ALI-ABA Course of Study The Subprime Mortgage Crisis: From A to Z September 18-19, 2008 Washington, D.C. 2007: Looking Back at What's Ahead

Transcription

1 67 ALI-ABA Course of Study The Subprime Mortgage Crisis: From A to Z September 18-19, 2008 Washington, D.C. 2007: Looking Back at What's Ahead By Jeffrey S. Nielsen Navigant Consulting, Inc. Washington, DC

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3 Subprime Mortgage and Related Litigation 2007: Looking Back at What s Ahead By Jeff Nielsen With Scott Paczosa and William Schoeffler 69 Contents 2 Executive Summary 2 Introduction 3 Presentation of Findings 7 An Historical Reference Point: RTC Litigation 7 Conclusion 8 Appendix

4 70 Subprime Mortgage and Related Litigation QUICK FACTS The number of subprime-related cases filed in federal court is accelerating dramatically. Indeed, the number of filings nearly doubled during the second half of 2007, from 97 to 181 (total of 278). Major case categories include borrower class actions (43 percent), securities cases (22 percent) and commercial contract disputes (22 percent), along with employment class actions, bankruptcyrelated, and other cases. Looking at litigation activity from the savings-and-loan crisis of the early 1990s as a benchmark, subprimerelated cases filed in 2007 (federal court only) already equal one-half of the total 559 actions handled by the RTC over a multiple-year period. Almost no one it seems is immune from the litigation. Mortgage Bankers & Loan Correspondents make up the largest category of defendants (32 percent), but named defendants also include mortgage brokers, lenders, appraisers, title companies, homebuilders, servicers, issuers, underwriting firms, securitization trustees, bond insurers, rating agencies, money managers, public accounting firms and company directors and officers, among others. Fortune 1000 companies were named in 56 percent of cases. Geographically, around half of all cases are filed in California and New York. Litigation activity is only likely to increase in 2008, as is already evident. The prospect of large-scale intervention by government and/or self-prescribed industry solutions, not to mention the economic environment, may affect the volume of future filings; however, the explosion of litigation activity in 2007 is likely only the foundation for expanded activity in I. Executive Summary As the deterioration in the credit markets gained speed during the second half of 2007, so did the related litigation. This paper presents an in-depth analysis of the subprime mortgage and related civil litigation filed in federal court during We identified 278 such cases filed during 2007, of which 65 percent were filed during the year s final six months. While our list may not be exhaustive, we believe it presents an accurate picture of the nature and volume of this rapidly emerging area of litigation. Based on our study of 278 cases, we seek to answer the following questions: Who are the parties involved? What types of cases are being filed? What is the status of the cases? Who is being sued? Who is filing the suits? Where are the suits being filed? What specific claims are being put forth? We have grouped these cases into the following six (6) major categories: 1) borrower class actions, 2) securities cases, 3) commercial contract disputes, 4) employment class actions, 5) bankruptcy-related, and 6) all other. As of year-end 2007, 90 percent of these cases continued to be active. While we observed a meaningful number of filings in each category, borrower class actions dominated, making up 43 percent of the total. The most common sub-categories among the borrower class actions are matters focused on inadequate disclosure involving a specific product type option ARMs and cases alleging discriminatory lending practices, particularly as it relates to mortgage pricing. 1 Each of the top 10 subprime mortgage lenders for 2006 was named in at least one borrower class action suit during Securities cases accounted for 22 percent of total filings. Of those, 54 percent were securities fraud class actions alleging temporary inflation in a company s stock price due to inaccurate or incomplete disclosures to shareholders. 2 Directors and officers of the target company were individually named as defendants in 97 percent of these class actions. The remaining securities cases targeted either underwriting firms for allegedly making material misrepresentations in connection with the issuance of mortgagerelated securities or investment managers who are alleged to have taken imprudent risks and/or to have misled investors in managing client portfolios. Commercial contract claims make up 22 percent of total cases with the majority of these (58 percent) involving litigation seeking to force mortgage originators to repurchase loans that went into early default or otherwise violated certain representations and warranties made at the time of sale. Employment class actions comprise nine percent of total cases with bankruptcy-related and other making up the remaining four percent. California and New York courts combine to account for approximately 50 percent of all cases filed. II. Introduction Standard & Poor s recently estimated that global bank losses tied to subprime mortgages may top $265 billion. 3 Other estimates have pegged total subprime-related losses at $400 billion or more, even positing that the spillover could result in a curtailment of lending totaling $2 trillion Throughout this paper, we are offering no opinion on the merits, or lack thereof, of the allegations contained in the complaints. We simply report the claims, as alleged. 2. Shareholder derivative claims and ERISA actions brought by company sponsored plans accounted for another 21 percent of securities case filings. 3. Shenn, Jody, Subprime, CDO Bank Losses May Exceed $265 Billion (Update 5), Bloomberg.com, January 31, 2008, Shenn, Jody, S&P Lowers or May Cut $534 Billion of Subprime Debt (Update 2), Bloomberg.com, January 30, 2008, 4. Chibber, Kabir, Goldman Sees Subprime Cutting $2 Trillion in Lending (Update 5), Bloomberg.com, November 16, 2007, Yoon, Al, Total Subprime Losses Seen As High As $480 Billion: UBS, Reuters, November 14, 2007,

