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Publications
Credit Crunch Digest
June 2009
The subprime lending crisis and ensuing credit crunch have resulted in significant losses and numerous lawsuits involving parties to the mortgage lending and securitization process. This digest collects and summarizes recent media reports and announcements regarding potential liability, government initiatives, litigation and regulatory actions arising from the subprime mortgage crisis and credit crunch, as well as the increasing number of reported cases of financial fraud.
This issue focuses on the developing civil litigation and regulatory and criminal actions relating to subprime and other high-risk mortgages and the collapse of the auction rate securities market, the growing number of reported Ponzi schemes and related litigation, and ongoing government efforts to ease the economic impact of the subprime crisis and credit crunch.
Litigation and Regulatory Investigations
Ponzi Schemes
Auction Rate Securities
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Citigroup Looks to Settle SEC Investigation; Concerns Arise About Source of Penalty Payments
An investigation by the U.S. Securities and Exchange Commission (SEC) that began in late 2007 into whether Citigroup misled investors by not properly disclosing the amount of troubled mortgage assets it held reportedly is now in the early stages of settlement negotiations. In November 2007, Citigroup announced that it held U.S. subprime-mortgage assets totaling $55 billion – including $43 billion that it had not disclosed in a release two weeks earlier. Commentators view the SEC’s recent settlement talks with Citigroup as a sign that the SEC may be looking to resolve several civil probes that began in 2007, when mortgage-related losses began mounting. In addition, the SEC apparently is considering actions against several individual top executives.
While settlement talks ramp up, there is new concern about troubled financial firms paying penalties with taxpayer money. Citigroup received $45 billion from the federal Troubled Asset Relief Program, and plans to raise an additional $5.5 billion in capital from private investors. SEC officials reportedly are concerned that any penalty paid by Citigroup would simply shift federal funds around. (“Citi, SEC Are in Talks to Settle Asset Probe,” Wall Street Journal, May 28, 2009)
Goldman Sachs Pays $60 Million in Subprime Mortgage Settlement with Massachusetts Attorney General
Goldman Sachs will pay out $50 million to subprime mortgage holders in Massachusetts and an additional $10 million to the state as part of a deal to end an investigation by the Massachusetts attorney general. While Goldman was not directly involved in loan originations, the company purchased and securitized loans originated by others. This settlement marks the first payment by a subprime mortgage securitizer to resolve a state investigation.
As part of the settlement, Goldman agreed to restructure approximately 714 loans held by the company. Borrowers with first mortgages could see their principal reduced by 25 percent to 35 percent, and those with second mortgages held by Goldman could see their loan principal reduced 50 percent or more. Delinquent borrowers will be required to make reasonable monthly payments while trying to sell or refinance their homes. If they cannot sell the homes within six months, Goldman must reduce the principal owed. (“Goldman Settles Subprime Inquiry,” Wall Street Journal, May 12, 2009)
Six Securities Brokers Charged With Fraud Over Sales of Collateralized Mortgage Obligations
On May 28, 2009, the Financial Industry Regulatory Authority (FINRA) announced fraud charges against six brokers formerly associated with Brookstreet Securities Corporation, a now-defunct nationwide brokerage firm based in Irvine, Calif. The brokers have been charged with fraud and making unsuitable recommendations to retail customers in connection with the sale of collateralized mortgage obligations (CMOs). FINRA alleges that from June 2004 through May 2007, the brokers sold CMOs to retail customers even though the brokers lacked a basic understanding of the complex and illiquid securities. The complaint also alleges that the brokers misrepresented or failed to disclose important information about the risks associated with an investment in CMOs. (“FINRA Charges Six Former Brookstreet Securities Brokers with Fraud in Connection with Retail Sales of Collateralized Mortgage Obligations; Many Customers Suffered Substantial Losses to Retirement Savings,” Business Wire, May 28, 2009)
Federal Judge Rejects Lawsuit Against Washington Mutual, Orders Revisions
On May 15, 2009, a federal judge in Washington state rejected a key portion of a class-action lawsuit alleging fraud brought by Washington Mutual (WaMu) investors against the failed bank’s officers. The lawsuit alleges that WaMu’s officers and directors misrepresented the company’s financial results, secretly undermined its risk-management policies, corrupted its appraisal process and abandoned appropriate underwriting standards for home loans.
