Bank of America Subpoenaed by Massachusetts Over Bryn Mawr CLO II Ltd. and LCM VII Ltd. CLOs that Cost Investors $150 Million

Over the last decade, Bank of America underwrote and sold numerous CDO’s and CLO’s, including Bryn Mawr and LCM (Lyon Capital Management) VII. In general terms, CDOs and CLOs are created when an investment manager pools together a group of assets such as mortgages or syndicated bank loans. These assets are then “securitized”, meaning that the investment is turned into a security which will be sold as an interest in the pool rather than owning the CDO or CLO itself, similar to owning stock or bonds in a company. Most CDOs and CLOs issue a number of different classes of shares, or “tranches”, rather than a single, undivided interest in the overall pool of assets/loans. This process results in the creation of several levels of investments within the same CDO/CLO with varying degrees of return and risk. Typically, a number of tranches are created from each CDO/CLO, each of which has its own set of rules for payment. The way in which the income received from the underlying investments of the CDO/CLO is then distributed to the various tranches is often called the “cash waterfall rules” of the CDO/CLO. This term is meant to provide a visual depiction of what happens as all of the income from the investments are fed into a pool and then the money from the pool trickles down, like a waterfall, to the various tranches based on the rules set up for paying each tranche.

There are limitless ways to structure a CDO, and each way is seemingly more complex than the last. Many of these CDOs and CLOs were so complicated and convoluted that they were never fully understood by the purchaser or the seller, and many did not perform as expected or presented. In fact, many CDOs and CLOs resulted in massive losses for the investors and the absolute failure of multiple CDOs and CLOs created a large ripple effect and were one of the major contributors to the 2008 financial crisis.

Massachusetts securities regulator William Galvin recently subpoenaed Bank of America Corp. over two collateralized loan obligations that led to investors to lose $150 million. Galvin is trying to determine whether the financial firm knew it was overvaluing the portfolios’ assets so it could remove the loans from its books.

The state is looking to obtain records and documents from Banc of America Securities LLC related to two CLOs—Bryn Mawr CLO II Ltd. and LCM VII Ltd—that were sold in 2007. (Merrill Lynch and Bank of America Securities joined forces in 2008 when they were merged in an acquisition).

It was in 2006 that Bank of America had about $400 million of commercial loans from small banks. The following year, loans were put together as securities packages that were bought by investors.

Galvin has been taking a hard look at the way banks structured and sold debt products—especially mortgage-backed securities—leading up to the 2008 economic collapse. Galvin says his office is also interested in taking a closer look at other entities.

The subpoena came a day after Bank of America, Citigroup Inc., Wells Fargo & Co., JP Morgan Chase & Co., and Ally Financial Inc. agreed to settle for $25 billion allegations accusing them of engaging in abusive mortgage practices. The agreement was reached with federal agencies and 49 states (not Oklahoma) and is considered the largest federal-state settlement ever. All five banks will also pay the Federal Reserve $766.5 million in penalties.

The deal resolves allegations that the banks robo-signed thousands of foreclosure documents without properly reviewing the paperwork, engaged in deceptive practices when offering loan modifications, did not offer other options prior to closing on borrowers who had mortgages that were federally insured, and submitted improper documents in bankruptcy court.

Also as part of this securities settlement, Bank of America will pay $1 billion to settle a separate probe into allegations that it and its Countrywide Financial unit engaged in wrongful and fraudulent conduct. The $25B settlement is designed to provide mortgage relief and give $2,000 to about 750,000 borrowers whose homes ended up foreclosing after home values dropped 33% from what they were worth in 2006.

Per other terms of the settlement, the bank is to provide $17 billion in loan modification and principal reduction to delinquent borrowers whose homes are at risk of foreclosure. $3 billion is included for borrowers that are up-to-date on mortgage payments but cannot refinance because they owe more than what their home is worth. The banks have also agreed to new servicing standards.

An Arbitration Panel, under the auspices of the Financial Industry Regulatory Authority ("FINRA") has already awarded an investor in Lyon Capital CLO approximately $1.38 million This award encompasses Claimant’s losses in the product, along with attorney's fees, interest and hearing session fees. According to documentation in the matter, the Claimant in that case, alleged that Lyon Capital CLO was sold as a low risk investment. However, unbeknownst to the Claimant, while Banc of America was putting together the Lyon Capital deal, the loans which had been purchased in previous months were allegedly already losing value. Consequently, the Arbitration Panel evidently concluded that the Claimant had been wronged and presumably agreed with the allegation that LCM VII CLO had been purchased with artificially inflated assets that were likely, worthless on the day the deal closed.

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