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 actions arising from the subprime mortgage crisis and credit crunch.
This issue focuses on the increasing number of civil lawsuits, criminal and regulatory investigations and actions, government efforts to ease the economic impact of the subprime crisis and credit crunch, and litigation and regulatory actions relating to the collapse of the auction rate securities market.
Litigation and Regulatory Investigations
Five Securities Brokers Face Subprime-Related Fraud Charges by SEC
The U.S. Securities and Exchange Commission (SEC) filed an action for securities fraud in federal court in Los Angeles on October 3, 2008, against five former World Group Securities brokers. The lawsuit alleges that the brokers persuaded their customers to refinance their fixed-rate residential mortgage loans and enter into risky subprime mortgages as a means of financing the purchase of unsuitable securities, primarily variable universal life policies (VULs). The brokers allegedly paid themselves high commissions on both the subprime mortgages and the securities purchases, misrepresented the nature, liquidity and expected returns of the VULs, as well as the terms of the new mortgages, and falsified client account forms and order tickets relating to the sales of the securities.
The complaint charges the brokers with violations of the antifraud provisions of the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934, as well as aiding and abetting violations of the broker-dealer books and the records provisions of the Securities Act. The SEC seeks injunctive relief, disgorgement and civil penalties. Linda Chatman, director of the SEC’s Division of Enforcement, said “this case demonstrates the SEC’s commitment to halting fraudulent sales practices by brokers and others in the securities industry.” (“SEC Charges Five Brokers With Fraud in Sales of Unsuitable Securities Funded Through Subprime Mortgage Refinancings,” U.S. Securities and Exchange Commission, October 3, 2008)
New York, Federal Prosecutors Cooperate in Credit-Default Swaps Investigation
Michael J. Garcia, the U.S. attorney in Manhattan, and New York State Attorney General Andrew Cuomo (NYAG) have launched a rare joint inquiry to determine whether certain investors manipulated the market for credit-default swaps by driving up the price of swaps that were reported but never completed. Credit-default swaps are similar to insurance contracts in that they protect investors against defaults on bonds. By driving up the price of swaps, which indicate the cost of protecting a company’s debt, the alleged manipulators caused the company’s share price to decline. In that way, short sellers allegedly generated large profits for themselves. The NYAG has commented that “manipulation of the default swap market is equivalent to the spreading of extremely potent false rumors.”
A ruling in 2000 by the New York State Insurance Department held that credit-default swaps are not insurance contracts. Since that ruling, the market for credit-default swaps has been largely unregulated, but the swaps have come under increasing scrutiny since the collapse of Lehman Brothers. As part of the joint investigation, which is in its preliminary stages, the NYAG’s office has issued subpoenas to three market-data providers: Depository Trust Clearing Corporation, Markit, and Bloomberg. According to media reports, the SEC has launched an independent investigation into the credit-default swaps market. (“Joint U.S.-New York Inquiry Into Credit-Default Swaps, October 20, 2008; “Cuomo Probes Swaps Trading, The Wall Street Journal, September 26, 2008; “New York Tries Taming Credit-Default Swaps,” The Wall Street Journal, September 23, 2008)
Seizures and Sales
WaMu Seized, Then Purchased by JP Morgan for $1.9 Billion
On September 25, 2008, JP Morgan Chase & Co. agreed to pay $1.9 billion to the Federal Deposit Insurance Corp. (FDIC) for the banking operations and loan portfolio of Washington Mutual Inc. (WaMu). The Office of Thrift Supervision (OTS), WaMu’s chief federal regulator, seized WaMu and appointed the FDIC as receiver after the OTS concluded that a wave of deposit withdrawals had caused liquidity problems for the bank, leaving it in “an unsafe and unsound condition to transact business.” The seizure of WaMu marks the largest bank failure in U.S. history and the sale of its assets makes JP Morgan the largest U.S. bank in terms of nationwide deposits.
