Sunday, October 21, 2007

Subprime Lawsuits: Complex Instruments, Complicated Claims

As the subprime mortgage mess has unfolded, one of the contributing factors blamed for the meltdown has been the complicated investment instruments into which the subprime mortgage loans were packaged and then sold into the global financial marketplace. I have previously noted (most recently here) that the subprime mortgage meltdown has led to a growing wave of increasingly diverse litigation. A recent development as this wave has spread is the growth of complicated lawsuits arising from these complicated subprime mortgage-backed investments.

For example, as described in an October 19, 2007 Wall Street Journal article entitled "Metro PCS Sues Merrill Over Risky Investments" (here), Metro PCS Communications has sued Merrill Lynch in Dallas state court, alleging fraud, negligence and breach of fiduciary duty in connection with Merrill brokers’ investment of $133.9 million of Metro PCS’s cash in ten auction-rate securities, nine of which were collateralized debt obligations (CDO) that Merrill underwrote and that were backed by pools of mortgages and other assets. Metro PCS alleges that Merrill breached its duties in making the risky investments in violation of the company’s stated goal of holding only low-risk, highly liquid assets.

The Journal article notes that Merrill was the No.1 underwriter of CDOs since 2004, a ranking that depended on Merrill’s ability to sell CDOs to investors, such as Metro PCS. The Journal article notes that Metro PCS, which went public in April 2007, has seen its shares decline 48% since May. The Journal article also mentions MoneyGram International as another CDO investor that has sustained losses. On October 17, 2007, in connection with its third quarter earnings release Moneygram announced (here) that "net unrealized portfolio losses…increased by approximately $230 million as a result of illiquidity in the market for mortgage asset backed securities and CDOs" on a portfolio valued at $620 million as of June 30.

A separate October 19, 2007 Wall Street Journal article entitled "HSBC Is Sued Over Valuation of Fund’s Bonds" (here) describes a lawsuit that Luminent Mortgage Capital has filed against HSBC Holdings PLC. The lawsuit relates to so-called "repo" transactions that took place in late July and early August 2007, in which Luminent subsidiaries borrowed money from HSBC collateralized by securities that the subsidiaries issued to HSBC with the intent to repurchase at original cost plus interest. Luminent alleges that HSBC took advantage of turmoil in the mortgage securities marketplace to capture the nine mortgage-backed repo bonds from Luminent.

According to the Journal article, the Complaint alleges that when the market for mortgage securities "seized up" on August 6, 2007, repo deal lenders (such as HSBC) issued margin calls to make up for the falling bond values. Luminent claims that it stood ready to repurchase its subsidiaries bonds, but that it later learned that HSBC had auctioned the nine Luminent repo bonds and that "HSBC, conveniently, had submitted the highest bid for all of the bonds," allowing HSBC to take ownership of the bonds for little more than half of the bonds’ value. Luminent contends that the bonds "have little chance of not paying 100% of principal and interested owed."

A third Wall Street Journal article, an October 18, 2007 article entitled "State Street Is Sued Over Fund Losses" (here), describes an ERISA lawsuit that Unisystems filed in Manhattan federal court against State Street Corp., in which Unisystems alleged that State Street misrepresented its bond funds as conservatively managed even though the funds invested in "high-risk" investments and mortgage-backed securities. Unisystem alleges that 25 of its employees had $1.4 million in State Street’s Intermediate Bond Fund. (State Street was previously sued in a similar claim by Prudential Financial, about which refer here.)

The Unisystems complaint alleges that, contrary to the State Street fund's representations, the State Street fund was highly leveraged and had 25% of its portfolio in asset-backed securities, and lost 25% of its value between July 1 and September 1, 2007, while its tracking index actually rose in value.

What these diverse lawsuits have in common is common thread of subprime mortgage investment instruments and the critical issue of asset valuation. As I have previously noted (refer here) one of the scariest things about the subprime mortgage meltdown is the dispersion of mortgage investment risk throughout the economy. These cases demonstrate not only that mortgage investment risk is broadly dispersed, but that the rapidly decline in mortgage-backed asset valuations is producing both losses and lawsuits.

Among the more important details of the cases described above are the balance sheet losses that Metro PCS and Moneygram International have sustained. These two examples underscore a point I have noted in a prior post (here) that mortgage investment risk potentially affects a broad variety of companies, including those outside the core financial services industry. The continuing lawsuit proliferation related to mortgage-backed asset valuation declines seems unlikely to omit lawsuits by public company shareholders alleging that companies did not adequately disclose balance sheet exposure to mortgage investment risk – particularly where (as in the examples above) declining mortgage investment valuations have contributed to declining share prices.

The audit industry’s collective commitment (refer here) to enforcing valuation integrity will undoubtedly produce further financial statement dislocations, leading, in turn, to an even wider array of complicated subprime-lending related lawsuits, potentially including shareholder lawsuits alleging insufficient disclosure of balance sheet exposure to mortgage investment risk.

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