter of 2008, Countrywide disclosed a liability of 755 million, a 929% increase year over year. It is not possible to ascertain whether that trend of growth continued after BAC took over.

A Simple Solution

My take on this is fairly simple – BAC should accept the fact: they are a predator that ate toxic prey that in turn had eaten toxic prey, the toxins get concentrated as the morsel moves up through the feeding chain. You remember the cartoon, the big fish eating the little fish eating the minnow – just include the toxins into the picture. If BAC wants to buy outfits that book millions of dollars of liabilities to account for their own dishonesty then they have to take the consequences.

So BAC should step up to the plate, pay MBIA what they owe, and then watch in wonder as MBIA's credit ratings are restored and the paper they have wrapped begins to trade at much higher valuations.

BAC's fellow litigants could select a representative, somebody who is tactful and personable: he could approach Ken Lewis along these lines: “Ken, we got some problems here, all this stuff we own is trading at very low prices because people got these questions about MBIA. Seems like the problems at MBIA are mostly bogus stuff you sold into bonds they wrapped, we know you know you done it because its on your books and it was on the books of them bush league outfits you bought and you gotta just pay what you owe and then go to USG for more money.”

Then an even more personable and tactful representative could be dispatched to talk to Geithner, he could say something along these lines: “Tim, we got some problems here, all this stuff we own is trading at very low prices because people got these questions about MBIA. Now we know that you have a pretty good line of communication with those guys that own GMAC which owns ResCap which stuck a lot of bogus stuff into bonds MBIA wrapped and we are all in this together and we wouldn't need any more handouts from you if you would just tell those guys to stand up to the plate and have ResCap honor them warranties and representations, then MBIA's credit rating would go up and the crap they wrap would trade higher and our capital would look better, plus you are going to have to give GMAC more money anyway so they can prop up Chrysler so what's another billion?”

Finally an extremely humble and engaging person could be dispatched to see Sheila Bair about Indy Mac. I will leave it to the reader's imagination to develop that emissary's presentation.

Then the litigants who oppose the transformation could just give it up. But it is more likely they will prefer to have their day in court: after all, once you give ground on the warranties and representations issue then you have opened Pandora's box.

Moral Fulminations

Several years ago Bill Ackman asked the question: “who's holding the bag?” Bill Gross felt this would play out along the lines of a game of Old Maid, somebody has to wind up holding the bad card, its a game of wits to avoid being the one. The answer is fairly simple, those who furnished ineligible collateral in connection with securitizations will have to repurchase it. The whole securitization chain featured dishonesty and fraud at every link: every transaction should be pushed back along the chain to the responsible party, if they are still available.

Implications for Investors

I personally would not involve myself in trading BAC stock, either long or short. MBI has huge upside potential in the event our legal system can still dispense justice in the face of the massed might of the financial oligopoly. I wouldn't bet the farm on it.

Disclosure: long MBI, no position ABK or BAC

Comments

[dok tari:]

So if I read this correctly we should avoid BAC which has proven ability as a cash machine once its house is in order and invest in MBI who's future depends on lawsuits? That is fairly nuts.

May 14 11:20 AM

[Gtarras:]

Tom
would be interesting to know your thoughts on WHY you are long MBI (hopefully for other readers as well). Maybe you can write it up? :)))

I have thought about buying MBI long time ago, but after some research realized that without knowing details of their complex CDO transactions, it is impossible to figure out how much value it is there. I am not sure MBI themselves know. I tend to think they will climb back to $30-440 range but it is a game of hide-and-seek.

Btw, i would not listen to anything Ackman says. He is all about show. So completely wrong with MBI and ABK back in 2002!! Yes it did work out for him in 2008 because they plunged into CDO of ABS disaster (from 2005 on), but Gotham were laughable in their attempt to bring these two down 7 years ago...

May 14 11:25 AM

[Tom Armistead:]

dok tari and Gtarras,

Reason to be long, nonGAAP metric adjusted book value stands at 37.61, and does not include any possible recoveries from litigation. In the past MBIA traded at roughly 1X this metric, so a successful resumption of writing municiapl bonds and a resolution of the questions about the cost of their CDO liabilities could entail a recovery to that area.

There are a lot of uncertainties but it's a 6 bagger if it works out, from 5.90 as I type this.

I have a negative reaction to BAC due to the situations noted in the article, whether they can create value from what they bought is not something I want to guess at, hence neither long nor short.

May 14 11:37 AM

[Alessandro:]

Do you really think any financial stock can improve if the trillion dollars in consumer debt is not reduced?

