Crack in the Dam

Bank of America’s mortgage settlement doesn’t benefit homeowners now, but it may down the road.

Former Countrywide CEO Angelo R. Mozilo

On June 29 we learned that Bank of America will pay $8.5 billion to settle claims by big investors, including the New York Federal Reserve, that mortgage backed securities sold by Countrywide (which BofA acquired in the heat of the financial crisis) weren’t as pristine as they were cracked up to be. That’s good news for investors. The settlement may also, down the road, create some good news for homeowners.

BofA’s misadventures in mortgages began in early 2008, when the bank’s then-CEO, Ken Lewis, agreed to pay $4 billion to acquire Countrywide. It seemed like quite a bargain. The American Banker anointed Lewis “banker of the year,” calling him a “critical force for stability in a tumultuous economic time.”  But the Countrywide acquisition, combined with BofA’s purchase of Merrill Lynch in the fall of 2008, made BofA the only major financial institution to buy its way into the financial crisis.  Thanks to the terrible quality of the mortgages Countrywide made, the deal quickly turned out to be more expensive than it had originally looked. The first sign of that came in 2008, when BofA paid the estimated equivalent of $8.6 billion in loan modifications to settle a lawsuit brought against Countrywide by 11 state attorneys general.

BofA said it had anticipated that settlement, but another front opened last fall when the big investors, which in addition to the New York Fed included BlackRock and Metlife, sent a letter alleging that Countrywide’s “representations and warranties”—the legal promises to buyers about the quality of the mortgages they were buying—weren’t true.  The initial group of just eight investors who owned mortgage-backed securities that had had an original face value of $104 billion quickly mushroomed to 22 investors holding securities with an original face value of $424 billion.

On Wall Street, talk began to fly that activist hedge funds were buying up sour mortgage-backed securities that were trading at big discounts with the express hope of forcing the banks to buy them back at full price. Chris Gamaitoni, an analyst at Compass Point, estimated that the 10 biggest banks, including Bank of America and Goldman Sachs, could end up losing almost $200 billion thanks to mortgage repurchases. An investor named Ron Beller, who was a former Goldman partner, put out a presentation estimating that BofA alone might have to pay as much as $74 billion to repurchase mortgages, and that its stock could fall to as low as $6. Perhaps not surprisingly, BofA’s stock began to fall.

Right around the same time, the news hit that the big servicers, including, of course, BofA, had tried to turn the foreclosure process into a high-volume factory via sleazy practices like “robosigning”—having employees sign off on foreclosures without  properly reviewing the documents. A deeper worry emerged:  Could it be that the entire process of securitization was flawed? Sloppiness in the way the securities were constructed could mean that investors had been totally defrauded, because they never really owned the mortgages they thought they were buying.  That, of course, would mean astronomical liabilities for the banks.  By this spring, state attorneys general, some of whom were up in arms about the way homeowners had been treated, began to float the idea that banks would have to pay upward of $20 billion to settle some of this.

The banking industry’s initial response was to go to war against both aggrieved investors and homeowners.  BofA’s executives told investors that it had the “resources to deploy” against investors who wanted compensation for the bad loans they’d bought. CEO Brian Moynihan said he’d engage in “day-to-day, hand-to-hand combat” against such repurchase requests.  As for the foreclosure problems, BofA insisted that its mistakes were merely procedural, and that no real damage had been done. Any notion that it would willingly pay a large sum, or agree to any substantial principal modifications, was a nonstarter.

What ended the war? One thing, and one thing only:  BofA’s stock continued to slide.   In the second quarter of 2011, it was the worst performer in the Dow. Investors hate uncertainty, and the mortgage business had become a giant black hole of unanswered questions.  According to the strange rules of the stock market game, paying billions now to reduce uncertainty later can actually be a smart move. Investors are often willing to see such payouts as a “one time charge,” and focus not on today’s cost, but on the now more predictable level of future earnings.  This helps explain why Moynihan ended up saying, “It was much more adverse to the company if we kept fighting.”

In addition to the $8.5 billion, BofA is putting aside another $5.5 billion to cover additional claims, and it’s taking a noncash charge of $6.4 billion to reflect the drop in Countrywide’s value and increased costs in its mortgage servicing operations.  (In that, there’s already a sliver of good news for homeowners:  Borrowers are supposed to be able to get faster answers on modifications, for instance.) The lawyer for the investors told the New York Times that “Bank of America has charted a path that our clients expect other banks will follow,” and there are now predictions that JPMorgan and Wells Fargo may do just that.  (Countrywide was the nation’s biggest mortgage originator, so other banks have less exposure than BofA.)

There are still a slew of questions about what, exactly, this means. Compared to previous dire predictions about BofA’s mammoth liabilities, the bank is getting off lightly. As a consequence, some investors may not go along with the deal, especially since it’s not yet clear which investors will get what parts of the $8.5 billion. In a research note, Gamaitoni, the Compass Point analyst, noted that the settlement was “significantly below what many analysts had expected private label investors would eventually be able to recoup through litigation.” He thinks the number will have to be higher.  And there are securities that aren’t included in the deal, including BofA’s own mortgage deals, Merrill Lynch’s deals, and second lien mortgages issued by Countrywide. 

The biggest issue, though, is the potential settlement with the state AGs over the foreclosure abuses. In order to put the past behind it, BofA needs to resolve that, too.   Does this week’s settlement make it likelier that BofA will break ranks with the other banks and cut a deal here, too? Probably so. Such a deal might even involve modifications on the principal owed, something BofA has resisted in the past. The bank is desperate enough to put the mortgage mess behind it that what we once thought impossible is beginning to appear likely.