As one of the world’s largest asset managers, PIMCO (Pacific Investment Management Company) saw losses mounting as a result of the subprime mortgage crisis in the residential mortgage markets. The company was determined to act, and under global general counsel David Flattum, led an effort that resulted in an $8.5 billion settlement for its clients.
The subprime mortgage crisis was a nationwide financial emergency that coincided with the recession of December 2007 through June 2009. Low interest rates led banks to offer mortgages to unqualified borrowers; those loans were then securitized, or bundled into mortgage-backed securities and sold to large financial institutions such as PIMCO, which included them in portfolios of assets they managed for clients, such as pension funds and retirement plans. Ultimately, the lower credit quality of the loans caused massive defaults, which decimated the value of the mortgage-backed securities.
When the financial crisis ended, it became obvious to the global investment community that there had been significant wrongdoing, and perhaps even fraud, in the construction and servicing of numerous mortgage-backed securities. First, there was significant misrepresentation regarding the qualifications of the borrowers and thus the quality of the loans. Second, the servicers who were collecting payments, handling escrow accounts, and the like for the loans inside the mortgage-backed securities were not complying with their contractual obligations, which are described in pooling and service agreements (PSAs).
“Until PIMCO and the other investors organized themselves, there had been no large-scale effort to enforce securitization contracts to address the twin problems of bad mortgages and poor mortgage servicing”
While the problem was clear, the solution was not. There were a number of structural hurdles standing in the way of recovery against these parties. The first hurdle was that investors had to band together to direct a trustee to act, rather than the investors being able to enforce against the parties directly. However, there were thousands of mortgage-backed securities, each one structured as a separate trust and with thousands of investors diffused around the world. On top of that, investors would need to indemnify the trustees—that is, offer to pay the trustees’ legal bill. “This gave rise to a significant collective-action problem,” Flattum says. “Some of the traditional devices you might use, such as the class-action lawsuit, didn’t work very well in this space, which had a multitude of different investors, many of whom competed against each other. As a result, some actions had been filed, but it wasn’t clear that they’d be successful.”
Rick LeBrun, a member of the PIMCO legal department, took the challenge to heart and began working with PIMCO portfolio manager Dan Ivascyn to understand the problems embedded in the mortgage-backed securities. They started with a long list of questions: What were the defects in the mortgages? What warranties were violated? Who was responsible for those misrepresentations? How do we hold the responsible parties accountable? Then, LeBrun and Ivascyn had to develop a legal strategy to overcome the collective-action and other problems, all associated with trying to achieve a recovery for PIMCO investors. The appropriate remedy with respect to the misrepresentations would be for the mortgage originator—the bank that misrepresented the quality of a mortgage when putting it into a mortgage-backed security trust—to take the bad mortgage out of the trust and give back the cash. “But how do you do that?” he asks. “That was the question.”
The solution LeBrun and Ivascyn came up with was a novel one. “We realized that if we could assemble a group of some of the biggest mortgage-backed security holders in the world and pool all of our collective holdings in these thousands of mortgage-backed security trusts, we could get the requisite voting power to direct the trustees to take action,” Flattum says.
That was easier said than done, however. This meant finding the other holders, many of which were PIMCO competitors, and getting them to join a common effort, select the same legal counsel, and agree on the same strategy. “It was more like herding hungry lions than cats,” he says. To that end, Flattum selected a law firm he had worked with in the past, Gibbs & Bruns, and through partner Kathy D. Patrick, he reached out to the affected investment community—firms that included BlackRock, Wamco, MetLife, Goldman Sachs, and others. All told, 22 institutional investors ultimately joined the effort.
Although many banks had sponsored problematic mortgage-backed securities, the investor group identified Bank of America as the one with the largest number, largely because in 2008, it had purchased the failing Countrywide Financial, which reportedly financed more US mortgages than any other lender. “Together, we wanted to bring Bank of America to the table to reach a settlement whereby it would make each of those trusts whole by injecting capital into each [one],” Flattum says. “We also wanted Bank of America to agree to certain reforms in regard to how its affiliated servicer organizations serviced mortgages.”
Once the group was assembled and the initial target was selected, the group faced the next major challenge: getting the trustees to act. The trustees had their reasons for not proactively holding loan originators and servicers accountable. “Even though we now had the requisite percentage to direct them,” Flattum says, “they were saying they weren’t under obligation to follow the direction unless they were adequately indemnified by security holders.”
Reaching an agreement on the terms of the indemnity with a trustee proved to be an exceedingly difficult task. That’s when the legal team at PIMCO got the idea that if a group of mortgage-backed security holders declared that servicer was in default of its obligations to putback mortgage loans to Countrywide via a notice of nonperformance, the trustees may feel that they had a heightened duty to act against the servicer. “The idea was to change the negotiation dynamics,” Flattum says.
When the group of investors sent notice of nonperformance, Bank of America’s stock plummeted, and immediately thereafter, negotiations began. The groups worked hard to come up with an economic solution both sides believed was fair but also create a legal mechanic that would allow the trustees of these thousands of trusts to be comfortable accepting the settlement. The challenge was that any number of parties with an interest in the trusts might object to the settlement, and unlike in a class-action lawsuit, which is “blessed” by a judge, the trustees weren’t acting under court order. “We needed to come up with a legal mechanism to bless the settlement,” Flattum says. “That was what we called an Article 77 proceeding, under which the trustees would ask the New York court to approve their actions in accepting the settlement.”
It took several months, but Bank of America ended up settling for $8.5 billion. Once the Article 77 concludes, all of that money will not go to PIMCO or the other institutional investors, but to the trustees to be injected back into the mortgage-backed securities that had been hurt by failed subprime mortgages. “It didn’t just help the 22 institutional investors who were members of the investor group,” Flattum says. “Anyone who held securities in the trusts benefited.”
Although the lawsuit is still going through the legal systems, it set a precedent as the largest settlement in private litigation in US history. “Until PIMCO and the other investors organized themselves, there had been no large-scale effort to enforce securitization contracts to address the twin problems of bad mortgages and poor mortgage servicing,” says Patrick.
PIMCO then used the model to get additional settlements from other companies. Today, the group of investors has obtained settlements totaling more than $21 billion from Countrywide, Residential Capital, JP Morgan, and Citigroup. “This is a superb result and one that is entirely unique in the history of securitization litigation,” Patrick says. “No other group, before or since, has achieved such spectacular successes not just for the benefit of themselves and their clients, but for the benefit of all holders of the trusts’ securities.”