Thursday, August 23, 2007

Will the Subprime Meltdown Affect the D & O Marketplace?

As I have previously noted (most recently here), the subprime mortgage meltdown has produced a wave of lawsuits, including securities class action litigation (which I am tracking here). Even thought we are clearly only at the beginning of what will undoubtedly be a very long-developing story, the question is already being asked: what impact will the subprime mortgage mess have on the D & O insurance marketplace? For example, an August 22, 2007, Insurance Journal article entitled "The Blame Game and the Subprime Mortgage Meltdown"(here), among other things, examined the possible impact of the subprime mess on the D & O insurance marketplace. (Full disclosure: I was interviewed in connection with the article.)

In one sense, it may simply be too early to be asking these questions. As I noted in the Insurance Journal article, we are only at the very top of the first inning in what will probably be an extra-inning contest. This story has much further to run. But on the other hand, it may not be too early to begin to make some assessments of the seriousness of the situation.

And for my money, this is a very serious situation, indeed. It already may be potentially far more serious for the D & O industry than the options backdating scandal. The options backdating scandal involved chronologically remote events, arcane accounting principles, and, except in a few extreme cases, the claims were not accompanied by significant loss of market capitalization or other investor loss. (The exceptions to these generalizations are of course quite noteworthy, but from the perspective of the D & O industry, the backdating scandal taking collectively is simply not a market changing event.) By contrast, the subprime mess is immediate, involves immediately apparent and emotionally compelling issues, and has been accompanied by very substantial investor loss. Even though the backdating scandal involved many more lawsuits (so far, at least), the subprime mess already poses a potentially far more serious problem for the D & O industry, and the potential will only grow in the months ahead.

But what does all of that imply as a practical matter for the D & O marketplace? Because of the marketplace context within which the subprime mess is now unfolding, the subprime meltdown may or may not mean anything, at least in the short term, other than for companies directly involved in the subprime lending industry. The D & O marketplace has been in a declining pricing mode since late 2003, characterized by high levels of competition, with new entrants recently coming into the marketplace. These conditions are not going to change overnight, even given the potential seriousness of the developments resulting from the subprime mess. However, it is not too early to begin to ask whether or not the subprime mess might begin to have some effects, and to ask where all of this might eventually lead.

First of all, companies involved in the mortgage lending business are going to face a far different D & O insurance marketplace than even just 2 or 3 months ago. D & O underwriters are on high alert status for subprime lending risk. Companies with perceived subprime exposure will face, at an absolute minimum, heightened underwriting scrutiny, tightened terms and conditions, and increased pricing. It is fair to say that this sector will be in the "hard to place" category for the foreseeable future. Nor will these tightened circumstances be limited just to subprime lenders. Since problems have already begun to emerge with so-called Alt-A loans (for example, refer here), and even some other loan categories, the scrutiny will extend to all companies involved in the residential mortgage lending business.

Along those same lines, the exact location of the outer edge of the heightened scrutiny category will remain ill-defined for some time, and could potentially encompass a variety of other kinds of companies beyond those involved directly in residential mortgage lending. Certainly, home builders, real estate agents, residential REITs, and other businesses whose fortunes are tied directly to the residential real estate sector will also face a different D & O environment than even just a couple of months ago. The environment for commercial banks and other traditional lending institutions will also be affected, but the extent of the impact will vary, depending on the extent of each bank’s exposure to residential mortgage risk, particularly subprime mortgage risk. But even banks that no longer hold the mortgages could face stricter scrutiny to the extent the banks off-loaded the mortgages to outside investors.

In addition, all companies seeking D & O insurance will be facing the possibility of additional underwriting inquiry around the companies’ balance sheet exposure to mortgage investment risk. As I noted in my prior post (here), there is $1.08 trillion in subprime mortgage backed asset investment (meaured by cost, not necessarily current value) sitting on balance sheets somewhere out there. D & O underwriters will be trying to determine applicants’ balance sheet exposure to this mortgage investment risk. Obvious places to look for this risk include hedge funds and other alternative investment vehicles, mutual funds, investment banks, residential mortgage REITs, and insurance companies. But the inquiry will likely not be limited just to companies in these sectors; given the sheer magnitude of the mortgage-backed investment risk dispersed in the economy, the mortgage investment risk may have wound up in some unexpected places. In addition, underwriters’ questions will likely not be limited to whether the applicant directly holds investments in mortgage-backed assets, but will also inquire whether the applicant has investments in hedge funds or other investment vehicles with significant exposure to mortgage-backed investments.

