Subprime Litigation Wave Hits Bond Insurer, Freddie Mac; Larger Problems Loom

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On November 21, 2007, plaintiffs’ lawyers initiated separate securities class action lawsuits against the Federal Home Loan Mortgage Corporation (better known as Freddie Mac) and against bond insurer ACA Capital Holding. Both of these lawsuits reflect the deepening seriousness of the credit problems arising from the subprime lending meltdown, and the problems besetting these companies suggest even larger problems ahead.

Freddie Mac is the better known of the two companies, and the November 20, 2007 announcement (here) of a larger-than-expected third quarter loss of $2.03 billion due to its deteriorating home mortgage loan portfolio caused its share price to drop by 29%. Perhaps not unexpectedly, plaintiffs’ lawyers have seized on these developments and launched a lawsuit against Freddie Mac and certain of its directors and officers. A copy of the plaintiffs’ lawyers November 21, 2007 press release can be found here and a copy of the complaint can be found here. According to the press release, the complaint alleges that

defendants concealed the following information, which caused their statements to be materially false and misleading: (a) defendants were not implementing sufficient risk management controls to protect the Company from acquiring billions of dollars worth of mortgages with poor underwriting standards, causing the Company to have an untenable amount of risky loans; (b) defendants were not implementing controls to ensure that appraisals were done appropriately and to prevent collusion between lenders and appraisers, increasing the risk of defaults; (c) the Company was not adequately reserving for uncollectible loans, causing its financial results to be misleading; and (d) the Company had billions of dollars of bad loans which it would eventually have to write off, causing losses and capital deficiencies.

The problems at the heart of this lawsuit bespeak the fundamental problems afflicting the U.S. residential real estate market. Just since the end of October, problems stemming from these issues have led to lawsuits against some the country’s largest financial institutions, including Citigroup, Merrill Lynch, Washington Mutual – and now Freddie Mac. But the problems leading up to the lawsuit against relatively small ACA Capital hint at even more complicated problems that may yet arise, and may lead to even larger problems outside the residential real estate sector.

ACA Capital is a bond insurer that conducted its initial public offering barely a year ago, on November 10, 2006. Like other bond insurers, ACA Capital provides bond issuers credit enhancement and protection by agreeing to cover interest and principal payments in the event of credit default. Like other bond insurers, ACA Capital’s main traditional business is insuring municipal bonds. But again, like many other bond insurers, ACA Capital has in recent years become increasingly involved in insuring structured financial products, including collaterlized debt obligations backed by residential mortgages. Because of rating agency downgrades of many CDOs over the course of recent months, ACA Capital’s stock price has plunged precipitously, down by over 90% this year.

As a result of these developments, on November 21, 2007, plaintiffs’ counsel initiated a securities class action lawsuit against ACA Capital. A copy of the plaintiffs’ counsel’s November 21 press release can be found here, and a copy of the complaint can be found here. According to the press release, the complaint alleges that the company’s Registration Statement (prepared in connection with the company’s November 2006 IPO) "failed to disclose that the Company’s CDO assets were materially impaired and overvalued."

While ACA Capital clearly already had lots of problems and the lawsuit merely adds to its woes, an even greater potential concern looms ahead. According to a November 21, 2007 Bloomberg.com article (here), ACA Capital’s credit ratings are under review for possible downgrade. Indeed, according to a November 8, 2007 Wall Street Journal article entitled "Bond Insurers Shaky As Credit Climate Worsens" (here), the same combination of circumstances plaguing ACA Capital afflicts a number of other bond insurers, and a number of the bond insurers may be in line for a rating downgrade. Nor is this problem limited to U.S bond insurers; the Financial Times reports in a November 22, 2007 article (here) that French bond insurer CIFG has received a $1.5 billion transfusion from two French mutual banks in order for the insurer to maintain its triple-A rating.

If a bond insurer were to be downgraded, there would be immediate repercussions, none of them pleasant. The most immediate concern if a bond insurer were downgraded is that "it could," according to the Journal article, "trigger a domino effect of bond-rating downgrades." Looming in the background is the possibility that a bond insurer, like ACA Capital, defaults. If a bond insurer were to default, banks would be, according to Bloomberg, forced to "take on $60 billion of collateralized debt obligation." Merrill Lynch alone may need to write down $3 billion of CDOs if ACA defaults on its obligations. A November 22,2007 Financial Times article entitled "CDOs and Insurers" (here) discusses in greater detail the consequences that would follow if ACA were to be downgraded.

