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Publications
Subprime/Credit Crunch Digest
December 2008
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 ongoing government effort to ease the economic impact of the subprime crisis and credit crunch, including newly proposed and enacted market regulations aimed at the market crisis, as well as litigation and regulatory actions relating to the collapse of the auction rate securities market.
Litigation and Regulatory Investigations
Suit Against Former AIG CEO Dismissed as ‘Waste of Time’
On November 17, 2008, New York Supreme Court Justice Charles Ramos dismissed a lawsuit filed against American International Group, Inc. (AIG) accusing its former chief executive officer of misrepresenting billions in losses in the company’s credit-default swap portfolio and fraudulently reassuring the plaintiff that the “risk of loss from its credit-default swap portfolio was remote.” The plaintiff essentially alleged that it would have sold all of its stock sooner if it had known that AIG had significant exposure to subprime mortgages. Counsel for AIG argued that the claims were “totally speculative and irrational.” Judge Ramos apparently agreed. He dismissed the claims against AIG, stating that the case was a “waste of time.” (“Starr Foundation’s Suit Against Ex-AIG Chief Tossed,” Bloomberg.com, November 21, 2008)
Former UBS Executives Forgo Bonuses; Shareholders Demand Derivative Litigation
Three former UBS executives announced on November 25, 2008, that they would voluntarily return about $58.3 million in bonuses. The former chairman, vice president and chief financial officer reportedly oversaw the risky subprime investments that led to substantial losses at UBS. Following the announcement, an activist UBS shareholder group representative stated that, although the bonus forfeiture was a “positive gesture,” the shareholder group would demand that UBS file lawsuits against its former managers for damages. In response, UBS stated that while the company’s internal investigation continues, it has not found any evidence that a lawsuit against the executives would be successful.
UBS, which posted about $48.6 billion in write-downs related to the collapse of the U.S. subprime mortgage market, received about $60 billion from the Swiss government as part of a bailout package in October 2008. Before the announcement by the former executives, UBS had announced that it would halt bonus payments to its chairman starting in 2009 and not award bonuses to other board members or executives responsible for high-risk business units when UBS suffers a loss. (“3 Former UBS Executives Forfeit Pay,” The New York Times, November 26, 2008; “UBS Former Executives Repay $58.3 Million of Bonuses (Update 3),” Bloomberg.com, November 27, 2008)
Government and Regulatory Intervention
Congress Seeks Greater Transparency in Federal Bailout
On November 17, 2008, during a hearing held by the Senate Finance Committee regarding the nominee for special inspector general, legislators expressed frustration regarding the lack of transparency in the Treasury Department’s implementation of the $700 billion bailout plan. Republican and Democratic senators alike stated that U.S. Treasury Secretary Henry Paulson has not adequately accounted for the $290 billion that his department has already spent under the bailout legislation passed by Congress in September 2008.
The committee members stated that the special inspector general must ensure that banks are not hoarding federal funds or using the funds for excessive executive pay, dividends or acquisitions of other banks. Committee members also expressed concern that the implementation of the bailout plan has the potential for conflicts of interest among Treasury officials, law firms, asset managers and other contractors appointed by the Treasury Department. In addition, the legislators sought an explanation regarding the Treasury Department’s abandonment of its original plan to buy troubled assets from financial institutions. The bailout legislation provides for a congressional oversight panel in addition to the special inspector general, who will report to Congress once every four months. (“Little Transparency in How Bailout Money Is Being Spent, Say Lawmakers,” Financial Week, November 17, 2008)
Government Bailout Results in New Federal Programs
Treasury Secretary Paulson announced plans on November 25, 2008, to implement a $200 billion lending facility operated by the Federal Reserve (the Fed) to increase the availability of automobile loans, student loans and credit cards in an effort to stimulate the economy and consumer borrowing. The Treasury Department plans to contribute between $25 billion to $100 billion to the facility from the $700 billion Troubled Asset Relief Program. In addition, the Fed will lend up to $200 billion to holders of asset-backed securities supported by car loans, credit card loans, student loans and business loans guaranteed by the Small Business Administration. The credit facility program includes $20 billion in “credit protection” from the Treasury Department. It is believed that the facility could eventually broaden to include mortgages and other kinds of assets. Although the Treasury Department initially planned to buy consumer loans itself, it decided instead to invest money into banks and other financial institutions. To this end, the Treasury Department has created a $250 billion program to invest directly in banks.
