Court Orders Mortgage Securitizer to Pay Mortgage Insurer $90.1 Million – Part I

June 7, 2013

Insurance LawThe collapse of the subprime mortgage market has resulted in a growing number of claims against financial guaranty insurers.  The insurers agreed to provide coverage based on representations of loan originators and bankers responsible for packaging the loans into bonds about the creditworthiness of the borrowers and the value of the collateral underlying the lines of credit. By purchasing financial guaranty insurance, the banks were able to obtain higher credit ratings for their mortgage-backed bonds, making the bonds more salable and allowing the banks to pay bondholders lower interest rates.

As we all now know, many of the bank’s opinions and/or representations (depending on one’s perspective) were wildly inaccurate. Many lenders, knowing they could pass the risk of default to others by packaging their loans into bonds and then selling the bonds to investors, allowed borrowers with poor credit to borrow against nearly the entire value of their homes. This was based on what we now know was a fanciful assumption that the value of real estate would grow unabated, and certainly never would fall. When the real estate bubble burst in 2008, many borrowers found themselves underwater due to upward adjustments in their variable rate loans. Mortgage defaults increased and claims under financial guaranty policies followed. These claims have given rise to lawsuits in which insurers seek to avoid payment based on the bond issuer’s misrepresentations.

Legal Solutions Blog recently reported the result in the first such suit to go to trial, Assured Guaranty Municipal Corp. v. Flagstar Bank, FSB —a $90.1 million verdict for the insurer. This post will examine Judge Rakoff’s key pre-trial legal rulings allowing the insurer’s claims to proceed to trial. See, 892 F.Supp. 2d 596 (S.D.N.Y. 2012).  My next post will examine the key evidentiary rulings supporting Judge Rakoff’s verdict following a 12-day bench trial. See, 2013 WL 440114 (S.D.N.Y. Feb. 5, 2013).

Judge Rakoff’s Pretrial Rulings on Causation

Flagstar Bank, FSB, the issuer of the bonds, moved for summary judgment on the ground that the insurer, Assured Guaranty Municipal Corporation, had failed to raise triable issues of fact regarding whether the alleged misrepresentations and warranty breaches caused any actual loss. Judge Rakoff denied the motion, pointing out that Flagstar’s contractual obligation to repurchase and replace loans that do not satisfy various warranties was triggered when a breach “materially and adversely affects the interest of the Issuer, the Noteholders or the Note Insurer in the related Mortgage Loan.” Thus, Assured Guaranty need only prove that the misrepresentations were “material” and “adverse.” Judge Rakoff interpreted “material” to mean information that “would affect [Assured Guaranty’s] decision making” and “adverse” to mean “‘opposed to one’s interests.’” Accordingly, he concluded “that plaintiff must only show that the breaches materially increased its risk of loss. Put another way, the causation that must here be shown is that the alleged breaches caused plaintiff to incur an increased risk of loss.”

Judge Rakoff rejected Flagstar’s argument that Assured’s Guaranty should be bound by the findings of third party due diligence firms it hired to evaluate Flagstar’s loans before entering into the transaction. Flagstar’s argument, he pointed out, would render the representations and warranties in the transaction documents superfluous. Moreover, under the New York Court of Appeals’s decision in CBS Inc. v. Ziff–Davis Publishing Co., 75 N.Y.2d 496, 554 N.Y.S.2d 449, 553 N.E.2d 997 (1990), doubts as to the truth of facts warranted before closing do not preclude recovery for breach of warranty. Under Ziff-Davis, Assured Guaranty would be precluded from recovering only if it entered into the contract with Flagstar with full knowledge and acceptance of knowledge disclosed by Flagstar. Here, “although the data came from Flagstar, the relevant information came from third party due-diligence firms.” Judge Rakoff refused to allow Flagstar to “just dump a Mountain of data” on Assured Guaranty in order to argue that Assured Guaranty had waived the contract’s express warranties.