March 15, 2011 / 4:00 PM / 9 years ago

Mortgage bondholders gain key ally in putback fight

WILMINGTON, Delaware (Reuters) - U.S. banks may be turning on one another in the legal battle over losses on mortgage-backed bonds.

A vacant home for sale is pictured in Yonkers, New York, October 26, 2010. REUTERS/Mike Segar

Big pension funds and other investors are demanding compensation from banks that sold them supposedly low-risk mortgage-backed bonds that disintegrated in the housing crisis, a fight that ultimately could cost Wall Street $100 billion or more.

One big legal obstacle for investors has been getting documents they say will prove those bonds were anything but low-risk. Demands for documents have to come from the trustees who administer the bonds, and until recently trustees have stayed out of the legal fray.

That may be changing. A recent Delaware lawsuit illustrates the increased aggressiveness of trustees in helping investors make their case. An attorney for one trustee, Wells Fargo & Co, spent a year pursuing documents from EMC Mortgage Corp, a unit of JPMorgan Chase & Co.

Court documents show EMC, which JPMorgan inherited as part of its shotgun acquisition of Bear Stearns in 2008, faces several other requests from trustees, including Citigroup Inc.

The lawsuit is among the first of its kind by a trustee, partly because investors have only recently organized themselves in large enough numbers to force trustees to consider their demands.

Trustees “understand investors are standing up on their hind legs and saying, ‘Go sue someone,’” said Chris Whalen of Institutional Risk Analytics, which analyzes risks facing banks.

The legal battle is complex, in part because the trustees themselves are often from big Wall Street banks, such as Wells Fargo, Citigroup and Deutsche Bank, which also sold mortgage-backed bonds that went bad.

“They are certainly more aggressive for loan documents,” David Grais, an attorney for investors, said about trustees.

Mortgage bonds were at the heart of the financial crisis. Banks and mortgage companies such as Countrywide assembled the bonds from pools of thousands of home loans, often “subprime” mortgages with high rates of default. The loans were placed in trusts, which in turn issued bonds, some portions of which were given top-quality ratings.

If investors can get documents such as credit reports, details on borrowers’ reported income and home appraisals, they expect to prove that banks breached their own guidelines for writing mortgages.

Having proactive trustees “significantly increases” the likelihood that investors will succeed in forcing banks to buy back soured loans, said Chris Gamaitoni, an analyst with Compass Point Trading & Research LLC.

In a report last August, he estimated combined losses by banks such as Bank of America Corp and Morgan Stanley could top $200 billion in a worst-case scenario.

Critics have suggested trustees knew of loan problems but did little about them. Trustees are quick to point out they are not fiduciaries like board members, and the often feel caught in the middle.

Citi Agency & Trust director Jennifer Cupo told the American Securitization Forum last month, “We’re really just a conduit, and people need to understand that our hands are tied as well.”

But trustees are finding it hard to ignore evidence that has begun to spill out of related lawsuits and investigations.

For example, internal emails disclosed in a New York state lawsuit appear to show Bear Stearns managers knew that more than half of the loans held in some EMC bonds did not meet stated underwriting guidelines.

Rather than replace the dud loans, the lawsuit alleges that a Bear Stearns manager brags about “shorting,” or betting against, the stock of the financial institutions likely to be hurt if EMC bonds cratered.

Better organized bondholders will likely force more trustees to work on their behalf, according to observers following the legal maneuvering.

Generally, investors must form a group representing at least 25 percent of the holders of a particular bond before they can make a demand on a trustee. Talcott Franklin, a Texas attorney, says he has rounded up enough bondholders to meet that threshold on more than 2,000 bonds.

Those better organized bondholders are also turning to the courts. One group of bondholders represented by Grais recently sued a trustee, Bank of New York Mellon, for refusing to comply with the group’s requests.

To date there have not been many of these so-called “putback” lawsuits, but that is expected to change.

“If you measure it in terms of cases filed, we’re probably in the second inning,” said Grais, “because I think there will be a lot more cases filed this year.”

Additional reporting by Al Yoon in New York; editing by John Wallace

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