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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 investigations arising from the subprime mortgage crisis and credit crunch. This issue focuses on litigation and regulatory investigations, auction rate securities, the scope of the subprime/credit crunch crisis, government and regulatory intervention, and ratings agency investigations.
Litigation & Regulatory Investigations
AIG’s Subprime Losses Prompt Lawsuits
Maurice R. Greenberg, the former CEO of American International Group (AIG), recently issued a letter to AIG’s board of directors, a copy of which was filed with the Securities and Exchange Commission (SEC). The letter expressed his concerns that “AIG is in crisis” and that “several top shareholders of AIG have called me expressing deep concern about the persistent and seemingly endless destruction of value at AIG.” The letter was issued shortly after Starr International, a company controlled by Greenberg, filed a lawsuit against AIG in New York state court, alleging that AIG “fraudulently misrepresented its exposure to credit default swaps,” and seeking to recover at least $300 million in damages. Starr International is one of AIG’s largest shareholders. (“Former Chief Tells Board That AIG Is in Crisis,” The New York Times, May 13, 2008)
A Florida pension fund filed a purported securities class action in New York federal court against AIG and several of its top executives. AIG and the named executives are accused of allegedly making false and misleading statements regarding the company’s exposure to the subprime mortgage crisis to artificially inflate its stock price. The complaint alleges that AIG’s top executives, including its CEO, falsely assured investors that AIG’s risk management and diversification practices effectively insulated the company from the credit crisis turmoil. In February 2008, AIG disclosed that its outside auditors found problems in the company’s financial reporting and oversight, requiring AIG to revalue its credit default swap portfolio. AIG subsequently declared losses of more than $11 billion related to its credit default swap portfolio, and declared a 2008 first-quarter loss of $7.8 billion. According to the plaintiffs, AIG’s management knew of the impending problems in its derivatives unit but hid them from investors. (“Florida Pension Fund Is Suing AIG,” The New York Times, May 22, 2008; “AIG Faces Lawsuit by Florida Pension Fund,” Business Insurance, May 22, 2008)
Citigroup Hedge Fund Losses Prompt Investor Lawsuits
Last fall, Citigroup’s Falcon Strategies hedge fund began to falter as a result of the credit crunch. By March 31, 2008, the fund had lost 20 percent of its original value. After sustaining large investment losses in the fund, Fifth Third Bancorp filed a lawsuit in Ohio federal court against an insurer and brokerage firm that arranged the bank’s investment in Falcon. The lawsuit alleges that Transamerica Life Insurance Co. and Clark Consulting Inc., both units of insurer Aegon NV, “utterly failed to properly manage and monitor” premiums invested in the fund. While Citigroup has not been named as a defendant, it may be forced to return a portion of the $1.6 billion that Fifth Third and other banks invested in Falcon. Citigroup already has spent more than $250 million in order to allow its retail investors to exit the fund without suffering a total loss. (“Citigroup Hedge-Fund Loss Weighs on Three Banks,” The Wall Street Journal, May 20, 2008)
Auction Rate Securities
Wachovia Faces Inquiries by the SEC and State Regulators Concerning the Sale of Auction-Rate Securities
In recent regulatory filings, Wachovia disclosed that the company had received inquiries and subpoenas from the SEC and state regulators concerning the sale and auctions of municipal auction-rate securities and auction-rate preferred securities. Regulators are examining whether broker-dealers sufficiently disclosed to investors the level of risk associated with auction-rate securities. Wachovia announced that “further review and inquiry is anticipated by the regulatory authorities, and Wachovia will cooperate fully.” (“Wachovia Faces SEC Inquiry Over Auction-Rate Securities,” The New York Times, May 13, 2008)
Refinancing of Troubled Auction-Rate Securities By Large Closed-End Fund Gives Investors Hope
Nuveen Investments Inc., the country’s largest manager of closed-end funds, recently announced that it has secured a commitment for up to $1.75 billion in liquidity to allow the company to refinance troubled auction-based securities previously issued by its funds. The move is expected to benefit holders of auction-rate preferred shares, who are currently locked into the investments as a result of the recent collapse of the auction-rate securities market, by replacing the auction-rate securities with newly issued variable-rate instruments. (“Nuveen to Restructure Auction-Rate Debt Issues,” The Chicago Tribune, May 21, 2008; “Fund Manager Is to Refinance Stalled Auction-Rate Notes,” The New York Times, May 22, 2008)
BlackRock Expected to Announce Plans to Redeem Tax-Exempt Auction-Rate Securities
