Wednesday, December 19, 2007

Subprime: The Truth-Telling (and the Lawsuits) Yet to Come

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The various central banks' efforts to improve short-term liquidity in the global financial system have dominated the headlines the business pages in recent days, most recently with respect to the news that the European Central Bank has injected an astonishing $501.7 billion of lending capacity into the banking system, an amount that the Wall Street Journal called "the largest sum the central bank has ever lent in a single shot."

These measures reportedly are calculated to overcome banks’ reluctance to provide each other with short-term loans. What has received less attention is why the banks are reluctant to lend to each other. Closer scrutiny suggests that the banks are wary because they know that many other banks have not yet come clean about the existence of undisclosed losses relating to subprime mortgage problems in the U.S. As one commentator stated in a December 19, 2007 Wall Street Journal article (here),
"Given the degree of uncertainty [and] continuing concerns about where the next losses are and what the next shoe to drop will be, that certainly drives the cautious behavior….It’s a question of grater clarity." That might not come until next spring, when auditors comb through banks’ financial statements in advance of their annual reports. That process "could prove better disclosure and greater clarity to the market. But it might not."
The view that the root cause of the banks’ unwillingness to provide each other short-term credit is based on a perception of undisclosed losses was echoed by the Bank of England governor Mervyn King. In a December 19, 2007 Wall Street Journal article entitled "Bank Losses Still Unclear" (here), King is quoted as saying "We need patience now to get through the period where banks have to disclose the losses they’ve made."

There are several thoughts implicit in these comments. The first is that the banks do in fact have extensive as-yet undisclosed losses. (The banks’ refusal to lend to each other eloquently testifies to the existence of this generalized perception within the banking industry.) The second is that there are banks that will not be disclosing these losses until the banks are compelled to do so by a combination of their reporting obligations and their auditors’ insistence. The overall implication is that these companies have a appointment with truth-telling, scheduled according to their next reporting obligation, presumably to take place sometime in early 2008.

All of this suggests that we should expect a series of bank announcements of losses or significant asset write-downs during the first weeks, perhaps months, of 2008. But the mortgage-backed assets at the center of these losses and write-downs are not held only at banking institutions. Hedge funds, pension funds, insurance companies, mutual funds, REITs and other companies carry these assets as well, and as I have pointed out before (most recently here), this exposure is not limited solely to companies in the financial services sector. There may be a wide variety of companies that have an appointment with truth-telling early in 2008.

Reporting obligations may compel eventual disclosure, but the longer the day of reckoning is delayed, the greater may be the ire of disappointed investors. As I have detailed in my running tally of the subprime-related lawsuits (here), many of the subprime related securities lawsuits have followed dramatic announcements of losses or asset-write downs. With more announcements ahead, further lawsuits seem probable. My depressing assessment is that the worst is yet to come, a conclusion reinforced by the analysis in the following section, below.

Along those lines, it is worth noting that, in connection with the latest big bank write-down announcement – Morgan Stanley’s $9.4 million fourth quarter write-down – that Morgan Stanley employees have already filed a purported class action lawsuit (refer here) on behalf of Morgan Stanley employees in connection with their holdings of company stock in their 401(k) plans.

Why The Losses Will Take Time to Tally: While it is easy to bemoan the truth-telling delay, the reality is that it is going to take time for many of the losses to work their way through the system. These problems are fully illustrated in the December 17, 2007 Wall Street Journal article entitled "CDO Battles: Royal Pain Over Who Gets What" (here), which details the dispute that has arisen as a result of an "event of default" on a single $985 million collateralized debt obligation (CDO) called Sagittarius CDO I Ltd.

Deutsche Bank, the Sagittarius CDO trustee, has filed an interpleader action (view complaint here) to determine whether the CDO’s investors (led in this case by UBS) or the CDO’s credit insurer (a unit of MBIA that entered into a credit default swap) have the right to the remaining payments under the CDO. As the interpleader complaint states, "different Defendants now claim different rights in how the limited fund of Interest Proceeds and Principal Proceeds should be applied." The interpleader complaint names as defendants "Does 1 though 100, the owners of the beneficial interests" – that is the investors who bought the interests in the CDOs. The MBIA unit claims it has senior rights as a result of provisions in the credit default swap agreement, a position that unnamed investors have, according to the complaint, characterized as "neither reasonable nor correct." The interpleader action seeks to sort out the competing interests.

There are several interesting things about this dispute. The first is that it shows that as the mortgage-backed investments deteriorate, there are going to be disputes over who gets stuck with the losses or at least who gets which proportion of the losses. The second is that the Sagittarius "event of default" is not an isolated occurrence; according to the Journal article, "about 40 consumer-debt backed CDOs have declared an event of default; their face value is near $45 billion – about 7% of the $640 billion in the CDOs outstanding rated by Moody’s." Indeed, three CDOs have started liquidation, and JP Morgan projects that by the second quarter, "$40 billion to $50 billion in subprime-mortgage bonds could be sold by distressed CDOs that decide to liquidate."

