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Publications
Subprime/Credit Crunch Digest
January 2009
The subprime lending crisis and ensuing credit crunch have resulted in significant losses and numerous lawsuits and regulatory investigations 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 issue focuses continuing government efforts to ease the economic impact of the subprime crisis and credit crunch, including oversight of the remaining bailout funds and the potential need for additional government rescue measures, and recent developments in related litigation.
Litigation and Regulatory Investigations
Merrill Lynch Agrees to Pay $550 Million to Settle Subprime Lawsuits
On January 16, 2009, Merrill Lynch and Co., which was acquired by Bank of America Corp. on January 1, 2009, disclosed in a document filed with the Securities and Exchange Commission that it has agreed to pay $550 million to settle certain subprime-related claims brought by plaintiffs in an ERISA lawsuit and related securities class action pending in New York federal court. The plaintiffs generally alleged that Merrill misled investors regarding the value of collateralized debt obligations and other mortgage-backed assets on its balance sheet from September 2006 to December 2008. Under the settlement, Merrill agreed to pay $475 million in cash to resolve the securities claims. Additionally, Merrill agreed to pay $75 million in cash to company employees who held stock in retirement plans to settle the ERISA claims. The settlement does not resolve the related derivative and bondholder claims, which remain pending. (“Merrill to Pay $550 Million in Subprime Settlements (Update 2),” Bloomberg.com, January 16, 2009)
Court Denies Motions to Dismiss Countrywide Securities Action
A California federal court judge issued an order on December 1, 2008 that substantially denied the defendants’ motions to dismiss the In re Countrywide Financial Corporation Securities Litigation. In July 2008, the plaintiffs filed a consolidated amended class action complaint, which generally alleged that changes in Countrywide’s core mortgage-related business operations during the class period (2003 through 2007) negatively affected the value of its securities and that Countrywide made misrepresentations and omissions regarding its operations and the value of its mortgage-related assets during that period. In addition to Countrywide, the complaint names the underwriters of its securities offerings and the company’s auditors as defendants. In denying the motions to dismiss, the judge concluded that the allegations set forth an “extraordinary case where a company’s essential operations were so at odds with the company’s public statements that many statements that would not be actionable in the vast majority of cases are rendered cognizable to the securities laws.” (“Countrywide Securities Class Action – An ‘Extraordinary Case,’” Mortgage Meltdown, December 3, 2008; “Countrywide Securities Suit Dismissal Motions Substantially Denied,” D&O Diary, December 3, 2008)
Summary Judgment Granted to Former Bear Stearns’ Directors in Lawsuit Over JPMorgan Buyout
On December 4, 2008, a New York state court judge granted summary judgment to former Bear Stearns’ directors and JPMorgan Chase in a lawsuit challenging JP Morgan’s acquisition of Bear Stearns in March 2008. The judge found that the directors had not breached their fiduciary duty to shareholders by approving the federally assisted stock-for-stock merger with JPMorgan, whereby JPMorgan acquired Bear Stearns for $10 per share. At the time that Bear Stearns’ board of directors approved the merger agreement, the company faced imminent bankruptcy.
Bear Stearns shareholders filed a class action complaint alleging $10 per share was inadequate. The judge found, however, that the business judgment rule applied to the directors’ approval of the merger and that they were “attempting to preserve a modicum of stock value as opposed to entering the uncertain world of bankruptcy.” (“New York State Supreme Court Rules Bear Stearns Directors Did Not,” Daily Record, December 10, 2008; “NY Judge Tosses Lawsuits Over Bear Stearns Buyout,” International Business Times, December 5, 2008)
Securities Class Action Against BankAtlantic Dismissed
A Florida federal court on December 11, 2008 dismissed a securities class action filed against BankAtlantic Bankcorp alleging the bank and its executives intentionally misled investors regarding commercial real estate and land development loans. Plaintiffs alleged that seven confidential witnesses formerly employed by BankAtlantic had information, including internal reports detailing problems with commercial real estate loans, which would demonstrate BankAtlantic intentionally misled investors. The judge found, however, that the complaint did not adequately allege facts to explain how the confidential witnesses knew of the bank’s alleged internal documents and meetings.
In an opinion issued on January 5, 2009, denying an emergency motion by plaintiffs to hold a hearing regarding the filing of an amended complaint, the judge further stated that a court “must be able to tell whether a confidential witness is speaking from personal knowledge or merely regurgitating gossip and innuendo.” Plaintiffs have argued that the confidential witnesses do not want to reveal their identities because they are afraid of retaliation from BankAtlantic. The judge emphasized, however, that she did not dismiss the complaint because the witnesses were confidential but because the complaint alleged no facts “for the court to discern the basis of the sources’ purported knowledge.” Attorneys for the lead plaintiff stated that their client would file an amended complaint by January 12, 2009. (“Judge Dismisses Class Action Against BankAtlantic,” Triangle Business Journal, January 7, 2009)
Securities Class Action Filed Against Farmer Mac Arising Out of Its Exposure to Fannie Mae and Lehman
On December 5, 2008, a shareholder of Federal Agricultural Mortgage Corporation, commonly known as “Farmer Mac,” filed a purported securities class action in the U.S. District Court for the District of Columbia. Farmer Mac, like Fannie Mae and Freddie Mac, is a government sponsored entity. Farmer Mac was established to support a secondary market for agricultural real estate and rural housing mortgage loans. Farmer Mac held both Fannie Mae and Lehman Brothers securities, and was exposed to the crises faced by those companies during the class period.
