Wednesday, August 15, 2007

All Subprime, All the Time

At about this time last year, it sometimes seemed to me as if all I was writing about on this blog was the options backdating scandal, but that was because there were backdating-related issues emerging on virtually a daily basis. Now it is beginning to feel as if all I am writing about is the subprime lending mess, but if that is so it is because it is an issue that is dominating the headlines, the financial markets, the credit markets, and, predictably, the litigation docket.

Of perhaps greatest interest to readers of this blog, the wave of litigation growing out of the subprime lending related mess continues to grow. Yesterday, plaintiffs’ lawyers initiated a purported securities class action lawsuit (press release here) against Countrywide Financial Corp., the number one mortgage originator in the country. This lawsuit preceded by one day the drubbing that Countrywide’s stock took today, when a Merrill Lynch analyst’s downgrade (and speculation that Countrywide could face bankruptcy risk as liquidity worsens) triggered a 13% decline in the Countrywide’s share price.

Then today, the Lerach Coughlin firm filed a securities class action lawsuit (press release here) against Radian Group, a credit enhancement company that provides credit protection products (such as mortgage guaranty insurance) and financial services to mortgage lenders and other financial institutions. The lawsuit relates to circumstances arising from Radian's affiliate, Credit Based Servicing & Asset Securitization (C-Bass), an investor in the credit risk of subprime residential mortgages. Radian, which is a joint venturer in the affiliate with MGIC, recently announced that the value of its investment in C-Bass is "materially impaired." According to the Wall Street Journal (here) "disruptions in the market for risky mortgages might wipe out the value of C-Bass, which was valued at more than $1 billion just five weeks ago." The turbulence surrounding the C-Bass affiliate may also have undermined a pending merger beteween Radian and MGIC (refer here).

In addition to the Countrywide and Radian lawsuits, plaintiffs’ lawyers also filed a purported class action lawsuit (here) against IndyMac Bancorp. Special thanks to a loyal reader who prefers anonymity for drawing my attention to the IndyMac case, and to Adam Savett of the Securities Litigation Watch blog (here) for providing a link to the IndyMac complaint.

The addition of these three lawsuits brings the total number of subprime lending-related securities class action lawsuits to 10, according to the running tally of subprime lending-related lawsuits I am maintaining here. In an earlier post (here), I described the flood of new subprime lending related lawsuits as a "wave" which I also said is growing. The influx of new lawsuits certainly reinforces the view that we face a growing wave of subprime related lawsuits.

Will the Gatekeepers Get Blamed?: One of the things that happened after the options backdating scandal first emerged is that momentum quickly developed to try to hold the corporate gatekeepers responsible for permitting the backdating to happen (for example, see my prior posts on this topic, here and here). It remains to be seen whether or not this same dynamic will emerge in connection with the subprime lending mess, but the questions are clearly already being asked.

For example, an interesting August 15, 2007 column by Jonathan Weil on Bloomberg.com (here) examines questions surrounding the possible responsibility of subprime lenders’ auditors. Weil points out that a number of the auditors quite recently gave some of the now-failed subprime lenders clean audit-opinion letters. He cites the example of American Home Mortgage Corporation, whose auditors (Deloitte & Touche) gave the company a clean opinion in March, five months before the company’s August 6 bankruptcy filing. He notes the auditors’ dilemma, which is that a going concern letter would have represented a default to the company’s own lenders, and so the issuance of a going concern audit letter would almost certainly represent a self-fulfilling prophecy. On the other hand, a going concern letter "would have spared investors from the company’s April 30 public offering of 4 million shares at $23.75 each, the prospectus for which incorporated Deloitte’s audit opinion."

Weil also cites as an example of this same issue HomeBanc Corp., which filed an August 9 bankruptcy petition "still sporting a clean opinion from Ernst & Young." (By contrast, Weil notes, KPMG issued a going-concern letter on New Century Financial Corp. a month before the company’s Chapter 11 filing.)

It may not yet be blame the gatekeeper time, but I think it is probable that we will get there sooner or later -- most likely sooner rather than later.

Lax Underwriting or Fraud?: One recurrent theme surrounding the subprime lending mess is wheter the lenders lax underwriting standards are to blame for the whole situation. But an article in the August 20 issue of Business Week entitled "Did Big Lenders Cross the Line?" (here) asks the question whether at least some of the lending went beyond lax underwriting all the way to fraud.

The article cites several recent lawsuits in which borrowers have sued lending institutions alleging that the lenders, eager to "keep up loan volume and generate sales," falsified documents by beefing up the borrower’s income and "lowballing" the borrower’s outstanding debt. In another instance cited in the article, a lender is alleged to have "created false tax returns, employment records and a 401(k) to make it appear that the loan was affordable." The article also states that in "some cases lender fraud appears to have involved forged signatures and other deceptive practices."

As in-force adjustable rate mortgages reset at higher interest rates, borrowers face increasing pressure to escape the financial consequences. It is hardly surprising that borrowers are alleging entrapment or worse to try to evade the loan’s requirements. A cynic might well ask exactly where the fraud might be found to lie on some of the loan transactions. That said, the recent allegations do raise serious concerns about certain practices that may have developed as the residential real estate frenzy built. The one thing that is for certain is that all of these concerns are further grist for the subprime lending related litigation wave.

"And the Jaguar is Black, Dammit! Can't You Bastards Get Anything Right?": Some readers may recall that Jonathan Weil (author of the Bloomberg piece cited above), a former Wall Street Journal reporter widely credited with breaking the Enron story while at the Journal, earlier this year rather publicly resigned from his position as research director of Glass Lewis proxy advisory firm (refer to news coverage of his resignation here). His widely quoted letter of resignation said, among other things, "I am uncomfortable with and deeply disturbed by the conduct, background and activities of Glass Lewis's new parent, Xinhua Finance Ltd., its senior management, and its directors." Apparently after his resignation, Weil landed at Bloomberg.

The Journal recently ran a fascinating biographical study (here) of Xinhua's Chief Executive Officer, Loretta "Fredy" Bush. The Journal subsequently ran what is my all-time favorite "correction" item, about the Fredy Bush article: "American businesswoman Loretta Fredy Bush's ranch property in Hawaii totals 1,172 acres, and she is chauffeured around Shanghai in a black Jaguar. The article incorrectly said that the ranch is 230 acres and that her Jaguar is blue."

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