Once in a while, you can discern a linchpin lie on which other important lies hinge. We can point to quite a few in America: the notion of a permanent war on terror, which somehow justifies vitiating not just the Constitution, but even the Magna Carta, or the idea of an imperial executive branch.

Now the apparently-to-be-filed-in-court-today Federal/state attorneys general mortgage settlement is less consequential than matters of life and limb. But it still show the lengths to which the officialdom is willing to go to vitiate the law in order to get its way.

HUD Secretary Donovan, the propagandist in chief for the Federal/state mortgage pact, has claimed he has investor approval to do the mortgage modifications that are a significant portion of the value of the settlement. We’ll eventually see what is actually in the settlement, but the early PR was that “no less than $10 billion” of the $25 billion headline total was to come from principal reductions. Modifications of mortgages not owned by banks, meaning in securitized trusts, are counted only 50% and before Donovan realized he was committing a faux pas, he said he expected 85% of the mods to be from securitizations, so that means $17 billion.

Bear in mind that investors, analysts, and commentators have objected to the very premise of this arrangement. A settlement involves a release of liability, and in anything other than the through-the-looking-glass world of rule by banks, the party that did the bad stuff is the one that pays for the settlement. This deal is like stealing your neighbor’s gold watch and using it to resolve charges of embezzlement.

But what about this investor approval that Donovan says he has? He has told both journalists and mortgage investors directly that the bulk of the mods will come from Countrywide deals and he has consent via the $8.5 billion Bank of America/Bank of New York settlement. Huh? First, it seems more that a bit cheeky to rely on a major piece of a program via a deal that has not yet gone through (the Bank of America settlement was removed to Federal court and has now been sent back to state court, and there will be discovery in the state court process, so approval is not imminent).

But second and more important, investors approved nothing. Bank of New York is trying to act well outside its authority as trustee for the 530 Countrywide trusts in the settlement. It’s tantamount to having a friend that you gave a medical power of attorney claim that it gave him the authority to sell your car and write checks on your account.

The terms of Countrywide PSAs vary, but all appear to restrict mods. The prohibitions varied by credit quality of the deal. Alt-A and early vintage (2004 and earlier) deals often barred mods completely; subprime and later vintage deals generally allowed for a higher limit on mods, with 5% the top amount across these deals. The idea was that some mods were expected in the dreckier mortgage pools. Nevertheless, all of them, as well as the few that had no caps, also required Bank of America to buy the modified loans back at par. That is something the battered Charlotte bank would be very keen to avoid doing.

Now remember, as we have discussed, that these Countrywide deals also typically elected New York law as governing law for the trust. New York trust law is both well settled and unforgiving. Trusts are permitted to act only as stipulated; any deviation is a “void act” and has no legal force. And a trustee can ONLY exercise the authority the trust has; as an agent, it cannot exceed the legal rights its principal has.

On top of that, Countrywide pooling and servicing agreements (the contracts that govern the securitizations, and in particular, set forth the duties of the servicer and the trustee), again like all PSAs, require an amendment to the PSA to change their terms. That in turn requires approval of the certificateholders, meaning the investors. Our Tom Adams has looked at a few Countrywide PSA, and what he has found so far is that it take the approval of either 51% or 2/3 of the certificateholders in each class, meaning in each tranche of the deal. To wit:

This Agreement may also be amended from time to time by the Depositor, each Seller, the Master Servicer and the Trustee with the consent of the Holders of a Majority in Interest of each Class of Certificates affected thereby for the purpose of adding any provisions to or changing in any manner or eliminating any of the provisions of this Agreement or of modifying in any manner the rights of the Holders of Certificates; provided,

however, that no such amendment shall (i) reduce in any manner the amount of, or delay the timing of, payments required to be distributed on any Certificate without the consent of the Holder of such Certificate, (ii) adversely affect in any material respect the interests of the Holders of any Class of Certificates in a manner other than as described in (i), without the consent of the Holders of Certificates of such Class evidencing, as to such Class,

Percentage Interests aggregating 66-2/3% or (iii) reduce the aforesaid percentages of Certificates the Holders of which are required to consent to any such amendment, without the consent of the Holders of all such Certificates then outstanding.

