Perfect time to engage on a short primer on the difference between establishing liability, on the one hand, and pursuing remedies by recovering damages, on the other hand. You have to keep these elements of a plaintiff's case separate in order to appraise the status of the case. A plaintiff needs to develop a theory of liability in the first instance. If proved, then the plaintiff must seek a remedy by developing a theory of damages. Here's a go at what the New York Appellate Division First Department giveth and taketh away from MBIA. Net, net, advantage MBIA.
In MBIA v. Bank of America (BAC), MBIA is seeking to prove BAC's liability for breach of representation and warranty (R&W) under each of contract law and insurance law. These are two separate theories, and by proceeding under insurance law, MBIA believed it could obtain rescissory damages as a remedy.
The remedy available under contract law is spelled out in the governing contracts, specifying that the originator is obligated to repurchase loans that breach R&Ws. Rescission is a different remedy, which essentially terminates the contract and seeks to restore the parties to their original positions. This would put the plaintiff back in the position it would have been in if it hadn't entered into the transactions in the first place. Rescission is a remedy explicitly permitted by insurance law, while it is an extraordinary remedy under contract law. More about that later. Essentially, however, the proof of liability under insurance law and contract law is the same.
MBIA has asserted that BAC's liability under both insurance law and contract law can be established if MBIA proves that BAC breached its R&Ws in the governing documents and those breaches materially increased MBIA's risk of loss. Under each theory it is unnecessary to show further that MBIA's losses were caused by those R&W breaches. In other words, MBIA asserts that the test for BAC liability is a Day 1 test, measured as of the closing date of the securitization, while BAC asserts that the test for its liability is whether MBIA can prove that the particular R&W breach actually caused a loan to go into default, as opposed to some other causal event, such as the financial crisis or the debtor's losing his job.
So, under MBIA's theory of liability, all that is required is that a breach of a R&W by BAC that materially increased MBIA's risk of loss. Under BAC's theory of liability, MBIA must establish that there is a causal connection (loss causation) between the breach of a R&W and the default of the loan and any consequent loss incurred by MBIA.
This question as to whether loss causation must be established in order for BAC to be found liable is of huge importance in the case, because it would be impossible for MBIA to prove that any breach of R&W was the specific cause of MBIA's loss. To repeat, this was a huge win for MBIA. The recent New York Appellate Division First Department decision is the first instance of an appellate court in New York holding that no mbs loss causation is necessary in order to establish liability. This decision is binding upon all justices in the Commercial Division of the NY Supreme Court, New York County, where most of the mbs fraud litigation is being conducted. While BAC is entitled to seek an appeal of the First Department decision to the NY Court of Appeals, the highest New York court, that appeal would be granted only at the discretion of the NY Court of Appeals (and is unlikely to be granted since there is no contrary holding in any other department of the Appellate Division in New York).
Before this New York Appellate Division First Department decision, all prior holdings to the effect that a showing of loss causation was unnecessary, including that of Justice Bransten in the MBIA v BAC case, were from trial courts. While these decisions might have persuasive power, they were not binding on other trial courts in New York County. This First Department ruling is a huge adverse development with respect to the establishment of liability for BAC and all other investment banks and mbs originators with cases that are pending or may be brought in the Commercial Division of the Supreme Court, New York County. Of course, a litigant in another case might seek to distinguish its mbs case from the facts of the New York Appellate Division First Department decision, but this would be extremely difficult, as all of these securitization R&W breach cases present identical questions of law and very similar factual patterns.
So, given this liability ruling on the absence of loss causation and the requirement that performing loans be repurchased if they breached R&Ws, it is clear that in the event MBIA meets its burden of proof in establishing breaches of R&Ws, MBIA can require BAC to repurchase every loan in the trusts it insured with respect to which BAC breached a R&W that materially increased MBIA's risk of loss, whether or not that loan is in default.
According to MBIA, this ruling with respect to liability means that, assuming MBIA carries its burden of proof, BAC breached its R&Ws to MBIA with respect to at least $12.7 billion of loans. See p. 19 of MBIA slide presentation on SJ motion for primary liability. Now, given this state of play with respect to BAC's massive liability exposure, let's proceed to MBIA's potential remedies.