The federal judge has ordered the plaintiffs to revise and resubmit their claims of securities fraud against the WaMu executives, finding that the complaint failed to adequately allege security fraud as to each defendant, and included numerous irrelevant allegations. The judge, however, allowed a claim against WaMu’s investment banks, accounting firm and outside board members relating to misrepresentation in securities offering documents to proceed. (“Class Action Lawsuit Against Washington Mutual Sent Back for Revisions,” Seattle Times, May 16, 2009)
BankAtlantic’s Motion to Dismiss Class Action Lawsuit Denied
A class action lawsuit against BankAtlantic Bancorp will proceed after a federal judge denied the bank’s motion to dismiss on May 11, 2009. The amended complaint, filed in January 2009 by lead plaintiff State-Boston Retirement System, accused BankAtlantic of ignoring its own lending guidelines in approving some land development loans and failing to disclose the high likelihood of losses on those loans to investors. The lawsuit targets BankAtlantic, its chair and CEO Alan Levan, and other top executives.
In the past year, Florida-based BankAtlantic has lost $245 million. BankAtlantic’s attorney described the lawsuit as frivolous and asserted that the bank’s losses were caused by the deteriorating Florida real estate market, rather than the bank’s lending practices. (“Judge Lets Class Action Suit Proceed Against BankAtlantic Bancorp,” South Florida Business Journal, May 22, 2009)
Beazer Mortgage Subsidiary Agrees to Pay $2.5 Million Settlement
Homebuilder Beazer Homes USA, Inc. announced on May 19, 2009 that its subsidiary, Beazer Mortgage Corporation, which ceased operations in February 2008, agreed to pay $2.5 million in restitution to certain borrowers under a settlement agreement with the North Carolina Office of the Commissioner of Banks. Under the agreement, Beazer Mortgage agreed to the entry of a consent order without admitting any wrongdoing in relation to its mortgage lending practices. The $2.5 million payout was included in the $13 million set aside by Beazer last quarter to satisfy any payments related to government investigations. (“Beazer Homes Announces Settlement with North Carolina Office of the Commissioner of Banks,” Business Wire, May 19, 2009)
Securities Fraud Class Action Against MoneyGram Allowed to Proceed
A federal judge ruled on May 20, 2009 that a securities fraud class action lawsuit may continue against MoneyGram International, even though the plaintiffs, members of the Oklahoma Teacher’s Retirement System, failed to assert a primary violation. The U.S. District Court judge ruled that although the complaint did not adequately allege violations against MoneyGram, there is sufficient cause to pursue allegations of irregularities in stocks and securities since a “reasonable investor may have been misled by the concealment of specific information” by MoneyGram. The plaintiffs allege that MoneyGram’s officers falsified financial statements in an effort to sell stock at an inflated price in the midst of the subprime mortgage meltdown in 2007 and 2008. (“Class Action Alleging Securities Fraud Will Proceed Against MoneyGram,” LawyersandSettlements.com, May 25, 2009)
SEC Charges Former Chief Executive of Countrywide with Fraud
The SEC has brought a civil suit alleging securities fraud and insider trading against Angelo Mozilo, the co-founder of Countrywide Financial Corporation. SEC officials allege that Mozilo misled investors about growing risks in Countrywide’s lending practices from 2005 to 2007 while simultaneously generating $140 million in profits by selling stock in the company. The SEC has also charged two other former top executives at Countrywide with fraud. The lawsuit says that Countrywide’s former president and former chief financial officer hid the high-risk nature of the company’s loans from investors.