Now how does the Bank of America/Bank of New York settlement agreement deal with this wee problem? It pretends it does not exist (emphasis ours):

(e) Loss Mitigation Considerations. In considering modifications and/or other loss mitigation strategies, including, without limitation, short sales and deeds in lieu of foreclosure, the Master Servicer and all Subservicers shall consider the following factors: (a) the net present value of the Mortgage Loan at the time the modification and/or other loss mitigation strategy is considered and whether the contemplated modification and/or other loss mitigation strategy would have a positive effect on the net present value of the Mortgage Loan as compared to foreclosure; (b) where loan performance is the goal, whether the modification and/or other loss mitigation strategy is reasonably likely to return the Mortgage Loan to permanently performing status; (c) whether the borrower has the ability to pay, but has defaulted strategically or is otherwise acting strategically; (d) reasonably available avenues of recovery of the full principal balance of the Mortgage Loan other than foreclosure or liquidation of the loan; (e) the requirements of the applicable Governing Agreement; (f) such other factors as would be deemed prudent in its judgment; and (g) all requirements imposed by applicable Law. When the Master Servicer and/or Subservicer, in implementing a modification and/or other loss mitigation strategy (which may, pursuant to the Governing Agreements, include principal reductions), considers the factors set forth above, and/or acts in accordance with the policies or practices that the Master Servicer is then applying to its or any of its affiliates’ “held for investment” portfolios, the Master Servicer shall be deemed to be in compliance with its obligation to service the Mortgage Loans prudently in keeping with the relevant servicing provisions of the relevant Governing Agreement and the requirements of this Subparagraph 5(e), the modification and/or other loss mitigation strategy so implemented shall be deemed to be permissible under the terms of the applicable Governing Agreement, and the judgments in applying such factors to a particular loan shall not be subject to challenge under the applicable Governing Agreement, this Settlement Agreement, or otherwise. Notwithstanding anything else in this Subparagraph 5(e), no principal modification by the Master Servicer or any Subservicer shall reduce the principal amount due on any Mortgage Loan below the current market value of the property, as determined by a third-party broker price opinion, using a fair market value method, applying normal marketing time criteria and excluding REO or short sale comparative sales in the valuation calculation.

Now this might not strike you as amiss until you realize this deal is between the trustee, Bank of New York, and Bank of America. The investors are NOT party to it and their consent has not been obtained, either properly, via amendments to the PSA, or by any other means.

You might say, “Weren’t there 22 big investors who originally signed a letter that led to this deal?” Yes, and that happens to be irrelevant. Those 22 investors didn’t have even as much as 25% in most of the 530 trusts (the necessary percentage to take action against a trustee); there are many trusts in this settlement where these 22 investors have NO interest at all. So Bank of New York can’t pretend it has enough in the way of investors via the investor letter to give it the authority to ignore the PSA.

Keep this in mind: Bank of New York’s petition to the court to approve the deal in an Article 77 hearing makes NO mention of the fact that they will effectively be amending the PSA to permit modifications to stay in the trust and to exceed 5% of the pool balance.

Since the purpose of the hearing is to obtain a judicial determination whether Bank of New York acted properly in settling with Bank of America, one would assume the parties to the action are bound by the normal requirements of making accurate submissions to the court, just as they are at trial (Judge William Pauley, who approved the removal of the case to federal court, argued that this hearing fits “comfortably” within the definition of a trial). Thus BoNY should mention that the modification provision excerpted above requires an amendment which requires consent of 51% or more of the certificateholders in each class in each trust. Instead, they instead discuss the broad powers of the trustee! And yet they later argued the reverse to Judge Pauley. He noted in his ruling: “If, as BYNM [Bank of New York Mellon] argues, the only relevant legal standards for evaluating its conduct as trustee are found in the PSAs…” If they have only the authority given them by the PSA, they have no authority to authorized mods beyond those contemplated in the PSA for each deal.

And as we observed above even if BoNY could be argued to have additional authority under common law, that extra common law authority in New York is nada.

It is hard to conclude anything other than that Gibbs & Bruns, the firm representing Bank of New York, lied to the court about what the settlement constitutes and what the PSAs permit. The PSAs have very clear terms on modifications and changing them should require an amendment.

But lying to the court seems to be standard operating procedure for Kathy Patrick, the partner leading the settlement deal. Alison Frankel of Reuters described how Gibbs & Bruns lied about why they were leading this action:

The most dramatic moment at the Sept. 21 hearing on Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed securities investors came near the end, when Gibbs & Bruns partner Robert Madden stood up to address Manhattan federal judge William Pauley’s concerns about how the settlement came to be. Tall and clear-spoken, Madden captured the judge’s attention as he explained that his clients, a group of 22 large institutional investors, hadn’t entered a sweetheart deal with BofA, but had banded together to force the bank to pony up billions to investors for claims BofA thought it would never have to deal with. “The problem was that these repurchase claims were lying fallow,” Madden said, according to the transcript of the hearing. “No one was doing anything. None of (the investors now objecting to the deal) were doing anything. And, I’m sorry to say, the trustee wasn’t doing anything. Limitations were running on those claims, and nothing was happening.” Or was it? I’ve learned that in the summer of 2010, as Gibbs & Bruns began to push Countrywide MBS trustee Bank of New York Mellon to act on its assertions that mortgages underlying the Countrywide securities were deficient, another group of Countrywide MBS investors was finalizing its own notice of default to serve on BNY Mellon.