MBIA presented two separate theories of damages: (i) rescissory damages, and (ii) compensatory damages arising from BAC's breach of its obligation to repurchase loans with respect to which BAC breached R&Ws. [Update: I have reviewed MBIA's letter to Justice Bransten regarding the Appellate Division First Department decision, filed soon after I first posted this blogpost. It is clear that MBIA is asserting a third theory of damages, compensatory damages for breach of insurance contract. It is not clear to me that this theory of compensatory damages differs from (ii) above in any important respect]
Rescissory damages is a one step remedy, while compensatory damages arising from breach of BAC's repurchase obligation is a two step remedy. The greater simplicity of seeking rescissory damages over compensatory damages is one reason why MBIA sought rescissory damages.
In the case of rescissory damages, the court would find that BAC would be obligated to reimburse MBIA for all of its losses and expenses MBIA incurred in connection with the insured transactions, so as to place MBIA in the position it would have been in had MBIA not entered into the transactions. This amount is approaching $5 billion according to MBIA, and would include all of its insurance payments and lawyers expenses. This is a single step analysis.
In the case of compensatory damages, the court would find that BAC was obligated to repurchase all loans that MBIA put back to BAC for repurchase, with respect to which BAC breached a R&W, but irrespective of whether the breach caused any MBIA loss and whether the loan was in default. MBIA has made a showing at the motion for summary judgment on primary liability that BAC breached this obligation to repurchase loans. See pps. 100-103 of MBIA slide presentation on SJ motion for primary liability.
So, as a first step, assuming that the court holds that BAC breached its obligation to repurchase loans properly put back by MBIA for repurchase, the court would proceed to a second step, a "what if" analysis to see what MBIA's recovery should be. In this second step, the court needs to determine whether if BAC had repurchased all loans properly put back and deposited the purchase price for these putback loans into the trusts, would MBIA have ever needed to make any insurance payments to noteholders.
If the answer is no, then MBIA would be entitled to full recovery for its damages (all insurance payments made plus, as provided by the governing documents, reimbursement of legal expenses)...in other words, the same recovery as MBIA would be entitled to in the case of rescissory damages. To the extent that MBIA would still have had to make insurance payments even if BAC repurchased all properly putback loans, then that amount of hypothetical insurance payment would reduce MBIA's recovery from BAC.
An example of this "what if" compensatory damages analysis can be seen in Judge Rakoff's opinion in Assured Guaranty v. Flagstar bank. In the damages portion of the opinion that begins on page 94, Judge Rakoff speaks to this two step process of determining compensatory damages:
"Therefore, Assured is not entitled to direct payment of the amounts Flagstar should have paid for purchase...but rather to reimbursement of the claims it has paid to the bondholders to the extent that the amounts Flagstar should have paid into the Trust would be sufficient to cover Assured’s claim payments...Moving on to the calculation of damages, what Assured showed through Dr. Mason’s damages model was that Flagstar’s failure to repurchase those defaulted loans that had breached the representations and warranties directly and proximately caused Assured to improperly bear the burden of paying claims on the transactions. Dr. Mason testified that, had Flagstar repurchased the defective loans, Assured would have been reimbursed for all the claims paid to the bondholders."
In that case, Judge Rakoff reviewed the expert statistical testimony of Dr. Mason to find that, indeed, Assured Guaranty would have been able to avoid all of its insurance payments if Flagstar had not breached its repurchase obligation.
This two step analysis to prove compensatory damages has been referred to as "damage causation". This is not to confuse damage causation with loss causation, discussed above, which is not required. This is why you have to keep liability and remedies separate in your mind. BAC cannot escape liability by a showing of causation. But, going on to remedies, MBIA must still show that its damages would not have been incurred if BAC had done what was required of it with respect to its obligation to repurchase loans.
Also, it is important to keep in mind what a showing of damage causation entails. This is simply a mathematical analysis using statistical sampling and extrapolation to the entire trust pool to determine, based upon the number of loans that contained breaches of R&Ws and the amount of the insurer's payment, whether the insurer would have made any insurance payments had the originator repurchased all breaching loans.
MBIA has apparently done this analysis and it is confident that its remedies will not be limited. in a recent article soon after the First Department ruling, an MBIA spokesman said the ruling on damages “does not limit our ability to achieve or change our expectation of a full recovery of all our losses.”
So, it can be seen that among two viable alternative routes for MBIA to obtain full recovery of its losses, the two step process of pursuing compensatory damages remains in full force.
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.