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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, government and regulatory intervention, auction rate securities, and the scope of the subprime/credit crunch crisis.
Litigation & Regulatory Investigations
SEC Report Finds Flawed Practices at Ratings Firms
The Securities and Exchange Commission (SEC) released a “blistering” 37-page report on July 8, 2008, regarding the findings of its 10-month examination of practices by the three largest ratings agencies in the United States – Moody’s Corp., Standard & Poor’s and Fitch Ratings. The SEC found that the ratings agencies engaged in poor disclosure practices, lacked policies and procedures guiding the analysis of mortgage-related debt, and paid insufficient attention to managing conflicts of interest. In addition, the examination found that analysts were cognizant of and influenced by fees the firm would make on deals and that analysts considered the impact of their ratings on their business prospects. Further, the SEC found that the agencies became overwhelmed by an increase in the volume and sophistication of the securities they were asked to review. The report cites to several emails from ratings agency employees, although it does not identify for which company the employees worked. In an April 5, 2007, exchange, an analyst complained that the ratings model did not capture half of a deal’s risk, but that “it could be structured by cows and we would rate it.” Another email appears to suggest that managers were aware that the ratings quality for collateralized debt obligations (CDOs) had diminished significantly and that the CDO market could collapse. In a December 15, 2006, email, a manager stated that the rating firms continued to create “an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.” Each rating agency has agreed to take remedial measures to address the issues raised in the SEC report and issued statements expressing commitment to reforming their practices. It is currently unclear whether the SEC Enforcement Division will file a lawsuit relating to the findings, and whether criminal charges might be brought. The SEC plans to conduct a similar review in the next few months of seven other rating firms registered with the SEC. (“Study Finds Flawed Practices at Ratings Firms,” The New York Times, July 9, 2008; “SEC Says Debt-Rating Firms Sacrificed Quality for Profit,” The Wall Street Journal, July 9, 2008)
More Credit Crunch/Subprime Lawsuits Expected in Australia
While many subprime-related lawsuits have been filed in the United States, only a few have been filed in Australia. However, additional litigation is expected. To date, subprime-related lawsuits in Australia can be grouped into two categories: (1) lawsuits arising from stock drops resulting from the credit crunch; and (2) lawsuits filed against companies involved in structured finance. For example, IMF Limited and Slater & Gordan have filed class action lawsuits against two property investment vehicles of the Australian company Centro. The actions are brought by investors alleging that investment vehicles failed to issue adequate disclosures regarding their short-term debt and their difficulties in refinancing such debt. IMF also announced its intention to file similar lawsuits against MFS and Allco. Further, at least one investor lawsuit has been filed in connection with the marketing of CDOs backed by subprime mortgages. Such lawsuits are unusual in Australia, given that purchasers of structured finance products generally are sophisticated investors. Australian courts will consider the level of an investor’s sophistication when analyzing whether statements were false or misleading, as sophisticated investors are presumed to have adequate resources to evaluate independently the merits of any investments. The Minister of Corporate Law in Australia also announced that the Treasury and the Australian Securities and Investments Commission intend to review the regulation of credit rating agencies and financial product research firms in response to the subprime mortgage crisis. (“Australia: Subprime Crisis Related Litigation in Australia,” Mondaq.com, June 24, 2008)
Bear Stearns Executives Indicted
The U.S. attorney for the Eastern District of New York is investigating whether Ralph Cioffi and Matthew Tannin deliberately misled investors regarding the strength and performance of the portfolios of two Bear Stearns hedge funds. Email correspondence between the two former Bear Stearns hedge fund managers is expected to play a major part in the indictment charging them with securities, wire and mail fraud. In an email to Cioffi, who was his more senior colleague, Tannin expressed his fears regarding the complex bond securities market in which the funds had been invested, and discussed shutting down the funds. Cioffi eventually persuaded Tannin that the fund actually was well-positioned to succeed in the coming months. Four days later, both Tannin and Cioffi held an investor conference call in which they assured investors that the portfolios were on solid ground. Shortly after that call, the funds collapsed, costing investors approximately $1.6 billion. (“Prosecutors in Bear Case Focus in on Email,” The Wall Street Journal, June 19, 2008; “Prosecutors Build Bear Stearns Case on E-Mails,” The New York Times, June 20, 2008)
