For bond insurers suing banks, the ruling Tuesday night by U.S.
Senior District Judge Jed Rakoff in Assured Guaranty's suit
against Flagstar is as welcome as a glass of single-malt scotch
at the end of a long work week. The Manhattan judge's 103-page opinion doesn't simply award Assured $90.1 million, nearly all
the bond insurer wanted for Flagstar's alleged breach of
representations and warranties on home equity loans underlying
two securitizations with a combined face value of $900 million.
Rakoff's decision also supports just about all of the theories
that Assured's fellow monolines are relying upon in put-back
cases claiming billions from banks that issued mortgage-backed
notes. Assured's case was the first put-back suit to be tried,
and Rakoff's ruling is the first decision to weigh a bond
insurer's evidence and expert testimony. The opinion isn't
binding on any other court, but Rakoff is a well-respected judge
who presided over a lengthy bench trial in this case. If lawyers
representing monolines were the types who turned cartwheels in
glee, we'd have seen a lot of shiny shoes in the air Tuesday
night.
To cite just some of the great news for bond insurers in the
opinion: Rakoff endorsed the use of loan sampling to establish
both a breach rate and damages, which relieves put-back
plaintiffs from having to slog through loan pools one file at a
time. He accepted the testimony of Assured's underwriting
expert, even while acknowledging that underwriting involves
subjectivity (and that this particular expert made some
mistakes). He said that the materiality of reps and warranties
breaches doesn't depend on what ultimately caused underlying
loans to default, but instead on whether the loans failed to
meet stated underwriting standards and whether breaches
significantly affected the risk profile of the underlying pool.
Rakoff said Flagstar was put on notice of widespread breaches
when Assured first informed the bank of reps and warranties
breaches; and he adopted Assured's damages model, awarding the
bond insurer money that would have flowed into the trusts if
Flagstar had repurchased defective loans when breaches were
discovered. Implicitly, but importantly, Rakoff's decision also
repudiated a troubling put-back ruling from a Minnesota federal
judge who held issuers cannot be sued for money damages based on
foreclosed loans.
Rakoff even ruled that Assured is entitled to legal fees and
costs under its insurance contract. And because the judge
referred repeatedly to his own review of individual loan files
(including the notorious loan to a Detroit cop who supposedly
moonlighted as the president of a mortgage company) and his
personal assessment of the credibility of both sides' experts,
he made the ruling tough for Flagstar to reverse on appeal. As
monoline lawyer Donald Hawthorne of Axinn Veltrop Harkrider told
my Reuters colleague Nate Raymond, "This is game-changing. The
opinion proves what some of us have been saying for some time:
Put back claims are quick and efficient to prove and extremely
potent."
But is Rakoff's ruling equally potent for MBS noteholders?
After all, put-back suits by monolines such as MBIA, Ambac,
Assured, Financial Guaranty and Syncora are only one slice of
MBS litigation. The latest trend is reps and warranties claims
by MBS trustees acting at the direction of noteholders. Some
judges, most notably U.S. District Judge Paul Crotty and New
York State Supreme Court Justice Eileen Bransten, have clearly
distinguished between monoline and investor claims when they've
issued rulings in bond insurer cases. On the other hand, when
Rakoff denied Flagstar summary judgment on the loss causation
issue last September, he didn't draw that line.
Nor does he in the Assured opinion. In most regards,
Tuesday's decision should be as valuable to noteholders as to
bond insurers. One exception is Rakoff's holding on Assured's
right to attorneys' fees, which is based on a provision of the
insurance contract. Noteholders aren't covered by insurance
contracts, only by pooling and servicing contracts. But most of
Rakoff's findings were based on PSA-type contracts, not
insurance documents. So on such key questions as the
interpretation of what constitutes a material breach, the use of
loan sampling to establish liability and the availability of
money damages to cure breaching loans, Rakoff's reasoning should
apply equally to bond insurers and investors. Michael Shuster of
Howell Shuster & Goldberg, who represents noteholders in at
least half a dozen trustee suits, said he thinks the Rakoff
ruling will prompt more filings by investors. "Overall, this
decision is highly favorable for all put-back plaintiffs," he
said. "Banks will not take comfort from this opinion."
Shuster and other plaintiffs' lawyers told me that Rakoff's
admission of testimony by Assured's underwriting expert, whose
methodology was vigorously attacked by Flagstar's lawyers at
Arnold & Porter, will be especially helpful in other put-back
cases. Rakoff concluded that underwriting just isn't an
objective exercise. Nevertheless, he said, "the absence of
mechanical standards for defining all the circumstances that
might create a material breach of Flagstar's representations and
warranties with respect to any given loan reflects not a failure
of methodology, but a candid recognition of the multi-variable
nature of the inquiry." When he personally reviewed loan files
that Assured's expert found to contain breaches, he found that
the expert's assessments "were right on target, for many of the
loans ... exhibited precisely the defects - many of which were
blatant - that (she) posited," Rakoff wrote. "In short, the
court finds (her) methodology not only appropriate to the
courtroom but corroborated by the court's own review."
All put-back cases hinge on underwriting standards, so,
according to Hawthorne, Rakoff's ruling "provides a road map" by
which plaintiffs can establish deficiencies. "After this
decision, the defendants will be reduced to quibbling over
reunderwriting standards," Hawthorne said in an email. "But the
bigger battle has been won: Bond insurers, investors and
government entities had a right to rely on the representations
and warranties given by mortgage originators."
Flagstar told Reuters that it disagrees with Rakoff's ruling
and intends to appeal.
Follow us on Twitter: @AlisonFrankel, @ReutersLegal | Like us on Facebook