WaMu announced a $3.3 billion loss in the second quarter of 2008, but its decline hastened after Lehman Brothers Holdings Inc. filed for bankruptcy. The Lehman Brothers bankruptcy filing reportedly prompted WaMu customers to withdraw about $16.7 billion in deposits, roughly 9 percent of its total deposits. WaMu’s loan portfolio, which totaled $307 billion at the time of its seizure, included $53 billion in option adjustable-rate mortgages and $16.1 billion in subprime loans. JP Morgan reportedly plans to write down $31 billion of the assets in WaMu’s loan portfolio. (“WaMu Is Seized, Sold Off to J.P. Morgan, in Largest Failure in U.S. Banking History,” The Wall Street Journal, September 26, 2008)
Wells Fargo Outbids Citigroup For Wachovia
Wells Fargo and Co. outbid Citigroup, Inc. for the purchase of beleaguered Wachovia Corp., a deal estimated at $11.38 billion. Unlike the earlier agreement with Citigroup, the Wells Fargo deal does not involve financial assistance by the government. Citigroup reportedly abandoned takeover talks after its due diligence investigation led to concerns about the quality of some Wachovia assets. Although Citigroup abandoned negotiations, it now seeks $60 billion in damages from Wachovia and Wells Fargo under the terms of an exclusivity agreement with Wachovia. For its part, Wachovia argues that its directors were bound by a fiduciary duty to its shareholders to accept Wells Fargo’s offer. Wachovia recently reported a quarterly loss of $23.88 billion, which is among the largest quarterly losses ever reported by a U.S. company. According to reports, the loss is largely the result of its takeover of mortgage lender Golden West Financial Corp. (“Wells Fargo Grabs Wachovia as Citi Walks,” The Wall Street Journal, October 10, 2008; “Wachovia’s Last Act: $23.88 Billion Loss,” The Wall Street Journal, October 23, 2008)
CIBC to Limit Subprime Mortgage Exposure With Help of Private Equity Firm
In an apparent effort to strengthen its balance sheet and limit exposure to the U.S. real estate market, Canadian Imperial Bank of Commerce (CIBC) has secured a $1 billion investment by private equity firm Cerberus Capital Management. In exchange for the investment, Cerberus reportedly will receive a “substantial” interest rate. According to media reports, CIBC, which has been affected by the credit crisis more than any other Canadian bank, has taken $6.8 billion in write-downs during this past year. As a result of these write-downs, CIBC was forced to raise capital to strengthen its balance sheet, which led to its negotiations with four private equity firms, including Cerberus. (“CIBC Cuts Subprime Mortgage Exposure,” Business News Network, October 3, 2008)
Government and Regulatory Intervention
President Bush Signs $700 Billion Financial Bailout Plan
President Bush signed into law a $700 billion financial rescue package. An earlier version of the bill had been rejected by the House of Representatives. The final version of the bill provides for funds to be allocated to the Treasury Department in two disbursements of $350 million each. Congress, however, retains the power to block the second disbursement. Under the plan, the Treasury Department will use the cash to purchase distressed assets from financial institutions in an effort to add liquidity to frozen credit markets. In addition, the rescue package: increases deposit insurance from $100,000 per account to $200,000 per account; allows the government to actively prevent home foreclosures; attempts to restrict “golden parachute” retirement packages for executives whose firms seek federal money under the plan; and establishes two boards to oversee the financial rescue program. Proponents of the plan believe that the total cost to the U.S. government will be much less than $700 billion because the government will eventually be able to resell the assets in the market. (“Bailout Plan Wins Approval; Democrats Vow Tighter Rules,” The New York Times, October 4, 2008)
Federal Reserve to Provide Liquidity to Commercial Paper Markets
The Federal Reserve announced plans on October 7, 2008 to buy commercial paper, which is sold by corporations to fund day-to-day business operations. Commercial paper is bought primarily by money market fund managers and institutional investors. After Lehman Brothers filed for bankruptcy in mid-September 2008, the commercial paper market virtually froze, causing market-wide fear that companies would be unable to pay their debts as they came due. Between September 10, 2008 and October 1, 2008, the amount of commercial paper outstanding declined 11 percent from $1.82 trillion to a seasonally adjusted $1.6 trillion. The Federal Reserve was prompted to take action because it feared that when companies sought to renew their outstanding commercial paper, the majority of which was coming due within days of the announcement, the companies would find it difficult to renew. With its announcement, the Federal Reserve hopes to restore confidence in the commercial paper market but it will purchase only top-rated three-month unsecured and asset-backed commercial paper and the program will expire in April 2009. (“Fed’s New Tool: Business Loan Bailout, Federal Reserve to Buy Loans to Unfreeze Markets,” CNNMoney.com, October 7, 2008)
