In this issue of The Institutional Risk Analyst, IRA Vice Chairman Christopher Whalen returns to a favorite topic, namely the zombie dance queen known as Bank of America. We have been writing about the need to resolve Bank America in bankruptcy for a number of years, most recently in the article "Should the Courts Appoint an Equitable Receiver for Bank of America?," November 28, 2011.
The most recent BAC earnings report does little to change our earlier views. You can read all of our previous comments on BAC in The Institutional Risk Analyst by obtaining a subscription to the archive at www.irabankratings.com.
In particular, the absence of any recognition by management that the tens of billions of dollars in festering legal claims against the bank will require large reserve increases and eventually payments seems to fly in the face of BAC's responsibility to be honest and forthright with investors. We continue to believe that a combination of put-back demands and judgments in various ongoing litigations will eventually cost the bank significantly more than the $30 billion in loan loss reserves BAC reported as of the end of Q2 2012.
One of the more significant pieces of litigation facing BAC is the put back claims arising from poorly underwritten loans originally made by Countrywide Bank. According to a letter filed this week with the New York State Supreme Court, one of the leading Plaintiffs in that case, Walnut Place, has withdrawn as an intervenor. This has led some Sell Side analysts to conclude that BAC is out of the woods in terms of eventually reaching a settlement. The settlement also affects Bank of New York Mellon, which is custodian on hundreds of Countrywide RMBS trusts and has huge legal liability as a result.
But before we start popping the champagne corks, it is important to recall that the most important player in the Countrywide put-back litigation is the State of New York, which has already made serious allegations of fraud and malfeasance against both BAC and BK. American International Group is also an intervenor in the litigation, but the real end game in this lengthy saga is being played by NY AG Eric Schneiderman.
As we've noted in previous comments, the NY AG is ultimately is concerned not just with the Countrywide litigation, but more broadly with the acts of BAC and BK with respect to all of the RMBS trusts created and maintained by these two large banks. And behind the issue of raping and pillaging the assets of investors lies other, more complex issues regarding things like taxes and accounting fraud.
Any settlement in the Countrywide case must be paid to investors through the REMIC structure of the existing RMBS trusts. But if the State of New York, including Schneiderman's office and the NY tax authorities, as well as the Internal Revenue Service and US Attorney, decide that the RMBS trusts are busted, then the entire Countrywide settlement becomes moribund.
A number of conversations have occurred between investors in RMBS involving BAC and BK and the NY and federal authorities mentioned above. And there are several different angles of attack that the New York and/or federal authorities can take that could potentially force BAC into an involuntary restructuring. There is not just one shoe waiting to drop, but several that could either force BAC into a massive settlement of all existing claims. And remember that, in any event, you cannot wash away tax liabilities to Uncle Sam or New York State in bankruptcy.
Consider one example. In a class action complaint filed against Bank of America NA in the Southern District of California, the Plaintiffs state:
"The purpose of this action is to: (1) prevent BOA from continuing its wrongful practice of under-reporting to the Internal Revenue Service ("IRS") milions, if not billions, of dollars of properly-deductible 'mortgage interest' payments made by milions of BOA customers across the nation; and (2) compensate Plaintiff and Class Members for BOA's prior under-reporting of their "mortgage interest" payments as reported on IRS Form 1098."
Over the past decade and more, Bank of America and its predecessors, including Countrywide Bank, apparently made false tax filings with the IRS regarding interest payments on Option ARMS originated by Countrywide. The payments were received by investors, but BAC essentially had to advance part of the cash because the Option ARMS allowed the borrower to defer some interest payments.
Instead of reporting the interest income actually paid to investors properly, Bank American NA (as successor to Countrywide Home Services) reported a false principal reduction to the IRS in the amount of the deferred interest payment and then falsely reported the bogus principal reduction as an expense. But in fact, the Plaintiffs allege, what BAC and Countrywide were doing was engaging in a massive conspiracy to defraud investors and tax authorities of billions of dollars in tax deductions and taxes owed.
What is really interesting about this mess is that the false tax reporting to the IRS (and the State of New York, BTW) is that these allegations, if proven, also means that BAC and Countrywide deliberately falsified their SEC filings over many years to the tune of billions of dollars. By taking the phantom principal reduction as an expense, the parent of Bank of America NA, BAC, deliberately understated its earnings and essentially offset the cash that the bank had to advance to bond holders as a fraudulent tax deduction. Officials at the SEC and IRS have been made aware of these allegations by counsel for several investors who have spoken to The IRA, but as yet neither agency has taken action.
