"This Year’s Model" (2007 Edition): Subprime Lending Lawsuits

In early 2006, I nominated (here) the then-beginning wave of options backdating lawsuits as "this year’s model" – that is, the hot litigation trend that was being driven by the business scandal most prominent at the time. We are now well into 2007, but I have only just now determined the 2007 nominee for this year’s model. I can now say it with confidence: This year’s model undoubtedly has to be subprime lending related lawsuits.

The litigation fallout from the subprime lending morass has already taken a wide variety of forms. In an earlier post (here) that I have been updating periodically, I listed the securities class action lawsuits that have ensnared subprime lenders, as well as the class action lawsuits that have been filed against home builders in the wake of decreased availability of easy credit. (I also noted in my prior post the ERISA lawsuit that employees have filed against Fremont General, the subprime lender, in connection with Fremont stock in their 401(k)).

In addition to these lawsuits listed in my prior post, subprime lending related litigation is arising in an ever-increasing variety of additional forms:

Borrowers Suing Lenders: These lawsuits allege that lenders have misrepresented aspects of their mortgage loans. For example, a class action brought by 1,600 borrowers against NovaStar Mortgage recently settled for $5.1 million (refer here). The NovaStar lawsuit alleged that the broker or lending officer who placed the mortgage was financially rewarded for steering borrowers to higher interest rate loans.

A more recently filed class action lawsuit filed by the NAACP (refer here) alleges that mortgage companies discriminated against African Americans by steering them toward higher-interest rate subprime loans while giving more favorable rates to white borrowers.

Borrowers Suing Financial Institutions: As detailed in a June 27, 2007 Wall Street Journal article entitled "How Wall Street Stoked the Mortgage Meltdown" (here), borrowers have sued a unit of Lehman Brothers for its investment involvement with a subprime mortgage lender, essentially on the theory that the Lehman unit was an enabler that encouraged unsavory tactics and practices from which Lehman profited.

Regulators Suing Lenders: A story this big inevitably will attract grandstanding politicians, and so in June, Ohio Attorney General Marc Dann sued 10 mortgage lenders (refer here), accusing them of pressuring real estate appraisers to inflate home values, a practice Dann claims left borrowers with homes that can’t be sold and loans that can’t be refinanced. (It is worth noting that Ohio’s foreclosure rate is nearly twice the national average.) In addition, 49 states announced on July 12, 2007 (refer here) that Ameriquest Mortgage had agreed to pay a class of 481,000 borrowers $325 million for not properly disclosing terms of home loans.

Financial Institutions Suing Lenders: According to recent press reports (here), a subsidiary of Deutsche Bank has filed at least 15 lawsuits seeking as much as $14 million from mortgage companies, alleging they failed to buy back loans with early defaults. Subsidiaries of Credit Suisse and UBS reportedly also have filed similar lawsuits.

Investors Suing Financial Institutions: In April, Bankers Life sued Credit Suisse Group alleging that it lost money on investment grade bonds backed by subprime mortgages sold by the bank (refer here). Bankers Life is seeking to recover about $1.3 million for losses of principal, interest and market value.

Investor concerns about mortgage-backed securities are likely to continue. Moody’s has recently indicated (refer here) that it intends to cut its credit ratings on a group of collateralized debt obligations (CDOs), the day after Moody’s and S & P both said they would downgrade hundreds of subprime-mortgage backed bonds widely held by CDOs. Undoubtedly these downgrades (and others likely to come in the months ahead) will affect asset values for investors holding these assets. Credit Suisse recently attempted (here) to quantify the likely magnitude of the losses to come from bonds backed by subprime mortgages, and put the number at $52 billion. Other estimates range as high as $90 billion.

As investors experience declines in asset values, they will increasingly turn against the financial institutions that created the financial instruments. As I detailed in my prior post (here), investors may also turn against the rating agencies that assigned investment grade ratings to the financial instruments whose high-grade (or higher-grade) valuations stoked the entire machine.

While all of these identifiable threats and existing lawsuits would alone be sufficient to earn subprime lending lawsuits their designation as "this year’s model," there is a deeper reality that makes the designation even more compelling.