UPDATE: Events move faster than even the most diligent blogger can keep up with; it appears that on November 21, 2007, S & P in fact already downgraded bond insurer MGIC, and is reviewing three other bond insurers for possible downgrade, as reported here. Obviously the MGIC downgrade puts the other comments in this blog post in even sharper relief.

The contagion effects from the bond insurers’ weakness is already roiling the municipal bond market, according to a November 16, 2007 Wall Street Journal article entitled "Credit Pressure Filters Down to Muni Market" (here). According to the Journal, the bond insurers’ troubles are "affecting the market for new municipal debt" because "buyers are backing away, in part because of concerns about the financial guarantors." The Journal reports that if the bond insurers were to be downgraded, it would "have a direct negative impact on the muni debt they insure, potentially even triggering forced selling by some investors."

All of these fears are fed by concerns that the bond insurers may not have come clean about their exposures. These concerns were underscored on November 19, 2007, when giant reinsurer Swiss Re announced (here) that it had accrued $876.4 million in after-tax losses on credit default swaps. The credit default swaps on which Swiss Re took the losses present one form of the kind of financial guarantee that bond insurers provide. Swiss Re’s reduction of the value of these instruments to zero certainly raises concerns about valuations that the bond insurers themselves may be retaining for similar transactions. Swiss Re’s write down raises concerns about the possibility of even greater turbulence ahead for the bond insurers, and perhaps for other reinsurers and insurers, that, like Swiss Re, had diversified into nontraditional products like credit default swaps.

All of which suggests that ACA Capital may not be the last bond insurer to face a shareholder claim. But of even greater concern is the possibility that ACA or another bond insurer will be downgraded, or worse, default, which would lead to a cascade of adverse consequences for bond issuers and bond investors alike. Moreover, Swiss Re’s announcement underscores that these concerns are not limited just to bond insurers. Indeed, the November 20, 2007 Wall Street Journal article discussing the Swiss re write-down (here) specifically emphasized that Swiss Re is only one of many traditional reinsurers and other insurers that expanded into nontraditional products such as credit default swaps in recent years.

So it appears that the subprime litigation wave will continue to spread outward, encompassing an ever broader diversity of companies. Indeed, in a November 21, 2007 article (here), the Wall Street Journal took a close look at the subprime credit problems distressing General Motors, as a result of deteriorating mortgage assets held by its finance unit, GMAC. The dispersion of the subprime credit problems throughout the economy suggests that the negative effects, and the ensuing litigation, will impact a widening array of companies.

I have added the Freddie Mac and ACA Capital lawsuits to the list of subprime-lending related securities class action lawsuits that I am maintaining here. With the addition of these two most recent lawsuits, the tally of subprime lending related lawsuits now stands at 22, not counting the two securities lawsuits that have been initiated against the credit rating agencies and the four subprime lending related securities class action lawsuits that have been filed against residential construction companies. (That makes 28 total.)

It is probably worth noting that the lawsuit against ACA Capital is not the first subprime lending related securities lawsuit against a bond insurer. That distinction belongs to the securities lawsuit (refer here) filed against bond insurer Radian Group earlier this year after its planned merger with rival MGIC fell through.

Yes, But Who Insures the Insurer?: Adding to the drama of the Swiss Re downgrade is the fact that it came just two weeks after the company announced its third quarter results. Floyd Norris, the New York Times financial reporter, commenting on the Swiss Re writedown in his blog (here), noted that

Analysts are feeling abused and embarassed. One muttered that such losses evidently were not unforseeable to the people who bought the insurance. Another suggested that perhaps this would become an issue for whatever company provides directors and officers insurance for the people who run Swiss Re, and asked what company had taken on that risk.

Swiss Re would not answer that question.

Special thanks to alert reader Matt Rossman at Citigroup for links to the Swiss re articles and the Floyd Norris blog post.