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Publications
Subprime/Credit Crunch Digest
Civil Litigation
Subprime Class Action Filed Against Societe Generale SA
An investor lawsuit was filed against the French bank, Societe Generale SA (SocGen), in reaction to the widely publicized multibillion-dollar trading scandal involving a low-level employee. The complaint, filed in U.S. District Court in Manhattan on behalf of purchasers of the bank’s American depository receipts and U.S. purchasers of SocGen securities overseas, alleges that SocGen made false and misleading statements regarding its exposure to the subprime crisis, as well as to the strength of its internal controls. Contrary to the “prudent” image SocGen portrayed, the bank allegedly fostered a “culture of risk” that engendered traders such as Jerome Kerviel, who lost more than 4 billion euros over a two-year period, to engage in unauthorized trades. The purported class action was filed shortly after the police took a second SocGen trader into custody. (“DJ Law Firm: Investor Lawsuit Filed vs. SocGen Over Rogue Trader,” Dow Jones Newswires, March 12, 2008)
Seventh Circuit to Decide Whether Borrowers May File Class Actions Against Lenders
Mortgage firms across the country anxiously await the Seventh U.S. Circuit Court of Appeals’ decision regarding a dispute between a Wisconsin couple and Chevy Chase Bank. Last year, a federal judge in Milwaukee held that the couple had been deceived by the bank into taking out a high-interest rate mortgage loan, and that similar borrowers could join the suit. If the Seventh Circuit upholds the district court’s decision, it would enable homeowners to file class action lawsuits against mortgage firms and potentially rescind their mortgages. This may have grave consequences for Wall Street banks that could end up bearing the cost of reimbursing all mortgage interest, closing costs and broker fees to homeowners. (“Door Could Open to Class Actions,” The Washington Post, February 27, 2008)
Law Firms Anxiously Awaiting Subprime Lawsuits
Law firms have yet to see the flood of subprime-related lawsuits that they anticipated, although a steady stream of litigation has been filed. According to many attorneys, this may be attributed to the sheer complexity of the investment vehicles backed by subprime mortgages, which is making it difficult for investors to sort out their respective losses. Moreover, it may be tough for investors to establish blame and accountability in situations where judgment calls led to write-downs. As compared to similar credit busts, the current situation is more complicated and the liability of potential defendants is considerably “murkier.” The lack of litigation also may be due to individuals and institutions awaiting the results of federal and state investigations before heading to court, hoping to obtain substantive information to bolster their cases. (“Waiting for the Subprime Lawsuits,” BusinessWeek, March 13, 2008)
Class Actions Filed Against Banks Regarding Auction-Rate Securities
Several purported class action lawsuits have been filed against UBS AG (UBS), Deutsche Bank AG, Merrill Lynch & Co. (Merrill Lynch), Morgan Stanley, Citigroup and other banks regarding alleged misstatements made in connection with the marketing of auction-rate securities. Massachusetts securities regulators also have subpoenaed UBS, Merrill Lynch and Bank of America Corp., requesting documents regarding the sale of auction-rate securities to individual investors.
Auction-rate securities are “long-term bonds that have a short-term debt component” because they can be sold at regularly scheduled auctions held to reset interest rates and often have a long-term or no maturity date. Auction-rate securities, which are issued by municipalities, nonprofits and closed-end mutual funds, historically were regarded and marketed as a safe alternative to money market funds or savings accounts but that yielded higher returns. As a result of the credit crunch, however, several auctions failed in the past few months due to a lack of interest. On February 13, 2008, the country’s major broker-dealers, including UBS and Merrill Lynch, allegedly collectively decided to “withdraw their support” for the periodic auctions, and auction-rate securities ceased trading. Investors contend that as a result, they have been left with illiquid investments, and banks have begun to write down the value of auction-rate securities they hold.
