Posts filed under “Derivatives”
Last week, I wrote about a few developments that should boost RMBS litigation recoveries, especially for bond insurers – Judge Crotty’s summary judgment decision in Syncora v. EMC (JPMorgan) and Syncora’s subsequent settlement with BofA, resolving all of the parties’ ongoing relationships. It appears I’m not the only one who has concluded that banks may need to reassess their potential payouts as a result of recent legal setbacks.
In this July 27 client alert, major financial services firm O’Melveny & Myers, which represents BofA in MBIA’s putback suit in New York, addressed the impact of Crotty’s Opinion [hat tip Manal Mehta from Sunesis Capital for passing this along]. While the alert is short and worth reading in its entirety, the gist of O’Melveny’s conclusion is as follows:
In light of a recent federal court ruling, banks may wish to reevaluate litigation risk from plaintiff insurers claiming injury from alleged breaches of representations and warranties regarding mortgage securitization notes that they insured…
Institutions facing such lawsuits may wish to re-evaluate their exposure, and possibly adjust reserves set aside to cover such risks, based on the type of plaintiff and the specific language of the securitization agreements at issue.
Hold the phone – so BofA’s own law firm in its putback litigation with MBIA is publishing an alert saying that banks may need to adjust their loss reserves associated with monoline putback litigation? This is essentially an admission that the firm sees the tide turning against the banks in these suits. Shouldn’t this have generated some serious pushback from O’Melveny’s powerful client?
Short answer: yes. According to Mehta, this alert was pulled from O’Melveny’s website shortly after publication, only to be re-posted today. We can only speculate as to why the alert was pulled and then re-published (without significant revision), but I can imagine that there were a few heated phone calls in between.
Regardless, now that we finally have a definitive decision from a respected court on the proper standard for mortgage putbacks, we have enough guidance to begin discussing RMBS litigation end games in earnest. Today, we’ll begin by looking at the bond insurer suits.
These, along with mortgage insurer suits, were some of the earliest filed pieces of RMBS litigation and have been prosecuted aggressively since the onset of the mortgage crisis by some of the most skilled and aggressive private legal teams in the business. And for good reason: the monolines issued what are known as “financial guaranty” policies, which included a guarantee that insurers would make policy payments if losses mounted; they could not deny claims or rescind coverage.
This means that bond insurers have already suffered massive, company-crippling losses as a result of insuring pools of misrepresented loans, and have been forced to pursue years of contentious litigation just to try to recover the funds they paid out. The good news for them, is that after 4+ years of litigation, they’re finally beginning to see the light at the end of the tunnel.
Monoline End Game Scenarios
As I mentioned at the top of this article, Syncora and Countrywide just reached a settlement of all their outstanding RMBS litigation and other issues, in which Syncora will receive a cash payment of $375 million and a return of certain of its preferred shares, surplus notes and other securities. It’s no coincidence that this settlement comes on the heels of several wins for the monolines in their suits against the major Wall St. banks. It demonstrates that the banks (or at least Bank of America), are beginning to realize that the bond insurers’ claims in these suits are potentially expensive and difficult to defeat. This settlement, in conjunction with BofA’s settlement with Assured Guaranty (AGO) back in April of 2011 and its proposed settlement of investor putback claims initiated in June 2011, show that BofA is making a concerted effort to put legacy Countrywide liabilities behind it.
This bolsters my long-held view that the most likely end game scenario for the monolines consists of party-by-party settlements with their various bank counterparties that address all of the outstanding legal issues between the parties. As I’ve discussed in the past, the last thing that an issuing bank wants is for one of these cases to go to trial and to see the parade of horribles that the monoline will trot out before the factfinder, showing clear breaches of underwriting guidelines time and time again. Not only would such a trial be long and embarrassing, but it would open up the banks to paying upwards of 75-80 cents on the dollar of losses to the insurers, rather than the 25-30 cents they might be able to pay in settlement.
Of course, the tougher questions surround the timing and the ultimate size of these potential settlements. If we could get our arms around the size of prior settlements, this might help give us a ballpark of the size of the settlements to come. In my prior article on the Assured Guaranty settlement (at item No. 4), I noted that based on BofA’s estimates, they were covering about 55% of AGO’s losses. The Syncora-Countrywide settlement is much more difficult to parse as the deal, according to Syncora’s press release was part of “an effort to terminate other relationships between the parties,” aside from simply the putback disputes. My guess is that the putback disputes constituted the bulk of the outstanding liabilities, but it’s difficult to assess the exact proportion, as well as the value of the other consideration received by Syncora.
