By: Fred Poritsky
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Litigation Resulting from the “Subprime” Meltdown
The fallout from the subprime mortgage crisis has had a devastating and rippling effect on the U.S, economy and has even spilled over into the global credit markets. One need only look at the collapse of the investment bank Bear Stearns—which once was the country’s fifth largest investment bank—or the massive losses sustained by mortgage lender Countrywide Financial Corporation to appreciate the current state of the U.S. financial markets.
As the facts begin to emerge, state and federal lawsuits and securities arbitrations are being filed which address the numerous claims stemming from the sub-prime crisis. The broad range of defendants in these suits includes mortgage bankers, commercial lenders, investment banks, brokerage firms and rating agencies. The types of claims range from securities/investor suits to consumer/ borrower and discriminatory lending actions. In this year alone, major Fortune 50 companies such as Citibank, Wells Fargo, and Merrill Lynch have all been named in multi-million dollar lawsuits. In fact, with the world’s largest banks and securities firms claiming write-downs and credit losses in excess of $370 billion since 2007, one would expect litigation to increase dramatically over the next several years.
To fully comprehend the underlying principles driving lawsuits stemming from the subprime meltdown, it is necessary to have a cursory understanding of the history of the mortgage and securities industries and how each one interacted and conducted business.
Up until the 1980s, homeowners simply applied to their local bank or mortgage company for a loan to purchase or refinance a home. The lending institution would then evaluate the borrower’s creditworthiness and have an appraisal of the property performed to determine the value of the collateral. If the loan was approved, it would often be done so on relatively straight forward terms ranging from 15 to 30 years with a fixed interest rate for the entire duration of the term. Simply put, there was accountability in this system. If a borrower defaulted, the financial institution that approved the loan would suffer an economic loss of some measurable amount. Moreover, the shareholders of the bank or mortgage company could hold the management team accountable if loans were not performing as expected.
In the mid 1980s, the lending process slowly began to shift when Fannie Mae and Freddie Mac (both government sponsored i enterprises that are financially protected by the U.S. Federal Government) began to buy qualified mortgage loans from lending institutions and used the mortgages as collateral to issue securities. From the government’s standpoint, key goals such as expanding the available mortgage funding and increasing home ownership were all achieved by the creation of Fannie Mae and Freddie Mac. The investor in these newly issued mortgage pass-through securities or mortgage-backed securities (”MBS”) received a pro-rata share of the interest and principal payments made by the borrowers. The creation of Fannie Mae and Freddie Mac MBS made investing in mortgages much more appealing because the investors received a timely payment each month, regardless of whether or not the borrowers made their monthly payments. Additionally, securities backed by Fannie Mae and Freddie Mac did not need to be evaluated by rating agencies because of the support from the U.S. government. That being said, Fannie Mae and Freddie Mac were very selective in the types of mortgages they purchased. In fact, the U.S. government would only allow certain loans—which became know as “conforming” loans—to be purchased by Fannie Mae and Freddie Mac. For a loan to be considered conforming it needed a specific debt-to-income ratio and the borrower’s employment and income had to be verified. Additionally, restrictions were placed on the size of the loan. In 2007, the Fannie Mae and Freddie Mac limit for single-family homes and condominiums was $417,000.
While Fannie Mae and Freddie Mac offered investors an investment vehicle without credit risk, these types of MBS had significant interest rate risks. When interest rates fall, many borrowers refinance to take advantage of the lower rates. In fact, the average 30-year mortgage is paid off in roughly 18 years. These prepayments by borrowers harm investors because the MBS managers must reinvest principal at lower investment rates. Conversely, if interest rates rise, mortgage prepayments come in slower than initially estimated and harm the investors because the MBS managers cannot reinvest as much of the principal at the new, higher interest rate. While the effect of fluctuations in interest rates and the borrower’s prepayment speed could be estimated and incorporated into the MBS payment models, Fannie Mae and Freddie Mac MBS were still not as attractive to some investors as non-callable bonds and investors began looking for other ways to invest in mortgages.
By the 1990s, with the MBS framework firmly established and the passage of several federal acts which made creating MBS more advantageous, financial engineers and Wall Street investment bankers began designing “private” MBS for all types of mortgage loans. The first step in the process was to form a bankruptcy-remote Special Purpose Trust (”SPT”). The SPT was formed specifically to purchase mortgage loans from the banks or mortgage companies which originated the loans. The creation of an SPT shielded the originator from liability since the transaction was considered a sale of the loan and was immediately removed from the originator’s financial statements. From an economic standpoint, the aggregate amount of loans used to create a SPT is often more than $100 million. Once the loan pool has been set, an investment bank is engaged to complete the securitization process. Since the private MBS had no government involvement, the MBS also had to be rated by an accredited rating agency so that investors could gauge the credit risk associated with the MBS. The process and methods used by rating agencies such as Standard & Poors and Moody’s included many assumptions about default rates, credit ratings, and even an analysis of the loan originator. Unlike its predecessors, these private MBS often contained a variety of complex customized classes which became known as tranches—the French word for slice. Each tranche contained different financial models that would often vary with regard to coupon rates and priority of principle repayment.
