In a major setback for Bank of America, a federal judge has moved the venue for their $8.5 billion settlement with investors on mortgage-backed securities issues to federal court. In so doing, the judge criticized the arrangement on a variety of fronts.

BofA hoped to do away with all of their investor liability on Countrywide MBS in one fell swoop with the settlement, negotiated with only a small sliver of institutional investors through the trustee, Bank of New York Mellon. Other investors, as well as the Attorneys General of New York and Delaware, criticized the deal and took BofA and BNYM to court over it. Keep in mind that the $8.5 billion settlement represented around 2-3 cents on the dollar for the total pool of mortgage securities affected. By point of comparison, yesterday Citigroup settled an SEC civil complaint on a $1 billion mortgage deal (similar to the Abacus deal, where Citi stuffed a bunch of bad mortgages into a pool, sold them to investors, and bet the other side) with a $285 million settlement. The Citi deal was a different kind of fraud scheme, but the percentages involved in the settlement are far more reasonable than what BofA is trying to get away with.

This probably extends the uncertainty for BofA, as the federal court case will take more time. But it also takes the case out of a venue that looked like an easy mark for them. The state judge assigned to the case in New York had a history of bank-friendly rulings. By contrast, US District Court Judge William Pauley in this case blistered the participants in the settlement in yesterday’s ruling. Here was his first paragraph:

“The Bank of New York Mellon, as trustee for hundreds of trusts, seeks to dispose of billions of dollars in toxic mortgage claims through an arcane summary procedure in state court. The question presented is whether this mass settlement, which implicates core national interests in the integrity of the financial markets, is immune from review in federal court.”

It goes downhill from there.

Specifically, Walnut Place, a collection of investors unhappy with the settlement, sought the move to federal court, and Pauley allowed it. He questioned the Article 77 proceeding sought by Bank of New York Mellon as inappropriate for the settlement, and he criticized Bank of New York Mellon for their massive bad-faith operating, claiming to be acting for investors but avoiding identifying the participants. A preliminary hearing in the case will come November 3.

In another setback for BofA, California has subpoenaed the bank for documents related to selling and marketing mortgage backed securities to state investors. That was the initial salvo by NY AG Eric Schneiderman in his investigation of the banks. CA AG Kamala Harris appears to be moving in the same direction.

The state is trying to determine whether the bank and its Countrywide Financial subsidiary sold investments backed by risky mortgages to institutional and private investors in California under false pretenses, according to the person, who was not authorized to speak publicly and requested confidentiality […]

Many of these investments plunged in value as the housing market collapsed. Under California’s False Claims Act, which makes it a crime to defraud the state, damages of up to three times the amount of the claim can be awarded if the victim was an institutional investor, such as one of the state’s pension funds.

This is the state version of a representations and warrants case. It would mean a lot of money for BofA, just adding to their troubles.

No wonder they tried to put their derivatives exposure on the FDIC this week.

David Dayen

David Dayen