For some time now I have argued that Bank of America needs to be restructured via a bankruptcy of the parent company. The reason for this apostate view about one of the nation’s largest banks? The growing mass and intensity of securities fraud litigation against Bank of America and its subsidiaries like Countrywide Financial and Merrill Lynch.
The Department of Justice filed a lawsuit recently seeking at least $1 billion in penalties against Bank of America for troubled loans sold to several government-sponsored enterprises, including mortgage finance giants Fannie Mae and Freddie Mac. The government complaint is anchored upon a program to push out mortgages implemented by Countrywide Financial, which Bank of America acquired in July 2008 without a bankruptcy.
Fraudulent mortgage securities or RMBS originated by Countrywide and Bear Stearns are the worst of the remaining exposures of subprime investment banks yet to be resolved by the courts. Most people in the mortgage industry know that the production from Countrywide, Bear Stearns and other banks was defective. Both Countrywide and banks such as Washington Mutual and Lehman Brothers perfected the process of submitting flawed loans, over and over again, in order to defeat the risk management systems of the GSEs.
In May of 2008, I wrote a column for “The Institutional Risk Analyst” asking “Is WaMu the Next Bear Stearns?” I understood that Washington Mutual, like Bear Stearns, had significant problems with fraud, thus it was likely that the bank was going to fail. The reason for this surmise of impending failure was funding. The core principal of the subprime crisis was that institutions failed based upon the degree of weakness in their liability structure, especially reliance upon short-term market sources for funding.
On Sept. 25, 2008, the banking operations of Washington Mutual were sold to JPMorgan Chase in a transaction facilitated by the Office of Thrift Supervision and the Federal Deposit Insurance Corp.
The parent of WaMU ended up in bankruptcy court, where most of the unliquidated claims for securities fraud died. The investors in WaMu were far from happy with the FDIC takeover, including Texas Pacific Group, which actually invested more money in the bank before it failed. But the fact is that the assets and deposits of WaMu were separated from the litigation and were put into strong hands at JPMorgan. The claims of all of the litigants were litigated and eventually settled in the bankruptcy process.
But the WaMu resolution was also the last time that U.S. banking authorities were willing to restructure a large bank. In particular, Bank of America and the festering situation around Countrywide have yet to be resolved. The bank’s management led by Brian Moynihan has not even begun to create a reserve against the tens of billions in settlements likely to be required to settle civil claims — claims which are several orders of magnitude larger than the $1 billion sought by the DOJ.
If you follow Bank of America closely, what you see is an organization that has been selling assets and slowly taking itself apart in an effort to raise cash and avoid creating new liabilities. Once the leading real estate lender in the U.S., last year Bank of America withdrew from correspondent and wholesale lending. The marginalization of Bank of America is taking huge capacity away from the real estate sector at a time when the U.S. needs more leverage supporting home ownership.
In August 2011, New York Attorney General Eric Schneiderman intervened in New York state court to object to the proposed $8.5 billion settlement of put-back claims over hundreds of residential mortgage-backed securities trusts created by the Countrywide unit of Bank of America. The trustee — Bank of New York Mellon — had reached a settlement with a self-appointed “Group of 22” large investors that was intended to be binding on all investors. The NY AG objected on grounds that the settlement was unfair to trust investors. He also made serious charges over BoNY’s actions as trustee, but so far Schneiderman has yet to act further in the litigation.
The whole premise of the $8.5 billion settlement is that Bank of America really isn’t responsible for Countrywide, but out of the goodness for the hearts of the long suffering shareholders, the bank will offer this token to injured investors. Even though Bank of America has taken the position since 2007 that it isn’t responsible for the acts of Countrywide, that position now lies in tatters with the DOJ action.
The litigation involving Bank of America and Countrywide raises the possibility that the bank will be forced to repurchase bonds from investors. The Bank of America litigation is a case in point when it comes to fraud, but in that litigation as well as with the JPMorgan litigation involving Bear Stearns & Co., the plaintiffs arguably have the potential to win rescission of the original RMBS. The only question is whether the investors and their advisers understand their rights and the value of potential claims.
Something like half of the potential claims in the BAC and JPM litigation have not been filed with courts, raising an interesting question about the legal exposure of advisers who failed to act in a timely fashion to protect the rights of their clients. And worst of all, Schneiderman has yet to do his duty under the law to help investors. And what should Eric Schneiderman do?
1) The state of New York should be seeking the removal of Bank of New York as custodian with respect to all RMBS trusts operated pursuant to N.Y. law and immediately file a claim on behalf of all investors against BoNY for negligence.
2) Scheiderman should seek the appointment of a new custodian to replace BoNY and also seek a receiver under federal law with respect to these RMBS issued by Bank of America and Bear Stearns. We need the power of a federal receiver to attack the alleged legacy fraud at JPMorgan, Bank of America and the other zombie. That receiver will also act to restore monies owed to investors.
The bottom line for JPMorgan, Bank of America and other banks facing RMBS litigation is that the proverbial party is just getting interesting. But will we be speaking about new reserves for these “potential” claims in fourth quarter earnings statements? Hell no. Both Bank of America and JPMorgan will drag their feet as long as possible to avoid the day of reckoning that must come with these two truly hideous subprime banks. Only by acting with purpose and using the power of bankruptcy and receivership can we bring finality and equity to investors defrauded in the subprime mess.