BlackRock Inc. is expected to announce plans to redeem more than $1.5 billion in tax-exempt auction-rate securities from investors. Although $13.7 billion in buybacks have been announced industrywide, less than $650 million of that amount covers tax-exempt funds. If BlackRock raises the $1.5 billion necessary, it will be able to repurchase approximately 20 percent of outstanding preferred shares issued by its tax-exempt funds. According to Alex Reiss, a closed-end fund analyst at Stifel Nicolaus & Co., “it’s a sign that these guys are really trying to get their investors out whole.” (“BlackRock Ups Auction-Rate Buyback to $1.5 Billion, Person Says,” Bloomberg.com, June 2, 2008)
Companies Struggle With Valuation of Auction-Rate Securities
Several companies continue to deal with problems associated with auction-rate securities. After the market for auction-rate securities froze in February 2008, companies invested in the securities have been scrambling for cash and forced to deal with complex accounting issues. In a recent study issued by Pluris Valuation Advisors LLC, it was reported that only half of the 402 public companies with holdings in auction-rate securities have taken write-downs. With regard to the companies that have taken write-downs, the average write-downs total only 13.2 percent. Moody’s has lowered the credit ratings of companies invested in auction-rate securities due to the effects the securities have on the companies’ liquidity, as auction-rate securities now are illiquid and no longer worth their face value. Several companies have been forced to take significant discounts in order to sell their bonds. (“Auction-Rate Securities Give Firms Grief,” The Wall Street Journal, May 27, 2008)
The Scope of the Subprime/Credit Crunch Crisis
Lloyd’s of London Report Shows Increased Fear of Subprime Lawsuits Among Company Directors
Lloyd’s of London recently issued a report regarding the results of its global survey of more than 183 officers and directors. According to the survey, more than half of the corporate directors surveyed believe they are more at risk of being sued today than they were three years ago. Specifically, the directors fear being a target of professional liability claims related to the credit crisis. Financial company directors are the most pessimistic, with 64 percent fearing exposure to litigation.
The report also announced that in the United Kingdom, directors and officers’ liability insurance is becoming more expensive due to recent changes in British law and the increasing trend of regulators pursuing claims against individual directors. Officers and directors in the United Kingdom also are fearful because European legislation is being passed that will make it easier for investors to file American-style class action lawsuits. According to Sean McGovern, the general counsel of Lloyd’s and one of the report’s authors, “insurance rates are based on the underlying risk … [and] we’re operating in an increasingly uncertain environment.” (“Company Directors Fear Subprime Lawsuits, Lloyds Says,” Bloomberg.com, May 13, 2008)
Wachovia CEO Asked to Retire
Following a series of disappointments for Wachovia, Chief Executive Officer Ken Thompson has been asked to retire. The current chairman of the Wachovia Board of Directors, Lanty Smith, who has served as a Wachovia director since 1987, will replace Thompson. Wachovia recently was forced to nearly double its first-quarter losses to $708 million after factoring in additional write-downs on the value of its bank-owned life insurance policies taken out on employees. Moreover, at the height of the housing boom, Wachovia, under Thompson’s lead, acquired Golden West Financial, a California mortgage lender, which was hit hard by the mortgage crisis as a large number of first-time home buyers defaulted on adjustable-rate loans offered by Golden West. (“Wachovia Asks Chief to Retire,” The Financial Times, June 2, 2008)
Smaller Banks Gain Market Share by Capitalizing on Larger Banks’ Subprime Problems
While many large banks have been hit hard by subprime losses, the banking industry as a whole has not experienced the same problems. According to the Office of Thrift Supervision, a federal savings bank regulator, as of the fourth quarter of 2007, banks with less than $1 billion in assets have continued to turn a profit on an aggregated basis, while profitability at banks with more than $1 billion has turned negative. As a result of the current credit crisis, many larger banks have tightened their lending practices and retreated from consumer lending. Smaller banks now are capitalizing on the void left by large banks harmed by subprime losses by increasing qualified consumer lending to customers who cannot be serviced by larger banks. Ben Bernanke, the Federal Reserve chairman, indicated that “[f]or well-run, well-capitalized community banks—the great majority of them—I think there are some good opportunities right now.” (“Small Banks Gain Market Share,” The Wall Street Journal, May 28, 2008)
Subprime Mortgage/Credit Crisis Leads to Layoffs at Large Law Firms
Sonnenschein, Nath & Rosenthal, a Chicago law firm with approximately 700 attorneys, recently fired 37 attorneys and 87 members of its staff. Large layoffs, which generally are uncommon in the legal world, also have been announced by Cadwalader, Wickersham & Taft; Thacher Proffitt & Wood; Clifford Chance; Dechert; and Thelen Reid. Many of the firings were prompted by the general slowdown in legal work resulting from the subprime mortgage crisis and the recent credit crunch. (“Sonnenschein Law Firm Fires 37 Lawyers, 87 Staffers,” Bloomberg.com, May 28, 2008)