How can the smug elite sleep at night believing things will be business as usual soon while the middle and lower class have little to cling to in the form of 30% credit card interest rate debt?

www.daily-protest.com

May 14 11:41 AM

[dok tari:]

Good questions all. i do know that BAC is not going away from the landscape and I went in at $3.50

May 14 11:50 AM

[Gtarras:]

thanks Tom
Problem (and maybe a blessing) with CDO of ABS is that this product is super sensitive to assumptions in individual mortgage losses. Subprime losses seem to be leveling off though, so I wanted to give MBI another look. Did not know the BV is mid-30s per their calc. Could be close to the fair value because their major problem is CDO of subprime ABS.. hmmm... Thanks!


On May 14 11:37 AM Tom Armistead wrote:

> dok tari and Gtarras,
>
> Reason to be long, nonGAAP metric adjusted book value stands at 37.61,
> and does not include any possible recoveries from litigation. In
> the past MBIA traded at roughly 1X this metric, so a successful resumption
> of writing municiapl bonds and a resolution of the questions about
> the cost of their CDO liabilities could entail a recovery to that
> area.
>
> There are a lot of uncertainties but it's a 6 bagger if it works
> out, from 5.90 as I type this.
>
> I have a negative reaction to BAC due to the situations noted in
> the article, whether they can create value from what they bought
> is not something I want to guess at, hence neither long nor short.
>
>

May 14 12:25 PM

[toomuchgas:]

Noticed that since MBI split its business the muni part has AA- ratings and the other part has BBB+ ratings. Looks like there is plenty of lawsuit fodder to go around.

May 14 12:54 PM

[Tom Armistead:]

toomuchgas, the cerdit ratings agencies have grossly over-compensated for their original mistakes in rating so much toxic waste as tripe A.

So, they reduce the ratings on MBIA Ins Corp, changing the stress tests every month, increasing the stress case by arbitrary and capricious assumptions, basically as a CYA maneuver.

When this is over MBIA will have more credibility that Moody's, S&P and Fitch combined.

May 14 01:55 PM

[Jasper M:]

He sued, she sued.
A plague on both their houses.
BoA is a TARP zombie, would be dead as mutton without the bailout.
MBIA's business model is based on an environment that no longer exists. An Awful lot of debt is going to go 'toes up' shortly (munis And mortgage, so splitting is no escape), and metrics adopted in earlier, easier credit times are not relevant.

disclosure: bought a few puts on MBI, just in case market participants realize the above sooner than later.

May 14 03:34 PM

[Spare Me!:]

I agree with your analysis of what BAC should do but the US gov't doesn't own a part of MBIA so they would support BAC instead of MBIA. It is becoming obvious how corrupt our gov't is. I wouldn't be surprised to see an overt action by this gov't to make money off of MBIA.

Rick P

May 14 06:13 PM

[MutantCapit...:]

Tom,
Fine piece ! One unspoken element running through these cases - Mortgage Servicing Fraud. Merrill's subsidiary and contract servicers, following orders from higher up the food chain manufactured defaults. Servicers add their toxic fraud fabricating these 'credit events' to ensure CDS profit. Case in point, FTC settlement with ML contract servicer Select Portfolio Servicing fka Fairbanks Capital.
www.ftc.gov/bcp/cases/...
This case involved some 280,000 mortgage servicing fraud victims. FTC settlement goes into great detail on how mortgage servicing fraud is inflicted on borrowers who are in good standing with their loans.

May 15 12:43 AM

[Mark Alexander:]

MBIA shareholders would love to see BAC simply walk away from the deals causing such large losses. Unfortunately, this would be unrealistic even if MBIA were truly a naive victim. However, MBIA is a multi-billion dollar institution in the business of evaluating credit risk and there are billions of dollars at stake, so the chances of BAC leaving billions of dollars on the table are approximately 0.

MBIA will almost definitely benefit from repurchases of loans that breach representations and warranties. But this won't happen simply because the loans are bad. There need to be clear (and probably very explicit) breaches.

BAC (including Countrywide and Merrill) originated hundreds of billions of securitized loans, of which the MBIA deals make up a very small subset. The $360M in repurchased loans represents a drop in the bucket. (As an aside, I do not think that the $760M mentioned in BAC’s financials relate to amounts that MBIA is claiming.)

The quality of most of the other Countrywide securitizations was comparable or worse than the MBIA deals. So if a court determined that Countrywide needed to repurchase a high percentage of the securitized loans, BAC would probably let Countrywide go under and walk away.