Beginning with the housing boom in 2000, mortgage companies began to become increasingly aggressive in extending credit and loans to borrowers. The term “subprime” became the industry buzz word to refer to the practice of making loans to borrowers with compromised credit who could not otherwise qualify for market interest rate loans. In fact, it was not uncommon to extend loans to borrowers who could not provide documentation for income and whose credit report indicated a history of late payments to creditors. Additionally, problems with the loan-to-vaiue ratio or even a previous bankruptcy filing ultimately did not affect a borrower’s ability to obtain a mortgage. Loan originators and lenders all financially benefited by extending these types of loans as the increased risks in these borrowers created higher loan fees and interest rates for lenders.
As the real estate market continued to thrive throughout the mid 2000s, the subprime mortgage market exploded from $100 billion in new loans in 2001 to over $600 billion in new loans in 2006. By 2007, the value of U.S. subprime mortgage market was conservatively estimated at over $1 trillion. However, many of these loans were no longer on the books of the original lenders because they had been securitized and sold to Wall Street firms. In fact, many mortgage lenders chose to pass the rights to its subprime mortgage payments—and more importantly the related credit/default risk—to Wall Street firms who eagerly peddled MBS to end investors as conservative “bond-like” investments. Investors had little reason to question Wall-Street’s representations as rating agencies such as Standard & Poors often extended a “AA” or “AAA” raring (its highest ratings) to MBS which were heavily concentrated in high-risk subprime loans.
Once the housing boom cooled in 2006 and 2007, home prices began to decline throughout much of the U.S. and borrowers who had exotic loans with “teaser” rates had difficultly refinancing. In fact, it is estimated that the value of subprime adjustable-rate mortgages resetting to higher rates in 2008 will be over $500 billion. This fact, coupled with many borrowers succumbing to the overall U.S. economic downturn, virtually guarantees that default rates and foreclosures will continue to increase before stabilizing. As the default and foreclosure rates increase, MBS payment streams are crippled and investors in subordinate tranches may never recoup their initial investment in the MBS. Realizing the foregoing, Standard & Poors has downgraded over 16,000 tranches of U.S. residential MBS and related investments.
With the total subprime related losses estimated in the range of $250-$400 billion, the question now becomes who should ultimately bear responsibility for the subprime crisis? Should the mortgage brokers/ mortgage lenders whose lax standards led to the origination of millions of high-risk subprime loans be held accountable? Do the Wall Street investment bankers who- engineered complex MBS utilizing subprime mortgages as collateral have any legal exposure? Should the brokerage firms who sold billions of dollars of subprime-based MBS to unsuspecting investors be liable? Are the rating agencies who rubber-stamped sub-, prime MBS with “bond-like” ratings to blame? The answer, at this early stage, appears to be that everyone who participated in the subprime securitization process is finding themselves named parties in various lawsuits. To date, there have been over 500 federal lawsuits—many of them class actions—which target a variety of defendants. The simplest set of plaintiffs is individual borrowers who now are in default of their mortgages or are facing resetting interest rates which make their monthly payments financially onerous. Many of these plaintiffs are bringing claims against the lenders and mortgage brokers based on “predatory lending” and “misrepresentation” type claims and allege that the lenders and brokers falsified applications and included misleading and confusing language in the loan documentation. Many of the consumer claims also allege violation of state “deceptive trade practice” statutes.
The. second type of claim involves the investors who purchased subprime based MBS. Not surprisingly, many of the investor suits allege that the issuers failed to adequately perform due diligence and made material misrepresentations with regard to the underlying collateral of the MBS. In addition to the issuer type claims, suits are just starting to emerge against the rating agencies. These types of suits focus on “conflict of interest” claims. Specifically, the suits claim that the agencies such as Standard & Poors who were rating the investment firm’s MBS were biased because the investment firms were in fact the ones paying the agencies bills. Although few suits have been filed, there remains the possibility that accountants, auditors and lawyers who participated in the formation and sale of subprime laden MBS may also be named in lawsuits. Lastly, Attorney General Offices throughout the country, along with other governmental agencies, have all launched investigations into the subprime lending practices.
In conclusion, the extent and scope of litigation arising from the subprime meltdown is still very much unknown. However, given the types of suits being filed and the various legal principals being used to prosecute claims, it would appear that anyone who had a hand in the subprime process would be susceptible to being sued.
by Kyle M. Kulzer, Esquire
and Alan L. Frank, Esquire, C.P.A.