Credit Crunch Digest
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 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 recent significant developments in new lawsuits filed against major banks allegedly involved in the Credit Crisis; additional inquiries into Goldman Sachs by the Manhattan District Attorney’s Office; potential settlements with Fannie Mae and Freddie Mac; updates on recovery efforts and distribution in the Madoff Ponzi scheme; the New York Mets’ financial troubles; procedural status of the Stanford litigation; and the status of financial regulatory reform implementation in response to the subprime crisis and credit crunch.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Government and Regulatory Intervention
Litigation and Regulatory Investigations
FHA files multiple lawsuits against major Banks over role in Credit Crisis
The U.S. Federal Housing Finance Agency (“FHA”) filed 17 lawsuits on September 2, 2011, against 17 major U.S. and foreign banks regarding alleged false statements concerning the quality of approximately $182 billion in residential mortgage backed securities acquired during the expansion, and ultimate bursting, of the residential housing market bubble. The FHA, a federal agency vested with oversight of Fannie Mae and Freddie Mac, filed lawsuits in New York and Connecticut alleging misrepresentations in connection with the underlying characteristics of the mortgage loans. According to a related FHA statement, the agency determined that “the loans had different and more risky characteristics than the descriptions contained in the marketing and sales materials provided to the Enterprises for those securities."
The banks named in the lawsuits (and the FHA’s claimed losses) include: Bank of America Corp. (approximately $57 billion in claims); Goldman Sachs & Co. ($11.1 billion); JPMorgan Chase & Co. ($33 billion); Citigroup Inc. ($3.5 billion); Ally Financial Inc. ($6 billion); Barclays Bank PLC ($4.9 billion); Credit Suisse Holdings (USA) Inc. ($14.1 billion); Deutsche Bank AG ($14.2 billion); First Horizon National Corp. ($884 million); General Electric Co. ($549 million); HSBC North America Holdings Inc. ($6.2 billion); Morgan Stanley ($10.58 billion); Nomura Holding America Inc. ($2 billion); the Royal Bank of Scotland Group PLC ($30.4 billion) and Societe Generale ($1.3 billion).
The FHA alleges that the defendants failed to perform adequate due diligence on the underlying mortgages comprising the bundled securities, and failed to recognize that applicants’ incomes were either inflated or falsified. The FHA seeks damages and civil penalties. (“US Sues Banking Giants Over $200B In Failed MBS,” Law360, September 2, 2011.)
Manhattan District Attorney Continues Goldman Sachs Probe with Additional Subpoenas
The Manhattan District Attorney’s Office has continued its inquiry into Goldman Sachs’ marketing of mortgaged-linked securities by reportedly issuing additional subpoenas to investors in those packaged securities, including hedge funds and other major financial institutions that participated in the deals. The Manhattan District Attorney reportedly began its inquiry into Goldman Sachs following an April 2011 report issued by the U.S. Senate Permanent Subcommittee on Investigations, which accused Goldman Sachs of improper behavior relating to the financial crisis. Last year, Goldman Sachs agreed to pay $550 million to settle the Securities and Exchange Commission’s (SEC) allegations that it misled investors on a collateralize debt obligation known as Abacus.
The recent subpoenas, which were received over the last few weeks, were reportedly delivered to several investors, including Morgan Stanley. According to the Senate Report, Morgan Stanley lost approximately $960 million in one of the deals brokered by Goldman Sachs.
Recently, Goldman senior executives, including its CEO, have reportedly retained outside counsel to advise them following the referral of the Senate Report to the Department of Justice earlier this year. (“Probe into Goldman Widens,” Wall Street Journal, September 7, 2011.)
SEC on Verge of Settlement with Mortgage Giants Fannie Mae and Freddie Mac
Following a three-year investigation by the SEC, sources indicate that a settlement with Fannie Mae and Freddie Mac is nearing completion. At issue in the investigation is whether the mortgage companies properly disclosed their exposure to subprime loans. Under the terms of the proposed agreement, the settlement would not include any monetary penalty or admission of fraud, but would apparently represent a significant acknowledgement by the mortgage players of the role they served in the housing bubble and collapse.
The SEC has asserted that the companies underestimated the number of the subprime high-risk mortgages on their balance sheets. The SEC acknowledged that its allegations revolve around the meaning of “subprime,” which has been difficult to definitively define. Specifically, it is unclear whether such a designation belongs to a borrower with low credit scores or whether the term refers to the category of loans based on the lender instead of the loan.
The proposed settlement comes just days after the FHA filed its own lawsuits against a number of major banks. The FHA was charged with oversight of Fannie Mae and Freddie Mac during the financial crisis. According to the article, the SEC’s proposed settlement with Fannie Mae and Freddie Mac could complicate the FHA’s lawsuits against the major banks should Fannie Mae and Freddie Mac accept blame for their role in the mortgage crisis.
