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Publications
Subprime/Credit Crunch Digest
Litigation & Regulatory Investigations
Bankruptcy Court Allows the DOJ to Investigate Countrywide
A federal bankruptcy court in Pittsburgh authorized bankruptcy investigators to examine Countrywide Financial Corp.’s mortgage-processing systems in order to determine whether Countrywide “systematically abused borrowers.” This is the first decision confirming the power of the Justice Department’s federal bankruptcy officials to investigate alleged abuse of borrowers.
In its decision, the court held that the Justice Department’s Office of the U.S. Trustee had demonstrated a “common thread of potential wrongdoing” in several bankruptcy cases involving Countrywide sufficient to allow officials to investigate allegations that Countrywide, among other things, “chronically” mishandled mortgage payments, issued improper fees and ignored court orders.
Countrywide, which has acknowledged that it made errors involving subprime loans, denies any conscious mistreatment of homeowners. Countrywide also has argued that the Justice Department lacks authority to investigate its business practices, and is currently undertaking a full review of the court’s decision. (“Judge Authorizes Probe of Countrywide’s Practices,” The Wall Street Journal, April 3, 2008)
Navigant Study Shows Increase in Securities Class Action Filings Due to Subprime Mortgage Crisis
According to a study published by Navigant Consulting, 170 securities class action lawsuits were filed in the first quarter of 2008, which is close to the 181 lawsuits filed in the final six months of 2007. According to the report, 448 lawsuits related to the subprime mortgage crisis have been filed to date, a number that may quickly surpass the 559 lawsuits filed in connection with the savings-and-loan crisis of the early 1990s. While these cases are still in their early stages, classes have only been certified in 10 percent of the 191 subprime-related class action lawsuits that have been filed, and decisions on motions to dismiss have been issued in only 15 percent of the lawsuits. The study further indicates that the number of lawsuits against lenders is likely to decrease given reduced subprime mortgage activity. However, Navigant reports that “intra-industry disputes appear likely to expand as financial institutions shun traditional mores and pursue remedies from one another through litigation.” (“Subprime Crisis Provokes 'Tsunami' of Lawsuits,” The Financial Times, April 23, 2008)
Auction Rate Securities
NYAG Subpoenas 18 Banks in Auction Rate Securities Probe
Andrew Cuomo, the New York attorney general (NYAG), has subpoenaed 18 investment banks that underwrote and brokered auction rate securities. Securities regulators from nine other states have joined forces with the NYAG. The regulators are examining how the banks marketed auction rate securities to investors, and whether the banks accurately disclosed the level of risk associated with these investments. Among the banks subpoenaed by the NYAG’s office include Citigroup, Merrill Lynch, Morgan Stanley and UBS. (“Inquiries Into Auction-Rate Securities Widen,” The New York Times, April 18, 2008; “Auction Rate Securities Failure Implications,” Insurance Day, May 2, 2008)
Fund Managers Offer Redemptions to Auction Rate Securities Holders
Aberdeen Asia-Pacific Income Fund, Inc. recently reported that it will redeem $600 million in auction rate securities in an effort to assist its clients in exiting the now-frozen securities. The securities will be replaced with $600 million in debt financing provided by a loan syndicate headed by Scotia Capital. (“Aberdeen Will Replace Auction-Rate Securities,” The Wall Street Journal, April 21, 2008)
BlackRock, Inc. also announced plans to refinance $1.9 billion in auction rate securities issued by its close-end funds. According to BlackRock’s president, Robert Kapito, “This action represents the first step of our objective to provide financing for auction rate preferred shares issued by BlackRock’s closed-end funds, which we believe is in the best interests of our funds’ common and preferred shareholders.” In order to redeem 19 percent of its $9.8 billion in auction rate securities that remain outstanding, BlackRock announced that it intends to rely upon a mix of credit facilities, reverse repurchase agreements and tender option bond programs. (“BlackRock Refinancing ARS,” The Wall Street Journal, April 15, 2008)
Broker-Dealers Attempted to Prevent Auction Failures
According to various student loan companies, several months before the auction rate securities market collapsed, broker-dealers, including UBS, Citigroup, Inc. and Bank of America Corp., requested that student loan authorities waive certain restrictions in order to make auction rate securities less difficult to sell. This indicates that broker-dealers may have been attempting to keep the auctions alive, while more sophisticated investors, such as institutional investors, became reluctant to purchase securities in light of the credit crisis. After institutional investor interest waned, many investment banks purchased securities that other investors did not want. These activities raise questions as to whether the broker-dealers failed to disclose to their brokerage clients the emerging troubles in the auction rate securities market. (“Wall Street Firms Moved to Prevent Auction Failures,” The Wall Street Journal, April 24, 2008)
