The Biggest Unknown Threat to Bank of America Corp (BAC)

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This is the forth in a series of five articles covering Bank of America Corp (NYSE:BAC)’s legal problems since the financial crisis. To read the first three, click here, here, and here, respectively.

Since its fateful decision to purchase Countrywide Financial in 2008, Bank of America Corp (BAC) has faced a multitude of existential threats. But while an estimated $35 billion dollars in losses has already been realized by the nation’s second largest bank in its effort to combat these, a considerable amount of exposure remains. The biggest wild card in this regard concerns a series of multibillion-dollar securities fraud lawsuits brought by investors against B of A and its now-reviled subsidiary.

Bank of America Corp (NYSE:BAC)Putting the securities fraud claims into perspective
If the number of lawsuits filed against B of A resembles an unsolvable puzzle, here’s a framework to keep in mind. The bank faces liability under three legal theories:

  1. Breach of contract
  2. Securities fraud
  3. Malfeasance in mortgage servicing

The breach of contract claims can be further broken down into:

  • Those involving mortgages sold by Countrywide to government-sponsored agencies Fannie Mae and Freddie Mac.
  • Those involving private institutions which invested in Countrywide’s mortgage-backed securities (MBS).
  • And, those involving monoline insurance companies which insured particular tranches of the private-label MBSes.

In this article, I’m focusing on the large number of lawsuits that allege Countrywide committed securities fraud in the marketing and sale of MBSes to investors, the vast majority of which are being litigated in a federal court in California.

The Securities Act of 1933 gives the purchaser of a security the right to recover damages when a registration statement or prospectus contains untrue statements or omissions of material fact. At issue here are Countrywide’s assertions in MBS offering documents about the credit quality of mortgages packaged into securities, as well as Countrywide’s declarations that it adhered to strict underwriting guidelines.

The allegations made by American International Group, Inc. (NYSE:AIG) against the mortgage originator provide a textbook example. After reviewing 262,000 loans in various Countrywide MBSes, AIG found that 34% had loan-to-value ratios that were more than 10 percentage points higher than represented in the registration statements. It also found that an average of 17% of the mortgages sampled had LTVs in excess of 100% despite Countrywide’s claims in the same statements that none did.

Although the damages in these cases overlap potential recoveries in the breach-of-contract actions against B of A, securities fraud claims offer aggrieved investors a number of advantages. To file a breach-of-contract claim, an investor must typically own 25% of the underlying MBS. This is a threshold few investors meet. Alternatively, no such threshold exists in an action for securities fraud. Investors also don’t have to show that Countrywide intended to defraud them. The federal securities laws hold issuers to a strict liability standard, meaning that investors only have to show that an offering statement contained false representations about the securities in order to recover damages.

On the other hand, the one distinct disadvantage is that federal securities fraud claims must be filed within a certain period of time. Any claims related to securities sold more than five years ago are barred — plain and simple. In addition, this time period shrinks to only three years from when investors were on notice about the alleged fraud, which the judge has ruled occurred no later than Feb. 14, 2008. As a result, any federal securities fraud actions that weren’t filed by Feb. 14, 2011 are no longer viable.

To say that this has been a coup for B of A would be an understatement, as it’s led to the dismissal of multiple lawsuits and claims against Countrywide.

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