Federal prosecutors have broadened their investigations, and are now looking into whether Cioffi and Tannin also made false and misleading statements to their funds’ major lending and trading partners, Bank of America, Barclays, Dresdner Bank and Merrill Lynch, in order to get the banks to invest more money in their ailing funds. Prosecutors also are investigating a $4 billion CDO (whose proceeds were used solely to purchase mortgage backed bonds from the Bear Stearns funds) that Cioffi and Tannin asked Bank of America to guarantee and sell last spring when the market for mortgage backed securities was starting to falter. During investor conference calls, Cioffi and Tannin allegedly advised investors that the Bank of America deal would add “significant liquidity” to the funds. The SEC alleges that these statements were false and misleading because at the time the statements were made, Cioffi and Tannin knew that there were no buyers for the CDO. (“Did Bear Stearns Fool the Street, Too?,” Business Week, June 25, 2008)
Illinois Attorney General Sues Countrywide The Illinois attorney general recently filed a lawsuit against troubled mortgage lender Countrywide Financial and its CEO Angelo Mozilo, alleging that Illinois borrowers were defrauded when they were sold costly and defective loan products that quickly went into foreclosure. The lawsuit accuses Countrywide and Mozilo of relaxing underwriting standards, structuring loans with risky features and misleading consumers by charging hidden fees and making false marketing claims. The complaint, which is based on the Illinois attorney general’s review of 111,000 pages of documents and interviews with various former Countrywide employees, alleges that the lending giant was more concerned with quantity than the quality of its loans. The lawsuit seeks unspecified monetary damages and asks the court to require Countrywide to rescind or reform all of the questionable loans sold by Countrywide from 2004 to date. The Illinois attorney general has asked Mozilo to personally contribute to the alleged damages, and commented that: “[p]eople were put into loans they did not understand, could not afford, and could not get out of. This mounting disaster has had an impact on individual homeowners statewide and is having an impact on the global economy. It is all from the greed of people like Angelo Mozilo.” (“Illinois to Sue Countrywide,” The New York Times, June 25, 2008)
Government & Regulatory Intervention
SEC Proposes New Rules Affecting Ratings Agencies The SEC proposed new rules that may diminish the importance of credit ratings. Current SEC rules require U.S. money market funds to purchase short-term debt with high credit ratings. Under the new SEC rules, however, money market funds could invest in short-term debt without regard to the ratings placed on the debt by ratings agencies such as Standard & Poor’s and Moody’s Investors Service. This change would allow money managers more discretion in determining whether debt is of investment grade. The proposed rules also would diminish the importance of the credit ratings agencies’ capital requirements. The rules were proposed in reaction to concerns that reliance on credit ratings gives investors a false sense of security and discourages investors from doing their own research regarding risk. (“SEC Aims to Rein in the Role of Ratings,” The Wall Street Journal, June 24, 2008)
Auction Rate Securities
Criminal Investigations of Auction Rate Securities
Federal prosecutors in the U.S. Attorney’s Office for the Eastern District of New York, which is emerging as the “primary inquisitor” of Wall Street firms regarding the credit crisis, is investigating whether two former Credit Suisse brokers lied to investors about how they placed their money in auction rate securities (ARS). This investigation is the first known criminal matter arising from the “rout” in the ARS market, which has punished thousands of U.S. investors and resulted in numerous class action lawsuits and more than 80 individual arbitrations against Wall Street firms and others. The emergence of criminal allegations against Wall Street brokers could put more pressure on firms to resolve the frozen ARS market or settle with investors. (“Auction-Rate Probe Grows Over Clarity From Brokers,” The Wall Street Journal, July 9, 2008)
Federal Court Allows Auction Rate Suit to Move Forward Against Deutsche Bank
