The Likely Areas of Litigation Flowing from the Crash of the Subprime Lending Market in the United States

July 27, 2007

Through this paper we summarize the principal arenas of litigation that likely will result from the severe downturn in the subprime real estate lending market in the United States. We briefly address the relationship between the rise of subprime loans and certain mortgage backed securities, including the role of credit rating firms, and how the decline in the subprime lending market already has spurred (and will continue to spawn) litigation on a number of fronts with multiple theories of liability. Finally, we outline the probable targets for claims and note the magnitude of the problem.

Background and Regulatory Structure

Until recently subprime lending was a growing segment of the mortgage business. In the words of the Ninth Circuit in First Alliance Mortgage Co. v. Lehman Commercial Paper, Inc., 471 F.3d 977, 984 (9th Cir. 2006), it "generally consists of borrowers who, for a variety of reasons, might otherwise be denied credit. A typical borrower in the subprime mortgage market is ‘house rich' but ‘cash poor'. . . and has a lower net income than the average borrower. Subprime lenders generally charge somewhat higher interest rates to account for the increased risk associated with these loans." Over the past decade many lenders ventured into the subprime market -- making loans to persons based primarily upon the assumption that the values of the real estate securing the loans will continue to rise -- and departed from traditional underwriting standards (with the focus principally upon the creditworthiness of the borrowers). Unfortunately, quite a few lenders in the subprime mortgage business engaged in unlawful, predatory practices.¹ Those practices include (without limitation) making loans with interest rates, fees or costs that the lenders cannot reasonably believe that their borrowers will be able to service. See Debra Stark, Unmasking the Predatory Loan in Sheep's Clothing: A Legislative Proposal, 21 Harv. Black Letter L.J. 129, 130 (2005).

During the past several years, the investment banking industry became intertwined in the subprime lending business. Investment bankers (including the arms of many large Wall Street firms) purchased from subprime lenders "mortgage loan packages" (the promissory notes of the borrowers and the ancillary mortgages) and bundled and resold (or issued) the packages as mortgage backed securities ("MBS"), sometimes called collateral debt obligations ("CDOs"). The process of mortgage securitization transformed the mortgage loans into CDOs/MBS and facilitated the trading of CDOs/MBS in the capital markets. In issuing MBS/CDOs the investment bankers pooled the principal and the interest payments on the mortgage packages and passed a portion of them through in payments to the buyers of the CDOs/MBS. The lenders that originated the loans put the proceeds from their selling the loans (to the investment banking firms) back to work via new mortgages (many subprime). The process built upon its elements - more subprime lending and more CDOs/MBS.

In purchasing the subprime loan packages, many issuers of CDOs/MBS did not analyze the likely performances of the mortgages, that is whether the borrowers will timely make their payments. Loans with predatory (or simply onerous terms) experience higher rates of default than traditionally underwritten mortgage loans. Add to that mix the downturn in the housing market -- with the attendant stabilization or retreat of the prices of real estate -- and one should not be surprised by the underperformance or non-performance of many subprime loans and CDOs/MBS based upon the subprime loans. While many investment bankers/purchasers of mortgage loan packages and issuers of CDOs/MBS did not complete adequate due diligence when they bought the mortgage loan packages, under HOEPA they acquired liability for the improper conduct of the originators of many subprime loans.² Additionally, the consultants (chiefly, accountants and attorneys), the credit rating firms and the officers and directors of the investment bankers/purchasers of the mortgage loan packages and the issuers of CDOs/MBS may have liability for their acts or omissions in connection with the investment bankers buying the subprime loan packages and selling them as CDOs/MBS.³

This year the Federal Reserve Board and several other agencies jointly issued new guidance for subprime mortgage lenders that more strictly enforces the terms by which lenders may offer borrowers "creative" mortgage products. The inter-agency recommendations include comprehensive depictions of timelines for adjustable-rate mortgages, which often begin with a low "teaser" rate and then reset to a rate much higher than the borrower can pay.⁴

The guidance from the Federal Reserve Board and the other agencies signals a shift in policy towards home lending. Under former Chairman Alan Greenspan, the Federal Reserve Board encouraged lenders to provide easy access to credit in order to push for more home ownership.⁵ That view, in part, led to certain of the lending abuses - and the resulting rise of the market in CDOs/MBS - that led to the fall of the subprime industry. Current Chairman Ben Bernanke has stated that financial institutions must reconsider their lending standards and offer more counseling and education services for prospective buyers seeking mortgages.⁶ The Federal Reserve Board's shift in policy, however, will not quell the lawsuits that likely will flow from the crash of the subprime lending market.