The federal government also unveiled a plan to invest $800 billion in new loans and debt purchases, which are expected to unfreeze the troubled credit markets and make borrowing easier for homebuyers, small businesses and students. In addition, the Fed intends to buy $600 billion in mortgage-backed assets from Fannie Mae and Freddie Mac and $100 billion in debt directly from the companies. It also plans to purchase $500 billion in mortgage-backed securities. (“New Facility Targets Consumer Lending,” The Wall Street Journal, November 25, 2008; “U.S. Unveils New Programs to Ease Credit,” The New York Times, November 26, 2008)
Federal Government Announces Plan to Aid Citigroup
The federal government and Citigroup Inc. reached an agreement on November 23, 2008, whereby the federal government will provide additional financial assistance to the company. Under the agreement, the government essentially will insure a portion of Citigroup’s balance sheet by allowing the Fed, the Federal Deposit Insurance Corporation (FDIC) and the Treasury Department to absorb 90 percent of the losses suffered by Citigroup after the first $29 billion from a pool of about $306 billion worth of assets on the company’s balance sheet. The pool includes Citigroup’s U.S. residential and commercial mortgage and leveraged corporate loan portfolios. The agreement also provides that the Treasury Department will inject $20 billion of capital into Citigroup. The amount is in addition to the $25 billion that the Treasury Department injected into the bank under the initial phase of the federal bailout plan. In return for its investment, the government will receive warrants to purchase shares of Citigroup. The agreement does not require Citigroup to replace any executives or board members, but the company did agree to “comply with enhanced executive compensation restrictions.”
Citigroup’s troubles mounted after a deal to purchase Wachovia Corp. in late September 2008 fell through following a higher bid by Wells Fargo and Co. Citigroup had hoped to unload some of its troubled assets through that proposed deal. During the week before the November 23 agreement, Citigroup announced that it was abandoning its plan to sell $80 billion of troubled assets and would buy $17.4 billion of assets, including risky mortgage-linked securities, from its structured investment vehicles. Those announcements along with general market fears caused Citigroup’s common share price to plummet 60 percent.
Commentators and some Citigroup executives are uncertain whether the federal assistance will stabilize the troubled bank. Citigroup’s executives have represented that, in an effort to decrease risk, Citigroup may seek to reorganize through the sale of certain business divisions or mergers with other financial institutions. Citigroup faces substantial losses on loans (e.g., Citigroup’s credit card line of business) that are not covered by the federal loss-sharing agreement. (“U.S. Agrees to Rescue Struggling Citigroup, Wall Street Journal, November 24, 2008; “Citi Faces Pressure to Slim Down,” Wall Street Journal, November 25, 2008)
FDIC Seizes Three More Banks
The FDIC announced on November 21, 2008, that state bank regulators closed The Community Bank of Logansville, Ga. (Logansville). In addition, as part of a FDIC-brokered deal, U.S. Bancorp of Minnesota acquired the banking operations of Downey Savings and Loan Association of Newport Beach, Calif., and PFF Bank and Trust of Pomona, Calif. U.S. Bancorp agreed to absorb up to $1.6 billion in loan losses and the FDIC would absorb the remainder. All three banks were large mortgage lenders in the California market. Downey is the third-largest bank to fail this year, after Washington Mutual and IndyMac Bancorp.
