Ambac faces key hearing ahead of $1 bln Countrywide mortgage-backed securities trial

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An empty courtroom is seen at the New York State Supreme Court in Manhattan, New York City, U.S., August 21, 2020. REUTERS/Andrew Kelly

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  • Countrywide's motion
  • Ambac's opposition to the motion

(Reuters) - No, you didn’t misread that headline: After 12 years of litigation, the insurer Ambac Assurance Corp is scheduled for a bench trial in September in Manhattan state court to prove its claims that Countrywide Home Loans Inc is on the hook for more than a billion dollars because it allegedly stuffed 375,000 defective loans into mortgage-backed securities Ambac insured.

To make that case, Ambac is hoping to convince New York State Supreme Court Justice Richard Reed at a hearing on Wednesday to allow the company to admit documents showing Countrywide’s exceedingly risky mortgage underwriting practices as the housing market careened toward a crash 15 years ago.

Countrywide, which was acquired by Bank of America Corp in 2008, has moved to exclude what it calls “extraneous” evidence about its rush at the end of the housing boom to make mortgage loans that could be packaged into MBS. It argues that Countrywide’s increasingly lax policies and procedures in the run-up to the mortgage meltdown are “irrelevant” to Ambac’s claim that Countrywide breached contractual obligations to repurchase specific loans that turned out to defective.

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Ambac, meanwhile, insists the documents prove that Countrywide — as the originator and servicer of the mortgages and the sponsor of the MBS that contained them — knew or should have known that hundreds of thousands of underlying loans were defective. Its own underwriting and securitization practices, according to Ambac, triggered Countrywide’s contractual liability for bad mortgages.

“When an aspect of case is ‘knew or should have known,’ it’s hard to imagine more relevant evidence,” said Ambac lead counsel Michael Carlinsky of Quinn Emanuel Urquhart & Sullivan. “We don’t even think it’s a close call.”

Wednesday’s hearing is also likely to reveal whether Ambac has an even bigger challenge in advance of its September trial.

In March, New York’s highest court issued a landmark opinion in U.S. Bank National Association v. DLJ Mortgage Capital Inc, holding that an MBS trustee’s liability against an MBS sponsor was limited to defective underlying mortgages for which the trustee had provided specific notice to the sponsor. The trustee had argued that when it alerted the sponsor about defects in about 300 underlying loans, that notification triggered the sponsor’s liability for hundreds of additional loans that turned out to be problematic. The New York high court rejected that reasoning as contrary to the MBS contract, ruling that contract terms required the trustee to provide specific, loan-by-loan notifications in order to demand repurchase.

Countrywide contends that under the U.S. Bank decision, Ambac can assert claims based only on about 7,000 underlying mortgages for which it provided adequate notice of defects — a tiny sliver of the more than 375,000 mortgages at issue in the insurer’s long-running case. Countrywide’s outside counsel from Williams & Connolly argued in a March 24 letter to Reed that the U.S. Bank decision would have “a profound impact on this trial” because it underscores the New York high court’s adherence to the loan-by-loan requirements in MBS contracts.

Ambac retorted in a March 28 letter that Countrywide’s assessment was “hyperbolic and incorrect.” The U.S. Bank decision, wrote Ambac counsel Carlinsky, addressed only one avenue of recovery — notification — under MBS contracts. But Ambac’s primary theory, the insurer told Reed, is based on a second, independent avenue of recovery, which requires MBS securitizers to repurchase loans with defects they themselves have discovered. The so-called “discovery prong,” Ambac said, imposes liability on MBS originators, sponsors and servicers when they know (or should know) that underlying loans are flawed.

The Court of Appeals explicitly distinguished between the two contractual routes to recovery in the U.S. Bank decision, noting that the ruling did not address the discovery theory. Ambac said Countrywide had ignored that critical distinction in its arguments about the ruling’s implications in the Ambac case.

“U.S. Bank did not address ‘discovery,’ let alone the standard for discovery,” Ambac told Reed. “Countrywide’s efforts to import language from the decision relating to notice into a discussion of what the ‘discovery’ prong requires should be rejected.”

Ambac said Reed didn’t even need to entertain briefing on the impact of the U.S. Bank decision because it was so clearly inapplicable to the insurer’s theory that Countrywide knew or should have known about widespread defects in underlying mortgages, based on its role as the originator and servicer of the vast majority of the loans in the MBS trusts.

Countrywide didn’t respond to Ambac’s letter and a Bank of America spokesman declined to provide a statement to me about the Ambac case. But Countrywide's initial letter to Reed offered a clear hint about what its lawyers will say if the judge asks about the U.S. Bank decision at Wednesday’s hearing.

The ruling, Countrywide said, “makes Ambac’s constructive-discovery theory ‘untenable.’” The Court of Appeals, Countrywide said, was unequivocal in its insistence that the only way to approach MBS contractual obligations is on a loan-by-loan basis, not by considering allegedly pervasive breaches of representations about underlying mortgages. That emphasis, according to Countrywide, is incompatible with Ambac’s assertion that it should have known about bad loans.

It’s not entirely clear that Reed will entertain arguments about the U.S. Bank decision on Wednesday, since neither side has formally briefed its implications. There’s a chance the judge will stick to just the fully briefed dispute over Ambac’s “bad actor” evidence, although that seems unlikely since he scheduled the hearing after Countrywide filed its letter about the Court of Appeals ruling.

Ambac has already signaled to investors that the decision may be consequential. Last week, in its latest financial filing, Ambac estimated a recovery of nearly $1.5 billion from its remaining MBS cases, Countrywide chief among them. That estimate is $225 million less than Ambac’s $1.7 billion projection a few months ago. The insurer attributed most of the downward estimate to the U.S. Bank decision.

We should get some signal on Wednesday about how good a guess Ambac has made about the impact of that ruling.

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Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.