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Publications
Subprime/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 and announcements regarding potential liability, litigation and regulatory actions arising from the subprime mortgage crisis and credit crunch.
This month’s issue focuses on the increasing number of civil lawsuits, criminal and regulatory investigations and actions, government efforts to ease the economic impact of the subprime crisis and credit crunch, and litigation and regulatory actions relating to the collapse of the auction rate securities market.
Litigation & Regulatory Investigations
FBI Targets IndyMac in Mortgage Fraud Inquiry
IndyMac is the latest bank to come under scrutiny by the FBI for possible mortgage fraud. The investigation reportedly began shortly before regulators seized IndyMac on July 11, 2008, in the third-largest bank failure in U.S. history. The FBI is investigating 21 other banks. Although officials would not provide further details on the IndyMac inquiry, the FBI is apparently focusing on accounting fraud, mortgage-backed securities and insider trading in its other investigations. (“IndyMac Is Included in FBI Fraud Inquiry,” The Wall Street Journal, July 17, 2008)
Lenders Face Increasing Lawsuits Over Construction Financing Decisions
Lender-liability lawsuits commenced by builders are predicted to rise in the coming months. Lenders are trying to curtail their real estate exposure and preserve needed capital. The restriction on construction financing comes as banks face pressure from both shareholders and regulators to reduce their real estate losses. This is leading to lawsuits by builders alleging that banks unfairly cut off their financing, stopped projects midstream and forced companies to the brink of bankruptcy. Builders will argue that their lenders did not act in good faith when they cut off construction financing. (“Builders Sue Banks That Pull Financing as Construction Projects Lie Unfinished,” The Wall Street Journal, July 23, 2008)
Canadian Securities Class Action Filed Against CIBC Related to Undisclosed Subprime Risk
A securities class action was recently filed in the Ontario Superior Court of Justice against Canadian Imperial Bank of Commerce (CIBC) and eight of its current and former executives arising out of the bank’s failed investments in U.S. residential mortgages. The lawsuit is brought on behalf of all investors who bought CIBC common stock and sustained losses as a result of material misrepresentations and omissions about the bank’s exposure to the U.S. subprime mortgage market. The plaintiffs assert that “CIBC continuously failed to disclose the true materially impaired value of its mark-to-market assessments” of subprime mortgages, “with the result that it overvalued its assets in the financial statements and failed to issue earnings warnings when they were warranted.” In addition, CIBC allegedly failed to conduct proper due diligence or implement adequate risk-management control with regard to investments in collateralized debt obligations and subprime mortgages. The lawsuit seeks maximum statutory damages of $1.75 billion, as well as either $10 billion for negligence or $10 billion under shareholder oppression laws. (“CIBC Hit by Suit Over Subprime Lending,” National Post, July 24, 2008)
Grand Jury Investigating Lenders
A federal grand jury in Los Angeles is investigating mortgage lenders Countrywide Financial Corp., New Century Financial and IndyMac Bancorp., Inc. in connection with each company’s lending practices. Federal prosecutors apparently seek to determine whether the mortgage lenders contributed to the mortgage crisis, which led to their collapse. On July 11, 2008, regulators seized IndyMac’s assets, and in April 2007, New Century sought Chapter 11 bankruptcy protection. Countrywide has already been sued by California, Illinois, and the city of San Diego in connection with its lending practices. (“Grand Jury Investigating 3 Mortgage Lenders,” USA Today, July 24, 2008)
Government & Regulatory Intervention
Federal Reserve Predicts Turbulent Economic Picture Through 2009
Federal Reserve Chairman Ben Bernanke believes the current problems in the U.S. housing and financial markets will continue well into 2009. To address the problem, Bernanke is considering extending low-interest lending programs to Wall Street’s largest investment banks into next year. One such program is set to expire in September but may continue if the Federal Reserve issues a finding that there are “unusual and exigent circumstances” to justify extending the program. Bernanke also recommended that Congress grant the Federal Reserve broad authority to monitor and supervise the financial markets to assure greater stability in the future. Officials at the Federal Reserve remain concerned that the housing market will not reach its bottom and the financial markets stabilize before some time next year. Bernanke recently stated that the “financial turmoil is ongoing, and our efforts today are concentrated on helping the financial system return to more normal functioning.” (“Fed Sees Turmoil Persisting Deep Into Next Year,” The New York Times, July 9, 2008)
IndyMac Seized by Federal Regulators
Federal regulators seized IndyMac Bank on July 11, 2008, marking one of the largest bank failures in American history. The Federal Deposit Insurance Corporation (FDIC), which guaranteed most of IndyMac’s deposits, took control of the bank and will operate a successor institution called IndyMac Federal Bank FSB. Government intervention came after a chaotic week in which IndyMac stopped issuing new loans and announced layoffs of more than half its 7,200 employees. On June 26, 2008, Sen. Charles Schumer, D-N.Y., sent a letter to federal regulators questioning the viability of the bank. Shortly after Schumer issued the letter, many IndyMac customers, afraid of losing their savings, withdrew their deposits and left the bank short on cash. The director of the Office of Thrift Supervision (OTS) cited Schumer’s comments as the immediate cause for Indymac’s demise. Schumer responded by stating that “IndyMac’s troubles, like Countrywide, were caused by practices that began and persisted over the last several years. If [the OTS] had done its job as a regulator and not let IndyMac’s poor and loose lending practices continue, we wouldn’t be where we are today.” (“IndyMac Seized by U.S. Regulators; Schumer Blamed for Failure,” Bloomberg.com, July 12, 2008; “Regulators Seize Mortgage Lender,” The New York Times, July 12, 2008)