The complaint alleges that Farmer Mac and certain of its officers and directors violated federal securities laws by making materially false and misleading statements regarding its business and operations between March 15, 2007 and September 12, 2008. The complaint specifically alleges that Farmer Mac misrepresented financial results and its hedging activities. It is alleged that the misstatements became apparent in documents filed with the Securities and Exchange Commission on September 12, 2008, which revealed that Farmer Mac expected to “incur significant charges due to its exposure to Fannie Mae securities.” Following that disclosure, Farmer Mac common shares lost 30 percent of their value, falling from $23.78 per share to $16.56 per share. (“Class Action Lawsuit on Behalf of Federal Agricultural Mortgage Corp.,” ShareholdersFoundation.com, December 11, 2008)
Securities Class Action Filed by Purchasers of WaMu Mortgage Pass-Through Certificates
On January 14, 2009, a purported securities class action was filed in a Washington federal court on behalf of all purchasers of Washington Mutual mortgage pass-through certificates traceable to a December 30, 2005 registration statement against Washington Mutual Bank, WaMu Asset Acceptance Corporation, certain officers and directors and numerous issuing trusts. The complaint generally alleges that the defendants made materially false and misleading statements and omissions regarding the collateral underlying the mortgage pass-through certificates in connection to their issuance in violation of federal securities laws. (“Schoengold Sporn Laitman and Lometti, P.C. Announces Class Action Lawsuit Against WaMu Mortgage Pass-Through Certificates Series 2006-AR1 Trust and Others,” Market Wire, January 14, 2009)
Government and Regulatory Intervention
Obama Advisor Outlines Plan For Remaining Bailout Funds
On January 12, 2009, President Barack Obama’s top economic advisor issued a letter to top congressional leaders requesting authority to release the remaining bailout funds and outlining a plan to ensure that the funds will be used for lending or preventing further crisis. The plan would limit executive compensation for institutions receiving “exceptional assistance,” which includes a ban on dividend payments beyond de minimis amounts and limits on buybacks and the acquisition of financially strong companies. In addition, the plan provides for renewed lending for small businesses, auto loans and municipalities, strengthened oversight of financial institutions, international coordination on recovery, financial and regulatory policies and restructured bankruptcy laws and strengthened homeowner initiatives.
Before President Obama’s inauguration on January 20, 2009, his aides began lobbying to release the funds in an attempt to show an aggressive approach to the financial crisis. In addition, aides are trying to convince lawmakers that the Obama Administration will make better use of the bailout money, including new home foreclosure prevention efforts and increased restrictions on banks to get aid.
Responding to the Obama Administration’s efforts to release the remaining bailout funds, Senate Banking Committee Chair Christopher Dodd stated on January 12, 2009, that the Senate is unwilling to approve the disbursement of additional federal funds to aid banks unless limits are placed on executive pay and mortgage relief is provided to struggling homeowners. Sen. Dodd, D-Conn., also stated that any additional aid sought by the Obama Administration must include “stronger oversight provisions, limits on merger and acquisition activity and protections for taxpayers.” (“At Obama’s Urging, Bush to Seek Rest of Bailout Funds,” The New York Times, January 13, 2009; “Further Bank Aid Must Include Pay Limits: Dodd,” Reuters, January 12, 2009)
Federal Reserve Chair Anticipates Need for Additional Bank Bailouts
On January 13, 2009, Federal Reserve Chair Ben Bernanke endorsed President Barack Obama’s proposed fiscal stimulus package. Bernanke predicts, however, that additional bailouts of financial institutions will be necessary to fix the economy. Although Obama’s plan consists of $800 billion in funds to be used to boost economic activity in the United States, Bernanke warned that the plan is unlikely to promote long-term recovery without strong measures to stabilize and strengthen the financial system, including additional capital injections of federal funds into banks and financial institutions. In addition, Bernanke estimates that further guarantees of banks’ and financial institutions’ debt could be necessary as a condition for government funding. (“Bernanke: More Bank Bailouts Needed,” CNNMoney.com, January 13, 2008)
Banks to Begin Monitoring Use of Bailout Money
The Federal Deposit Insurance Corp. (FDIC) issued a directive on January 12, 2009 to approximately 5,100 state-chartered banks and savings and loans for which the FDIC is the primary regulator asking financial institutions that have received funds from the $700 billion financial rescue program to monitor how the federal funds or guarantees assist them in carrying out prudent lending and efforts to work with existing borrowers to avoid foreclosures. Under the directive, the financial institutions are expected to report how they are using the funds to support consumer lending and foreclosure relief, as well as document how the institutions are continuing to meet the credit needs of borrowers. The FDIC directive applies to the Treasury Department program, which injected $250 billion into banks and other financial institutions by purchasing shares in them. In addition, the directive applies to several Federal Reserve initiatives that provide temporary loans approximating $2.25 trillion and the FDIC’s program of three-year guarantees for as much as $1.4 trillion in new loans between banks. Citigroup, Bank of America, JP Morgan Chase and Wells Fargo are among the banks that have received the most funds from the various government programs.