Federal Government Plans to Purchase Ownership Stakes in U.S. Banks
The U.S. Treasury Department announced an unprecedented plan on October 14, 2008 to purchase equity shares in U.S. banks and thrifts. The Treasury Department’s plan allocates $250 billion of the $700 billion financial rescue package to purchase preferred shares of U.S. banks. Treasury Secretary Henry Paulson explained that institutions selling their preferred shares to the government “will accept restrictions on executive compensation, including a clawback provision and a ban on golden parachutes during the period that Treasury holds equity issued through [the] program.” The preferred shares will also include warrants for common shares. Paulson expressed regret that the government must seek such active participation in the market but, through the plan, the Treasury Department hopes to provide needed capital to banks so that they can resume lending to businesses and consumers. (“Statements by Paulson, Bernanke, Bair,” The Wall Street Journal, October 14, 2008)
Swiss Government Buys Stake in UBS
The Swiss government announced its plans on October 16, 2008 to buy a 9 percent stake in UBS. According to reports, UBS suffered the largest losses from the U.S. subprime mortgage meltdown. The Swiss government reportedly will provide UBS with 6 billion Swiss francs in capital, or $5.36 billion. Swiss regulators also will establish a $60 billion fund to absorb the troubled assets on its books and increase depositor protection. Under the agreement, Switzerland’s central bank will take over $31 billion of U.S. assets, much of it linked to subprime and Alt-A mortgage debt and securities linked to commercial real estate and student loans. The government’s stake in UBS is intended to restore confidence in the bank’s core wealth management business.
Many Swiss shareholders are angry that UBS, which has been known as a prudent and conservative bank, is becoming partly nationalized due to “un-Swiss habits” of “reckless borrowing and betting on shaky American mortgages.” In the last 18 months, several top executives have resigned and UBS has written down more mortgage securities than any other bank in the world. UBS has conceded that it misread the market for mortgage securities. The Swiss government has reprimanded the bank for failing to maintain adequate risk controls. Credit Suisse, Switzerland’s other major bank, denied government offers for direct help and said that it would raise $8.75 billion on its own from private backers. According to reports, neither UBS nor Credit Suisse are in danger of collapse. (“UBS Given Infusion of Capital,” The New York Times, October 17, 2008)
Credit Rating Agencies Questioned by Congress Over Role in Subprime Crisis
On October 22, 2008, a congressional panel investigating the credit meltdown grilled several credit rating agency executives regarding the “good-as-gold ratings” given to securities backed by subprime mortgages. The U.S. House of Representatives investigative panel revealed that internal company documents indicated that executives knew that there was little basis for giving “AAA” ratings to thousands of mortgage-related securities and that the ratings were inflated. At a presentation made to Moody’s board of directors last year, executive Raymond McDaniel apparently warned that company employees often were pressured to issue undeserving high ratings.
Former ratings agency executives testified before the House panel, arguing that there is an inherent conflict of interest in the industry because ratings agencies are paid by bond issuers instead of investors. Large credit ratings agencies such as Standard and Poor’s, Moody’s and Fitch made substantial profits by issuing ratings on several mortgage-related securities as long as housing prices went up. The inflated ratings in turn led investors to buy enormous amounts of securities backed by subprime loans. To date, Standard and Poor’s has downgraded more than two-thirds of its “AAA”-rated securities and Moody’s has downgraded more than 5,000 mortgage-backed securities, which contributed to the current credit crisis. (“Credit-Rating Agencies Get Earful on Capitol Hill Over Subprime Securities,” The Seattle Times, October 22, 2008)
Bank Failures Expected to Increase in 2009
Analysts question whether the $700 billion rescue plan will stabilize the financial sector and prevent additional bank failures in the United States. According to commentators, the banking industry is on its “shakiest ground” since the early 1990s, when more than 300 federally insured institutions failed in a three-year period. A Stanford financial analyst predicts that more than 100 U.S. banks will fail in 2009.
