The Butterfly Effect is a term coined by meteorologist and mathematician Edward Lorenz to describe how small events can have huge consequences: a butterfly flapping its wings can set off a chain of events that culminates in a hurricane thousands of miles away.
The butterfly began flapping its wings in a court ruling this week involving Bank of America and bond insurer MBIA. The story attracted little notice outside the financial community, but its implications could be enormous.
In 2008, MBIA sued Countrywide Financial for fraud and misrepresentation regarding the quality of certain mortgage-backed securities (MBS) the bank had issued. When the mortgages in those securities turned out to have unexpectedly high default rates, MBIA was forced to pay claims to the investors that purchased them. The lawsuit basically alleges that Countrywide knew the securities contained bad loans, and should pay damages.
In its response to the suit, Bank of America, which now owns Countrywide, contended that MBIA should have to prove that the misrepresentations actually led to increased claims payouts. The Supreme Court of New York ruled this week that this high standard of proof was unnecessary, and the suit could go forward solely on the basis of the misrepresentation.
The court also rejected Bank of America’s contention that the only remedy available to MBIA should be the cancellation of the insurance policies. Justice Eileen Bransten ruled that MBIA may pursue monetary damages. She also rejected BofA’s insistence that each individual mortgage be scrutinized–which would have prolonged the case dramatically. Instead, MBIA may use representative samples of loans.
Why does this matter to ordinary people—particularly those in the real estate industry?
Here’s a breakdown of the possible ramifications:
- This ruling increases the chances that MBIA’s lawsuit will succeed. That could expose Bank of America to huge monetary penalties—$1.4 billion in this suit alone.
- The suit could serve as a precedent for similar suits from other insurers and investors. (The ruling this week was accompanied by a similar ruling involving a less-known company, Syncora Guarantee, Inc.) This could represent the first ripples in a tsunami of decisions against BofA.
- BofA’s liability exposure would thus skyrocket. Manal Mehta, a partner at Branch Hill Capital, estimates that BofA’s liability could grow by $8 to 9 billion.
- These events could trigger the “put back” provisions in the representations and warranties that accompany the suspect MBS’s. BofA would be forced to buy back scores of bad mortgages and include them on its balance sheet.
The Good News
The buy-back scenario is what Bank of America has been trying fervently to avoid. Now, it looks all but inevitable. The aftermath could unfold in two possible ways, both of them favorable to real estate professionals:
- Bank of America can’t afford to have more liabilities on its books. It will move quickly to dispose of these problem loans—and the best way to do that is through short sales. Since these loans will no longer be owned by diverse groups of investors, the bank will have free rein to act decisively.
- If actual fraud is proved in court, the servicing rights to these loans could be stripped from BofA and transferred to specialty servicers. These servicers would be geared to a quick disposition of the assets—again favoring the short sale option.
Analysts have dubbed 2012 The Year of the Streamlined Short Sale. That could prove to be more accurate than anyone imagined.