Countrywide Wages Victorious Tranche Warfare Against Investors

Investors who sued over $351 billion in downgraded Countrywide Financial Corp. mortgage-backed securities after the 2007 subprime market collapse may have to settle for less than 1 percent of what they initially sought.

U.S. District Senior Judge Mariana Pfaelzer in Los Angeles, who narrowed the case to $2.6 billion in bonds and dropped Countrywide parent Bank of America Corp. (BAC) as a defendant, has gone further than other judges in scaling back such claims. Her rulings in April and May show the difficulty of trying to hold banks liable for billions of dollars in debt downgraded to junk.

“The recent court rulings provide encouragement for Countrywide and Bank of America and could indicate that the courts would limit or reduce the number of claims in these cases or perhaps dismiss them in their entirety,” said Patrick McManemin, a lawyer with Patton Boggs LLP in Dallas who has worked on both sides of mortgage-securities cases and isn’t involved in the Los Angeles litigation.

Countrywide, based in Calabasas, California, was once the biggest U.S. residential home lender, originating or purchasing about $1.4 trillion in mortgages from 2005 to 2007. The bulk of them were sold to investors as mortgage-backed securities. Bank of America acquired Countrywide in 2008.

The Los Angeles lawsuit, filed last year and led by the Iowa Public Retirement System, was, at $351 billion, the largest in terms of securities at stake among dozens of cases brought against lenders and underwriters. A hearing on Countrywide’s next bid to have the claims dismissed is scheduled for Sept. 12.

Securities Act

The case, like similar suits brought under the U.S. Securities Act of 1933, isn’t part of an $8.5 billion settlement announced June 29 between Bank of America and 22 institutional investors in Countrywide mortgage-backed securities. That accord, if approved, will resolve investors’ claims that Countrywide was required under contract to repurchase loans that didn’t meet its underwriting guidelines.

Pools of home loans securitized into bonds were a central part of the housing bubble that helped send the U.S. into the biggest recession since the 1930s. The housing market collapsed, and the crisis swept up lenders and investment banks as the market for the securities evaporated.

Banks and underwriters being sued argued that the offering documents for those bonds adequately warned investors of the risks. They claimed the securities have performed as intended and the investors have been paid what they are owed from the underlying mortgages.

Judges in New York, Boston, Los Angeles and San Francisco have dismissed or scaled back claims because plaintiffs lacked standing -- meaning they haven’t shown how they were sufficiently damaged or that they are the right party to sue -- or failed to sue before the statute of limitations expired.

Challenging Aggressively

“It’s real clear the defendants are challenging these cases aggressively,” said William Sullivan, a lawyer with Paul, Hastings, Janofsky & Walker LLP in Los Angeles who represented two former Countrywide executives dropped from the case in Pfaelzer’s court. “The plaintiffs got exactly what they bargained for, and now they are trying to shift the responsibility.”

Shareholders who sued lenders including Countrywide and investment banks whose stock plunged have been more successful than buyers of mortgage bonds. The stockholders alleged they lost money because the companies didn’t disclose their risky lending and the danger posed to them by mortgage-backed securities.

Shareholders have reached settlements in 23 cases for a total of about $2.36 billion, according to data compiled by Kevin LaCroix, a lawyer in Beachwood, Ohio, who tracks the cases on his blog, the D&O Diary. The largest was settled last year by Bank of America with Countrywide shareholders for $624 million.

Three Settlements

Among bond investor suits filed during the same period as the shareholder cases, there may be as few as three settlements.

One was filed in 2009 by mutual funds and clients of Pacific Investment Management Co. over $550 million in securities that Newport Beach, California-based Pimco bought from a former General Motors Corp. unit. That case was settled in January 2010 in federal court in Santa Ana, California. Terms weren’t disclosed in court filings.

A second case pitting New Mexico pension funds against Countrywide settled in November for $162 million in Santa Fe state court. And on July 6, Wells Fargo & Co. (WFC) agreed to pay $125 million to settle claims by investors including pension funds in Detroit and New Orleans that it misled them about the risks of mortgage-backed securities they purchased.

Damaged by Downgrades

LaCroix attributes the low number of settlements to the complexity of the cases, the large number of companies involved, and disagreement about whether investors were damaged by downgrades of the securities.

“It’s difficult to find common ground if you can’t agree on what damages there might have been,” LaCroix said in a telephone interview.

In the Los Angeles case before Pfaelzer, investors claim that Countrywide’s public offering documents for the mortgage- backed bonds didn’t disclose it was disregarding its guidelines for originating home loans.

The value of the securities plummeted when they were downgraded to junk in 2008 and 2009, the investors said, without specifying losses in court papers.