Under the government rescue plan, the FDIC, the government agency that insures consumer deposits in banks and savings and loans, will increase the deposit insurance limit from $100,000 to $250,000 per account. Using statistics from the past savings and loan crisis, commentators have estimated that the total deposits of banks that have failed during the current credit crisis at about $1.1 trillion. It has also been estimated that the FDIC faces potential liability of between $140 billion and $200 billion. According to reports, the FDIC has about $45 billion reserved for insured accounts, but it can borrow additional funds from the U.S. Treasury, which it will repay by raising premiums charged to stable financial institutions.
As of September 2008, 13 financial institutions have been taken over by the FDIC. This figure is more than the previous five years combined. Analysts suggest that the FDIC is underestimating the number of banks in trouble. For example, neither Washington Mutual nor Wachovia appeared on the June 2008 problem list. In September 2008, Washington Mutual became the largest bank failure in U.S. history. In addition, Wachovia last month engaged in negotiations with Citigroup and Wells Fargo for the sale of its banking operations. Relying on data provided by the FDIC, observers estimate that 426 federally insured institutions, or 5 percent of all banks and savings and loans, are dealing with major liquidity problems. (“U.S. Bank Failures Almost Certain to Increase in Next Year,” cnn.com, October 6, 2008)
Auction Rate Securities
RBC, BofA Agree to Buy Back More Than $5 Billion ARS
Bank of America (BofA) and Royal Bank of Canada (RBC) have agreed to settle allegations that they made misrepresentations in the marketing and sale of auction rate securities (ARS). As part of a settlement with federal and state authorities, RBC will pay a $9.8 million fine and reimburse customers for its role in the collapse of the ARS market. RBC, which is the largest bank in Canada, agreed to buy back $850 million of ARS from more than 2,000 retail clients in the United States as part of its agreement with the SEC and NYAG. Despite the agreement with U.S. regulators, the bank may be required to pay additional penalties in the future. RBC said that it will agree to participate in an arbitration process overseen by Financial Industry Regulatory Authority (FINRA) if future damages are sought from the bank. BofA agreed to return $4.5 billion to investors and pay a $50 million penalty. Under the settlements, neither bank will admit or deny any wrongdoing. (“RBC to Buy Back US$850,000 in Auction-Rate Securities,” National Post (Canada), October 3, 2008; “Bank of America and RBC Settle Over ARS,” Yahoo! Finance, October 8, 2008)
Lawsuit Arises Out of Merrill Lynch ARS Settlement
On October 3, 2008, a securities class action was filed in New York state court on behalf of investors who purchased bonds and preferred securities offered by Merrill Lynch. The complaint filed against Merrill and related entities, certain directors and officers, underwriters of the offerings and Merrill’s auditor alleges that the offering documents misstated Merrill’s financial condition, failed to disclose its exposure to losses from subprime mortgage investments and improperly valued mortgage-backed assets. In addition, the plaintiffs allege that Merrill did not disclose its own susceptibility to liability in connection with its issuance or sale of ARS and that it is liable for its participation in the ARS market. It is alleged that later disclosures of the company’s actual financial condition caused a substantial decline in the value of the securities sold in the offering. Unlike a previous securities class action brought against Merrill by purchasers of ARS, the plaintiffs in this action purchased Merrill securities in the offering. The complaint asserts claims under Sections 11, 12 and 15 of the Securities Act. (“Now, Lawsuits Concerning the Auction Rate Securities Settlements,” The D&O Diary, October 15, 2008)
UBS General Counsel Settles with NYAG Over ARS Sales
David Aufhauser, former general counsel for UBS AG’s investment bank unit, settled with the NYAG over allegations of insider trading in the ARS market. The complaint filed by the NYAG alleged that Aufhauser and six other UBS executives possessed inside information about the problems in the ARS market and sold their ARS before the information became public. Aufhauser is the only UBS executive who has settled with the NYAG to date. Under the terms of the settlement, Aufhauser will pay the state a $500,000 fine plus $6 million, representing his entire 2008 incentive compensation package from UBS. In addition, the settlement agreement bars Aufhauser from practicing law in New York, serving as an officer or director of a public company or participating in the securities industry for two years. A spokesman for Aufhauser commented that he did not gain any personal profit from his sale of $250,000 of ARS in December 2007. (“Aufhauser, New York Settle Insider-Trading Allegations, The Wall Street Journal, October 7, 2008)