This false reporting of interest payments actually made by BAC/Countrywide is on a similar scale to the thievery perpetrated by Countrywide and other large servicer banks over the years via fraudulent collateral practices such as selection and substitution of collateral. If you think of it, investors in private label RMBS trusts have been assaulted and raped in several respects.
First, the servicer banks have for years stolen tens of billions of dollars from investors via shady servicing practices. The latest revelations about tax fraud and fraudulent SEC filings by BAC are merely another example of this public rape of private investors by the largest banks. And so far, neither the Obama Administration, New York Governor Andrew Cuomo, nor NY AG Schneiderman have done anything about it.
Second comes the robo-signing settlement, which is another act of public rape against investors in private label RMBS, this time perpetrated by politicians. The various state AGs, led by California Attorney General Kamala D. Harris, looted the RMBS trusts to fund their own personal political ambitions, not to protect consumers.
Our friends at the New York Times led the Big Media in lauding the "hard line" taken by Harris in the robo signing negotiations, but never noticed that Harris intends to use the billions in funds taken from investors to fund her gubernatorial campaign. As we've noted previously, the proposal by Harris to distribute funds from the robo signing settlement to home owners is akin to a Mexican politician giving away bags of groceries to starving campesinos on Election Day.
It is investors in private label RMBS serviced by the TBTF banks, not the big banks themselves, who are paying for the robo signing settlement. And in any event, BAC and the other large banks already stole enough money from investors in act one of this tragedy to defray the cost of any portion of the settlement that actually costs them money. As in the case of the tax fraud perpetrated by BAC, the TBTF banks are way ahead of the curve in the robo signing charade.
The third and final act of rape against RMBS investors now looms with the threat of states and localities using eminent domain to seize under water mortgages, this ostensibly to help homeowners. In fact what is happening here is that another wave of aspiring politicians will fund their future ambitions for higher office on the backs of private investors.
Notice, for example, that the threatened seizures are focused on investor-owned loans inside private label RMBS, not bank owned loans still held in portfolio. And once these seizures take place, the localities concerned will for generations be red lined by private investors. Aspiring home owners seeking to get mortgages in communities where eminent domain seizures take place will be SOL for decades to come. But remember that the politicians involved will rejoice since the private mortgage investors will become very convenient targets for their public outrage.
To take another example, note that Harris is working to change the foreclosure process in CA from a non-judicial process to one requiring a judge to rule as in the case of NY. This change will do irreparable damage to the CA mortgage market and discourage investors from holding loans originated in that jurisdiction, but like her political role model Barack Obama, Harris is not concerned with the legal and financial implications of her policies - only in winning higher office.
In NY, meanwhile, AG Schneiderman is already planning a race for governor, in part funded with the funds looted from investors in private label RMBS. The TBTF banks will be asked to throw a few gold coins into the proverbial collection plate to be sure, but just know that any settlement extracted from BAC and the other big banks will be to fuel future political ambitions. Just as investors are unlikely to be able to fight any attempts to seize their property in an eminent domain action argued in a state court before an elected state court judge, neither are investors likely to get fair justice from Schneiderman. This may be why Walnut Place has withdrawn from the Countrywide put back litigation; because they know that obtaining justice in a NY kangaroo court is impossible.
You see Schneiderman's predecessor as AG, NY Governor Andrew Cuomo, was aware of the financial looting of private label RMBS trusts and the related tax problems of BAC and the other large banks prior to his first election run, but did nothing. Attacking the TBTF banks prior to an election, you see, would not have been politically expedient. And in the case of Schneiderman the calculus regarding BAC will ultimately be decided by what best helps the current NY AG reach the governor's mansion when Cuomo makes a run for the presidency.
So ask not whether there will ultimately be a settlement in the BAC litigation; there will. The only question is the cost to be borne by investors and home owners. In that sense the cynical calculus of Wall Street that says that BAC will eventually emerge from a decade of litigation is correct. The only wild card that exists is whether the courts or one of the politicians concerned decides to do the right thing, in which case BAC could still end up in a restructuring. Indeed, there is a school of thought that says that BAC may ultimately be restructured and thus made an example to the other TBTF banks. The message: when the political collection plate passes by, give generously.