Beyond these predictable underwriting effects, it is simply too early to tell what the overall impact will be on the D & O marketplace. The quick emergence of claims frequency around subprime mortgage issues and the uncertainty of the eventual extent of the problem has to be making the managers at the D & O insurers (and their reinsurers) more than just a little bit uncomfortable right now. But whether that uneasiness alone is enough to reverse the current downward pricing trend remains to be seen. My own expectation is that the effects on the D & O marketplace will be uneven, with some predictable sectors constricting but most others remaining competitive, at least in the short term. Whether the constrictive impact will become more generalized will depend on how large and how widespread the subprime litigation wave becomes. Stay tuned.

One Example Why I Think The Subprime Litigation Wave Will Grow: The potential for the subprime litigation wave to encompass an ever-wider variety of companies in an ever-broader variety of claims may be seen in the purported class action lawsuit previously filed in federal court in Florida against D’Alessandro & Woodyard, a Florida residential real estate broker; First Home Builders of Florida, a residential home builder specializing in the first-time home buyer segment; these two companies’ successors in interest; and certain principals of the real estate agency. The complaint may be found here.

The complaint alleges that the home builder would attract would-be home buyers to new home open houses. Would-be home buyers who could not qualify for home purchase financing were allegedly referred to the real estate broker, who helped the would-be buyers enter a lease-to-buy program, where the lease payments were intended to be used as documentation to help a later mortgage application to support the tenant’s ultimate purchase of the home. The homes to be leased purportedly were sold to investors, who would carry the home during the tenancy, and then after an interval would sell the homes to the tenants. The investors purportedly were promised "ready made" tenants, and a 14% return.

The plaintiffs allegedly purchased 3 lots on which 3 of these lease-to-own home would be built, borrowing $790,000 in construction financing from an alleged "hand picked" lender, despite having only $90,000 in gross annual income. The plaintiffs allege that no tenants have been procured for these houses, and that they now face foreclosure on the three properties. The plaintiffs allege on behalf of themselves and other similarly situated investors that the defendants breached Section 12 of the ’33 Act, Section 10 of the ’34 Act, breached their contract with the plaintiffs, and violated a variety of state trade practices acts.

There are several parts of these alleged factual circumstances that are interesting. The first is that the defendants include not only the home builder but also the real estate agents. As I have previously suggested (here), the wave of blame for the subprime mess will spread outward, and will involve an ever-broader variety of purported scapegoats, and an increasingly large number and variety of professionals. This gatekeeper blame is already being assigned to directors and officers, credit rating agencies, mortgage brokers and real estate appraisers. Before this situation is entirely played out, we undoubtedly will have blame cast upon auditors, attorneys, investment advisors, hedge fund and pension fund managers, and many others whom circumstances will show to have played some role.

The second is what this alleged investment opportunity required for its prospective success. Not only did it require the availability of tenants who could pay the rent under the lease to own program –even though they couldn’t afford a mortgage at the outset – but it also required a tenant who could later successfully acquire financing to buy out the investors. Allegedly, the Prospectus that was provided to potential investors explained that the "exit strategy" was possible due to the availability to the tenant-buyers of subprime financing. Among other things, the Prospectus allegedly stated that 14% gain would be paid to the investors

once the tenant refinances the home in their name buying the investor out of the deal. The refinance is possible because Sub-prime lenders will allow a refinance on a property with 12 cancelled monthly checks for a lease payment. Tenants are preliminarily screened for credit, income, and debt analysis. They are coached in the process of the refinance and how to qualify in the upcoming year.
In addition to the tenant, the investors too had to be able to secure financing. But the ultimate benefit to the tenants and investors depended upon their ability not only to qualify for but to repay the debt. Of course, in some circumstances (if not in these precise circumstances) the ability to repay may have been of less concern to some brokers or home builders, and for that matter, to some lenders, who counted on their ability to sell their loans to third party investors.

