Subprime Contagion: Where Will the Litigation Wave Spread Next?
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As I have previously noted (here), subprime risk may be found in some unexpected places. But since I first wrote about the dispersion of subprime risk, subprime contagion has spread to other parts of the credit marketplace. As a result, the credit meltdown story is no longer just about subprime.
By the same token, there are also concerns that problems in the subprime mortgage industry could spread to auto and truck loans. As discussed in a November 20, 2007 Associated Press article entitled "Analysts Fear Auto Loans Next Problem" (here), the major auto and truck lenders are already experiencing rising delinquency levels. One analyst is quoted as saying that there is no question that the mortgage woes will spill into car and truck financing. "The only question is how big a worry it is."
In addition to consumer-related loans, another segment of the credit marketplace that may be affected is the commercial property mortgage sector. As discussed in a November 28, 2007 Bloomberg.com article (here), the lax underwriting standards that are now coming back to haunt the residential mortgage sector also spread to commercial mortgages. While the article notes that the commercial property market’s credit stability is far greater than in the residential real estate sector, the article also quotes several individuals to the effect that the commercial real estate market is "a full-blown bubble" that is at "the bursting point."
According to a December 2, 2007 Financial Times article (here), the aftershocks from the subprime meltdown could "hit lenders with a second real estate-related punch, if the highly leveraged commercial property market succumbs to the contagion." As a result of growing anxieties concerning the commercial property market, as well as the turmoil from the subprime meltdown, the cost of credit swaps to protect investors from commercial mortgage defaults has skyrocketed since October. Banks are on holding tens of billions of dollars worth of unsold commercial mortgages. According to the Financial Times article, "US banks could see $11bn to $78bn of commercial real estate losses if the lending crisis spreads, according to Goldman Sachs."
Many of these loans from other areas of the credit marketplace, just like the subprime mortgage loans, have been repackaged into asset-backed securities. And just like the subprime mortgage-backed securities, the securities backed by these other types of loans are also facing a significant valuation slump -- not only because of concerns about borrower defaults, but also out of concern that constrained banks and investment funds will be, according to the Bloomberg article, "forced to sell the securities, pushing prices lower before any recovery." In other words, investors in these other asset-backed securities may be facing many of the same kinds of asset valuation and investment disclosure issues that have been plaguing holders of mortgage-backed securities in recent months.
The subprime meltdown has hit some unexpected companies, such as E*Trade, whose involvement in mortgage lending might not previously been well known, and similarly there may be some unexpected companies affected by the growing turmoil in the larger credit marketplace. For example, an article in the December 10, 2007 issue of Forbes magazine (here), discusses how a number of manufacturers have in recent years become increasingly involved in financial services; "a lot of companies that are not classified as financial have financial arms and could suffer along with banks…if borrowers stop paying their bills." For example, the Forbes article says, General Electric gets 34% of its pretax earnings from financial services, and Deere & Co., Caterpillar and Pitney Bowes all get at least 12% of their earnings from financing. Other unexpected companies named in the article with significant financing operations include Sony and Harley-Davidson. Other companies mentioned in the article as carrying significant customer leases or other significant interest bearing receivables include Boeing and Paccar (a tractor truck manufacturer).
Whether any of these companies, or other financing companies outside the subprime mortgage lending arena, will ultimately get drawn into securities litigation as a result of broader credit marketplace turmoil remains to be seen. But the possibility of these kinds of lawsuits arising is not merely theoretical. If the deterioration of these other sectors continues, as seems probable, then the possibility that aggrieved investors will initiate securities litigation contending that they were not fully apprised of the credit or default risk, is just as likely.
The risk of subprime-related securities litigation has not been restricted to the subprime loan originators, and the securities litigation that would follow further deterioration in these other credit sectors would not be restricted to the originating lenders. Based on what happened following the subprime meltdown, other targets might well include the companies that were involved in securitizing these loans into investment securities (including investment banks, credit rating agencies, bond insurers, or other credit default swap providers).
