Wednesday, February 6, 2013

Rakoff Makes Clear What Materiality and Risk of Loss Means

Tonight, Judge Rakoff issued the first opinion ever after trial, holding an mbs originator liable for breach of representations and warranties (R&W) made to a monoline insurer, in Assured Guaranty v. Flagstar.  See Rakoff-Trial-Opinion.  This is a significant holding for at least two reasons.

First, Judge Rakoff commands respect not only from the legal community as a whole, but also from the community of judges that have similar monoline R&W cases before them.  Judge Rakoff is not only the smartest guy in the room after you and I have walked in, he is the smartest guy in the room after those judges have walked in...and they know it.

But more importantly, second, Judge Rakoff soundly put to rest the main argument that mbs originators have presented to counter the monoline insurers' claim that the mbs originators' breach of R&Ws materially and adversely affected the monoline insurers' risk of loss (which is the key determination to be made under the transaction documents).

For example, in MBIA's motion for summary judgment (SJ) against Bank of America (BAC) for primary liability, you will recall that  BAC's primary defense with respect to materiality was to introduce expert testimony from Dean of Columbia Business School Glenn Hubbard to the effect that loans bearing such breaches of R&Ws do not give rise to a higher incidence of actual incurred losses, when compared to a population of loans that do not contain such breaches.  In other words, how can a breach be material if it doesn't create additional incurred losses?

This is just a backhanded way for mbs originators to argue that their R&W breaches did not cause monoline losses, and this argument was soundly dispatched by Judge Rakoff as immaterial to whether the R&W breaches materially increased the monoline insurers' risk of loss.

Quoting from Judge Rakoff's opinion:

"Furthermore, Flagstar, while repeatedly attacking Ms. Walzak’s [Assured Guaranty's underwriting expert] methodology, was notably unable to show actual instances where the loan files themselves did not contain material breaches of the guidelines. Thus, even though Flagstar’s expert, Griggs, agreed with Walzak as to material deficiency on only three loans,[citation omitted], he was unable to illustrate his conclusions with respect to specific loan files in a manner that the Court found convincing; and for the most part he did not even try. Indeed, the filters Griggs employed – not reviewing the 484 loans that had paid in full or are still performing [Flagstar argued that no misrepresentation could be deemed "material" if the loan was still current] and the 43 “life event” loans [loans deemed by Flagstar's underwriting expert to have resulted in nonpayment because of subsequent adverse developments occurring with respect to the borrower, such as loss of employment etc, rather than from borrower misrepresentation made to obtain loan], and deeming immaterial any breach of the representations and warranties if the borrower made his or her payments for twelve months – meant that Griggs failed to challenge the vast majority of Walzak’s findings. Assured is free to prove the fact of Flagstar’s breach, if not its damages from that breach, by demonstrative pervasive, materially defective underwriting equally for performing, delinquent and defaulted loans, as the “cure or repurchase” remedy in the Transaction Documents is not limited to defaulted or delinquent loans. Thus, the 484 loans that went unreviewed [out of a total 800 loans that were underwritten in connection with the trial] based on their payment status remain relevant to the Court’s determination of material breach.

Moreover, given the Court’s prior ruling that “the causation that must here be shown is that the alleged breaches caused plaintiff to incur an increased risk of loss,” [citation omitted], it is irrelevant to the Court’s determination of material breach what Flagstar believes ultimately caused the loans to default, whether it is a life event or if the underwriting defects could be deemed “immaterial” based on twelve months of payment. Risk of loss can be realized or not; it is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach. Thus, the Court concludes that Walzak’s [Assured] findings were largely unrebutted by Griggs [Flagstar]."

The importance of this finding cannot be overstated:  "Risk of loss can be realized or not; it is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach."

Remember for purposes of defending against primary liability, BAC used precisely this line of argument to claim that BAC's R&W breaches were not material.  Judge Rakoff has supplied not only the intellectual support for Justice Bransten to rule against BAC in MBIA's motion for summary judgment on primary liability; Judge Rakoff may have supplied some judicial backbone as well.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Disclosure: long MBI.  Follow me on twitter.

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