The lawsuits allege that the banks and their brokerage units violated federal securities laws by failing to disclose to clients the risks associated with auction-rate securities, and, instead, marketing the securities as “cash alternatives.” According to the lawsuits, the banks deceived investors by encouraging them to invest in auction-rate securities instead of money market funds or savings accounts, leaving investors “locked into illiquid investments.”
(“UBS Lowers Price of Security Seen as ‘Cash,’” The Wall Street Journal, March 29, 2008; “UBS, Brokerage Arm Are Sued Over Marketing of Auction-Rate Securities,” The Wall Street Journal, March 14, 2008; “3 Firms Are Asked for Data on Auction-Rate Shares,” The New York Times, March 29, 2008; “Citigroup Sued Over Auction Rate Securities,” The New York Times, March 27, 2008; “Girard Gibbs LLP Announces Class Action Lawsuit Filed Against UBS AG,” March 21, 2008, press release available at: http://www.girardgibbs.com/auctionrate.html)
High-Yield Bond Investors Sue Charles Schwab
Charles Schwab Corp. was sued by investors in the Schwab YieldPlus Fund, a high-yield, short-term bond fund, which was allegedly marketed as a higher-yield investment alternative to money market funds. In May 2007, Schwab YieldPlus Fund had more than $13 billion in assets. Since that time, however, the fund’s assets have declined to $2.5 billion as a result of the fund’s investment of 46 percent of its assets in mortgage-backed securities. When the credit crunch began last summer, the fund slowly began to lose value and investors began redeeming their investments. In order to satisfy the redemptions, the fund was forced to sell assets to a declining market, thereby causing the fund additional losses and prompting additional investors to exit the fund. The lawsuit, which was filed in the U.S. District Court for the Northern District of California, alleges that Charles Schwab investment advisors made false and misleading statements regarding the fund’s diversification and risk.
(“Schwab Bond Fund Spurs Suit,” The Wall Street Journal, March 27, 2008; “Led by Schwab, Higher-Yield Bond Funds Run Into Trouble,” The San Francisco Chronicle, March 25, 2008)
Government Intervention in the Subprime Crisis
Bush Threatens to Veto Relief Bill
In late February 2008, President George W. Bush threatened to veto a bill offered by Senate Democrats that would allow bankruptcy court judges to modify the terms of a primary home mortgage as part of the debt restructuring in a bankruptcy filing. Supporters of the bill argue that it could prevent as many as 600,000 home foreclosures, and would be the best method to help individuals renegotiate mortgages that have been bundled into securities and turned into complex investment vehicles. Mortgage lenders and Wall Street firms believe that the bill would lead to higher borrowing costs as a result of the likely increases in interest rates and down payments that would ensue. In siding with banks and mortgage lenders, the White House stated that the bill would “undermine existing contracts” and lead to tighter credit. It also strongly opposed certain provisions that would provide $4 billion for state and municipal governments to redevelop abandoned homes and support homeowner counseling programs. (“Bush Vows to Veto a Mortgage Relief Bill,” The New York Times, February 27, 2008)
Bush and the Federal Reserve Intervene in the Subprime Crisis
In the past month, the Bush administration and the Federal Reserve have become more involved in the subprime mortgage crisis, focusing primarily on the roles of the Federal Housing Administration (FHA) and government-sponsored mortgage companies Fannie Mae and Freddie Mac.
Traditionally, the FHA, Fannie Mae and Freddie Mac concentrated on mortgages for individuals borrowing conservative sums. However, the economic stimulus bill signed by President Bush in February 2008 greatly increases the size of loans that can be insured by the FHA, and allows Fannie Mae and Freddie Mac to purchase substantially larger mortgages from lenders and guarantee them against default. The administration has also removed limits on the number of mortgages that Fannie Mae and Freddie Mac can hold in their respective portfolios, which may allow each to purchase billions in mortgages.