A deeper concern may be the companies, funds and other investment vehicles that are carrying significant amounts of securities backed by these other credit assets on their balance sheets. These companies will face many of the same kinds of well-publicized valuation and disclosure issues that have troubled companies invested in mortgage-backed securities. And just as the subprime-related valuation and disclosure challenges have led to securities litigation, so too the challenges ahead involving valuation and disclosure of these other asset-backed investments could also lead to litigation.
For D & O underwriters and others whose job it is to identify and locate risk, these evolving exposures represent and enormous new challenge. Indeed, D & O underwriters are still struggling just to get a handle on risk segmentation related to subprime lending. Underwriters have quickly learned that it cannot be assumed that subprime-related risk is restricted only to a narrow category of companies; so too they must face the challenge of identifying an evolving risk that is threatening to spread throughout much of the economy.
As I have previously noted (here), subprime risk may be found in some unexpected places. But since I first wrote about the dispersion of subprime risk, subprime contagion has spread to other parts of the credit marketplace. As a result, the credit meltdown story is no longer just about subprime.In an op-ed column in the November 26, 2007 Financial Times (here), former Treasury Secretary Lawrence Summers, commenting on what he called "the dangers of a deepening crisis," noted that most current estimates about the ultimate losses in the financial sector from the subprime meltdown "take no account of the likelihood that losses will spread to credit card, auto and commercial property sectors." As the December 2, 2007 Sunday (London) Times noted (here), "There are mounting fears that the problems could engulf other types of American debt – credit cards, car finance and unsecured loans."
To the extent the turmoil spreads to other parts of the credit marketplace, the current questions about the extent of the subprime litigation wave will become -- how much further beyond subprime will the litigation wave spread?
Even in just the first five months of 2007, late credit card payments rose thirty percent (refer here). Further delinquencies are almost certain due to problems arising from subprime mortgages. Home owners struggling to make mortgage payments are likelier to make their house payments a priority over credit card payments. As interest payments due on adjustable mortgages reset upwards, this tension with house payments will only increase. Tightened credit requirements will foreclose the ability of many consumers to tap into home equity lines of credit or to refinance in order to retire mortgage debt. All of these circumstances could contribute to further deterioration in credit card debt repayments.
To the extent the turmoil spreads to other parts of the credit marketplace, the current questions about the extent of the subprime litigation wave will become -- how much further beyond subprime will the litigation wave spread?
Even in just the first five months of 2007, late credit card payments rose thirty percent (refer here). Further delinquencies are almost certain due to problems arising from subprime mortgages. Home owners struggling to make mortgage payments are likelier to make their house payments a priority over credit card payments. As interest payments due on adjustable mortgages reset upwards, this tension with house payments will only increase. Tightened credit requirements will foreclose the ability of many consumers to tap into home equity lines of credit or to refinance in order to retire mortgage debt. All of these circumstances could contribute to further deterioration in credit card debt repayments.
Even a small increase in credit card defaults could do serious economic damage; according to creditcards.com (here) total U.S consumer debt (including installment debt but excluding mortgage debt) reached $2.46 trillion as of June 2007. One indication of the kinds of problems that could come is the $422 write down that Discovery Financial Services announced on December 3, 2007 (here) in connection with its Goldfish credit card division.
By the same token, there are also concerns that problems in the subprime mortgage industry could spread to auto and truck loans. As discussed in a November 20, 2007 Associated Press article entitled "Analysts Fear Auto Loans Next Problem" (here), the major auto and truck lenders are already experiencing rising delinquency levels. One analyst is quoted as saying that there is no question that the mortgage woes will spill into car and truck financing. "The only question is how big a worry it is."
