Image: Fotolia

Banks that spent years defending themselves against claims and paid billions of dollars in fines for bundling faulty mortgages and selling them as securities may soon play a new role: plaintiffs in their own lawsuits against the banks that originated the mortgages.

That's the turn taken by Rescap Liquidating Trust, the surviving entity to emerge from bankruptcy proceedings initiated in 2012 when Residential Capital, a subsidiary of Ally Capital and a former mortgage aggregator and securitizer, filed for bankruptcy.

Rescap's bankruptcy crystallized its losses early on, so it may be a bellwether of what's to come.

"The other aggregators have been fighting these suits, but when they do settle or face judgments, they'll likely to go downstream to the companies that sold them the loans [to recoup losses]," said Isaac Gradman, an attorney at Perry, Johnson, Anderson, Miller & Moskowitz whose blog, www.subprimeshakeout.com, tracks mortgage-related legal developments.

"It suggests a new wave of litigation to come," Gradman said. "Morgan Stanley, JPMorgan and the other big players, once they have to pay out on these put back claims, will likely turn around and try to get indemnification from the folks that sold them the loans."

Those aggregators are almost certainly now gauging RLT's success. Investors in RMBS issued by Residential Capital sued the loan aggregator, and losses stemming from those suits pushed it into bankruptcy.

Those investors received some payments as well as stakes in RLT in the form of unit trusts, which allow stakeholders to hold them until the suits are resolved or sell them in the public market.

In a sign if the potential value of these claims, two boutique brokers, Odeon Capital Group and BWS Financial have initiated "buy" ratings on the unit trusts, which began trading early this year.

A banker at Odeon said that normally he would discuss the reasons behind a rating, but "given the complexity of this situation and the proprietary nature of our research, I'm going to have to decline."

Hamed Khorsand, principal and research analyst at BWS, said that a fair value comprising RLT's assets when they were liquidated and the handicapped potential returns from litigation provides a bullish estimate upwards of $50 a unit.

The security, under the ticker symbol "rescu," recently traded over $17 a unit.

"A bearish view would limit the valuation to the net asset value of the trust," Khorsand said. "I believe, however, that RLT will see some recovery."

Some well-known investors appear to agree. John Paulson, who famously bet against RMBS, reportedly said in his March investor letter that he had purchased a large position in the trust from an insurance company.

Rescap has filed suits seeking $9 billion in mortgage loan losses, and whatever is recovered, after fees for managing the trust, will be distributed to unit trust holders. More suits may come.

A high recovery rate would certainly encourage other mortgage-loan aggregators to follow with their own lawsuits, although there may be complications.

Gradman said the contracts between RLT's predecessor and its correspondent banks were drawn up in the loan aggregator's favor and have been upheld in court. However it's unclear whether contracts used by other aggregators were as strong.

In addition, Rescap is suing both for breaches of contract and indemnity, the former of which may be limited in scope depending how the six-year statute of limitations is interpreted. There is litigation winding its way through the courts now that's anticipated to clarify next year whether the statute of limitations begins when the securitization trust is formed, or when the RMBS sponsor was alerted to the breach of contract and given time to "cure" it. The former would nullify numerous suits currently in progress and prevent others from being filed or refilled.

Subscribe Now

Authoritative analysis and perspective for every segment of the mortgage industry

30-Day Free Trial

Authoritative analysis and perspective for every segment of the mortgage industry