Mortgage-Backed Securities Litigation - Greenberg Traurig LLP

Mortgage-Backed Securities Litigation: Claims and Defensive Strategies 

By Victor Vital and Aiesha Redmond 

W 

hat do Charles Schwab 

Corp.; MBIA, Inc.; Ambac Financial 

Group, Inc.; and various Federal Home 

Loan Banks have in common? They have 

all sued major banks in connection with 

the mortgage-backed securities (MBSs) 

Vital 

issued by those banks. A couple of the 

latest entrants to this fray are Allstate 

and the TIAA-CREF fund family, having 

sued Bank of America’s Countrywide 

mortgage unit in late December 2010 and 

in January 2011, respectively. See Mark 

Jewell, Investors Allege Massive Fraud by 

Countrywide, Associated Press, Jan. 25, 

Redmond 

2011, www.bloomberg.com/news/ 

2011-01-25/investors-allege-massive-fraud-by-countrywide 

.html. The real estate “bubble” that popped in 2007 is 

credited widely to mortgages extended to unworthy borrowers 

to feed the mortgage-securitization machine. 

The wave of current litigations shows that MBSs have 

come full circle, with investors and insurers seeking recourse 

against major banks for these bank-created and marketed 

products. But are the extra-contractual theories asserted in 

these lawsuits novel, or do they actually resemble past claims 

by sophisticated parties concerning bank-created and bankmarketed 

products? Moreover, will the investors and insurers 

be successful on their extra-contractual claims? 

These lawsuits assert extra-contractual theories that are 

standard fare for dissatisfied yet sophisticated purchasers of 

bank-marketed products. Banks in the past have argued that 

tort theories of recovery fundamentally change the risk allocation 

contemplated by the contracts that were executed in full 

view of the transaction’s risks. How the present MBS-related 

claims will be resolved remains to be seen, but banks will 

likely defend these extra-contractual theories using welldeveloped 

arguments from past cases. 

Mortgage-Loan Securitization 

Securitization is a process by which intangible and illiquid 

assets are monetized into cash. Securitization is also the term 

used to describe the process of issuing securities backed by the 

cash flows from a pool of underlying assets. D. Michael Long 

& Gregory Rohan, “The Securitization of Assets: The New 

Finance,” 7 Int’l J. Bus. Strategy 142 (2007). 

Mortgage-Backed Securitization 

MBSs are asset-backed securities or debt obligations that 

represent claims on the cash flows from securitized mortgage 

loans. These securitizations are done by government 

agencies, government-sponsored enterprises, and private 

entities. Most MBSs are issued by the Federal National 

Mortgage Association (Fannie Mae) and the Federal Home 

Loan Mortgage Corp. (Freddie Mac). Private institutions, 

however, such as brokerage firms, banks, and homebuilders, 

also securitize mortgages known as “private-label” mortgage 

securities. U.S. Securities & Exchange Commission, 

Mortgaged-Backed Securities (July 23, 2010), www.sec.gov/ 

answers/mortgagesecurities.htm. 

Though MBSs are considered complex, the process 

through which banks create them is rather straightforward. 

First, a bank aggregates hundreds if not thousands of mortgages 

that the bank has originated or acquired from other 

originators. Second, these pooled loans are transferred into 

a trust formed to issue securities backed by the pooled loans, 

i.e., MBSs. Banks create these trusts, which are bankruptcyremote 

entities, to separate the ultimate MBS investors from 

the banks’ credit risk. Third, the trust issues MBSs from the 

pooled loans transferred by the bank, in a transaction underwritten 

by the bank. 

MBSs are well established in the world of finance as a 

1980s creation of Wall Street. In their early years, MBSs 

were backed by the best of mortgage loans—those extended 

to solvent, credit-worthy borrowers. The biggest 

risk associated with MBSs in those days was the risk of 

early payment. With mortgage holders having the option 

of prepaying their mortgages, this accelerates the cash 

flows to the investors, who receive the principal payments 

early but do not receive the future interest payments that 

would have been made on that principal. Because MBSs 

are essentially a claim on future cash flows from a pool of 

mortgages, prepayment of the loans, which borrowers typically 

do when rates fall, diminishes an investor’s return, 

leaving the investor with cash to then invest, but in a 

lower-rate environment. The advent of subprime mortgage 

securitization, however, introduced a new risk: the 

risk of nonpayment. 