The allegations in the complaint are mere assertions, and I have no way of knowing whether or not they are true or false, nor do I know whether the plaintiffs’ claims are meritorious. However, the plaintiffs allegations suggest the true seduction that came with the availability of easy credit at a time of rising prices – everyone involved was going to make money, or at least prosper. The number of investors or eventual home-buyers who may have incurred debt beyond their means hoping to prosper or benefit in situations like this one, or in the untold number other variants that played out over the past few years, where marginal borrowers were "coached" into debt qualification but not on the challenge of debt repayment, create a multitude of individual situations where financial reversals will leave a plethora of aggrieved parties, whose grievance will, more likely than not, wind up in court. The assignment of blame will extend beyond individual cases to attempts to cast collective blame against the companies that facilitated and prospered from these arrangements, as well as the managers who ran the companies, the investment bankers who financed the lending and packaged the debt for resale, the investment managers who supported the system by buying the debt on behalf of their investment funds, and outward and onward. As this case shows, the blame shifting game will be actively supported by lawyers willing to pursue creative theories in support of their clients' interests.

As I have said, we are only in the top of the first inning. But the scoreboard already looks alarming, at least to me. Contrasting perspectives from responsible spokespersons are welcome.
Very special thanks to Timothy Raub at LexisNexis for calling my attention to this case, and to Adam Savett of the Securities Litigation Watch for providing a link to the complaint.
Speaking of the SLW, a hearty welcome back to Adam for his (alleged!) return (here) to the blogging circuit.

An Historical Sidenote: In his recent splendid biography (here) of Andrew Carnegie, historian David Nasaw describes the Panic of 1873, caused by the October 1873 failure of the Philadelphia finance firm of Jay Cooke & Co., which had overextended itself after getting caught up in the euphoria that accompanied the attempt to build the transcontinental railroad. Nasaw writes:
Like all financial panics, the signs had been there to see -- but no one bothered to look until it was too late. Businesses had been failing and banks hiking their interest rates since the spring. Jay Cooke, who had in 1869 been overtaken by the transcontinental madness, found it difficult, then impossible to borrow what he needed to complete construction of his Northern Pacific Railroad....He attempted to sell Northern Pacific bonds at a deep discount, but there were no takers....The failure of Jay Cooke & Co. set off a round robin of bank and business failures. Stocks tumbled, out-of-town banks took back the reserves they had parked in New York City, causing New York banks to call in their old loans and raise rates on new ones.... The railroads, which survived on credit, were instantly crippled. The effect on Pittsburgh's manufacturing firms, including Carnegie's, was immediate because the railroads with which they did so much business no longer had money to pay their bills. Banks were no use in the crisis. Those that remained open suspended payments....
The world is a different place than it was in 1873. The economy is stronger, more diverse, and is protected with more safeguards now, and there is no reason at this point to think the current conditions will lead to anything like what happened in 1873. But those prior circumstances have some oddly familiar echoes. One thing that has not changed is the fundamental dependence of the credit system on the ability of borrowers to repay their debt. When they cannot, then problems ensue, now as then, and the effects still reverberate across the entire economy.
Meanwhile, Back at the Ranch: The subprime mess may be the headline story, but that does not mean that the backdating scandal has gone away, and indeed, just this week a securities class action lawsuit was filed (press release here) against another company, in this case Semtech. (Semtech was already involved in an options backdating related shareholders derivative suit.) According to the running tally of options backdating related securities class action lawsuits that I am maintaining here, that brings the count of options backdating related class actions to 32. I also added two options backdating related shareholders derivative suits to the list as well (iBasis and Citrix), bringing the tally of options backdating related shareholders' derivative suits to 163. Thanks to Timothy Raub at LexisNexis for identifying the omissions.

Speaker’s Corner: The subprime mortgage litigation wave has captured the attention of quite a few observers, and it will undoubtedly lead to a number of legal issues as well as insurance coverage issues. On October 29-30, 2007 in Chicago, I will be co-Chairing, with Matt Jacobs of Jenner & Block, a Mealey’s conference entitled "Subprime Mortgage Litigation", the agenda for which may be found here. The conference will feature a number of recognized experts, both in the field of mortgage lending and in the field of insurance coverage issues. Because of the growing importance of these issues, this conference will surely attract a great deal of interest and attention.

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