On The Case

MBS trustees score wipeout win in first trial of noteholder claims

(Reuters) - Big banks facing billions in dollars in claims by mortgage-backed securities investors who allege the banks failed to live up to their obligations as MBS trustees can breathe a little easier today. On Friday, Judge Steven Martin of the Court of Common Pleas in Hamilton County, Ohio, delivered a complete defense win to MBS trustee Bank of New York Mellon in the first noteholder case to go to trial.

Judge Martin not only found the specific evidence offered by noteholder Western and Southern Life Insurance to be unconvincing, but also – and more importantly for all MBS trustees – rejected investors’ entire theory that MBS trustees were obliged to protect noteholders as the mortgage market soured.

“The trustee was not a gatekeeper,” wrote Judge Martin, who presided over a three-week bench trial in January and February. “It was also not a trustee in the common law sense of the word. The trustee had the duties set forth in the contracts and only those duties. It did not have a fiduciary duty to the plaintiffs.”

As you know, noteholder litigation against MBS trustees is the last big uncertainty in investors’ litigation to recoup their vast losses. Noteholders have brought more than two dozen suits against trustees such as Bank of New York Mellon, HSBC, Deutsche Bank, Wells Fargo and others, arguing that trustees breached their contractual and common law duty to apprise investors of deficient underlying mortgage loans. The trustee litigation has been a seesaw affair: In the main, state and federal judges have refused to dismiss noteholder suits but have held that investors must prove trustees failed to act on individual loans in specific trusts, and that the failures harmed investors.

Judge Martin’s decision shows how high an obstacle investors face. Western and Southern, which was represented by Wollmuth Maher & Deutsch and White Getgey & Meyer, claimed that it lost about $100 million in 31 Countrywide MBS trusts in which BNY Mellon was the MBS trustee.

The insurance company offered two theories of how BNY Mellon failed noteholders: It alleged that the trustee did not demand Countrywide repurchase underlying mortgage loans that were not adequately documented; and BNY Mellon failed to demand repurchase of loans that didn’t meet Countrywide’s representations and warranties. Western and Southern attempted to prove widespread problems with the underlying loan portfolio by examining a sample of the mortgages.

Judge Martin didn’t think much of the sampling methodology, which he called “so riddled with holes as to make it unreliable and unusable.” Citing 2014 precedent from the 2nd U.S. Circuit Court of Appeals in an early MBS trustee case, the Ohio state judge emphasized that investors’ proof must be loan-by-loan and trust-by-trust. Moreover, he said, it’s not enough for noteholders to show simply that individual mortgages weren’t properly documented or even that they didn’t meet contractual representations. Western and Southern was required to show that the supposed deficiencies caused its losses, Judge Martin said. The noteholder failed to make that link.

“At the end of the case, after all of the witnesses and exhibits, there is no evidence as to whether the losses of the plaintiffs came from loans with no defects or loans with many defects,” the judge wrote. “The plaintiffs have simply failed to prove anything the defendant did or did not do caused them to lose money.”

And meanwhile, according to Judge Martin, BNY Mellon’s lawyers at Mayer Brown; Keating, Muething & Klekamp; and Ice Miller showed that Western and Southern was a sophisticated MBS investor that believed it could outrun a declining market. None of the insurance company’s internal documents – neither before it invested in the Countrywide MBS trusts nor afterward, when it conducted a post-mortem analysis of its losses - reflected reliance on BNY Mellon as a gatekeeper, Judge Martin said.

The judge said the lack of evidence was hardly a surprise, considering that the trust contracts specified only limited duties and responsibilities for BNY Mellon as the trustee. Perhaps Western and Southern could have negotiated pooling and servicing agreements tagging the trustee with a more substantive obligation to police the underlying loans, Judge Martin suggested. But according to him, that’s simply not the deal it made. “Essentially,” he wrote, “the plaintiffs are asking this court to enforce agreements they wish were in place instead of the contracts they signed.”

There’s really not a single bit of good news for MBS investors in Judge Martin’s decision, nor in his findings of fact, which closely track BNY Mellon’s post-trial proposal. The judge basically said that Western and Southern can’t retroactively hold Bank of New York Mellon liable for failing to fulfill responsibilities the trustee never had in the first place.

The conclusions of one Ohio state judge aren’t going to bind the various other courts entertaining investor suits against MBS trustees, of course. But the result of this first-of-a-kind trial will surely discourage noteholders, who so far haven’t gotten enough litigation leverage to force trustees to start settling cases. Judge Martin’s decision highlights the risk for investors that, at a minimum, trustee cases are going to be very expensive to prosecute.

For MBS trustees, on the other hand, the decision is justification for remaining resolute. Remember, many of these banks act as trustees for all kinds of asset-backed securities, not just MBS. Their contractual duties as trustees are similar across the structured finance spectrum, so, in a way, their entire corporate trust business model is under attack in the MBS trustee cases.

If Judge Martin had tagged BNY Mellon with liability in the Western and Southern case, there would be a lot of worried bank executives trying to figure out how best to respond to a litigation threat they hadn’t expected. Instead, the banks can enjoy their summer vacation.

A BNY Mellon representative said in an email statement that the bank is “gratified that the court found we fulfilled our duties as trustee and (is) pleased to put this matter behind us.” Western and Southern counsel David Wollmuth emailed a statement from his client: “We respectfully disagree with the court’s decision and are in the process of considering all of our options.”