The Department of Justice (DOJ) did not file criminal charges simultaneously with the SEC, as is often the case in these types of proceedings. The lack of criminal charges at this point does not mean that Mozilo and his former colleagues are in the clear. The DOJ may be waiting to see what type of evidence the SEC possesses before filing a criminal action. Mozilo also has been named in civil suits filed by attorneys general in four states alleging improper lending practices at Countrywide. (“S.E.C. Accuses Countrywide’s Ex-Chief of Fraud,” New York Times, June 4, 2009)
Ponzi Schemes
South African Ponzi Scheme Could Be Country’s Biggest Fraud Ever
Private investigators have uncovered one of South Africa’s largest Ponzi schemes, estimated to be worth up to 10 billion rand, or $1.24 billion. Hundreds of investors have lost money in the fraud allegedly spearheaded by Barry Tannenbaum, the South African son of one of the founders of the pharmaceutical firm Adcock Ingram. Reports indicate that suspicious investors recently hired Investigator Specialized Services Group (SSG) to look into Tannenbaum’s scheme. SSG said Tannenbaum offered annual returns of up to 200 percent, and persuaded investors to put their money into a pharmaceutical ingredient import business by faking purchase orders from Africa’s biggest generic drug maker, Aspen. The investigation into Tannenbaum began when investors demanded to be repaid and new funds could not be found. The Department of Trade and Industry, responsible for investigating pyramid schemes, said it was looking into the alleged fraud. (“S. Africa Fraud Worth Up to $1.2 Bln Uncovered,” Guardian (U.K.), June 10, 2009)
Law Firm Sued in Connection With Alleged Ponzi Scheme
The law firm Holland & Knight has been sued by several investors who allege that they have lost $4.5 million in a $360 million Ponzi scheme allegedly run by Florida fund manager Arthur Nadel. The investors allege that the firm helped Nadel prepare offering documents that omitted several key facts, including that Nadel had been disbarred for fraud. The plaintiffs assert claims against Holland & Knight for malpractice and negligent misrepresentation arising out of the firm’s alleged failure to perform due diligence on the private placement memoranda Nadel prepared to entice investors. Legal analysts predict that the plaintiffs will have a hard time making their case against the firm, especially if Holland & Knight only reviewed the documents and did not actively draft or discuss the omitted facts with Nadel. Nadel is currently being held on $5 million bond after pleading not guilty in April 2009 to a 15-count fraud charge. (“Our Ponzi Nation: Holland & Knight Sued Over Alleged Nadel Fraud,” Wall Street Journal Law Blog, May 19, 2009)
‘Rampant Ponzimonium’; Skittish Investors Increasingly Alert Investigators to Possible Ponzi Schemes
In a trend that officials are labeling “rampant Ponzimonium,” nervous investors are blowing the whistle on questionable investment plans and increasingly withdrawing their funds or declining to invest at all. The U.S. Commodity Futures Trading Commission (CFTC) has filed civil actions in connection with 22 alleged Ponzi schemes this fiscal year alone, which began October 1, 2008. That number is up from 13 during the last fiscal year, and from seven in all of 2007. Federal officials now say that they are gearing up for a flood of cases, and believe that there is a possibility of even more dangerous schemes popping up in the years to come. In this regard, the acting director of enforcement for the CFTC commented that “[t]hese schemes are collapsing under their own weight,” and “[w]hat we're really seeing is the curtain being pulled back on the Great Oz – and there ain't no Great Oz.” (“Authorities: Ponzi Scams Unraveling with the Economy,” Charlotte Observer, May 29, 2009)
Lawsuit Filed Against Adviser Over Madoff Investment
An investor filed a lawsuit on May 29, 2009 against Meridian Capital Partners Inc., a New York-based investment adviser, for the company’s alleged investment of $13 million of its funds with jailed conman Bernie Madoff. The lawsuit alleges that Meridian acted with “utter disregard” and failed to perform an appropriate level of due diligence when it invested the group’s money in one of Madoff’s feeder funds. Meridian asserts that the lawsuit is “completely without merit.” (“Meridian Capital Denies Claims in Suit Over Madoff Investment,” Bloomberg.com, June 1, 2009)
Hedge Funds May Pay to Show They Aren’t Frauds
In the wake of the Madoff Ponzi scheme, a new company is banking on hedge funds paying as much as $20,000 for a certificate stating that the funds are legitimate. Protean Fraud Risk Appraisal is launching a new service that will evaluate hedge fund managers against criteria based on 72 hedge fund frauds since 1997 during a four- to five-week investigation. A founding partner of the company says that he started the business after hearing from managers who “want a way to show they’re legitimate.” The review will include due diligence, site visits, background checks and checks of valuation techniques. The names of managers who pass will be published on Protean’s website but those who do not pass will not be disclosed. Despite the rarity of hedge fund fraud, investors have been especially jittery after Bernie Madoff’s confessed $65 billion fraud. (“Hedge Funds May Seek Fraud Certification After Madoff ‘Damage,’” Bloomberg.com, June 1, 2009)
Madoff Victims Seek New Loss Calculation, More Money
Lawyers for a group of Madoff’s victims filed a lawsuit on June 5, 2009 in federal bankruptcy court in New York asking a judge to reject the way the Madoff bankruptcy trustee calculated their losses. The lawsuit alleges that Madoff’s victims should be given credit for the full value of the securities shown on the last account statements they received before Madoff’s arrest in mid-December 2009, even though the statements were false and none of the trades were ever made. The account balances sought under this approach add up to more than $64 billion.