Senate Approves Housing Bill Aimed at Boosting the Economy
President George W. Bush signed into law on July 30, 2008, legislation that includes a program intended to save hundreds of thousands of families from losing their homes to foreclosure. The 694-page housing bill is aimed at reassuring the credit markets and boosting the economy. It also provides the Treasury Department with broad authority to safeguard Fannie Mae and Freddie Mac by allowing the investment of billions in federal money to prop up the struggling companies. Further, the bill outlines a new regulatory structure for mortgage companies, including the creation of an independent regulator and federal agency with a director appointed by the president and confirmed by the Senate. Sen. Christopher Dodd, D-Conn., the chairman of the Banking Committee, stated before the vote: “We are in the midst of the most serious economic crisis to face our nation in many years. This bill is going to make a difference almost immediately.” Critics of the bill, however, warn that the government is taking on too much risk and creating a “moral hazard” that will only reward irresponsibility by corporations and individuals in the future. (“Senate Gives Final Approval to Sweeping Housing Bill,” The New York Times, July 25, 2008)
Federal Reserve Approves New Mortgage Lending Rules
The Federal Reserve unanimously approved on July 14, 2008, new mortgage lending rules “intended to protect consumers from unfair or deceptive acts and practices in mortgage lending, while keeping credit still available to qualified borrowers and supporting sustainable homeownership.” According to Federal Reserve Chairman Ben Bernanke, “[b]esides offering broader protection for consumers, a uniform set of rules will level the playing field for lenders and increase competition in the mortgage market, to the ultimate benefit of borrowers.” Although the new rules - which go into effect on October 1, 2009 - will not apply retroactively to help the millions of homeowners who already have fallen behind in their mortgages, they will tighten lending standards for future loans classified as “subprime.” The rules will apply to all mortgage lenders, not just those companies supervised and examined by the Federal Reserve. The National Association of Mortgage Brokers hails the rules as “just the right amount of regulation.” (“Fed’s War Against Shady Home Loans,” CNNMoney.com, July 14, 2008)
Federal Reserve and SEC Push for Tougher Bank Rules
At a Congressional House Financial Services Committee hearing held on July 24, 2008, SEC Chairman Christopher Cox and New York Federal Reserve Bank President Timothy F. Geithner urged Congress to give both agencies more power to oversee investment banks and modernize financial regulation. Both men agreed that the current “patchwork” of regulatory agencies - much of which dates back to the Depression era of the 1930s - are partially to blame for the current financial turmoil. It was argued that modern financial service companies offering a broad array of services and having both commercial and investment banking arms have left the regulatory lines blurred, and an overhaul of the current regulations must establish clear authority. Geithner told the committee that the Federal Reserve must have a direct supervisory role over any firms that borrow from the central bank. Cox urged Congress to give the SEC authority over investment banks because the agency is already responsible for the securities and financial markets in which they operate. (“Fed and SEC Push for Tougher Bank Rules,” Reuters, July 25, 2008)
Auction Rate Securities
Securities Class Action Filed Against Bank of America Over Auction Rate Securities
On July 17, 2008, investors in auction rate securities filed a securities class action in the U.S. District Court for the Southern District of Illinois against Bank of America Investment Services, Inc. and Bank of America Securities (BOA), alleging that they were deceived about their investment risk. Bank of America allegedly represented that auction rate securities were highly liquid, cash-management instruments and suitable alternatives to money market mutual funds. BOA and other major broker-dealers allegedly withdrew support for the auctions in February 2008, which resulted in the market failing and investors unable to access their money. The lawsuit generally alleges that BOA failed to disclose that auction rate securities were not cash alternatives and were only liquid at the time of sale. In addition, BOA allegedly failed to disclose that it and other broker-dealers routinely intervened in the auctions for their own benefit to set rates and prevent all-hold auctions and failed auctions and continued to market auction rate securities as liquid investments even after it decided to withdraw its support for the auctions. The plaintiffs also allege that BOA failed to disclose that auction rate securities are municipal or corporate debt securities that pay interest rates set through periodic auctions. (“Investors Sue Bank of America Over Auction Rate Securities,” Nashville Business Journal, July 18, 2008)
New York Attorney General Files Complaint Against UBS for Securities Fraud