According to Banc of America Securities (refer here), about $515 billion in adjustable rate home loans, more than 70 percent of which were made to subprime borrowers, will have interest rate resets before year end. Another $680 billion reset next year. Borrowers unable to support higher interest payments will also likely to be unable to refinance, and so the current wave of defaults and foreclosures will only grow in the near term --which in turn further erodes the values of the financial instruments that the loans backed.

The recent (and seemingly belated) investment downgrades for mortgage-backed securities, not to mention the recent near-collapse of the two Bear Stearns hedge funds (refer here), represent the canary in the coal mine on the issue of asset valuations. Institutions that own financial instruments with valuations now pegged at certain levels will increasingly find themselves compelled by events or expectations to reassess the valuations at which these assets are carried, and make disclosures about those valuations. Any balance sheet resets (or for that matter, failure to reset balance sheets) will mean increased turbulence for financial institutions involved in the mortgage backed securities business as well as for investors that hold the securities. As the concentric rings from asset valuation issues spread outward, an increasing array of companies will become engulfed in the litigation wave.

These threats, immediate and future, pose an enormous challenge for D & O underwriters and others who must identify and quantify risk exposures across companies and industries. The most obvious center of concern is the companies in the subprime lending and mortgage backed securities industries. But investors owning the subprime mortgage-related financial instruments also carry a significant risk profile. This investor group includes not only hedge funds (and hedge fund investors), insurance companies, pension funds (and pension fund beneficiaries), and commercial banks, but others whose balance sheets reflect significant asset values from mortgage backed securities. This latter group could include some surprising players, as many companies (for example, high tech companies) that have carried significant cash or cash investments on their balance sheets may have invested in mortgage-backed securities to boost returns.

And in the outermost of the concentric circles, there will be the universe of companies whose financial fortunes were driven by the availability of easy credit for home buyers: home builders, home improvement companies, home furnishing retailers, appliance manufacturers, construction materials companies, not to mention real estate brokers, surveying companies, title insurance companies, and everybody else whose fortunes may shrink in an era of tighter lending guidelines and a housing stock oversupply driven by a crescendo of defaults and foreclosures.

All in all, this year’s model is pretty darn unattractive. It could get even uglier in the weeks and months ahead.

"Rahodeb" Means "Incredibly Stupid": One of the strangest stories to come along in a very long time has to be today's news (refer here) that for eight years Whole Foods Markets co-founder and chief executive John Mackey was posting online remarks in a Yahoo stock-market forum related to Whole Foods' archrival Wild Oats Markets under the pseudonym "Rahodeb." Whole Foods is now trying to buy the very company that Mackey had been for so long badmouthing online. Mackey not only used the forum to criticize the competition and, it seems, defend his own haircut, but, ironically, to assert that Wild Oats' managment "clearly doesn't know what it is doing." (He would appear to be somewhat of an expert on the topic of management that clearly doesn't know what it is doing.)

Mackey's online activites not only show incredibly poor judgment. They also beg the question: how in the world does the CEO of a $5 billion market cap company have time to hang around in online chat rooms?

As might be expected, this story has attracted some pretty interesting commentary, including this discussion of the possible legal issues Mackey's activities raise, in the Legal Pad blog (here). Yahoo has helpfully compiled all of Mackey's message board posts here.

Did You Hear the One About the Naked Sleepwalking Director?: Perhaps today was just the day for strange D & O related stories, but the July 12, 2007 Financial Times has this item (here, entitled with classic Brit restraint, "Kenmare Row Over Nude Director") about the now-former director and audit committee head of Kenmare Resources who apparently engaged in a May drink-fueled naked sleepwalk that somehow managed to bring him to the door of the company's (female) secretary and financial comptroller three times. Somewhat reassuringly, all three occasions apparently occured on the same evening. The individual former director in question, who does not deny that the incident(s) occured, insists that his ouster relates to his disagreement with other board members over strategy. I know this sounds like a bad Monty Python skit, but I promise, I am not making this up.