The court-appointed trustee currently overseeing the claims process for the Securities Investor Protection Corporation (SIPC) has tallied the losses to result in a significantly lower payout. The trustee is calculating investor losses as the difference between the total amount the customer paid and the total amount withdrawn before the Ponzi scheme collapse. Although customers who qualify under this calculation are eligible for an immediate $500,000 payout from SIPC, thousands of long-term investors do not qualify because they withdrew considerably more over time than they originally entrusted to Madoff.
The outcome of the dispute will be important for SIPC and the brokerage firms that pay into its compensation fund. So far, more than 8,800 claims have been filed and most investors with valid claims have qualified for the full $500,000 payment. If claims continue to follow this pattern, SIPC could owe Madoff victims close to $4.4 billion, a total that taxpayers would have to cover if SIPC could not. The deadline for filing SIPC claims is July 2, 2009. (“Victims of Madoff Seek Claims Overhaul,” New York Times, June 7, 2009)
Auction Rate Securities
SEC Settles with Bank of America, RBC Capital Markets and Deutsche Bank Regarding Their ARS Practices
On June 3, 2009, the SEC announced that it has finalized agreements with Bank of America Corp. (BofA), Deutsche Bank AG and RBC Capital Markets in connection with allegations that the firms misled investors about risks associated with ARS. The firms have agreed to pay nearly $6.7 billion to about 9,600 customers who invested in ARS before the February 2008 collapse of the ARS market. The firms have not admitted or denied the charges, but have agreed to be permanently enjoined from violations of broker-dealer fraud provisions. In addition, the firms agreed to offer to purchase ARS at par from individuals, charities, and small or medium businesses that purchased those ARS from the firms. They also agreed to use their best efforts to provide liquidity solutions for institutional and other customers and will pay eligible customers who sold their ARS below par the difference between par and the sale price of the ARS. Once approved by the court, the settlements will reportedly restore approximately $4.5 billion in liquidity to BofA customers, $800 million in liquidity to RBC customers, and $1.3 billion in liquidity to Deutsche Bank customers. (“SEC Finalizes Settlements With BAC, RBC Capital Markets and Deutsche Bank,” ForexTV.com, June 3, 2009)
Government and Regulatory Intervention
Banking Stress Test Results Show Great Divide Between Strong Banks and Weak Banks; 10 U.S. Banks Ordered to Raise $75 Billion in Capital
After the government’s stress tests revealed big gaps between the industry’s strongest and weakest players, the Federal Reserve has instructed several of the largest U.S. banks to raise more capital. Wells Fargo & Co., Morgan Stanley, GMAC, State Street Corp., Bank of America Corp., Citigroup Inc. and Regions Financial Corp. are among the banks with the largest capital deficiencies. Bank of America must raise $34 billion, Wells Fargo needs $15 billion, and GMAC faces a $11.5 billion shortfall. Several other banks, including Regions Financial Corp., Fifth Third Bancorp, KeyCorp, PNC Financial Services Group Inc. and SunTrust Banks are being told to bolster their reserves. Healthy banks include American Express Co., Bank of New York Mellon Corp., Capital One Financial Corp., Goldman Sachs Group Inc., MetLife and J.P. Morgan Chase & Co.