The Scope of the Subprime/Credit Crunch Crisis
UBS Blames Ambition for Subprime Problems
Since the subprime crisis began last summer, UBS AG has written off $37.3 billion, including a $19 billion write-down for the first quarter of 2008, effectively undermining all profits the bank has generated since 2004. In response to a “tumultuous” shareholder meeting held in February 2008, at which shareholders demanded a special investigation into UBS’ practices, the bank released a 50-page report, indicating that the bank’s “blind drive for revenue” created a culture of poor risk management, an unsustainable build-up of investment banking activities and a clear lack of management hierarchy. According to the report, UBS predicts additional losses in 2008. (“UBS Faults Blind Ambition for Subprime Miscues,” The New York Times, April 22, 2008)
Credit Crisis Losses Likely to Reach $1 Trillion
In its annual Global Financial Stability report, the International Monetary Fund (IMF) reported that losses related to the mortgage crisis in the United States may reach $1 trillion as a result of a “collective failure” to predict the actual scope of the crisis. According to the report, the credit crunch is far from over, as “[t]he current turmoil is more than simply a liquidity event, reflecting deep-seated balance-sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper and more protracted.” As of mid-April 2008, banks and securities firms posted asset write-downs and credit losses totaling $232 billion.
While the IMF previously predicted that any collateral damage resulting from a subprime fallout would be limited, the IMF blames the current crisis on lenient regulations and a failure to understand the risks associated with structured financial products.
The IMF cautioned governments against hasty implementation of regulations, especially those that could “unduly stifle innovation or that could exacerbate the effects of the current credit squeeze.” Rather, the IMF recommended that banks improve transparency and take necessary write-downs and that policymakers prepare to address the fallout of troubled financial institutions.
The IMF also conceded that it was “not as vocal as it could have been about the risks that a subprime collapse posed for the global financial system.” As an explanation, the report cites a “collective failure” to understand the degree of risk taken by a wide range of financial institutions, including banks, monoline insurers, government-sponsored entities, and hedge funds. (“Credit Crisis Could Cost Nearly $1 Trillion, IMF Predicts,” International Herald Tribune, April 8, 2008)
Commercial Banks Increase Reliance Upon Fed Funds
Commercial banks in the United States have substantially increased usage of the Federal Reserve’s discount window. By the end of April 2008, average daily borrowings were the highest they have been since shortly after the terrorist attacks of September 11, 2001. In contrast, investment banks have reduced their reliance on federal loans. Some market analysts view this sea change as an indication that the credit crunch is making its way from Wall Street to Main Street. (“Commercial Banks Step to Fed Window,” The Wall Street Journal, April 25, 2008)
Smaller Banks Feel Pressures From the Credit Crunch
During the recent financial boom, several smaller and midsized banks expanded into unfamiliar markets and products, and began offering loans with more favorable rates or terms in order to compete with larger banks. However, the subprime mortgage crisis and credit crunch have revealed the problems associated with this expansion. In recent months, several smaller banks have posted significant losses and have been forced to cut their dividends and raise additional capital in order to repair their balance sheets that are plagued with real estate securities and bad loans issued to home builders and commercial real estate builders, among others. In fact, profits at banks insured by the Federal Deposit Insurance Corp. decreased 87 percent in the fourth quarter of 2007, which is a 16-year low, and less than half of the banks posted an increase in net income. Given these statistics, regulators are preparing for an increased failure of smaller banks, which lack diversification and are less appealing to investors. However, bank failures are not expected to be as severe as the savings-and-loan crisis of the 1990s, during which time 1,000 banks failed. (“Smaller Banks Begin to Pay Price for Their Boomtime Expansion,” The Wall Street Journal, April 21, 2008)
Government and Regulatory Intervention
States Step Up Efforts to Reduce Foreclosures
According to a recent report issued by the State Foreclosure Prevention Working Group, which is comprised of banking regulators and 11 state attorney generals, efforts by mortgage-service companies and government officials to address the nation’s mortgage crisis have been unsuccessful in curbing the rising rate of foreclosures. Specifically, the report (which is based on data from 13 of the largest mortgage providers, accounting for approximately 57 percent of the subprime market) found that seven out of 10 borrowers who are “seriously” delinquent are not on track to receive any form of assistance.