The Federal Reserve also has been active in advocating that the federal government intervene in the subprime crisis. In addition to slashing interest rates last month, the Federal Reserve, through a new program called the “Term Auction Facility,” has lent more than $160 billion to banks since December 2007, providing short-term loans to banks that have been hit hard by the subprime crisis. The “Term Auction Facility” program allows banks and other depository institutions to bid up to $100 billion in one-month loans, the amount of which was substantially increased from its debut of $20 billion. This constitutes a drastic change for the Federal Reserve because as recently as August 2007, Federal Reserve Chairman Ben S. Bernanke refused to lower interest rates, arguing that potential inflation was a larger risk than slow economic growth. Perhaps the strongest indicator of change is the Federal Reserve’s recent involvement in the bailout of Bear Stearns with a substantial short-term loan.
The willingness of the Bush administration and the Federal Reserve to directly address the subprime crisis has Democratic lawmakers hopeful that new legislation will be passed. One proposal would allow the FHA to insure up to $20 billion in at-risk mortgages if lenders agree to pardon a substantial percentage of the original loans. Also on the table is a longstanding bill that would reduce the down payment necessary for FHA loans to 1.5 percent of the home’s value, as opposed to the current 3 percent rate.
While many Americans, both homeowners and Wall Street executives, are emboldened by this potential federal bailout, others remain skeptical. Certain individuals and groups argue that expanding the influence and market share of the FHA and related entities may provide short-term relief. However, an inevitable decline in real estate value will eventually be shouldered by taxpayers.
Many market analysts also are concerned that the Federal Reserve’s actions are simply too late to abate a recession, and that drastically lowered interest rates combined with a weak dollar could lead to inflation. In any event, the Federal Reserve has made it clear that avoiding the collapse of major Wall Street trading firms is of preeminent importance, and that for all intents and purposes, “the bailout [may have] officially begun.” (“Bush and Fed Step Toward a Mortgage Rescue,” The New York Times, March 5, 2008; “Fed Chief Shifts Path, Inventing Policy in Crisis,” The New York Times, March 16, 2008)
Fannie Mae and Freddie Mac Take Action
Seeking to thwart potential lawsuits, Fannie Mae and Freddie Mac have reached an agreement with the New York attorney general (NYAG) to discourage inflated home appraisals in the mortgage market. The two have agreed to adhere to a code of conduct, set to be enacted in 2009. Due to their collective market dominance, this code is expected to set a new standard of practices in the market. An organization approved by the Office of Federal Housing Enterprise Oversight also has been created to act as an independent monitor in ensuring the code’s enforcement.
The primary purpose of the code is to prevent lenders from pressuring appraisers into providing inflated property value estimates. This practice is widely considered to be a significant cause of the current subprime crisis. Inflated appraisals undermine the lenders’ ability to consider the true market value of a home when issuing a loan, and cause them to advance more money than a particular property is worth. When home prices drop dramatically, the effects can be devastating to both borrowers and lenders. According to one New York appraiser, “70 percent to 80 percent of appraisals that were done during the housing boom are probably not worth the paper they’re written on.”
The newly established code will bar bank employees involved in making loans from choosing appraisers and prohibits lenders from using the estimates of their own appraisers in making loans. It also prevents lenders from using appraisals ordered by mortgage brokers. According to the National Association of Mortgage Brokers, this may put many brokers out of business. The NYAG, however, believes that the code of conduct will not adversely affect brokers who follow “legitimate” practices.
At the end of February 2008, Fannie Mae also announced its plan to help curb the number of nationwide foreclosures, as well as its own losses, due to loan write-downs. The plan will finance unsecured loans of up to $15,000 for individuals who have fallen behind on mortgage payments due to temporary financial troubles. The loans will be provided by mortgage lenders, with Fannie Mae purchasing the loans and assuming the risk.
The plan also provides Fannie Mae with a cushion against enormous loan write-downs. Along with Freddie Mac, one of the primary roles Fannie Mae plays in the mortgage market is as a guarantor of payments on mortgage loans, which are held by investors as securities. When a particular loan defaults, the companies may have a duty to compensate those investors. If Fannie Mae and Freddie Mac can assist borrowers in catching up on mortgage payments, they may avoid paying out large sums in compensation and write-downs.