The total number of bank closures this year stands at 22, including Logansville, Downey and PFF, which is the highest annual total since 1993 and double the highest number of annual bank failures for any year. Moreover, the pace at which banks have failed has accelerated during the past year. Eighteen of the 22 bank failures have occurred since July 1, 2008, with nine since October 1, 2008. Five banks failed in November alone, which marks that highest number of failures for any month. The FDIC estimates that it will spend $2.3 billion as a result of the three most recent bank failures and about $15 billion on 2008 bank closures. (“FDIC Seizes Three Banks, Expanding Loan-Relief Effort,” The Washington Post, November 22, 2008, “More Bad Bank News,” D&O Diary, November 23, 2008)
Mortgage Foreclosure Relief
Mortgage Companies Announce Plans to Suspend Foreclosures
Citigroup, Fannie Mae and Freddie Mac on November 11, 2008, announced plans to reduce mortgage payments for borrowers facing foreclosure. The announcements by the three mortgage lenders followed a push by Congress for lenders to negotiate with borrowers to prevent foreclosures after 765,558 properties received a default notice, a pending action notice or were foreclosed on during the third quarter of 2008, which represents the highest foreclosure rate on record in the United States. Fannie Mae and Freddie Mac also plan to renegotiate mortgage loans by reducing principal and interest rates and extending repayment terms. Citigroup stated that it has assisted about 370,000 people in avoiding foreclosure since 2007, and plans to contact about 500,000 homeowners with mortgages totaling $20 billion during the next six months. In addition, Citigroup promised to end foreclosures on homes where the borrowers reside and have “sufficient income for affordable mortgage payments.” Citigroup plans to focus its outreach to homeowners in “areas that are likely to face extreme economic distress.” Financial experts believe that decreasing home foreclosures and stabilizing the housing market are essential elements to restoring the overall economy. (“Citi, Fannie, Freddie to Halt Some Foreclosures (Update 3),” Bloomberg.com, November 11, 2008)
Market Regulations
Bank Examiners Under Pressure From OCC Following Treasury Department Report
The Office of the Comptroller of the Currency (OCC) is exerting new pressure on bank examiners to issue formal sanctions to banks when problems are found. This action follows the publication of a Treasury Department report that found that regulators at the OCC did not act forcefully enough to prevent risky practices at ANB Financial, a national bank that collapsed in May 2008. The Treasury Department report faults the OCC for waiting until 2007 to take action against ANB Financial even though examiners found problems in 2005 and 2006. The OCC expects bank examiners to act “while problems are still manageable and the prospect for rehabilitation or, alternatively, sale or merger of the institution are still good.” The Treasury Department and OCC hope that increased vigilance by bank examiners will reduce unhealthy lending and prevent banks from expanding too quickly into risky transactions. Some commentators fear that the new regulatory atmosphere will create an acrimonious relationship between banks and regulators where banks are frightened to lend but regulators push them to make loans with federal money received through capital injections. (“Bank Examiners Are Told to Step Up Sanctions on Lenders,” Wall Street Journal, November 28, 2008)
U.S. Regulators Agree to Guidelines for Oversight of Credit-Default Swaps
On November 14, 2008, the Fed, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) signed a memorandum of understanding in which the regulators agreed to provide consistent rules regarding the oversight of the credit-default swaps, which are financial instruments that allow investors to speculate on the ability of borrowers to repay debt. Under the agreement, the SEC will have greater access to market data, allowing it to more effectively monitor and control market fraud and manipulation. Since the collapse of Lehman Brothers Holdings, Inc. in September 2008, regulators and financial analysts have increasingly called for regulation of the mostly unregulated, over-the-counter market for credit-default swaps. According to a joint statement released by regulators and the Treasury Department, at least one clearinghouse for the credit-default swap market will be operational by year-end. The regulators are currently reviewing risk management functions at CME Group, Intercontinental Exchange Inc. of Atlanta, NYSE Euronext and Eurex, which have submitted proposals to run clearinghouses for credit-default swaps. (“Credit Swap Clearinghouse to Be Running by Year-End (Update 2),” Bloomberg.com, November 14, 2008)
Proposed Bills Address the Market Crisis
