Why Paulson Needn't Worry About Litigation Risk in his Mortgage Plan

Elizabeth Warren is worried about the investor lawsuits that Hank Paulson's mortgage-relief plan might trigger. "There is no clear legal basis for doing this kind of wholesale revision of the value of the collateral and forced revision of the mortgage terms," she writes. "The lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners."

To be clear, there's no risk that bond investors are suddenly going to start suing homeowners. But there is litigation risk to the Paulson plan, as Yves Smith explains:

This program is a repudiation of contracts. I don't see how any investor with an operating brain cell would ever buy an asset-backed security from a US issuer again, at least one backed by consumer assets...
The Journal states that:

A bill introduced by Rep. Mike Castle, a Delaware Republican, would temporarily free servicers from any liability for modifying loan terms. "Investors are still going to get a return and it's in their better interest to have those loans perform rather than fail," Mr. Castle said.

Any lawyers in the readership? How can the Feds indemnify parties against claims made under state law?
This whole scheme is an act of eminent domain, except the government isn't formally seizing property rights, but emboldening private parties to do so. Why is no one calling a spade a spade?

I'm slightly more sanguine than Warren and Smith on this point: I don't think there's going to be a rash of investor lawsuits if this plan goes through, for three main reasons.

Firstly, how would the investors show damages? Most loan modifications actually increase the total amount of money that the investors stand to receive. In this case, it's conceivable that might not be true, and that bondholders might get a bit less money than they would otherwise. But that's a really hard calculation to make, and unless you can make that calculation with some certainty, it's going to be very hard for you to show damages. And in the absence of damages, your contract repudiation and a buck fifty will get you a cup of coffee.

Secondly, how would these lawsuits scale? Let's assume that an investor in an RMBS tranche can compellingly show losses of say 5 cents on the dollar as a result of the Paulson plan. (We're talking about the difference, remember, between the present value of what that investor will now receive and the present value of what that investor would receive were the plan not in place.) Given the size of individual RMBS tranches, and the number of investors they were sold to, that investor probably has no more than about $20 million invested in the tranche. Which means that he'd be suing for $1 million. Not worth it.

What if he put a class action together, and got all the owners of that tranche to sue? Well, maybe the tranche was $50 million in total. We're still only talking $2.5 million in damages here. And since every tranche of every bond is different, it's going to be incredibly difficult to try to get a class action certified which tries to sue a bond servicer on more than one tranche at a time, let alone more than one bond at a time.

And finally, who would sue? Bond investors tend to be just about the most litigation-averse people in the financial world. The only bond investors who have any appetite for litigation risk are vulture funds, and they're a very special case. In general, bond funds have extremely low expense ratios and are passive, buy-and-hold investors. They're the polar opposite of the activist stockholders who will sue at the drop of a hat. Many of them are part of enormous international financial-services firms like Morgan Stanley and Allianz, and I can assure you that their corporate masters have no appetite at all for the kinds of headlines which would ensue were their bond-fund managers to start a wave of lawsuits.

A bond-fund manager who sues over an attempt to mitigate the subprime mortgage mess is going to be someone who calls attention to himself as a dupe of an investor and also an enemy of homeowners. In return for massive legal costs and uncertainty, he will get at best a tiny payday relative to the amount he invested. I just don't see it happening.

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