Fannie Mae’s loan-financing plan has not received universal praise from market insiders. One New York research firm says that it will “allow them to hide the true condition of their credit exposure.” (“Fannie, Freddie Set Stricter Appraisal Rules,” The Wall Street Journal, March 4, 2008)
Various Sectors React to the Subprime Crisis
Hedge Funds Limit Investor Redemptions
London-based hedge fund managers have recently taken steps to deter rapid investor outflow by utilizing gates, which limit investor exits to 10 percent-25 percent of assets per quarter, or by suspending investor redemptions entirely. According to market insiders, the current trend in investor outflow is largely the result of contracting lines of credit, illiquid investments and investor redemptions. This has negatively impacted a large number of funds, forcing some to liquidate rather valuable investments. These factors also present myriad problems for prime brokers, which are especially concerned about funds that have suffered large losses or contain illiquid investments. (“Hedge Funds Stem Exits as Credit Lines Tighten,” The New York Times, March 6, 2008)
Merrill Lynch Closes Home Loans Unit
Merrill Lynch recently announced that it would no longer issue subprime loans through its First Franklin Financial Unit. Merrill Lynch stated that it was leaving the subprime lending business due to the emergence of a vastly deteriorated subprime market, and would be eliminating 650 jobs. First Franklin, which employed 2,100 people as recently as May 2007, is expected to cost the company approximately $60 million in severance payments and other fees associated with the closing. Merrill Lynch also stated its intent to sell Home Loan Services, an arm of First Franklin that handles billing and collections. Merrill Lynch’s troubles are not unique to the banking industry, as several mortgage lenders have cut staff or closed similar offices in the past year, including Bear Stearns, Lehman Brothers and Morgan Stanley. (“Merrill Shuts Unit Making Home Loans,” The New York Times, March 6, 2008)
Cities and States Petition for Reevaluation of Bond Ratings
The recent losses incurred by municipal bonds have driven up borrowing costs for many communities. As a result, many states and cities, spearheaded by the California State Treasury, are petitioning ratings agencies to evaluate municipal bonds based upon the same scale used to evaluate corporate bonds. They assert that a universal rating system would help attract buyers by highlighting the relative safety of municipal debt, and that in troubled periods, such as now, a greater number of buyers would provide some insulation from instability and aid in keeping borrowing costs low. A House Financial Services Committee plans to examine the issue. (“States and Cities Start Rebelling on Bond Ratings,” The New York Times, March 3, 2008)
The Subprime Crisis Affects Smaller Banks
Although the media focus of the recent subprime crisis has been focused primarily on large, globally visible banks, many small and midsize banks in the United States have been impacted as well. Industry analysts estimate that losses for these banks have mounted so rapidly that as many as 7,500 banks could fail in the next 12 to 18 months. The KBW Regional Banking Total Return index, which tracks midsize U.S. regional banks, is down 16 percent since the end of August 2007. Even if these banks manage to avoid bankruptcy, many lenders are likely to close particular branches or otherwise seek mergers if the economy becomes more troubled. In light of these circumstances, government regulators are increasing regular bank examinations and requiring many lenders to bolster reserves. (“Small and Midsize U.S. Banks Also Face Subprime Fallout,” International Herald Tribune, February 26, 2008)
Bankruptcies Increase as a Result of Subprime Fallout
In addition to increased foreclosures and restricted credit, the subprime crisis has spurred a significant increase in bankruptcy filings. According to a recent study by the law firm, Jones Day, Chapter 11 filings climbed to 6,237 in 2007 from 5,010 in 2006, with a 15 percent increase in bankruptcy filings by publicly traded companies. Additionally, the study indicates that 4 of the 10 largest bankruptcy filings were directly caused by the deteriorating subprime market, and that 50 subprime lenders have filed for bankruptcy or otherwise gone out of business by liquidating their mortgage assets. (“Subprime Crisis Foments Bankruptcy Surge,” CFO.com, March 12, 2008)
The Bear Stearns Implosion
JP Morgan Acquires Bear Stearns
JP Morgan Chase acquired investment bank Bear Stearns in mid-March. As recently as one year ago, Bear Stearns’ shares were trading at $170 per share, and two weeks before the deal, Bear Stearns was trading at $65 per share. JP Morgan originally agreed to pay $2 a share but subsequently increased its offer to $10 a share.
