As this issue of HousingWire was going to press, Standard & Poor’s cut its ratings on 15 large banks such as Bank of America, Goldman Sachs and Morgan Stanley. The downgrades reportedly were driven by “a revision of the agency’s internal models,” Reuters reported, “and not because of a change in the banks.” Yet, the fact remains that the market perception of the solidity of large banks is clearly eroding because of the failure of U.S. officials to move aggressively to settle questions of solvency.

For most of 2011, Bank of America struggled to resolve financial issues that have dogged the nation’s second largest bank since the start of the housing crisis in 2007. In many respects, the problems facing Bank of America have only become more acute as efforts to settle the hundreds of billions of dollars in legal claims pending against the bank have shown small results.

There are several different types of legal claims pending against Bank of America.  Probably the most serious are claims by investors in securities issued by Countrywide Financial seeking to “put back” defaulted loans. These are essentially demands that Bank of America make investors whole for bad loans securitized into residential mortgage-backed securities. There are still roughly $100 billion in these claims pending.

The second, related area of financial exposure for Bank America comes from claims of securities fraud. These are similar to the put-back claims by investors and rely on the same basic facts, but the claimants are different and the potential risk to Bank of America totals more than $100 billion, including about $60 billion for Countrywide RMBS, another $30 billion for collateralized debt obligations issued by Merrill Lynch and $10 billion arising from securities created by Bank of America pre-Countrywide. All of these figures come from PACER, the electronic records system for the U.S. federal courts.

In addition to these two large groups of claims, Bank of America is also facing the more publicized claims of foreclosure abuse and other types of abuse of process. The amounts involved here are an order of magnitude smaller than the totals shown above. But there are other — as yet unpublicized — types of legal risk exposure facing Bank of America and other large banks.

SETTLEMENT HITS THE SKIDS

This past summer, Bank of America and The Bank of New York Mellon attempted to push through a settlement of a large portion of the Countrywide put-back claims in New York State Supreme Court, but the process quickly unraveled. First, New York Attorney General Eric Schneiderman and other state AGs intervened in the case. New York actually sued Bank of America and The Bank of New York Mellon for fraud under the Martin Act. The Federal Deposit Insurance Corp. and the government-sponsored enterprises also objected to the settlement. Then one of the private litigants filed a removal of the entire litigation to federal court. Federal Judge Jed Rakoff approved the removal, sending the entire settlement process back to square one.

Bank of America now faces the prospect of going to trial early in 2012 for the put-back claims, which have all survived motions to dismiss. The Bank of New York also faces extensive liability due to its alleged malfeasance as trustee for hundreds of RMBS trusts.  This may be why Robert Kelly departed suddenly as CEO of The Bank of New York Mellon last August.

Once the New York AG intervened in the Countrywide litigation, Kelly’s position of “litigate them into annihilation” regarding RMBS investors quickly lost board support. Kelly’s position reportedly was eroded because he told The Bank of New York board that the Countrywide settlement would be approved without any problems. It is interesting to note that Bank of America, unlike other issuers of RMBS, has yet to sue The Bank of New York for failure to perform its fiduciary duties as trustee. 

Because of the intervention of the New York AG in the Countrywide put-back litigation, there is also a significant and but imponderable risk that Bank of America, The Bank of New York and other lenders may face criminal prosecution in New York under the Martin Act for busted RMBS deals. The state has a statutory interest in all trusts formed under New York law, thus Schneiderman is almost compelled to discipline banks, trustees and even the law firms that failed to perform their duties with respect to these RMBS.

TIME TO RESTRUCTURE

Given the magnitude and range of legal claims facing Bank of America, my view is that the bank’s parent company must be restructured in order to end the uncertainty with respect to the liquidated and unliquidated claims against the bank. No amount of layoffs or other cost savings by the management of Bank of America will resolve the crisis of confidence affecting the bank due to unresolved claims from legacy RMBS and lending activities.

Like Robert Kelly at The Bank of New York, the current plan being followed by Bank of America CEO Brian Moynihan is to muddle along until events force the issue. I have argued for the past two years that Bank of America can be restructured a la General Motors and even Lehman Brothers, with the separate business units continuing to operate as the restructuring proceeds. If you recall that on a parent-only basis, Bank of America Corp. has only $200 billion in debt and no operations, the path to restructure the organization becomes clear.

First comes the question of what legal avenue to pursue to effect the restructuring. There are three choices: a resolution under Dodd-Frank; a voluntary Chapter 11 bankruptcy by the parent company only; and the appointment of a receiver by a federal court to oversee the restructuring and ensure all parties are treated equitably.

A Dodd-Frank resolution is the worst choice for both the bank’s customers and creditors.  A Chapter 11 bankruptcy filing is better for creditors, but precludes the pursuit of third parties such as The Bank of New York to contribute to cost of settling claims against Bank of America. 

The best choice for restructuring Bank of America, in my view, is the appointment of a receiver by a federal judge. This is different from a bankruptcy trustee because the receiver is independent of the debtor can pursue claims against third parties. As we wrote in a comment in The Institutional Risk Analyst, “Should the Courts Appoint an Equitable Receiver for Bank of America?,” the litigation surrounding the Madoff bankruptcy illustrates why a bankruptcy trustee cannot go after third parties whose actions may have precipitated the default.

In an article on the use of receivership and an alternative to bankruptcy, John Tanner of Fairfield and Woods notes:

“There are two primary advantages to the creditors of an equitable receivership over a bankruptcy. First, a receivership immediately replaces management (with the receiver), whereas a Chapter 11 bankruptcy proceeding tends to entrench management and give it even greater authority. Where the company would be sound but for management, a receiver is often the better solution. Stated differently, if money is really the problem, bankruptcy may be a good course of action. If money is just a symptom, however, and the problem is really management, a receiver may be a far superior approach for creditors and investors.

“Second, there are virtually no statutes that control a receivership in the manner that the Bankruptcy Code and Bankruptcy Rules control a bankruptcy. Therefore, a receivership has considerably greater flexibility than does a bankruptcy. There is no panel or pool from which receivers are selected, allowing a party seeking the appointment of a receiver to select the individual or company best suited to serve as receiver. A receivership judge, in the appointing or subsequent orders, can set out virtually any procedures, rules, mechanisms, etc. that are appropriate under the circumstances. This allows the receivership to be tailored to the circumstances of the case to a much finer degree than a bankruptcy.”

In terms of helping the housing market and the U.S. economy, either a Chapter 11 bankruptcy filing or a receivership for Bank of America would achieve the same positive results. But the former path allows the management of the bank to remain in place and, more important, precludes the pursuit of third parties that should arguably contribute to the resolution of the claims against the bank. Bondholders, litigants and other creditors of Bank of America would see their recoveries greatly diminished in a bankruptcy. 

But as in the case of the collapse of the Stanford Group in 2009, the appointment of a federal receiver avoids bankruptcy entirely and creates a flexible and very powerful forum for resolving all claims against Bank of America — and keep the company’s business units operating. A federal receiver would immediately replace management and the Bank of America board, and can restructure the company, sell assets and even spin off some or all of Bank of America’s operating units to pay claims. 

As one senior Fed insider told me in early December, the key term for 2012 when it comes to the legal claims against Bank of America and other large banks with gigantic legacy RMBS liabilities is “separability.”