State officials were concerned that the federal response to the recent housing crisis has been inadequate, and the report lends support to their concerns. In response, state officials have been taking an increasingly aggressive approach to address rising foreclosure rates. Thus far, the states’ efforts have focused on extending the foreclosure process in order to give borrowers more time to develop repayment plans with their respective lenders. State officials also are investigating whether to pursue litigation against mortgage brokers, investment banks and other entities involved in the mortgage process. Ohio Attorney General Marc Dann has issued more than 20 subpoenas to companies in connection with its investigation into mortgage industry practices.
The report further indicates that mortgage companies have experienced a recent flood of “seriously” delinquent loans, and are working hard to keep up. However, state officials argue that the current system for handling problematic loans, pursuant to which lenders evaluate borrowers on a case-by-case basis, needs to be overhauled in favor of a more systematic approach that treats borrowers the same, which is appropriate given the current crisis. Officials also have criticized mortgage brokers for ignoring more permanent solutions, such as loan modification, and, instead, opting for patchwork fixes such as repayment plans.
However, the report indicates that a greater proportion of individuals who recently began working with their lenders have been successful in getting their loan terms modified. The overall number of delinquent borrowers working with lenders also has increased. These gains, however, are largely undermined by the overall increase in the total number of delinquent loans. (“States Fault Effort to Stanch Foreclosures,” The Wall Street Journal, April 23, 2008)
FASB Proposes Stricter Rules for Securitized Loans
Under current accounting rules, banks are allowed to house mortgage and other loans packaged and/or sold as securities off of their balance sheets in special securitization vehicles, which makes it possible for banks to shift the risk of bad loans to investors. In response to the subprime mortgage crisis, the Financial Accounting Standards Board (FASB) recently voted to eliminate these special securitization vehicles. While the FASB has not indicated how banks will be required to account for these loans, the FASB has hinted that banks may be required to house the loans on their books, which could have major implications for banks. In 2007, J.P. Morgan Chase & Co. and Citigroup, Inc. held nearly $1 trillion in assets in special securitization vehicles housed off their books, and J.P. Morgan generated approximately 6 percent of its total revenues in 2007 from administering such vehicles. In response to the proposed regulations, Citigroup responded that it is “actively engaged in industrywide discussions on the development of the proposal.” The FASB further indicated that banks now will have a more difficult time maintaining loans in off-balance sheet accounts. (“FASB Signals Stricter Rules for Banks’ Loan Vehicles,” The Wall Street Journal, May 2, 2008)
The Fed Moves to Increase Liquidity
While analysts have reported that some stability has returned to the economy, the Federal Reserve (Fed) remains concerned. As a result of “persistent liquidity pressures” in the credit market, the Fed recently established two lending facilities to meet the needs of banks hardest hit by the subprime mortgage crisis and the credit crunch. The newly established term securities lending facility can lend up to $200 billion to 20 banks referred to as “primary dealers,” and the Fed now is allowing banks to post highly rated student loans, auto loans and credit card debt as collateral for these loans. The Fed previously limited the posted collateral to mortgage-backed securities. The Fed also expanded the credit available to banks though the term auction facility by authorizing $75 million in 28-day loans through its biweekly auctions with total outstanding loans capped at $150 million. The auctions were previously limited to biweekly auctions of $50 million with a cap of $100 million. Finally, the Fed, in cooperation with the Central Europe Bank and the Swiss National Bank, increased currency swaps pursuant to which the European banks can obtain dollars in exchange for pledges of European currency in order to provide the banks with necessary dollars to meet loan obligations they hold in the mortgage sector. (“Fed Takes Steps to Add Liquidity,” The New York Times, May 2, 2008; “Central Banks Take Aim at Elevated Libor,” The Wall Street Journal, May 3, 2008)
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