The Subprime Problem Exposes the Original Lenders, the Issuers of CDOs/MBS (Consisting in Whole or in Part of Subprime Loans) and the Persons that Consult with or Assist Other Persons in Making Subprime Loans or in Issuing CDOs/MBS

AIG's announcement on May 10, 2007 that it was taking a $128 million charge or write-down on the subprime loans that its savings banking division made illustrates the broad fallout from the subprime lending problem. There will be further troubles.

Joseph Mason of Drexel University and Joshua Rosner of Graham Fisher & Co. recently drafted Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions. The authors address how subprime lending grew, how rating firms assisted that growth and how the conflicts and the involvement of rating agencies in the process led to issues understating risks for investors buying instruments backed by subprime loans. Messrs. Mason and Rosner also reflect on future litigation.

The lenders that originated subprime loans attempted shift these assets off their balance sheets. The likeliest buyers for these kinds of assets -- pension funds and insurance companies -- may purchase only investment grade securities. To sell subprime loans to these institutional investors, the issuing industry (arms of investment banking firms) created a number of mortgage backed instruments (CDOs/MBS) from pools of subprime loans. A key element for the success of these instruments was the willingness of the rating firms (Moody's and Standard & Poor's to name two) to confer investment grade status upon the instruments (CDOs/MBS).

According to Messrs. Mason and Rosner, the rating firms intertwined themselves in the deal process. That is not surprising, the issuers paid the rating agencies for their ratings. The business of rating CDOs/MBS and other mortgage backed securities became a very important part of the business of the rating firms. According to Fortune, Moody's net income went from $259 million in 2000 to $705 million in 2006 in part because of increases in fees from "structured finance."

The rating agencies did not limit their role in the business of CDOs/MBS to expressing opinions of their creditworthiness. They were "interactive," advising the issuers of the "requirements to attain the desired ratings in different branches and largely defining the requirements of the structure to achieve target ratings." So the rating firms counseled the issuers in the ways to structure the deals so as to enable the agencies to confer investment grade ratings upon the issues (CDOs/MBS). With the rating agencies conferring investment grade ratings upon CDOs/MBS, the issuers sold the instruments to institutional investors.⁷

The downturn in the residential real estate market and the deterioration of the worth of mortgages threw back the curtain.⁸ Messrs. Mason and Rosner suggest that should home prices deteriorate further, CDOs/MBS and other instruments will face "significant losses." Should the market for these instruments narrow, a "major source of liquidity will evaporate," leading to a tightening of credit and the "potential for prolonged economic difficulties that could interfere with home ownership."

Should investors -- purchasers of CDOs/MBS -- lose money on the instruments that they purchased on the belief that they were acquiring investment-grade investments), litigation surely will follow against many of the persons involved, including the rating firms. In the past, when persons sued rating agencies (for instance, the Orange County bond debacle in the 1990s) the firms argued that their ratings simply were opinions of creditworthiness. That defense may not work now. The rating agencies played a major role in the creation of CDOs/MBS and other mortgage backed securities, including their "interactive" involvement in the structuring of the deals. They were participants in the transactions. This suggests that there "does seem to be some basis to consider" that the rating firms may have liability as "underwriters" under Section 11 of the Securities Act.⁹

Whether or not litigation against the rating firms develops, the threat looms for the collapse of the market for CDOs/MBS.¹⁰ Between 2003 and 2006, issuers sold nearly a trillion dollars of CDOs/MBS ($500 billion in 2006 alone). Investors/buyers will demand accountability from the issuers and the persons that consulted with and advised the issuers. Further, shareholders certainly will lodge claims when the officers and directors of some of the subprime lenders traded shares before making public disclosures (adverse) that affected the lender's share price. Also, adverse accounting errors in the financial reports of subprime lending companies may have artificially and fraudulently inflated the share prices of subprime lenders. 

Likely Targets for Claims

Litigation from the problems associated with subprime lending appears in a number of forms, including class action securities claims and class action lawsuits against lenders. In one suit, the employees of Fremont General Corporation ("FGC"), a one-time subprime lender, sued their employer in part because of the decline in the value of FGC's shares that the employees owned in their 401(k) plans. McCoy v. Fremont General Corp., 2:07-CV-02693, United States District Court for the Central District of California. The plaintiffs filed the complaint under Employee Retirement Income Security Act and named as defendants FGC and nine of FGC's directors. The plaintiffs alleged that FGC's executives sold $16.5 million of their shares of FGC from January 1, 2003 to April 24, 2007, while causing FGC's retirement plan to buy between $150 million and $210 million of FGC's shares. The plaintiffs urged that the defendants knew or should have known that FGC's shares were not prudent investments for FGC's ESOP (that held the shares exclusively) or for their 401(k) retirement plans (with employees investing about two-thirds of their savings in FGC's shares). We highlight other categories of suits.

