Bank of New York: A Train Wreck Waiting to Happen?

Posted: 19 Sep 2011 12:54 AM PDT Many readers no doubt know that the so-called $8.5 billion Bank of America mortgage settlement, which was between the Charlotte bank and the Bank of New York as trustee for 530 residential mortgage securitizations, had run into some very serious headwinds. The deal had to be approved in a socalled Section 77 hearing; a number of interested parties, including some investors, the attorneys general of New York and Delaware, and the FDIC, raised questions and objections to the deal, as well as to the use of a Section 77 hearing (which sets a very high bar for opposing an agreement). Although this saga has a quite a few more rounds to go, it looks likely that any settlement will be considerably delayed and will wind up costing Bank of America a good bit more than $8.5 billion. What has gotten less attention is the implication of the probable derailment of this deal for the Bank of New York, and its vulnerability to mortgage litigation. If you think, as banking expert Chris Whalen does, that BofA is a goner by virtue of the odds of very large damages in the various mortgage cases that are in progress, Bank of New York is a goner even faster if (and we really mean when) investors start saddling up to target the bank. The liability of trustees in mortgage securitizations is so obvious and comparatively easy to prove that I am surprised that no one has yet gone after it. However, investors are probably understandably cautious about filing suits that might expose widespread failures of originators and pacakgers to convey mortgage loans to securitizations, which would lead to lots of collateral damage (no pun intended). The Delaware filing on the BofA settlement highlights the issue, which is that the trustees had made multiple representations in securities filings that the mortgage trusts had the assets they said they did. From our post on the Delaware filing: And it goes straight to an issue we flagged, that the trustee makes annual certification in SEC filings, and the bar for securities fraud is much lower than under contract law theories. Delawares securities laws follow SEC 10(b)5 language re disclosure (that it not merely be narrowly accurate, but that it be free of material omissions). Boldface ours: The acts and practices ofBNYM alleged herein may have violated 6 Del. C. 7303(2), in that BNYM may have made untrue statements of material fact and/or omitted to state material facts in order to make the statements made, in light of the circumstances under which they were made, not misleading. BNYMs conduct as described above may have violated the

Delaware Securities Act insofar as the Trust PSA requires the Trust annually to certify the following servicing criteria: Collateral or security on mortgage loans is maintained as required by the transaction agreements or related mortgage loan documents. Mortgage loan and related documents are safeguarded as required by the transaction agreements; and Any addition, removals or substitutions to the asset pool are made, reviewed and approved in accordance with any conditions or requirements in the transaction agreements. [See generally, Trust PSA, [Ex W to NY Petition]]. The Delaware investors in the Trusts may have been misled by BNYM into believing that BNYM would review the loan files for the mortgages securing their investment, and that any deficiencies would be cured. As we reported in September, lawyers had found evidence that Countrywide did not transfer the notes (the borrower IOUs) to the securitization trusts as stipulated in the pooling and servicing agreements Because those agreements had strict cut off dates as to when those transfers had to be completed, and governing law for the overwhelming majority of the trusts (New York law) is unforgiving on this matter (New York trusts are not permitted to deviate from their written directives) the failure to perform as stipulated cannot be remediedHence the widespread use of document fabrication to get around this mess. Note that Biden is not going directly after Bank of New York. He is merely seeking to question and perhaps block the settlement with Bank of America. But the issue he raises is a nuclear weapon. Bank of New York was the preferred trustee for Countrywide. There is good reason to believe the Countrywide securitizations were a total fail as far as living up to the requirements of the PSA are concerned. Bank of New York nevertheless piously made multiple false certifications on which investors relied (if you doubt the evidence above, a Pacer scrape of foreclosures on Countrywide trusts will provide further support). This liability would almost certainly wipe out Bank of New York, which has $34 billion in equity. But Bank of New York is too big to fail by virtue of playing a crucial role in settlement, transfers, and custody. But the real reason no one is likely to sue on this issue is that confirming that the transfers were not done correctly and that this impairs the value of residential mortgage securitizations on a widespread basis. It makes them, again per Levitin, at best non mortgage backed securities (as counterintuitive as it sounds, treating regular borrower payments as if the deal were done correctly may well be a viable legal position but the ability of the trust to foreclose would be hopelessly impaired). Chris Whalen, in his current Institutional Risk Analytics newsletter, raises more ugly questions about Bank of New York. Although he refrains from using the expression securities fraud, any informed reader can see that it

precisely the issue Whalen is raising. He argues that the bank failed to disclose its mortgage liability in its recent SEC filings. And this is for a bank whose auditor has already highlighted problems in its trustee operations. The banks defense no doubt would be that any liability is not material, but you can see Whalen thinks, as we do, that the downside is plenty large: We wonder, does the auditor of record for BK, KPMG, understand that the NY AG has accused its client of a conflict of interest and a systemic failure to perform its role as trustee with respect to hundreds of billions of dollars worth of RMBS? Just when, we wonder, did the general counsel of BK bring the issue of potential trustee liabilities to the attention of the board of directors of BK? Has BK informed their liability insurance underwriters of the appearance of this large risk? Again, we note, there is no mention of the liability in the BK 2010 Form 10-K, this even though we understand that BK was aware of the NY AGs investigation into possible trustee lapses with respect to RMBS even before the end of last year. Certainly such information is material to investors Under Sarbanes-Oxley, the general counsel of BK has an affirmative duty to make members of the board of directors aware of any failure in terms of internal systems and controls or future risks. Looking at the public record, it does not appear that BK has yet acknowledged the problems regarding trustee activities that have been made public by the State of New York. The auditor of BK as well as the outside counsel to the bank also have affirmative duties to report to the SEC any failure to disclose such risks to investors in the event that the board fails to make such disclosure. Again, we see nothing in the public record indicating any disclosure by BK regarding these allegations by the State of New York. And is it not interesting that the New York AG was not represented at last Fridays meeting of parties in the Countrywide put-back litigation? While the penalties for failure to disclose in the Sarbanes-Oxley law are bad enough, a litigation by the NY AG using the Martin Act is the big shoe waiting to drop on both BAC and BK. What will the NY AG do? Stay tuned. No wonder New York Fed director and official friend of Bank of New York (by virtue of her not for profit having BoNY as a large donor) Kathryn Wylde has gone into aggressive overdrive to protect one of her meal tickets, attacking Eric Schneiderman for having the temerity to question the Bank of New Yorks role. Modern attorneys general apparently are supposed to understand that banks are above the law and act accordingly.