Saving BofA

Investment analysts, of course, were the first to see the walls closing in on Bank of America. Last October, Iridian Asset Management devoted its Q3 client letter to the confluence of legal pressures on BofA to "put back," or buy, bad securitized mortgages underwritten by its ill-starred acquisition, Countrywide Financial.

Put-backs, according to standard mortgage pooling and servicing agreements, are required if the underwriter breaches representations and warranties made to investors in residential mortgage-backed securities (RMBS). Iridian did the math on put-back requests pending with BofA: $47 billion in requests from a major investor group represented by Houston's Gibbs & Brun, plus $165 billion from Fannie Mae, Freddie Mac, and private insurers. Assuming that the bank would earn off-setting profits during several years of buy-backs, Iridian came up with an estimated total pretax loss of $113 billion.

"[I]t is very difficult for us to imagine an outcome where Bank of America does not suffer at least $50 billion in unanticipated pre-tax losses," the analysts wrote. "We are playing for credit defaults and bankruptcies, for - if not a systemic risk - then at least a mortal threat to important actors within the system," they concluded.

That 2010 letter - and others like it written by competing analysts - must have lit a fire under BofA's lawyers. According to pleadings in a New York proceeding to approve a proposed settlement, negotiations began in earnest last November between BofA, the trustee for Countrywide's RMBS, and 22 institutional investors. Announced in June, the deal required BofA to pay beneficiaries in 530 trusts with estimated losses of $108 billion a total of $8.5 billion - or about 8 cents on the dollar.

The trustee - Bank of New York Mellon (BoNY) - sought court approval under Article 77 of the New York Civil Practice Law and Rules (N.Y. C.P.L.R. § 7701), a unilateral proceeding usually invoked in family trust matters (In re Bank of New York Mellon, No. 651786/2011 (N.Y. Sup. Ct. (N.Y. Cnty.) petition for instructions filed June 29, 2011). Under the New York law, interested parties could move to intervene or object, but they could not opt out of the settlement. Most important, under the procedural rules the trustee is required only to show that it acted reasonably and within its powers.

There was much more in the agreement's fine print. The deal includes a permanent bar to further litigation by any trust investors against BofA or Countrywide Financial, and binds the bank, the trustee, and the 22 institutional investors in a three-way confidentiality agreement. In a side letter, BofA indemnified the trustee for any costs and liability it might incur for claims from other certificate holders. And the bank - ostensibly the liable party in this deal - agreed to pay $85 million in attorneys fees to the investors' counsel, Gibbs & Brun.

Though the 22 named parties lack the requisite percentage of voting rights in more than half of the covered trusts - and have no voting rights at all in 28 of them - they are a formidable group that includes the New York Fed, Goldman Sachs, PIMCO, Blackrock Financial, the Federal Home Loan Bank of Atlanta, and a long list of major insurers. In a petition to intervene in support of the deal, they argued it was "fair, reasonable and in the clear interest of the Covered Trusts." In July, BofA's stock inched upward.

But the proposed deal may be too clever by half, sparking immediate petitions to intervene or object. "Investors must - and, in my opinion, will - challenge this settlement as not in the interests of the bondholders," attorney Isaac Gradman posted on his blog, Subprime Shakeout. "A more reasonable settlement would be in the range of $25 to $50 billion."

The Article 77 strategy to get the deal approved drew as much flak as the settlement terms. Georgetown Law Professor Adam J. Levitan wrote on Credit Slips that "BoNY has not established its authority to settle claims on behalf of the trust." And in an academic paper, Levitan pointed out glaring conflicts of interest: two-thirds of BoNY's mortgage-backed securities trusteeships are for Countrywide/Bank of America. "Because such a large portion of [BoNY] Mellon's RMBS trustee business comes from one single depositor," he wrote, [BoNY] Mellon will inevitably have to be deferential to that depositor."

By the late August filing deadline, petitions to intervene or object had been filed by several groups of hedge funds, six regional Federal Home Loan Banks, union pension funds, AIG (which also sued BoNY alleging fraud), the Federal Deposit Insurance Corp., and the state attorneys general of New York and Delaware.

New York AG Eric T. Schneiderman's petition pulled no punches, invoking parens patriae on behalf of the state's investors and adding counter-claims of his own against BoNY for breach of fiduciary duty, fraud, and aiding-and-abetting violations. According to the petition, "Countrywide and BofA face liability for persistent illegality in: (1) repeatedly breaching representations and warranties concerning loan quality; (2) repeatedly failing to provide complete mortgage files as it was required to do under the Governing Agreements, and (3) repeatedly acting pursuant to self-interest, rather than investors' interest in servicing."

"This is big," posted Gradman, who is also principal at the RMBS consulting firm IMG Enterprises in Petaluma. "[T]he AG has blown the cover off of the issue of improper transfer of mortgage loans into RMBS trusts. This has truly been the third rail of RMBS problems, which few plaintiffs have dared touch, and yet the AG has now seized it with a vice grip."

Attorneys representing BoNY bitterly opposed Schneiderman's petition, asserting that he lacked standing and dismissing his fraud allegations as having "no bearing on the question of whether the Trustee acted reasonably and in good faith in entering into the Settlement." The institutional investors also objected, saying Schneiderman's petition "would deprive certificate holders of their right to an expedited resolution of this matter."

Days later at a funeral for former New York governor Hugh Carey, the deputy director of the New York Fed - one of the 22 institutional investors supporting the settlement - personally urged Schneiderman to back off. "Schneiderman is finding out the rabbit hole is far deeper than he had realized," Gradman says.

New York Supreme Court Judge Barbara R. Kapnick made a series of rulings on the various petitions and scheduled a hearing for November 17. But in late August David J. Grais of New York's Grais & Ellsworth, representing intervenor Walnut Place LLC, removed the case to federal court under the Class Action Fairness Act, claiming it was a mass action. Attorneys for the trustee quickly sought remand, asserting that "Walnut timed the removal to give itself two bites at the apple on contested procedural matters." Regardless of venue, however, arguments on standing and the scope of discovery will inevitably delay a ruling on the settlement for many months.

In an interview, Gradman says the proposed deal represents a bold move to quickly clean up BofA's immense Countrywide RMBS liabilities. But he adds, "If BofA's strategy was to settle all claims at once, it's not going so well. Schneiderman has shown he's willing to touch mortgage transfers - which is a nightmare that could undermine the entire system."

A year ago Iridian's Q3 letter concluded, "The big banks have reserved billions of dollars for litigation expenses concerning put backs. ... [W]e expect this all-out war between the biggest financial institutions in the world to be played out in the courts over a period of two to three years."

If you had shorted BofA stock on Iridian's recommendation, you'd have made a killing: Since January the share price has dropped by more than 40 percent.

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