Two bills were introduced in Congress on November 19, 2008, that addressed the current market crisis. The Financial Regulation Reform Act of 2008 introduced in the Senate would amend the Commodity Exchange Act. The proposed legislation seeks to extend regulations over credit default swaps and to provide the Fed with authority over investment bank holding companies. In addition, the Act would direct the SEC to issue rules regarding designation of clearing houses for credit default swaps and to prevent fraudulent practices in connection therewith. On the same day, the House of Representatives proposed the Financial Oversight Commission bill designed to investigate the causes of the financial crisis. A commission, comprised of 10 members, would be directed to examine and report on the causes of the current financial crisis and to make an accounting of the circumstances surrounding the crisis to the president and Congress within 12 months. (“This Week in Securities Litigation: The Market Crisis,” SEC Actions, November 28, 2008)
SEC Adopts New Conflict of Interest Rules for Credit Rating Agencies
On December 3, 2008, the SEC adopted new rules addressing conflicts of interest in the credit-rating industry aimed at increasing transparency. The three major firms – Standard & Poor’s, Moody’s Investors Service and Fitch Ratings – have been faulted for their role in the credit crisis and their failure to identify risks associated with subprime mortgages. As a result of the credit crisis, these firms have been forced to downgrade thousands of securities backed by mortgages, which has contributed to hundreds of billions in losses and write-downs at major banks and investment firms. The SEC chairman commented that the new rules are “a significant and substantive action” that will allow the public access to information about the industry. The SEC previously proposed a system similar to that proposed by the European Union, where ratings of complex securities would be distinguished by a special identifier from more traditional securities. That system, however, drew opposition from Wall Street. The new conflict of interest rules ban rating agencies from issuing ratings in cases where the agency made recommendations to the company issuing securities or the investment bank underwriting them concerning the corporate structure, assets or activities of the issuing company. Rating agencies also will be required to disclose statistics on all of their upgrades and downgrades and the extent of verification performed on the quality of the securities. (“SEC Issues Rules on Conflicts in Credit Rating,” The New York Times, December 4, 2008)
Auction Rate Securities
Investors May Litigate in Order to Opt Out of ARS Regulatory Settlements
Lawsuits arising from the collapse of the auction rate securities (ARS) market continue to be filed against major financial institutions despite recent settlements reached with regulators. Several investors feel that the regulatory settlements do not remedy the harm they suffered as a result of the ARS market collapse in February 2008. As a result, some investors may pursue litigation seeking to opt out of the regulatory settlements. On November 14, 2008, an investor filed a securities lawsuit in Minnesota federal court against UBS and related entities alleging the defendants committed fraud in connection with their purchase of about $70 million of ARS on behalf of the plaintiff. The complaint expressly acknowledges the August 2008 ARS settlement by UBS, but alleges that the settlement does not resolve the dispute between the plaintiff and UBS. In particular, the complaint alleges that the settlement terms do not return the plaintiff to the position it would have been but for UBS’ fraud. The plaintiff further alleges that the terms of the settlement requiring UBS to redeem the ARS at par will take years to execute. The plaintiff seeks to opt out of the regulatory settlement due to an immediate need for liquidity. (“Will Investors ‘Opt Out’ of Auction Rate Securities Settlements?” D&O Diary, November 23, 2008)
Massachusetts Regulator Sues Oppenheimer Over ARS Practices
Financial institutions that have not yet reached settlements are being pressured to do so by regulators. On November 18, 2008, the Massachusetts Securities Division initiated an adjudicatory proceeding against Oppenheimer and Co. for alleged violations of state securities laws in connection with the company’s sales of ARS to the firm’s clients within the state. The complaint alleges that Oppenheimer misrepresented the nature of ARS and the stability and health of the market. In addition, the complaint alleges that Oppenheimer committed fraud, as well as dishonest and unethical conduct in connection with its ARS sales. The complaint seeks an order requiring Oppenheimer to rescind sales of ARS at par and make full restitution to investors who already sold the ARS at less than par. The regulator also seeks to censure the firm, revoke the registration of its Chairman and CEO’ as broker-dealer agents of Oppenheimer and fine Oppenheimer and certain of its officers and directors. (“Oppenheimer Sued by Mass. Over ARS,” CFO.com, November 18, 2008)
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