The difference between securitized pools consisting of 

credit-worthy borrowers versus subprime borrowers is huge. If 

a mortgage pool is comprised of credit-worthy borrowers who 

consistently pay in a timely manner, MBS holders have a high 

degree of confidence in a steady flow of income. On the other 

hand, if the mortgage pool is subprime, or at risk for missed 

payments or nonpayment, then MBS holders should not have 

the same degree of confidence. However, subprime MBS 

investors are compensated for that risk through higher returns 

on their investments. 

Published in Commercial & Business, Volume 12, Number 3, Spring 2011. © 2011 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof 

may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

Underwriting, Insurance, and Assurances 

To enhance the marketability of MBSs, the bank or its 

affiliate sponsoring the MBS transaction obtains insurance 

to guaranty payment on the MBSs. To secure that insurance, 

banks make representations and warranties to financial guaranty 

insurers. Those representations and warranties concern, 

among other things: 

■■ 

■■ 

■■ 

the accuracy of the information supplied in connection 

with the financial guaranty transaction; 

the selection of loans for the securitizations based 

upon an acceptable quality benchmark; and 

adherence to appropriate and reasonable underwriting 

guidelines in respect to originating the underlying 

mortgage loans, as well as appropriate and 

reasonable loan-servicing practices in respect to the 

underlying mortgages. 

These same types of representations are made in the contract 

documents under which investors such as pension funds, 

hedge funds, Fannie Mae, and Freddie Mac purchase MBSs. 

Contract-Based Risk Allocation and Remedy 

Investors evaluate risk primarily based on whether the issuer 

is private or government-backed, the quality of the underlying 

mortgage loans, and the credit enhancement or credit 

ratings afforded to the securities. Generally speaking, there 

is no imbalance of sophistication or bargaining power among 

the parties to these transactions, given that both the investors 

and the insurers are well-established and known entities like 

TIAA-CREF, Fannie Mae, and Ambac. 

As one would imagine, MBS issuances and the underlying 

guaranty transactions are “papered” heavily with investors, 

insurers, and MBS sponsors and issuers generally relying on 

their freedom of contract to negotiate a specific allocation 

of risks with the benefit of due diligence and appropriate 

professional advice and counsel. For insurers, the agreed-upon 

bargain includes being paid substantial premiums in exchange 

for making payments on a policy. 

The extent to which banks retain recourse liability is one 

of many items heavily negotiated between the parties. The 

parties might agree that the bank retains no recourse; that it 

incurs conditional or limited recourse; or that it provides full 

recourse. Generally, investors or insurers negotiate and secure 

substitution or repurchase provisions, worded along the following 

lines: 

Upon discovery or upon notice of a breach of any 

representation or warranty set forth with respect to any 

loan that materially and adversely affects the interests 

of the parties in such a loan [the bank] shall, within 90 

days after the earlier of its discovery or receipt of notice 

thereof, either cure such breach in all material respects 

or (i) repurchase such a loan from the trust at the 

repurchase price or (ii) substitute one or more eligible 

substitute loans for such a loan. 

The Downturn of MBSs 

When the U.S. housing market collapsed, imploding home 

prices resulted in precipitously rising foreclosures. Obviously, 

in view of the wave of subprime mortgage loan defaults that 

ensued, the value of MBSs plunged from investment-grade 

securities to junk-bond status. This was because the cash flows 

from securitized mortgages were substantially lower than the 

MBS investors desired, given the numerous loan defaults. 

This, in turn, caused a shortfall in funds available to pay 

the interest mandated by the MBSs, bringing with it massive 

numbers of defaults by the issuers of the MBSs. In other 

words, the investment decisions made by the investors and 

the guaranty transactions entered into by the insurers ran in 

the opposite direction of what they desired. 

Investors and insurers are now pressing claims on the 

representations and warranties, alleging that banks securitized 

loans that failed to meet the 

representations and warranties 

due to things such as 

inflated appraisals, overstated 

borrower income figures, and 

borrowers failing to occupy 

the mortgaged homes. But 

the investors and insurers 

are also asserting extra-contractual 

theories premised on 

theories of reliance as well as 

implied-contractual duties. 

While banks thus far 

The extent to 

which banks 

retain recourse 

liability is one 

of many items 

negotiated. 

have resisted purchasing the alleged defective mortgages 

cart blanche, the larger question concerns the propriety and 

strength of the extra-contractual claims asserted in respect to 

the allegedly defective mortgages. 

Typical Claims Asserted by Plaintiffs 

Contract-Breach of Representations and Warranties 

In most instances, banks make representations and warranties 

with respect to each mortgage loan sold. A breach of contract 

occurs when the representations and warranties referenced 

earlier turn out to be false. This is the most straightforward 

claim and is premised upon the deal struck between the parties 

in the underlying transaction documents. 