• Borrowers Versus Loan Originators/Lenders. These claims typically assert that lenders misrepresented the terms of their loans. To illustrate, nearly two thousand borrowers recently settled their claims against NovaStar Mortgage, Inc. ("NovaStar"). Pierce v. NovaStar Mortgage, Inc., 3:05-CV-5835, United States District Court for the Western District of Washington. The plaintiffs alleged that the brokers and/or the lending officer that handled the mortgage loans received financial rewards for steering them to loans with hidden fees and costs and higher rates. The plaintiffs compromised with NovaStar for more than $5 million. In a similar vein, the NAACP recently sued several mortgage companies, contending that the defendants discriminated against African American customers by steering them toward higher-interest rate subprime loans.
• Borrowers Versus Investment Banks/Issuers. In First Alliance Mortgage Co. v. Lehman Commercial Paper, Inc., 471 F.3d 877 (9th Cir. 2006), the Court addressed the following scenario: borrowers/customers of First Alliance Mortgage Company ("FAM") filed claims in FAM's Chapter 11 bankruptcy proceeding, urging that FAM, a subprime lender, had defrauded them; borrowers/customers of FAM made claims against the entities (Lehman Commercial Paper, Inc. ("Lehman") for one) that financed FAM's operations on an aiding and abetting theory; and FAM's trustee sued the entities that financed FAM's operations to set aside FAM's payments to them as fraudulent transfers. The bankruptcy court referred these matters to the district court for a trial by jury. The jury found that Lehman aided and abetted FAM's wrongful conduct. The district court entered a judgment accordingly. The Ninth Circuit, among other things, affirmed the district court's judgment that imposed liability on Lehman for aiding and abetting FAM's fraud.
• Regulators Versus Loan Originators/Lenders. Ohio's Attorney General sued multiple mortgage lenders, averring that they pressured real estate appraisers to inflate home values with the result that the borrowers who purchased homes cannot sell them and cannot pay or refinance their loans. E.g., Ohio v. Premierce Service Mortgage Corp., CV2007062173, Court of Common Pleas, Butler County, Ohio. In a similar vein, Ameriquest Mortgage, at the prompting of regulators, recently committed to pay a class of 481,000 borrowers approximately $325 million because it did not properly disclose the terms of its loans to members of the class.
• Investment Banks Versus Loan Originator/Lenders. A subsidiary of Deutsche Bank (an issuer of CDOs/MBS) has filed multiple suits, seeking many millions of dollars, against mortgage companies that refused to repurchase loans that defaulted. Other financial institutions likely will file similar claims.
• Buyers of CDOs Versus Investment Banks/Issuers. Bankers Life Insurance Company sued Credit Suisse First Boston Corporation ("CSFB") alleging that it lost money on investment grade bonds backed by subprime mortgages (CDOs/MBS) that CSFB issued. Bankers Life Ins. Co. v. Credit Suisse First Boston Corp., 8:07-CV-690, United States District Court for the Middle District of Florida.

We add to these categories suits against the auditors/accountants of the original lenders, the attorneys for the original lenders, the officers and the directors of the original lenders, the auditors/accountants of the issuers of CDOs/MBS, the attorneys for the issuers of the CDOs/MBS, the officers and the directors of the issuers of the CDOs/MBS and the parents/owners of the issuers of the CDOs/MBS.

The Subprime Loan Problem Involves Many Billions of Dollars

Moody's announced that it intends to cut its credit ratings on a group of CDOs/MBS. Similarly, Standard & Poor's said that it will downgrade hundreds of subprime-mortgage backed CDOs/MBS. CSFB recently pegged at $52 billion its estimate of the losses that will flow from instruments backed by subprime mortgages. In testimony on July 19, 2007 to the Senate Banking Committee, Ben Bernanke, Chairman of the Federal Reserve Board, estimated that losses from the subprime mortgage fiasco will range from "$50 billion to $100 billion."

According to Banc of America Securities, about $515 billion in adjustable rate home loans, more than 70% made to subprime borrowers, will have interest rate "resets" by the end of 2007. Nearly $700 billion will be "reset" in 2008. Borrowers unable to support high interest payments likely will not be able to refinance their loans. The wave of defaults and foreclosures will grow, causing the values of the financial instruments that the loans backed to deteriorate further.