In addition to consumer-related loans, another segment of the credit marketplace that may be affected is the commercial property mortgage sector. As discussed in a November 28, 2007 Bloomberg.com article (here), the lax underwriting standards that are now coming back to haunt the residential mortgage sector also spread to commercial mortgages. While the article notes that the commercial property market’s credit stability is far greater than in the residential real estate sector, the article also quotes several individuals to the effect that the commercial real estate market is "a full-blown bubble" that is at "the bursting point."
According to a December 2, 2007 Financial Times article (here), the aftershocks from the subprime meltdown could "hit lenders with a second real estate-related punch, if the highly leveraged commercial property market succumbs to the contagion." As a result of growing anxieties concerning the commercial property market, as well as the turmoil from the subprime meltdown, the cost of credit swaps to protect investors from commercial mortgage defaults has skyrocketed since October. Banks are on holding tens of billions of dollars worth of unsold commercial mortgages. According to the Financial Times article, "US banks could see $11bn to $78bn of commercial real estate losses if the lending crisis spreads, according to Goldman Sachs."
Many of these loans from other areas of the credit marketplace, just like the subprime mortgage loans, have been repackaged into asset-backed securities. And just like the subprime mortgage-backed securities, the securities backed by these other types of loans are also facing a significant valuation slump -- not only because of concerns about borrower defaults, but also out of concern that constrained banks and investment funds will be, according to the Bloomberg article, "forced to sell the securities, pushing prices lower before any recovery." In other words, investors in these other asset-backed securities may be facing many of the same kinds of asset valuation and investment disclosure issues that have been plaguing holders of mortgage-backed securities in recent months.
The subprime meltdown has hit some unexpected companies, such as E*Trade, whose involvement in mortgage lending might not previously been well known, and similarly there may be some unexpected companies affected by the growing turmoil in the larger credit marketplace. For example, an article in the December 10, 2007 issue of Forbes magazine (here), discusses how a number of manufacturers have in recent years become increasingly involved in financial services; "a lot of companies that are not classified as financial have financial arms and could suffer along with banks…if borrowers stop paying their bills." For example, the Forbes article says, General Electric gets 34% of its pretax earnings from financial services, and Deere & Co., Caterpillar and Pitney Bowes all get at least 12% of their earnings from financing. Other unexpected companies named in the article with significant financing operations include Sony and Harley-Davidson. Other companies mentioned in the article as carrying significant customer leases or other significant interest bearing receivables include Boeing and Paccar (a tractor truck manufacturer).
Whether any of these companies, or other financing companies outside the subprime mortgage lending arena, will ultimately get drawn into securities litigation as a result of broader credit marketplace turmoil remains to be seen. But the possibility of these kinds of lawsuits arising is not merely theoretical. If the deterioration of these other sectors continues, as seems probable, then the possibility that aggrieved investors will initiate securities litigation contending that they were not fully apprised of the credit or default risk, is just as likely.
The risk of subprime-related securities litigation has not been restricted to the subprime loan originators, and the securities litigation that would follow further deterioration in these other credit sectors would not be restricted to the originating lenders. Based on what happened following the subprime meltdown, other targets might well include the companies that were involved in securitizing these loans into investment securities (including investment banks, credit rating agencies, bond insurers, or other credit default swap providers).
A deeper concern may be the companies, funds and other investment vehicles that are carrying significant amounts of securities backed by these other credit assets on their balance sheets. These companies will face many of the same kinds of well-publicized valuation and disclosure issues that have troubled companies invested in mortgage-backed securities. And just as the subprime-related valuation and disclosure challenges have led to securities litigation, so too the challenges ahead involving valuation and disclosure of these other asset-backed investments could also lead to litigation.
For D & O underwriters and others whose job it is to identify and locate risk, these evolving exposures represent and enormous new challenge. Indeed, D & O underwriters are still struggling just to get a handle on risk segmentation related to subprime lending. Underwriters have quickly learned that it cannot be assumed that subprime-related risk is restricted only to a narrow category of companies; so too they must face the challenge of identifying an evolving risk that is threatening to spread throughout much of the economy.
posted by Kevin LaCroix at 9:38 PM
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