The final thing to note about this dispute is who is identified as facing the losses. According to the Journal article, the UBS investors in the Sagittarius CDO are two UBS mutual funds – the UBS Absolute Return Bond Fund and the UBS Global Bond Fund – which bought $1.2 million of the CDO this year. As I noted above, the deteriorating market for asset-backed securities could impact a wide variety of investors, funds and companies. It may take a while for the losses to sort themselves out, but eventually the losses will hit home.

The investors who get hit with these losses are unlikely to take these losses quietly. In addition, many CDO investors (such as hedge funds, pension funds, and mutual funds) in turn have investors of their own that will upset about the fund losses. I have previously noted (here) that there has already been one securities class action lawsuit brought involving subprime-related losses in a mutual bond fund.
The lawsuits against these investment funds may well come from a variety of directions, as illustrated by the action that Barclays filed on December 19, 2007 against the Bear Stearns companies in connection with the subprime-related collapse of two Bear Stearns hedge funds. Barclays was not an investor in the collapsed funds, at least not in the conventional sense; it was rather in the position of lender, supplying borrowed capital, Barclays claims, based on misrepresentation, as part of a complex hedged counterparty relationship. The complaint alleges that Bear Stearns misled Barclays about the nature of the funds' investments as well as about the condition of the funds as they deteriorated. A December 19, 2007 Wall Street Journal article describing the Barclays suit can be found here. A copy of the Barclays complaint can be found here.
Lawsuits are also likely to follow against the entities that sold the CDO investments in the first place. For example, the Financial Times reports in a December 17, 2007 article entitled "Lehman Faces Australian Lawsuit Threat Over High-Risk Debt Deals" (here), Lehman Brothers faces the threat of legal action by three Australian municipal councils over the sale of CDOs by Lehman’s local subsidiary. The CDOs in which the municipal councils invested are in some cases now marked down to as low as 16 cents on the dollar.

All of which, I think, underscores the point that the losses and lawsuits yet to come will be widespread. The title of this December 19, 2007 Financial Week article (here) says it all: "Lawsuits Linked to Subprime Damage Expected Next Year." As the article notes, "the other litigation shoe to drop in the CDO implosion will involve legal claims against banks and hedge funds by institutional investors, including other hedge funds and pension funds."

Hat tip to the Law Blog (here) for the link to the Deutsche Bank interpleader complaint.

Subprime Litigation Wave Hits Huntington Bancshares: According to a December 19, 2007 press release (here), shareholders have initiated a subprime-related securities class action lawsuit against Huntington Bancshares Incorporated in the United States District Court for the Southern District of Ohio. A copy of the complaint can be found here.

According to the press release, the complaint alleges that
Huntington had acquired more than $1.5 billion in exposure to subprime mortgages with its July 2007 acquisition of Sky Financial Group, Inc. ("Sky Financial"). As the real estate and credit markets continued to soften, defendants repeatedly assured Huntington investors that the Company had undertaken significant preparations and implemented defensive measures to weather the deteriorating real estate and credit markets. By the time Huntington closed the merger with Sky Financial, the housing and credit crisis had deepened, yet defendants continued to conceal Huntington’s growing exposure to these problems so as to not acknowledge the acquisition was a debacle so soon after it closed. As a result of defendants’ false statements, Huntington stock traded at an artificially inflated price of approximately $18 per share during much of the Class Period.

Then, on November 16, 2007, Huntington announced its fourth quarter 2007 financial results, stating that as a result of the recently announced actions of Franklin Credit Management Corporation, which had a commercial lending relationship with Sky Financial, and related deterioration in Franklin’s mortgage portfolios, 2007 fourth quarter results for Huntington were expected to include an after-tax charge of up to $300 million, or $0.81 per common share. As a result of this charge, Huntington would report a 2007 fourth quarter net loss.

On this news, Huntington’s stock dropped from $16.08 per share to as low as $14.38 per share, closing at $14.75 per share on November 16, 2007 on volume of over 10 million shares.
I have added the Huntington Bancshares lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. The addition of the Huntington case brings the number of subprime-related lawsuits to 27, not counting the five subprime related securities lawsuits that have been brought against home builders, and the two that have been brought against the credit rating agencies. Adding these categories together brings the total number of subprime-related securities lawsuits to 34. The addition of the list of Morgan Stanley 401(k) lawsuit cited above brings the total number of subprime-related ERISA/401(k) lawsuits to 6.


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