Government and Regulatory Intervention
Federal Reserve Chairman Surveys Current Economic Landscape
Although the financial markets have stabilized in the past month, Federal Reserve (Fed) Chairman Ben Bernanke says the situation is still “far from normal.” The Fed has taken numerous steps to quell the turmoil in the financial markets, including cutting key federal fund rates seven times since September 2007 and allowing investment banking firms to seek emergency loans from the Fed. Bernanke notes that these steps “seem to have bolstered confidence [in the markets],” but ultimately financial companies will need to improve risk management procedures and raise new capital, a process which “is likely to take some time.” Mindful of creating a “moral hazard,” in which financial institutions would be more likely to engage in risky practices based upon a belief that the Fed will bail them out, Bernanke notes that “the problem of moral hazard can perhaps be most effectively addressed by prudential supervision and regulation that ensures that financial institutions manage their liquidity risks effectively in advance of the crisis.” (“Financial Markets Calmer, But Still ‘Far From Normal,’ Bernanke Says,” The New York Times, May 14, 2008; “Bernanke: Gloomy on Growth,” CNNMoney.com, June 3, 2008)
Federal Reserve Vice Chairman Discusses Possibility of Permanent Access to Fed Loans
In March 2008, the Fed rescued Bear Stearns from bankruptcy with a $13 billion temporary loan, and opened up lending to primary dealers, the Fed’s first extension of credit to a nonbank since the Great Depression. Federal Reserve Board Vice Chairman Donald Kohn recently discussed the possibility of allowing securities firms permanent access to Fed loans in exchange for tighter regulatory oversight of the companies. In a speech during a conference hosted by the New York Fed, Kohn commented that: “the more extensive the access, the greater the degree to which the market discipline will be loosened and prudential regulation will need to be tightened. … Unquestionably, regulation needs to respond to what we have learned about the importance of primary dealers and their vulnerabilities to liquidity pressures.” While Kohn has not reached a decision, his statements appear to contradict prior statements issued by the Fed’s chairman, Ben Bernanke, that Fed lending to investments banks will cease after the credit crisis has passed. (“Kohn Signals Wall Street May Get Permanent Access to Fed Loans,” Bloomberg.com, May 30, 2008)
Ratings Agency Investigations
SEC Initiates Probe Against Top Ratings Agencies
The SEC has initiated a probe against the nation’s major ratings agencies – Moody’s Corp., Standard & Poor’s and Fitch Ratings – to determine how the agencies evaluated and rated billions of dollars in mortgage-related securities. Moody’s recently came under scrutiny because of reports that top executives were aware that the company’s ratings of constant-proportion debt obligations, funds that utilize borrowed money to wager on credit-default swaps, should have been ranked at least four levels lower. Despite lowering many of the ratings on the securities it tracked, Moody’s has stated it did nothing wrong and that “the integrity of our rating and rating methodologies is extremely important to us … [and] we are therefore conducting a thorough review of this matter.” (“Moody’s Falls Most Since 1999 on Rating Error Probe,” Bloomberg.com, May 21, 2008; “Moody’s Tone About Probe Into Ratings Takes a Turn,” The Wall Street Journal, May 28, 2008)
Ratings Agencies to Overhaul Fee Practices
In connection with its investigation into the ratings agencies’ role in the subprime mortgage crisis, the New York attorney general is expected to announce a settlement with Moody’s, Standard & Poor’s and Fitch, which would include an overhaul of the ratings agency fee collection practices. Historically, investment banks that issued mortgage-backed securities hired ratings agencies to rate the securities in order to sell the securities to pension funds, mutual funds and other investors. The deals often were reviewed by more than one ratings agency, although the issuer ultimately selected one ratings agency to issue the rating and only that agency would be paid. Under the terms of the proposed settlement, ratings agencies also would be paid for their preliminary work, even if they are not selected to issue the rating, thereby removing some of the investment banks’ influence over the ratings agencies.
On June 11, 2008, the SEC also formally proposed rules in order to restore investor confidence in bond ratings, including a new rating designation for mortgage backed-bonds and other structured finance vehicles, which would warn investors of the inherent volatility of such investments. (“Bond-Rating Shifts Loom in Settlement,” The Wall Street Journal, June 3, 2008; "SEC Proposes Comprehensive Reforms to Bring Increased Transparency to Credit Rating Process," SEC Press Release, June 11, 2008)
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