You need to read the Alison Frankel article in full to have some appreciation as to what happened. The pre-existing, and likely larger group of investors (I am told it included Fannie, which is one of the biggest investors in MBS) had concluded an investigation and found breaches in every single Countrywide securitization (Bill Frey had developed proof of Countrywide modifying loans where Bank of America owned a second lien behind that first and had not wiped it out first, as would be required). But when Fannie confirmed the Frey information and said it was in, Blackrock suddenly withdrew and went with Patrick, as shortly did another existing Gibbs & Bruns client, Pimco.

Now why, might you ask, would investors drop out of a group that had hard evidence of breaches and could prove real economic harm, and switch to one that could only handwave? I’m no fan of rep and warranty cases, and even so, I’ve estimated this deal is a screaming bargain for those liabilities alone; the servicing breaches that the earlier (Grais & Ellis) group found would add to the total value of the deal, as does its waiver on chain of title claims. It’s not hard to guesstimate that this settlement is worth easily ten times the $8.5 billion Bank of America plans to pony up. And Mr. Market agrees. BofA’s stock was trading below $6 when both settlements were in doubt; it’s now up more than 33%, closing last Friday at $8.05.

So why would Pimco and Blackrock abandon a strategy that would seem likely to bear more fruit? Recall that Blackrock signed on to the Gibbs & Bruns negotiated settlement while it was still 49% owned by Merrill, um, Bank of America. So its motives seem straightforward, even if they also happen to be a breach of its fiduciary duty to its investors.

Pimco is awfully active in Washington; it is almost certainly one of the fund managers that the Fed chooses to talk to about its interest rate thinking, which effectively means Pimco has permitted inside information (one of my readers refused to invest in Pimco funds because the returns were sufficiently out of line with benchmarks that the funds either had to be taking on more risk than they pretended to or were reliant on privileged information). So Pimco has plenty of reason to curry favor rather than make life miserable for Bank of America, and by extension, the Administration, which has thrown its lot in fully with the big banks.

Now let’s go back to the Donovan lie, which depends on the Gibbs & Bruns lie not being challenged by the court, or the $8.5 billion settlement not coming unglued for some other reason. Donovan is relying on the authority supposedly conferred by the $8.5 billion settlement…which has not been approved by court, meaning it is not yet valid and may not come to fruition. Yet (per leaks) the banks are to get credit for mods starting March 31 even though the Federal/state AG deal won’t be approved by that date either. And remember also that four other large servicers are signing up to the Federal/state settlement. Even though the authorities anticipate that the other major servicers will enter into private settlements along the BofA/BoNY lines once it is approved, that is some ways away even if everything breaks in the banks’s favor.

Recall how sanctimonious Timothy Geithner has been about not breaking contracts, such as the AIG credit default swaps agreements and employment contracts with AIG staffers. Similarly, Obama pay czar Kenneth Feinberg excoriated bankers for the bonuses they took out of firms they blew up but refused to try to claw back pay, because it might lead to lawsuits. So? The Administration didn’t necessarily need to win that litigation to prevail. If it did discovery on what executives were paid, what they did, and how derelict they were in their duty, they could have created such a huge and cry so to keep bankers cowed for at least five years. And as we have pointed out repeatedly, Team Obama has also refused to use the best weapon in its arsenal: Sarbanes Oxley, which would allow it to file civil and from that if successful, criminal charges for false certifications about the adequacy of internal controls, in particular, risk controls.

Now the railroading of investors may not seem all that important to many of you. But you are in fact all exposed. The failure of Fannie to pursue valid claims, for instance, is a direct subsidy from taxpayers to Bank of America and other banks. And more important, if investors are for the most part, too afraid, too compromised, or too plain lazy to take action against banks, and will sit passively as their contracts are violated, what hope is there for ordinary, less well connected citizens?

This settlement farce reveals yet again that contracts in America have become decidedly one sided affairs: banks will take advantage of every trap and snare, and engage in further abuses if they can get away with them, but woe betide anyone on the other side. You have perilous little hope that you will get a fair hearing from regulators (witness the farce of the OCC foreclosure reviews) or courts, since banks both outgun and outlie most opponents.

The banks and the authorities seem remarkably unaware of what they are doing in undermining the rule of law, which is critical to resolving disputes peacefully in a complex and combative society. They are likely to find that undermining the protective role of the judiciary will leave them more exposed than they could possibly imagine.