MBIA is suing Merrill over CDOs, which involve a portfolio of securities, not loans. This suit is built on a false foundation – that Merrill’s special knowledge from detailed loan level analysis afforded an unfair advantage. About 18 months after the first Merrill deal (Broderick 2, possibly the worst of these CDOs), MBIA publicly stated that a very detailed loan level analysis had been performed and concluded that no impairments were likely on these deals.

As for your comments about ABV, this metric more or less takes all of the financial resources available to pay claims and subtracts known losses and other liabilities. It ignores exposures for which no liabilities have been established (around $700B for MBIA). If the value of these exposures were 0, financial guarantors would not need to charge for their product.

Because of this, financial guarantors should trade at a significant discount to ABV unless their franchises are extremely strong. MBIA is tainted by an onslaught of lawsuits, and its business is at best in hibernation, and quite possibly dead. Therefore, even if MBIA’s known loss estimates are OK, MBIA should trade at a very steep discount to ABV, so the upside for MBIA is more like $10 or so for the foreseeable future (not $37.61).

Making matters worse, there is a developing consensus among external analysts that MBIA is grossly understating its liabilities (by an amount that could easily exceed $37.61 per share). Do you really believe MBIA's liabilities are OK? Does it make sense to you that MBIA has a reserve equal to one quarter's worth of payments on second lien securitizations?

If you find time, I would encourage you to look at the points outlined in my Seeking Alpha post from two nights ago (MBIA: A Low Down Dirty Shame). I would prefer to realize I am wrong, and that MBIA really is a good investment and a good company overseen by good regulators.

May 15 01:30 AM

[Tom Armistead:]

I looked at your article, Part 1, paragraph 1 has several factual errors: 600M paid on second liens s/b 450M, 75% s/b 40%, 1.2B s/b 1.3B and there is no 600M of anticipated recoveries on servicer lawsuits anywhere in MBIA's reserves. They have not recognized any possible recoveries in their financial statements to date.

The allegations in MBIA's complaint against Merrill on the CDOs, if factual, demonstrate fraud. It is probably best for you and me to leave determination of that to the courts; although as a practical matter we have to form an impression when we make our investment decisions.

I personally am a big fan of Eric Dinallo and obviously don't support your views on what he has done as a regulator. Both the NYSID and MBIA used 3rd party consultants to look at the projected losses which are central to the issue. When the cases are resolved we will learn more.

I see you are short MBI: just a thought, but if I were you I would do it by options, buying puts, rather than shorting the stock.


On May 15 01:30 AM Mark Alexander wrote:

> MBIA shareholders would love to see BAC simply walk away from the
> deals causing such large losses. Unfortunately, this would be unrealistic
> even if MBIA were truly a naive victim. However, MBIA is a multi-billion
> dollar institution in the business of evaluating credit risk and
> there are billions of dollars at stake, so the chances of BAC leaving
> billions of dollars on the table are approximately 0.
>
> MBIA will almost definitely benefit from repurchases of loans that
> breach representations and warranties. But this won't happen simply
> because the loans are bad. There need to be clear (and probably very
> explicit) breaches.
>
> BAC (including Countrywide and Merrill) originated hundreds of billions
> of securitized loans, of which the MBIA deals make up a very small
> subset. The $360M in repurchased loans represents a drop in the bucket.
> (As an aside, I do not think that the $760M mentioned in BAC’s financials
> relate to amounts that MBIA is claiming.)
>
> The quality of most of the other Countrywide securitizations was
> comparable or worse than the MBIA deals. So if a court determined
> that Countrywide needed to repurchase a high percentage of the securitized
> loans, BAC would probably let Countrywide go under and walk away.
>
>
> MBIA is suing Merrill over CDOs, which involve a portfolio of securities,
> not loans. This suit is built on a false foundation – that Merrill’s
> special knowledge from detailed loan level analysis afforded an unfair
> advantage. About 18 months after the first Merrill deal (Broderick
> 2, possibly the worst of these CDOs), MBIA publicly stated that a
> very detailed loan level analysis had been performed and concluded
> that no impairments were likely on these deals.
>
> As for your comments about ABV, this metric more or less takes all
> of the financial resources available to pay claims and subtracts
> known losses and other liabilities. It ignores exposures for which
> no liabilities have been established (around $700B for MBIA). If
> the value of these exposures were 0, financial guarantors would not
> need to charge for their product.
>
> Because of this, financial guarantors should trade at a significant
> discount to ABV unless their franchises are extremely strong. MBIA
> is tainted by an onslaught of lawsuits, and its business is at best
> in hibernation, and quite possibly dead. Therefore, even if MBIA’s
> known loss estimates are OK, MBIA should trade at a very steep discount
> to ABV, so the upside for MBIA is more like $10 or so for the foreseeable
> future (not $37.61).
>
> Making matters worse, there is a developing consensus among external
> analysts that MBIA is grossly understating its liabilities (by an
> amount that could easily exceed $37.61 per share). Do you really
> believe MBIA's liabilities are OK? Does it make sense to you that
> MBIA has a reserve equal to one quarter's worth of payments on second
> lien securitizations?
>
> If you find time, I would encourage you to look at the points outlined
> in my Seeking Alpha post from two nights ago (MBIA: A Low Down Dirty
> Shame). I would prefer to realize I am wrong, and that MBIA really
> is a good investment and a good company overseen by good regulators.