Negotiations have been ongoing since early summer 2011, and the SEC has dropped its requests for fines against the entities as a result of their unstable financial condition and the government’s control of those entities since 2008. A previous criminal inquiry into former senior executives at the companies has been concluded with no charges being filed. The Obama administration previously announced earlier this year that it would wind down the operations of Fannie Mae and Freddie Mac. (“Settlement Said to Be Near for Fannie and Freddie” New York Times Deal Book, September 8, 2011)
Fraud and Ponzi Schemes
Madoff Trustee Prepares for First Round of Payouts to Former Investors
Madoff Trustee, Irving Picard, recently disclosed that his firm is planning to distribute $272 million to former Madoff investors by the end of the third quarter of this year. Picard has recovered $8.6 billion and has filed over 1,000 lawsuits in an effort to recover an estimated $17.3 billion on behalf of former Madoff investors. In May, Picard placed $2.6 billion in a fund for victims of Madoff’s Ponzi scheme. Picard stated that the average check will amount to $222,551. In contrast, Picard and his law firm, Baker & Hostetler LLP have earned approximately $179 million in legal costs arising out of their efforts to recover funds for investors. (“Madoff Trustee Sets $272 Million Payout, Sept. 15 Record Date,” Bloomberg, September 9, 2011).
Mets’ Financial Woes
Mets owners, Fred Wilpon and Saul Katz, are facing severe economic difficulties this season with roughly $60 to $70 million in losses, low season ticket sales and a likelihood of having to pay $300 million to settle the lawsuit brought by Irving Picard on behalf of former Madoff investors. Picard’s lawsuit styled, Picard v. Katz, et al., pending in the U.S. District Court for the Southern District of New York, seeks $1 billion from Wilpon and Katz and alleges that they knew or should have known about Madoff’s Ponzi scheme. Of this amount, $300 million represents alleged fictitious profits and $700 million represents alleged principal. The lawsuit is currently being mediated by former New York Governor, Mario Cuomo.
Exacerbating their purported financial woes, is the recent collapse of the sale of a $200 million stake in the Mets to hedge fund capitalist, David Einhorn. According to insiders, the Mets may have to request more money from Major League Baseball Commissioner, Bud Selig, in order to meet revenue payment obligations. (“Mets May Need Bailout From Baseball After Einhorn Deal Collapses,” Forbes, September 1, 2011).
Stanford Receiver Seeks Judicial Determination of Ponzi Scheme
The court-appointed Receiver for Stanford Financial Group, Ralph Janvey, has recently filed a motion with the U.S. District Court for the Northern District of Texas, Dallas Division, for summary judgment holding that the Stanford companies were in fact running a Ponzi scheme. Eight investor defendants, against whom Janvey seeks a return of proceeds received from investments into Stanford certificates of deposit, have filed a response. The defendants’ response argues that Janvey has erroneously asked the court to make this determination prior to conducting any criminal or civil trials and bases his claim on a forensic accountant’s assessment that the Stanford companies were “insolvent.” Defendants argue that the forensic accountant did “not review any balance sheets for the Stanford companies nor interview any employees relating to the period of 1986-1999,” and “as a result, there is a fact issue as to when (if ever) the Ponzi scheme began.” Defendants contend that timing is important because “there is no basis for returning interest if a Ponzi scheme arose after the funds were paid.” (“Houston investors dispute Stanford Ponzi scheme claims,” Houston Business Journal, September 12, 2011).
Government and Regulatory Intervention
New Financial Reform Rules Require Banks To Submit “Living Wills” to Government
On September 13, 2011, the Federal Deposit Insurance Corporation (“FDIC”) voted 3-0 to initiate rules that will require banks with $50 billion or more in assets to submit “living wills” to the agency. The new rules were mandated under last year’s financial reform legislation. The large banks will be required to submit detailed plans to regulators, outlining information concerning: (a) the bank’s business operations; (b) structure, assets and liabilities; (c) capital cushion held against risk; and (d) how much money is owed to other large financial institutions. The biggest banks will be required to file this information next July, while smaller banks are not required to file until 2013. Regulators would hold the power to seize and dismantle these financial institutions should they pose a systemic threat to the financial system. In addition, should regulators take issue with the information submitted by these banks, the regulators may purportedly be allowed to order the banks to make changes to their operations. (“Big U.S. Banks Must Show How They’d Break Up,” CBS News, September 13, 2011).
Congress Debates Future of Government Role in Housing Finance
In 2008, as mortgage losses continued to mount, the U.S. Government seized control of Fannie Mae and Freddie Mac. Both institutions provide financing to banks and lenders by purchasing mortgages and either keeping them on their books or selling packaged loans to investors. Since being placed under government control, $170 billion in taxpayer money has been expanded to support both entities. On September 13, 2011, the Senate debated the future of both Freddie and Fannie.
According to reports, both Democrats and Republicans seemed to agree that the entities need to wind down, however the future of the government’s role in housing finance is still undecided. Some Republicans are calling for an end to any government role in the mortgage market, pointing to the costly histories of Fannie and Freddie. Nonetheless, an all-out retreat from the housing finance arena is a point of contention: “I am concerned about the unintended consequences for our housing market and economy that could result if a government role is eliminated completely,” said South Dakota Democrat, and Senate Banking Committee Chairman Tim Johnson. It is reported that the government now backs nine out of 10 new mortgages. Any reforms that are eventually made are expected to take multiple years before being completed. (“U.S. Lawmakers Debate Housing Finance Reform,” Reuters, September 13, 2011).