Fraudulent Inducement 

To assert a fraudulent inducement claim, an investor or insurer 

must show that the bank represented that a material fact 

was true for the purpose of inducing the plaintiff to rely on it, 

knowing the representation was false. And, notably, a fraud 

plaintiff must have been justified in relying on the alleged 



misrepresentation, causing the plaintiff to enter the transaction 

and suffer loss and damages. 

Negligent Misrepresentation 

Investors and insurers also are asserting negligent misrepresentation 

claims, alleging that banks negligently supplied false 

information in respect to the MBS transactions. Like fraud 

claims, negligent misrepresentation claims require a showing 

of justifiable reliance. 

Breach of Implied Duty of Good Faith and Fair Dealing 

Investors and insurers often allege a breach of the duty of 

good faith and fair dealing, arguing that the banks failed 

to disclose information about the quality of mortgage loans 

and MBSs. 

Defending Against Extra-Contractual Claims 

Attacking Justifiable Reliance 

Sophisticated commercial parties in heavily papered 

transactions generally take a number of steps to protect 

their financial interests. In an MBS transaction, for instance, 

an investor or insurer will typically secure as much 

information as it deems necessary in the due diligence 

process. This point, however, sets up the argument that 

the MBS investor or insurer did not justifiably rely on any 

oral or written representation of the bank, particularly 

in transactions that include 

Investors and 

insurers often 

allege a breach 

of the duty of 

good faith and 

fair dealing. 

comprehensive merger-andintegration 

clauses and that 

involve the disclosure of copious 

amounts of information 

and data. 

An example of this defensive 

point can be found 

in United Guaranty Mortgage 

Indemnity, Co. v. Countrywide 

Financial, Corp., 660 F. Supp. 

2d 1163 (C.D. Cal. 2009). In 

this particular case, an insurer 

brought suit against a lender, alleging that the lender falsely 

represented that the mortgage loans were originated “in strict 

compliance with the originator’s underwriting standards 

and guidelines.” The court dismissed the insurer’s fraudulent 

inducement claim, however, stating that “any reasonable 

mortgage insurer that (1) was conducting multibillion-dollar 

transactions and (2) had an express right to audit or sample 

the underlying loan files before the transaction closed, would 

engage in some degree of auditing or sampling of the underlying 

loan files to be insured.” 

Because MBS investors and insurers receive substantial duediligence 

information, banks will likely mount “justifiable reliance” 

attacks arguing that these sophisticated plaintiffs cannot 

establish such reliance and, thus, cannot assert reliance-based 

claims such as fraud and negligent misrepresentation. While a 

non-sophisticated plaintiff could complain that the truth was 

buried in voluminous data, it will be difficult for a sophisticated 

party to so complain. 

Breach of Contract Masquerading as Fraud 

In many states, a line of argument has evolved disallowing 

a plaintiff to allege a fraud claim based upon alleged 

misrepresentations that are not independent of the underlying 

contract. Hawthorne Group, LLC v. RRE Ventures, 776 

N.Y.S.2d 273, 276 (N.Y. App. Div. 2004) (dismissing fraud 

claims arising from alleged breaches of warranty dependant on 

the underlying agreement). Under that theory, fraud claims 

will be dismissed as duplicative of breach of contract claims 

where the tort claims are derived directly from the terms of 

the agreement. 

Banks defending against fraud and negligent misrepresentation 

claims should argue that these claims are merely 

breach-of-representation and warranty claims masquerading as 

tort claims. In that respect, the underlying transaction documents 

define the parties’ rights and obligations. If the bank’s 

representations prove false, the failure of the representation 

constitutes a breach of contract claim for which contract 

law provides an appropriate remedy. RGH Liquidating Trust 

v. Deloitte & Touche, LLP, 851 N.Y.S.2d 31 (N.Y. App. Div. 

2008) (affirming the dismissal of fraud claims as duplicative of 

breach of contract claims where fraud claims were “based on 

alleged fraudulent misrepresentations related to defendants’ 

obligation under their agreements . . . and allege no misrepresentations 

collateral or extraneous to the agreements”). 

This principle was demonstrated recently in Lone Star Fund 

v. Barclays Bank PLC, in which a purchaser of MBSs asserted 

a fraud claim based on the allegation that certain representations 

about the loans were falsely made. The court held that 

there was no actionable misrepresentation or fraud where the 

contract warranties provided that if any of the loans did not 

meet certain representations, the bank would repurchase or 

substitute them. Even where investors and insurers claim that 

banks were aware of the poor loan quality, fraud claims will be 

dismissed if they are derived from the terms of the contract. 