5 71 «February 2008 In the span of less than a year, writedowns taken by large financial services firms have already surpassed $100 billion, members of Congress have introduced bills seeking to overhaul the mortgage industry, and the number of regulatory investigations has multiplied. In addition, government institutions have adopted increasingly activist approaches as approximately two million U.S. homeowners face the prospect of spiking mortgage rates and possible foreclosure. 5 While the origins of the socalled credit crunch center on mortgages originated in the United States, the effects have been widespread and the implications global in nature. The confluence of low interest rates, affordability products like hybrid and option ARMs 6, relaxed underwriting standards, and an insatiable appetite shown by the secondary mortgage market fueled an era of easy credit and a dramatic run-up in real estate values. Benign market conditions masked, for a time, the significant credit risk and in some cases even fraud that has since revealed itself with such ferocity. By the end of 2007, delinquencies, foreclosures, and bankruptcies were up. Home values, bank share prices, and investor confidence were down. And the lawsuits had been filed by the hundreds. III. Presentation of Findings This section of the paper presents the results of our review of 278 federal cases filed during 2007 and seeks to answer the following seven (7) principal questions Who are the parties involved? What types of cases are being filed? What is the status of the cases? Who is being sued? Who is filing the suits? Where are the suits being filed? What specific claims are being put forth? Each of these questions is addressed in turn below. In the Appendix, we revisit these same questions for each of the major case types and also describe our methodology for gathering the case data. 1. Who are the parties involved? Set forth below is a simplified schematic depicting the general mortgage origination and securitization process and some of the various parties involved. See Figure 1. The process begins when a prospective borrower seeks to finance the purchase or renovation of a home, refinance an existing loan, or monetize existing home equity. The borrower may go directly to a lender or may instead use the services of a mortgage broker, who will typically have access to a variety of loan products from several lenders. Once the loan is approved and funded 7, the lender will oftentimes act as a conduit (or else deliver the loan to a separate entity acting as a conduit), which pools the loan with other like loans and transfers them into a bankruptcy-remote securitization trust, or special purpose entity (SPE). The lender may continue to service the loan on behalf of the SPE, or this responsibility may be contracted out to another party. The SPE will, through the services of an underwriter, issue and market various securities backed by the mortgages, which are commonly referred to as residential mortgagebacked securities (RMBS). Typically, the marketability of the securities, or tranches, is enhanced by virtue of receiving a credit rating from one or more of the major rating agencies (i.e., Standard & Poor s, Moody s, Fitch Ratings). Higher credit ratings are assigned to those tranches that are structured to benefit from some form of credit enhancement, usually either priority claims on the cash flows generated by the underlying mortgages and/or credit insurance purchased from a third-party bond insurer (e.g., Ambac, MBIA, etc.). While we appear to still be in the early stages of the civil litigation emanating from the credit crunch, the cases filed during 2007 provide an instructive road map with respect to the course the litigation is likely to take. We have conducted an extensive analysis of these cases, which we present herein. We also compare these data to one notable historical benchmark the civil private liability litigation brought by the Resolution Trust Corporation (RTC) in connection with the savings-and-loan crisis of the late 1980s and early 1990s. Overview of the Securitization Process Figure 1 5. Schloemer, Ellen, Wei Li, Keith Ernst and Kathleen Keest, Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners, Center for Responsible Lending, December A hybrid adjustable rate mortgage (ARM) pays a fixed rate for a specified period of time, often times a low introductory teaser rate, after which it converts to a fully-indexed adjustable rate. Option ARMs provide the borrower with flexible payment options, including the opportunity to initially pay less interest than is actually owed (accruing) on the loan. The interest shortfall is added to the loan s principal balance, which is referred to as negative amortization. 7. Other parties involved in the loan origination and closing might include, but are not necessarily limited to, realtors, appraisers, closing attorneys, etc.