May 15 09:22 AM

[oldlures1:]

Thanks for your comments. It's good see a pro-MBIA veiwpoint. I'm long MBIA, and have been a fan of the co since before Ackman's shinanigans.

May 15 05:44 PM

[Mark Alexander:]

The key points that you raise do not alter my post’s fundamental conclusions about MBIA as an investment.

1. MBIA’s loss reserves are grossly inadequate.
2. The overall litigation is negative for investors because it increases uncertainty.
3. MBIA has minimal (perhaps negative) franchise value and is exposed to credit risk on over $500B+ of securities plus intra-group guarantees for which no reserve has been established. Therefore, the shares should trade at a steep discount to adjusted book value even if you choose to believe reserves are adequate.

At the risk of getting mired in details, page 79 of the 10-Q states that $617M was paid on second lien securitizations during the second quarter (consistent with servicer reports). Commutations may explain the difference between this and the $458M. The 10-Q indicates that salvage and subrogation collections were about $10M in the first quarter, so this does not explain the difference.

The $1.2B also came from page 79.

You are correct about the litigation recoveries. Thank you for pointing this out. The $600M represents anticipated salvage and subrogation recoveries, principally from excess interest.

The fact that MBIA is anticipating $600M in excess interest recoveries further illustrates how ridiculous the reserves are. The rates for the second lien loans in these securitizations are very high. Borrowers who can repay them will attempt to do so as soon as possible. The ones that cannot will continue to default at rates higher than historical averages. This goes for outstanding balances as well as future draws. The prospects of recouping significant amounts due to future excess interest are not good.

The basic picture remains the same regardless of the characterization of the $600M. The data suggests that MBIA will ultimately pay in the rough ballpark of $4B, though losses could plausibly grow higher. Recoveries from excess interest and originator repurchases will bridge this gap, but MBIA’s $600M estimate seems optimistic. Recovering a lot more than this will be very difficult even if the courts determine that it is warranted, because servicers won’t have the money.

When it comes to the Merrill suits, it is debatable whether MBIA would win even if the factual allegations are correct. However, you have sidestepped the most important point: many allegations are false. This includes arguably the most important allegation, which is directly contradicted by a company press release.

It is not surprising that any shareholder would be a fan of Eric Dinallo, because he has placed shareholder interests ahead of policyholder interests. It is especially convenient for shareholders to remain fans by ignoring difficult questions about Dinallo’s decisions.

I am not convinced that Eric Dinallo’s intentions have been bad. However, if he continues to sacrifice policyholders while attempting the nearly impossible task of saving monoline’s franchises, it will become progressively more transparent for outsiders, and progressively more difficult for him to defend.

May 17 12:59 PM

[User 305589:]

The cruicial point here is the reorganization of mbia. obviously, they want to strip assets off to another subsidiary. Which, if allowed by the courts, could severely impair the value of MBIA's common stock and the MBIA bonds.
Yourt fixation on some adjusted book value is grossly misplaced, imho. Even marty whitman, a long time defender of mbia, is severly dispappointed by mbia's mgmt and sees enormous risks for the surplus notes from the asset-stripping. which, of course, rank far superior to the common shares.

On May 14 11:37 AM Tom Armistead wrote:

> dok tari and Gtarras,
>
> Reason to be long, nonGAAP metric adjusted book value stands at 37.61,
> and does not include any possible recoveries from litigation. In
> the past MBIA traded at roughly 1X this metric, so a successful resumption
> of writing municiapl bonds and a resolution of the questions about
> the cost of their CDO liabilities could entail a recovery to that
> area.
>
> There are a lot of uncertainties but it's a 6 bagger if it works
> out, from 5.90 as I type this.
>
> I have a negative reaction to BAC due to the situations noted in
> the article, whether they can create value from what they bought
> is not something I want to guess at, hence neither long nor short.
>
>

Jul 01 05:17 AM