Banks Face Increasing MBS Litigation Risks

9/27/2011

On September 2, 2011, the Federal Housing Finance Agency, as conservator for Fannie Mae and Freddie Mac, sued 17 financial institutions, including Bank of America, Goldman Sachs and Morgan Stanley, in connection with mortgage-backed securities (“MBS”) that the institutions sold to Fannie and Freddie. The FHFA’s lawsuit alleges that the residential mortgage loans underlying the securities had different and more risky characteristics than those disclosed in the marketing materials provided by the financial institutions. As such, the lawsuit, like the majority of MBS actions filed to date, alleges common law misrepresentation claims and violations of the federal securities laws. MBS sponsors and underwriters may have more to fear, however, from impending breach of contract lawsuits that are gaining in both viability and urgency.

In connection with a typical mortgage-backed securitization, a sponsor (like Countrywide) creates “pools” that contain thousands of mortgage loans that the sponsor has either directly originated or acquired from smaller mortgage lenders. The loans are then securitized and conveyed to a trust. An underwriter helps to structure the securitization and to market the resultant securities to investors. The investors are entitled to principal and interest payments from the mortgage loans underlying the securitization. Because the quality of the underlying mortgage loans is very important to investors (e.g., an investor-owned condo in Las Vegas, purchased with no money down, has a very different risk profile than an owner-occupied single family home in Texas), the sponsor makes representations and warranties to investors regarding the characteristics of the mortgage loans. Typically, sponsors represent that the mortgage loans were acquired and originated in accordance with the sponsor’s underwriting guidelines. If a loan breaches a representation and warranty, the sponsor is required to repurchase the loan from the trust. This is typically referred to as a “put-back.”

Financial institutions may face significant and increasing put-back exposure because evidence is mounting that breaches of representations and warranties, including breaches of underwriting guidelines, were common – if not pervasive – during the height of the MBS boom in 2006 and 2007. For example, in connection with its lawsuit against Bank of America, AIG has recently alleged that it conducted a forensic analysis of more than 262,000 mortgage loans underlying securities that AIG purchased and concluded that 82% of the loans did not comply with the applicable underwriting guidelines, as represented. In addition, New York – where many MBS actions have been brought due to choice of forum clauses as well as the presence of plaintiffs and/or defendants – has a six year statute of limitations for breach of contract claims. As such, the deadline to file actions based on the worst-performing MBS vintages is rapidly approaching.

While put-back claims are not easy or inexpensive to prosecute, they have the advantage of being contractual in nature, which eliminates a plaintiff’s need to prove scienter or fraudulent intent. Moreover, courts have begun to authorize the use of statistical sampling, which will ease the logistical burden associated with litigating a case involving tens (if not hundreds) of thousands of mortgage loans. As such, financial institutions will have to continue to grapple with the legal fallout of the housing crisis.

For more information, please contact Jared Perez at jperez@wiandlaw.com.