The recent investment downgrades for mortgage-backed securities, not to mention the recent near-collapse of the two Bear Stearns hedge funds probably, likely are just the beginning. Institutions that own financial instruments that set valuations at certain levels will have to reassess their valuations and make disclosures about the adjustments. That will lead to difficulties for financial institutions in the business of CDOs/MBS and for investors in the securities business as well as the investors that hold the CDOs/MBS.

As we noted, underwriters of Directors and Officers coverage will face many claims: claims against the subprime lenders; claims against the issuers of CDOs/MBS; claims against the advisors and consultants of the subprime lenders; claims against the consultants and advisors of the issuers of CDOs/MBS; and claims against rating agencies. The plaintiffs will include (among others) hedge funds (and their investors), insurance companies, pension funds (and beneficiaries) and commercial banks.The plaintiffs' bar is gearing up. Several law firms have announced that they have formed "subprime lending task forces." On April 25, 2007, Law.com published an article entitled "Subprime Crash May be a Boon to Attorneys."

Footnotes

¹ With the Homeownership and Equity Protection Act ("HOEPA") in 1994 the Congress restricted certain lending practices for high-cost loans in an effort to protect the most vulnerable subprime borrowers. The legislation employed the concept of "assignee liability" with liability for lending violations flowing to the purchasers of loans (the investment banking firms). To combat predatory lending, many States enacted laws that went beyond HOEPA's assignee liability provision. The result is a mishmash of legislation in a cross-section of jurisdictions with vague and conflicting standards designed to make secondary market participants liable for original lending violations.

² Since 1994 HOEPA has served as the primary regulatory weapon against predatory lending. HOEPA created the concept of a "high-cost" loan as one with an annual percentage rate or fees that exceed a threshold. The Federal Reserve Board writes the regulations concerning HOEPA's implementation.

³ In recent years, most of the States expanded on HOEPA's assignee liability provisions. More than 40 varying State anti-predatory lending laws invoke lower thresholds than HOEPA.

⁴ The Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Deposit Insurance Corporation and the National Credit Union Administration drafted the policy. The guidance is voluntary and only affects federally-regulated lenders. That, however, was enough to draw protests from the Mortgage Bankers' Association. It said that the new guidelines will cause a greater weakening of the real estate market, prompt the Congress to enact more exacting laws of enforcement and foster litigation.

⁵ Many subprime lenders specifically targeted African American and Latino first-time homebuyers, pushing them into expensive subprime loans even when they could have afforded traditional fixed-payment mortgages at prime lending rates. As home inventory increased and prices fell, many cash-strapped homebuyers found themselves unable to sell the homes that they purchased but could no longer afford. Foreclosure rates are rising. The foreclosure data firm Realty Trac recorded a 90 percent increase in home foreclosures between May of 2006 and May of 2007.

⁶ The Congress has criticized the Federal Reserve Board's lack of guidance in the subprime lending crisis. Thousands of homeowners face default or foreclosure due to skyrocketing payments on loans they did not understand and that they cannot service.

⁷ As we noted, the ability of issuers to sell the re-packaged subprime loans as investment grade assets spurred the growth in the subprime loan industry. That expanded the credit available for potential homebuyers and prompted home prices to rise. And that allowed the mortgage pools to show a very low default rate, reinforcing the (apparent) validity of the alchemy - transforming subprime loans into investment grade securities.

⁸ The rating firms to-date have downgraded only a very small portion of the mortgage-backed securities. There may be good reasons for this, but two possibilities suggest themselves: the rating agencies are concerned about the effects that would follow widespread downgrades (collapse of the market for CDOs/MBS and the real estate market); and the rating firms have concerns about their own liability. The investors holding the instruments will have to divest themselves of the assets that fell below investment grade. That will cause the prices for these securities to fall even more than they have. And that will spur actions against the rating firms.

⁹ An article, dated May 11, 2007, in The Financial Times entitled "Rating Agencies Could Be Liable for Losses," discusses the issue. We also suggest an article in Fortune (dated March 19, 2007) entitled "The Dangers of Investing in Subprime Debt."

¹⁰ The following recently appeared in the Associated Press:Investors, bracing for a wilting economy, fled the already deflated subprime mortgage sector on more news that lenders New Century Financial Corp., Accredited Home Lenders Holding Co. and General Motors Acceptance Corp.'s residential unit are facing financial problems. The Mortgage Bankers Association bolstered the belief that the struggles are widespread after it said new foreclosures surged to an all-time high in the last quarter of 2006.

¹¹ That led to criminal inquiries in the case of New Century Financial Corporation.