Local Governments Which Entered Into Interest Rate Swaps Got Scalped
We know that the Libor manipulation effected the world’s largest market – interest rate derivatives.
But who are the biggest victims?
Sometimes the big banks manipulated the Libor rates up, and sometimes down. Different groups of people got hurt depending which way the rates were gamed.
Bloomberg’s Darrell Preston explained last year how cities and other local governments got scalped when rates were manipulated downward:
In the U.S., municipal borrowers used swaps to guard against the risk of higher interest costs on variable-rate debt by exchanging payments with another entity and tying how much they pay to an underlying value such as an index. The agreements can backfire if rates move in unexpected directions, resulting in issuers making larger payments.The derivatives were often designed to offset the risks of increases in the short-term rates tied to auction-rate securities, fixing borrowers’ costs by trading their debt- service payments with another party. Instead, rates dropped.
The yield on two-year Treasury notes fell from about 5.1 percent in June 2007 to a record 0.14 percent on Sept. 20. On Oct. 6, the U.S. Treasury sold $10 billion of five-day cash- management bills at 0 percent.
Ellen Brown adds:
For more than a decade, banks and insurance companies convinced local governments, hospitals, universities and other non-profits that interest rate swaps would lower interest rates on bonds sold for public projects such as roads, bridges and schools. The swaps were entered into to insure against a rise in interest rates; but instead, interest rates fell to historically low levels. This was not a flood, earthquake, or other insurable risk due to environmental unknowns or “acts of God.” It was a deliberate, manipulated move by the Fed, acting to save the banks from their own folly in precipitating the credit crisis of 2008. The banks got in trouble, and the Federal Reserve and federal government rushed in to bail them out, rewarding them for their misdeeds at the expense of the taxpayers. [The same thing happened in England.]
How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”:
In an interest-rate swap, two parties exchange payments on an agreed-upon amount of principal. Most of the swaps Wall Street sold in the municipal market required borrowers to issue long-term securities with interest rates that changed every week or month. The borrowers would then exchange payments, leaving them paying a fixed-rate to a bank or insurance company and receiving a variable rate in return. Sometimes borrowers got lump sums for entering agreements.
Banks and borrowers were supposed to be paying equal rates: the fat years would balance out the lean. But the Fed artificially manipulated the rates to the save the banks. After the credit crisis broke out, borrowers had to continue selling adjustable-rate securities at auction under the deals. Auction interest rates soared when bond insurers’ ratings were downgraded because of subprime mortgage losses; but the periodic payments that banks made to borrowers as part of the swaps plunged, because they were linked to benchmarks such as Federal Reserve lending rates, which were slashed to almost zero.
In a February 2010 article titled “How Big Banks’ Interest-Rate Schemes Bankrupt States,” Mike Elk compared the swaps to payday loans. They were bad deals, but municipal council members had no other way of getting the money. He quoted economist Susan Ozawa of the New School:
The markets were pricing in serious falls in the prime interest rate. . . . So it would have been clear that this was not going to be a good deal over the life of the contracts. So the states and municipalities were entering into these long maturity swaps out of necessity. They were desperate, if not naive, and couldn’t look to the Federal Government or Congress and had to turn themselves over to the banks.
While the name Abacus is famous as Goldman’s fraudulent CDO scheme – the poster child for the rampant fraud on Wall Street – another Abacus (a small bank) has just made news by being criminally indicted for mortgage fraud. Bloomberg’s Anthony Lee Pacchia interviewed Bill Black on the meaning and ramifications, and sent me the…Read More
Michael Belkin is the author of the eponymously named Belkin Report — a highly respected institutional quantititative/technical service that looks at global markets in equities, commodities, currencies and bonds. His report this week is tongue-in-cheek titled “Where Else Are You Going To Put Your Money?” and begins with this delightful spoof of the Euro bailout…Read More
As An Encore to Bailing Out the Big Banks, Government to Backstop Derivatives Clearinghouses … In the U.S. and Abroad … Which Will Lead to Bailouts and Encourage Even More Fraud The government has been bailing out the giant, insolvent banks for years. (Many of the bailed out banks are foreign.) That is preventing the…Read More