A federal judge has ruled that a plaintiff alleging to have lost $1.6 million in ARS can move forward with a claim against Deutsche Bank Securities for selling unregistered securities. Judge Alvin Hellerstein of the U.S. District Court for the Southern District of New York denied Deutsche Bank’s motion to dismiss a claim for violation of § 12(a)(1) of the Securities Act of 1933. The court dismissed related claims for violation of § 10(b) of the Exchange Act of 1934 and SEC Rule 10b-5 and for common law fraud, but granted the plaintiff leave to replead the dismissed causes of action. The action arises from the plaintiff’s claims that Deutsche Bank Securities allowed it to purchase ARS even though the company did not meet the necessary requirements for the transaction to proceed as a private placement. Deutsche Bank argued that it had no direct contact with the plaintiff and that a third-party securities broker purchased the ARS at issue from Deutsche Bank and then sold them to the plaintiff. (“Deutsche Bank Unit Must Face Auction-Rate Suit,” Dow Jones Newswires, July 8, 2008)
UBS Sued by Massachusetts Securities Regulators Massachusetts securities regulators recently filed a lawsuit alleging that UBS misled customers by pushing sales of ARS on individual investors in order to reduce the firm’s anticipated losses. According to the complaint, in August 2007, email messages were sent by executives of UBS indicating that the market for ARS was in jeopardy. When sellers of the securities began to outnumber buyers, UBS executives allegedly advised their sales personnel to aggressively promote ARS by marketing them as high-yield liquid alternatives to money market accounts. Significantly, David Shulman, the firm’s global head of fixed income distribution, was allegedly involved in urging employees to sell the securities, while at the same time selling all of his personal ARS holdings by December 12, 2007. The complaint demands that UBS repurchase the ARS from its clients and/or reimburse them for any ARS-related losses. UBS, which underwrote more than $43 billion, or 14 percent of the ARS market, has denied the allegations. (“Suit Claims UBS Misled Investors,” The New York Times, June 27, 2008)
Some Closed-End Funds Offer Redemptions to Holders of Auction-Rate Preferred Securities In the past few months, several closed-end fund companies, such as Nuveen Investments Inc. and Eaton Vance Corp., have announced plans to redeem preferred ARS securities held by frustrated investors, as the securities have been illiquid since broker-dealers walked away from ARS auctions in February 2008. Other closed-end fund companies, including Pimco, Nicholas-Applegate, Neuberger Berman, Dreyfus and Pioneer Investments, have not announced plans to redeem preferred ARS shares. This leaves investors in limbo and favoring instead the interests of the funds’ common shareholders, as the costs to redeem and replace ARS with other leverage may be expensive and chip away at the funds’ earnings. A Pimco spokesperson issued a statement indicating that Pimco is “working diligently” for a solution that “reconciles the competing considerations facing common and preferred shareholders.” (“When ‘Preferred’ Holders Come Second,” The Wall Street Journal, June 24, 2008)
The Scope of the Subprime/Credit Crunch Crisis
Recourse Loans Make a Comeback During the recent boom in commercial property sales, investment banks were more willing to offer non-recourse loans to developers because the loans were bundled and sold to investors as commercial mortgage-backed securities (CMBS), thereby transferring risk in the event of default. As a result of the recent credit crunch and subprime mortgage crisis, however, sales of CMBS have decreased 90 percent in the past year, and commercial properties securing loans have been decreasing in value. Because banks are now forced to hold on to the loans instead of selling them, banks are now requiring developers to guarantee financing for commercial real estate projects. While this requirement is hard on developers, recourse lending also is hard on banks because borrowers facing the loss of personal assets are more likely to put up a fight, and recourse loans earn lower interest rates. (“Guarantee Gamble: Developers Dread Return of Recourse,” The Wall Street Journal, June 18, 2008)
Smaller Banks May Need Bailouts While the failure of a few small or midsized commercial banks may not cause the same threat to the financial system that the collapse of Bear Stearns could have, the struggles of small banks is raising concerns. Smaller banks no longer have access to the usual “escape routes” historically available to them. For example, shareholders in the United States and Europe are increasingly reluctant to invest in banks, which have performed poorly over the past several months, and any news regarding capital shortages at a bank has caused investors to sell their stock. In today’s environment, potential acquirers also are less likely to invest in banks, which hold risky assets, such as credit card debt, car loans and commercial mortgages. Acquisitions of banks are down 80 percent from 2007. As a result, struggling smaller banks may be left with only one option: receivership under the Federal Deposit Insurance Corp. (FDIC). If several smaller banks fail, the FDIC may be overwhelmed, forcing the federal government, and taxpayers, to step in. (“More Bank Bailouts Ahead?,” The Wall Street Journal, June 23, 2008)
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