In a case against Goldman Sachs Group Inc. (GS) in Manhattan federal court, investors alleged their mortgage-backed securities were worth 35 cents to 45 cents on the dollar in December 2008.

Pfaelzer Downsized Case

Pfaelzer, 85, downsized the Countrywide case in November, ruling that under the 1933 law regulating the sale of new securities, the pension funds can sue only for offerings they participated in, not for all those sold based on the same allegedly misleading registration statement.

As a result, the judge reduced the case to 14 offerings with a face value of about $20 billion, out of 427 offerings covered by the original complaint totaling $351 billion. She went further in May, ruling that the plaintiffs may sue only for specific tranches they bought within the 14 offerings. Mortgage- backed bonds are sold in separate tranches, or layers, representing different levels of risk and interest rates.

Given the differences among underlying mortgage pools, the plaintiffs weren’t necessarily harmed by nonperforming loans in the tranches they didn’t buy, the judge ruled.

‘Significant Differences’

“The key to the standing issue is the significant differences between the underlying pools of mortgages,” Pfaelzer said in her May 5 decision. “In most of the offerings, the senior tranches were backed by different groups of mortgage loans within the overall offering pool.”

That ruling removed 96 percent of the tranches and cut the amount of the securities at issue to $2.6 billion.

The judge said in April that Bank of America couldn’t be held liable for bond investors’ losses. The bank bought Countrywide in 2008 after the lender’s shares fell 90 percent.

So-called successor liability doesn’t apply to an acquiring company when it buys all or most of the assets of another, she ruled. The investors failed to show that the transaction was a “de facto merger” rather than an asset transfer under the law of Delaware, where the bank is incorporated, the judge said.

Shirley Norton, a spokeswoman for Charlotte, North Carolina-based Bank of America, called Pfaelzer’s decision to exclude the bank “very comprehensive and well reasoned” in an e-mailed statement. She declined to comment on other aspects of the case, including possible liabilities the bank or its units may face.

Hold Request Denied

Pfaelzer, nominated to the bench by President Jimmy Carter, denied a request by the investors to put the Los Angeles case on hold so they may appeal her rulings. The plaintiffs said in a May 16 filing that the restrictions she imposed went further than those of any other federal judge.

Other courts have consistently allowed investors to sue for all the tranches in an offering, said Steven Toll, a lawyer for the plaintiffs with Cohen Milstein Sellers & Toll PLLC in Washington.

“It is the language in the offering prospectuses that is misleading,” Toll said. “It’s in the offering statement. It’s not in the tranches.”

The $8.5 billion settlement announced last month was reached by a different legal avenue: contract law. The bond investors asked Bank of New York Mellon, as their trustee, to force Countrywide to uphold its obligation to repurchase any delinquent loans. BNY Mellon negotiated the settlement, which must still be approved by a New York state judge in Manhattan, with investors and Bank of America.

Governing Agreement

Those bondholders together needed to own a total of at least 25 percent of the trust, under the governing agreement, said Isaac Gradman, a mortgage-backed securities litigation consultant with IMG Enterprises in Petaluma, California.

Many of the securities-law cases “were filed when the investors didn’t have 25 percent of a trust and didn’t have access to the loan files to show evidence of breaches of contract,” Gradman said. “They wanted to get a foot in the door and collect evidence once they got past motions to dismiss.”

Toll said he doesn’t expect the settlement to affect his lawsuit. Countrywide may argue that any claims by the investors in the securities lawsuit should be offset by the settlement of the repurchase claims, he said.

Fraud Claims

Bank of America said June 29 that the settlement doesn’t release securities law or fraud claims on bonds covered in the deal, and that investors including “certain members” of the group of 22 institutional firms that signed the accord are pursuing such claims.

Kathy Patrick, a lawyer for the investors in the $8.5 billion settlement, declined to comment on whether any of her clients are in securities-law cases against Countrywide.

Countrywide, meanwhile, is pushing for Pfaelzer to be put in charge of handling all of its institutional investor litigation in courts throughout the U.S.

Citing six new lawsuits filed by investors who opted out of the Iowa pension fund case in Los Angeles after Pfaelzer’s November rulings, Countrywide said in a May 23 filing with the U.S. Judicial Panel on Multidistrict Litigation that she is “uniquely well-positioned” to preside over a unified case.

The Los Angeles case is Maine State Retirement System v. Countrywide Financial Corp., 10-cv-00302, U.S. District Court, Central District of California (Los Angeles).

To contact the reporter on this story: Edvard Pettersson in Los Angeles federal court at epettersson@bloomberg.net.

To contact the editor responsible for this story: Michael Hytha at mhytha@bloomberg.net.

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