The drastically reduced share price is said to demonstrate “deep misgivings” about Bear Stearns’ future and to reflect the enormous obligations assumed by JP Morgan. JP Morgan will guarantee Bear Stearns’ trading obligations, which had recently driven the bank to the brink of bankruptcy. In order to facilitate the deal, the Federal Reserve agreed to assume control of a Bear Stearns’ asset portfolio valued at $30 billion. Any profits from the assets will go to the Federal Reserve, and JP Morgan will be responsible for the first $1 billion in losses.
The acquisition of Bear Stearns provides JP Morgan with an entry point into prime brokerage, and also gives the bank a much larger presence in the mortgage securities market. Despite the bargain price, the deal comes with high risk for JP Morgan. Although JP Morgan has proved to be somewhat of an anomaly given its relatively strong performance throughout the subprime meltdown, skeptics maintain that assuming the risk of Bear Stearns, including numerous perilous investments, may prove to be unwise. Also at issue are the more fundamental management difficulties associated with any large deal. Some individuals involved in the deal believe that as many as one-third of Bear Stearns’ staff members could lose their jobs. It is also unclear how JP Morgan plans to update Bear Stearns’ prime brokerage technology. In response, JP Morgan asserts that its acquisition of Bear Stearns will have broad implications and that “the market will behave quite differently.” (“JP Morgan Pays $2 a Share for Bear Stearns,” The New York Times, March 17, 2008; “Can’t Bear It,” The Wall Street Journal, March 24, 2008)
The Bear Stearns Bailout Sheds Light on Need for Regulatory Reform
In the days before its acquisition by JP Morgan, Bear Stearns faced what was essentially a “bank run.” Increasingly rapid cash outflows threatened to “outstrip Bear Stearns’ resources.” Additionally, Bear Stearns was plagued by rumors that it possessed scores of securities that it could not sell and that it would be unable to borrow enough funds to retain those securities. As a result, many customers pulled cash out of Bear Stearns. Although it was able to meet the initial onslaught of liquidity demands, the continued withdrawals put the company in danger of insolvency. Overnight, the Federal Reserve and JP Morgan arranged to provide Bear Stearns with necessary funds. The Federal Reserve, however, could not provide direct support to Bear Stearns because it is not a commercial bank, which is a necessary requirement of the federal protections against bank runs established by the Roosevelt administration 75 years ago.
At the heart of the subprime crisis is a deep distrust in financial institutions and the securities in which they deal. Despite federal reassurance and lowered interest rates, it is still unclear whether mortgage borrowers can repay their debts. Many see this as an opportunity to revise the banking industry’s traditional regulatory system, which has “evolved into a very complex and uneven framework.” The current system makes somewhat arbitrary distinctions between traditional banks and investment banks, even though they engage in similar practices. What has emerged is a system where substantial oversight and regulatory differences exist within an industry with only marginally disparate branches. Advocates of regulatory reform call for all banks, or institutions built around banks, to have access to federal protections and to be subject to a more uniform set of rules. Some see the Federal Reserve’s recent move to indirectly bail out Bear Stearns as acknowledging that such institutions cannot roam the financial landscape unfettered by restrictions and unprotected by federal safety nets. (“F.D.R.’s Safety Net Gets a Big Stretch,” The New York Times, March 15, 2008)
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