New York Attorney General Andrew Cuomo filed a civil complaint against UBS on July 24, 2008, accusing the bank of consumer and securities fraud and alleging that it misled investors in auction rate securities. The complaint contrasts the public statements by UBS officials against what was known inside UBS about the auction rate securities market. According to the complaint, when UBS executives with personal holdings in auction rate securities learned that auctions were failing, “they removed their personal money and corporate money from the auctions and were still bringing consumers into the auctions.” As a result of the February 2008 auction rate securities market collapse, investors’ funds were frozen and cannot be accessed. Although UBS has offered to lend its customers up to 100 percent of the value of the securities until liquidity returns, Cuomo asked that the bank return the full value of the securities to investors in cash. UBS responded to the complaint by stating: “It is frustrating that the New York attorney general has filed this complaint while we have been engaged in good-faith negotiations with his office to bring liquidity to our clients holding auction rate securities.” Cuomo is expected to bring several more cases in the coming weeks related to auction rate securities. (“New York Sues UBS for Securities Fraud,” The New York Times, July 25, 2008)
UBS Denies Allegations of Auction Rate Fraud by Massachusetts Regulator
UBS responded to a lawsuit filed last month by Massachusetts Secretary of State William Galvin accusing the bank of fraud by asserting that it was “honest and ethical” in its marketing of action rate securities. UBS denied any wrongdoing in its marketing practices regarding these securities, and argued that “the statements at issue were not false or misleading at the time they were made.” The bank added that “[a]ny misrepresentations or omissions were made in good faith.” According to UBS, it had grounds to believe the auction rate bonds it sold “were suitable for clients,” and since the market for these securities collapsed, the bank has “taken substantial measures” to help investors trapped in the securities. The secretary of state, however, alleges that UBS executives increased pressure on financial advisors to sell securities they knew were not liquid investments and cites to numerous emails to support his allegations. (“UBS Denies Auction Rate Fraud, Says It Was ‘Honest and Ethical,’” Bloomberg.com, July 25, 2008)
Surprise Inspection of Wachovia Securities
Securities regulators from six states mounted a surprise inspection on July 17, 2008, at the St. Louis headquarters of Wachovia Securities as part of a probe into the company’s sales of auction rate debt. The regulators reportedly sought information about sales practices, internal evaluations of the auction rate securities market and marketing strategies. The inspection came after Wachovia failed to comply fully with information requests from Missouri securities regulators. During the past four months, more than 70 formal complaints regarding the illiquidity of auction rate securities have been filed with the Missouri Securities Division. In addition, hundreds of Missouri investors have lodged verbal complaints with state regulator. According to the Missouri secretary of state, these complaints are from investors who allege they were misled by representations that auction rate securities were equivalent to cash or a money market fund. Investors repeatedly “were told these investments were safe and easy to cash in, but now they cannot run their business, make medical payments or pay school tuition.” The secretary of state added that she aims to take actions “to make these investors whole.” (“Wachovia Securities Hit With Inspection in Probe,” The New York Times, July 17, 2008; “Auction Rate Probe Hits Wachovia,” The Wall Street Journal, July 17, 2008)
Criminal Investigation Into Auction Rate Securities Against Former Credit Suisse Brokers
Federal prosecutors are investigating whether two former Credit Suisse brokers lied to investors about the structure of auction rate securities. The U.S. Attorney’s Office in the Eastern District of New York launched its investigation after clients accused the brokers of lying about the nature of their investments in the auction rate securities market. In September 2007, the brokers resigned from Credit Suisse amid complaints that they told clients the auction rate securities were backed by student loans, when in fact they were tied to pools of bonds backed by subprime mortgages. A lawyer for one of the brokers stated that his client should not be blamed for an unforeseeable market failure, and that his client’s sophisticated investors understood the risks inherent in the auction rate securities market. It appears that one of the brokers fled the United States as federal prosecutors prepared to bring criminal charges against him. The investigation is the first known criminal matter stemming from the collapsed auction rate securities market. (“U.S. Probe Focuses on Ex-Credit Suisse Brokers,” The Financial Times, July 9, 2008; “U.S. Prosecutors Probe 2 Ex-Credit Suisse Brokers,” Reuters, July 9, 2008); (“Broker Goes Missing as Securities Charges Near,” The Wall Street Journal, July 31, 2008)
Massachusetts Sues Merrill Lynch Over Auction Rate Securities
The Massachusetts secretary of the commonwealth has sued Merrill Lynch & Co., alleging that it committed fraud by pushing the sale of auction rate securities, knowing that the auction market was unstable. The complaint alleges that Merrill continued to sell auction rate securities and represented that they were “good, conservative and reasonable investment(s),” despite knowing for months that the market for such securities was in trouble. The complaint further alleges that Merrill made $90 million from the auction market in 2006 and 2007, and seeks restitution and an order that Merrill “make good” on its sales of auction rate securities. (“Massachusetts Charges Merrill Over Auction Rate Securities,” The Wall Street Journal, July 31, 2008)
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