Monday, October 29, 2012

A Mediator's Perspective on the MBIA v Bank of America Litigation---Part 2

I have discussed previously how from a mediator's perspective the litigation between Bank of America (together with its affiliates, BAC) and MBIA (MBI) is highly susceptible of settlement.  Both pieces of litigation, the Article 78 action brought by BAC against MBI and the New York State Department of Financial Services, and the fraud and breach of representation and warranty actions (R/W) brought by MBI against BAC, have been at issue with third parties in the same or identical litigation, and have been settled by MBI and BAC, respectively, to their satisfaction with those third parties.

So given this background, a mediator would go into a caucus with BAC and prepare a spreadsheet with BAC listing all of the R/W actions that it has settled as defendant with third parties, take an average, adjust that average for characteristics relevant to the MBI action (for example, since the MBI R/W action is closer to trial than other R/W actions BAC has previously settled, the average payment should be adjusted upward by a certain amount), and then obtain BAC's agreement to present that adjusted average of prior settlements as a reasonable offer to MBI.  If such a reasonable BAC offer can be constructed in this fashion that takes into account settlements that third parties standing in MBI's shoes found acceptable, the offer may be presented in a fashion that puts the onus on MBI to show why it is reasonable for MBI to insist on more.

Likewise, a mediator would go into a separate caucus with MBI and prepare a spreadsheet with MBI listing all of the plaintiffs in the same Article 78 action that BAC brought that MBI has settled with, and the various amounts MBI paid to commute its insurance of the plaintiffs' commercial mortgage backed securities (cmbs).  Again, this average would be adjusted for any characteristics relevant in any commutation of BAC's insured cmbs, and the mediator would obtain MBI's agreement to present that adjusted average of prior commutation amounts as a reasonable offer to BAC.  If such a reasonable MBI offer can be constructed in this fashion that takes into account commutations that third parties standing in BAC's shoes found acceptable, the offer may be presented in a fashion that puts the onus on BAC to show why it is reasonable for BAC to insist on more.

Of course, BAC and MBI each would likely insist on more, as is the prerogative of every negotiator engaged in a settlement negotiation.  The obligation of the mediator at this point is to devise one or more "bridging the gap" strategies or arguments that will convince the parties to "settle in the middle" once the reasonable offers discussed above can be constructed.

I have found as a mediator that there are two bridging the gap opportunities that are particularly useful:  (i) having the payor pay with "fifty cent dollars", and (ii) finding "freebie bennies" for the payee.  Interestingly, both bridging the gap opportunities are present in the case of the BAC v MBI litigation, leading me to believe that this litigation is especially amenable to settlement.

Payors can pay with "fifty cent dollars" when they pay in a manner in which the payee receives a full dollar of value for every dollar paid, but in which the cost to the payor of making each such dollar payment is only fifty cents.  This can occur, for example, when the payment is not in the form of money but rather in a product or service for which the payor has a 50% profit margin, such that the true cost to the payor of providing the dollar of value is only fifty cents.  The typical (and somewhat hackneyed) example is that of the dry cleaner that has damaged a customer's $100 sweater.  If the dry cleaner has a 50% profit margin, then the dry cleaner can award the customer $100 of free dry cleaning credits (worth $100 to the customer) that will cost the dry cleaner only $50 to provide.  This settlement offer is more likely to result in settlement than insisting that the dry cleaner pay the customer $100.

The most prominent fifty cent dollar example in the BAC v MBI litigation is for BAC to provide debt financing to MBI, in addition to the settlement payment, that would enable MBI to refinance outstanding high cost debt with much lower cost debt.  BAC holds over $100 billion (as of year-end 2011) in cash and cash equivalents.  This includes excess deposits held with the Federal Reserve, on which BC earns 0.25% per annum. If BAC were to provide $1-2 billion debt financing to MBI and receive, say, 3% interest income on the debt, this would provide a significant incremental return to BAC (and given the settlement with MBI, MBI's risk of nonpayment on this new refinancing debt would be reduced).

The benefit to MBI is that if it were able to refinance its outstanding debt, it would be easier for MBI to obtain a AA credit rating from Moodys, which would enable MBI to get back into the business of writing municipal finance insurance. MBI has outstanding approximately $1 billion in surplus notes bearing an interest rate of 14% per annum.  If MBI were able to refinance this issue with 3% cost debt, MBI would derive a substantial interest expense benefit and present itself to a ratings agency as a better credit risk.

From a mediator's perspective, the important bridging gap settlement strategy is that BAC is in the business of providing debt financing and it has excess capital capacity represented by substantial excess reserves held with the Federal Reserve earning a de minimus return.  MBI requires debt refinancing to lower its interest expense and facilitate a ratings improvement.  Both parties are in a position to benefit from a BAC-provided financing transaction that, when added to a settlement agreement relating to the Article 78 and mbs put-back litigation, could help bridge any settlement negotiation gap.

Moreover, BAC is in the position to derive "freebie bennies", or free additional benefits, from settling its litigation with MBI.  Similar to the risk-adjusted capital benefit derived by Morgan Stanley in connection with its Article 78 settlement and commutation with MBI, many market participants believe that BAC holds credit-default swaps in respect of its exposure to MBI-insured cmbs that requires a significant haircut to its capital position, and any commutation of these insured cmbs will not only result in a payment to BAC by MBI, but also create a significant increase in BAC's risk-adjusted capital for bank regulatory purposes.

I have criticized BAC's litigation strategy here, arguing that BAC is assuming excessive risk continuing its litigation with MBI in the shadow of a potential fraud action brought by the New York Attorney General.  When you consider the potential benefits that BAC would derive from settlement and the degree to which its litigation with MBI is amenable to a negotiated settlement, you have to wonder on what basis BAC can justify pursuing its current litigation strategy with MBI.


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