The nation’s 19 largest banks were subjected to exhaustive stress tests over several weeks. Banks that are deemed to need more capital have few options, including conversions of their preferred shares into common stock. Such conversions hurt existing shareholders, but boost the banks’ common equity levels, which measure the value left for investors if a company is liquidated. The Treasury Department is painting a grim economic picture, saying that the total losses at these banks could reach $950 billion. (“Banks Need at Least $65 Billion in Capital,” Wall Street Journal, May 7, 2009)
Banks, Once Millions in the Hole, Now Finding It ‘Easy’ to Raise Capital
Just one month after the government announced the results of its bank stress tests, U.S. banks have raised considerably more capital than regulators had required. As of June 2, 2009, J.P. Morgan Chase & Co., Morgan Stanley, American Express Co. and regional bank KeyCorp had sold a combined $8.7 billion in common stock, raising the total value of shares sold by the 19 stress-tested financial firms to at least $65 billion. Non-guaranteed debt sales and the conversion of preferred shares to common stock have generated an additional $20 billion.
Bank executives say money is “pouring in,” even though just three months before, investors declined to purchase financial stocks that were 40 percent cheaper. Executives attribute the renewed interest in investments in financial institutions to optimism about the economy and what many investors perceive are bargain prices for their stock. Analysts at Moody’s Investors Service warn, however, that U.S. banks still face about $470 billion in losses through next year and, if the economy continues to suffer, those losses could swell to $640 billion. (“Banks’ Telethon Is Nearly Over,” Wall Street Journal, June 3, 2009)
Plans Emerge for Single Regulator of the Banking Sector
U.S. Treasury Secretary Timothy Geithner and White House officials are planning to present a formal recommendation to Congress in mid-June 2009 that could create a single regulator to oversee the entire banking sector. The new agency is expected to be the central focus of a plan that will overhaul the current supervision of financial markets, and mark a major departure from the “hodgepodge” of federal agencies that failed to control the financial crisis last year. While state banks will still be overseen by state regulators, the new federal regulator would serve as a “secondary set of eyes” for more than 5,000 state regulated banks, and would be the primary regulator for nationally chartered banks and thrifts. The new system is expected to streamline supervision of banks and make it harder for banks to “game the system” by shopping for the “lightest form of oversight.”
Officials are also considering creating an agency to police financial products offered to consumers, as well as a regulator that would provide increased investor protection. President Obama is committed to signing a regulatory reform package by the end of the year, and the Treasury Department will submit its plan to Congress in mid-June 2009. Sen. Christopher Dodd, D-Conn., who is also chair of the Senate Banking Committee, has said, however, that he is reluctant to give federal regulators sweeping new powers to oversee risks to the economy. (“Single-Regulator Plan for Banks Now Close,” Wall Street Journal, May 28, 2009)
Biggest Bank Failure of the Year at BankUnited
On May 21, 2009, federal regulators seized Florida’s BankUnited FSB, marking the biggest bank failure this year and the second costliest bank failure of the financial crisis, second only to the failure of IndyMac Bank last July. BankUnited had $12.8 billion in assets and $8.6 billion in deposits, and regulators said it was critically undercapitalized. The Federal Deposit Insurance Corp. (FDIC) estimates that the failure will cost its already weakened insurance fund $4.9 billion.
The FDIC sold BankUnited’s banking operations to a private equity team, and the bank’s 85 branches resumed operations on May 22, 2009 under the same name. The new owners agreed to pour $900 million in new capital into the bank and to acquire $12.7 billion of the bank’s assets and $8.3 billion of certain deposits that are considered less risky. The FDIC has also agreed to absorb most future losses on a $10.7 billion pool of assets that the investment team will manage. (“BankUnited Fails in Year’s Biggest Bust,” Wall Street Journal, May 22, 2009)
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