Lone Star Fund V (US), LP v. Barclays Bank PLC, 594 F.3d 

383, 389 (5th Cir. 2010) (stating that “a sophisticated investor 

placing a $60 million investment in the trusts . . . has no 

basis to ignore these provisions or their consequences”). 

Defense Against Implied Covenant of Good Faith and Fair Dealing 

A cause of action for breach of the implied duty of good faith 

and fair dealing will not succeed where it is duplicative of the 

breach of contract claim. See, e.g., R.I. Island House, LLC v. 

N. Town Phase II Houses, Inc., 858 N.Y.S.2d 372, 377 (N.Y. 

App. Div. 2008). This particular cause of action cannot be 

used as a “pile-on” claim, where underlying documents are 

specific as to issues in disputes. Any related damages must be 



ecovered in the context of the breach of contract claim. Levi 

v. Utica First Ins. Co., 786 N.Y.S.2d 3 (N.Y. App. Div. 2004). 

In Levi, the plaintiffs brought a breach of contract claim 

and breach of the implied duty of good faith claim against an 

insurer, claiming that the insurer intentionally misrepresented 

certain terms in the policy. The court held that these claims 

“are redundant since a breach of the implied duty of good 

faith and fair dealing is intrinsically tied to the damages allegedly 

resulting from the breach of the contract.” 

Thematic Defenses 

Sophistication. Sophisticated investors are deemed to have 

sufficient investing experience and knowledge to weigh the 

risks and merits of an investment opportunity. The investor 

base remains overwhelmingly institutional. The MBS transaction 

participants, including the guaranty insurers, are “big 

boys” that can look out for and protect their own interests. As 

knowledgeable and sophisticated counterparties, MBS investors 

and insurers can do a number of things to protect themselves, 

including request and obtain appropriate financial and 

other disclosures; undertake extensive due diligence; retain 

and use legal, financial, and other professionals; and negotiate 

and secure appropriate consideration, risk-mitigation provisions 

and remedies. Furthermore, most modern transaction 

documents traditionally contain provisions emphasizing the 

equality of bargaining power, adequate and equal access to 

sufficient underlying data, and access to qualified legal and 

other professionals. 

These points should be developed fully and used prominently 

during pretrial discovery, particularly during depositions, 

and later at trial. 

“A deal is a deal.” The reality is that all MBS transaction 

participants are financially sophisticated, enter into 

these transactions knowing exactly what they are buying 

in terms of the quality of the investments, and understand 

the risks that they are taking. Now that some of the highyielding 

investments are not working out as planned, some 

investors want to blame someone for the fact that the declining 

economy caused their investments to lose value and 

are crying foul play. These investors made an informed and 

heavily negotiated investment and essentially “bet on the 

wrong horse.” The appropriate jury argument is that living 

with the negotiated risk rather than trying to make money at 

the courthouse is appropriate. 

Adequate disclosure and common sense. MBS issuers provide 

disclosure to investors in a series of documents and through 

a variety of means. Disclosure is particularly focused on helping 

investors evaluate the prepayment and credit risks. However, 

perfect disclosure is not the standard. Adequate disclosure is 

what the law and common fairness require. Moreover, common 

sense indicates that subprime borrowers with poor credit history 

and reduced repayment capacity are risky to bet on. And the repurchase 

remedy negotiated envisions the common-sense notion 

that subprime borrowers are a high-default risk. In light of prior 

real estate downturns (like the 1980s real-estate meltdown), 

sophisticated parties should have known that massive defaults, 

particularly in the subprime market, could occur. 

Conclusion 

With an unimaginable amount of litigation arising from the 

fallout of the collapse of the housing market, it will be interesting 

to see if courts give sophisticated investors and insurers an 

outlet to essentially rewrite their soured mortgage deals through 

extra-contractual theories. Banks will argue that the extracontractual 

claims constitute a quintessential after-the-fact 

attempt to escape deals that were consummated in full view of 

inherent and apparent risks. Viewing the present claims in light 

of past actions related to bank-created and marketed products 

provides an accurate manner of making predictions about how 

the claims might be defended and resolved. 

Victor D. Vital is a shareholder at Greenberg Traurig, LLP, in 

Dallas, Texas. Aiesha Redmond is an associate with Baker Botts, 

LLP, in Dallas, Texas.

Mortgage-Backed Securities Litigation - Greenberg Traurig LLP

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