The Treasury will begin demanding monthly reports from banks that have received federal funds under the Troubled Asset Relief Program (TARP). On January 16, 2009, an official at the Treasury Department wrote to the approximately 20 banks that have received TARP funds demanding that the banks provide data regarding business and consumer loans and the purchase of mortgage-backed and asset-backed securities. The Treasury Department implemented the monthly reporting requirement in response to criticism that the administration of TARP under the Bush Administration lacked transparency and accountability. (“FDIC Asks Banks to Monitor Use of Bailout Money,” The New York Times, January 12, 2009; “FDIC Pushes Banks to Monitor Use of Government Funds,” Bloomberg.com, January 12, 2009; “Treasury Demands Banks With TARP Funds Report Lending Activity, Bloomberg.com, January 20, 2009)
Fannie Mae and Freddie Mac Extend Moratorium
Fannie Mae and Freddie Mac have directed mortgage servicers to postpone any foreclosure or eviction proceedings through January 31, 2009. The moratorium, which began on November 26, 2008, was scheduled to expire on January 9, 2009. Under the moratorium, 6,000 homeowners would avoid bank repossession and qualify for mortgage modifications. The extension will give servicers additional time to assist at-risk borrowers in enrolling in the companies’ Streamlined Modification Program, which began on December 15, 2008 and is aimed at helping borrowers to reduce mortgage payments to no more than 38 percent of their income. The extension also will give Fannie Mae additional time to evaluate “seriously delinquent borrowers” who are eligible to receive aid from the company’s “Second Look” initiative. (“Fannie and Freddie Give Borrowers More Time,” CNNMoney.com, January 8, 2009)
Citigroup Agrees to Foreclosure Prevention Plan
On January 8, 2009, Citigroup agreed to legislation proposed by Sen. Dick Durbin, D-Ill., that would allow judges to reduce mortgage debt for individuals who have filed for bankruptcy. Under the proposed mortgage bankruptcy bill, judges could treat the portion of the mortgage balance that exceeds a home’s newly appraised value as unsecured debt. In addition, judges would have discretion to lower mortgage interest rates and extend the term of the loan as long as 40 years, which would help reduce monthly payments. Only homeowners with existing mortgages would be eligible to have their loans reduced, and these homeowners would be required to certify that they attempted to contact their lenders about modifying their loans before filing for bankruptcy. The Center for Responsible Lending estimates that more than 600,000 households across the country could avoid foreclosure under the proposed bill.
Citigroup and other members of the banking industry and housing-related groups have until now criticized the notion of allowing courts to regulate their mortgage portfolios. For example, the Mortgage Bankers Association argues that the idea of bankruptcy courts reducing the size of a home loan will increase borrowing costs in the future. The trade group has referred to the idea as “mortgage cram downs.” Other critics of the proposed legislation argue that the bill would add to investors’ risk in mortgage backed securities. Critics argue that allowing borrowers to have some of their mortgage debt written off reduces the value of these securities. As a result, investors would demand an extra risk premium to offset that risk, which would raise the costs of mortgage borrowing for everyone. Lawmakers hope that Citigroup’s participation would encourage other mortgage lenders to sign onto the program. (“Citi Backs Foreclosure Prevention Plan,” CNNMoney.com, January 9, 2009)
Hedge Fund Losses
Hedge Funds Report Record Losses During 2008
According to a preliminary report published in early January 2009 by Eurekahedge Pte, hedge funds worldwide lost $350 billion, which represents an overall decline in value of 12.3 percent during 2008. Ninety percent of the losses reportedly occurred from September through November 2008. Hedge funds, however, posted average gains of one percent during December 2008. According to the report, hedge funds were hit hard after the collapse of Lehman Brothers Holdings Inc. in September 2008 and the credit crunch that followed because the funds relied heavily on investment banks such as Lehman Brothers to fund loans and perform investment services. After Lehman Brothers filed for bankruptcy, more than 80 hedge funds were forced to liquidate, segregate and limit withdrawals. Since 2000, when Eurekahedge began tracking the performance of approximately 2,000 hedge funds worldwide, the hedge fund industry has never posted an annual loss. (“Hedge Funds Lost $350 Billion in 2008 Amid Global Market Rout,” Bloomberg.com, January 13, 2009)
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