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Publications
Subprime/Credit Crunch Digest (Part II)
September 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 interim issue of the digest focuses on the recent turmoil in the U.S. financial market stemming from the bankruptcy filing by Lehman Brothers and proposed government bailouts. In addition, this issue summarizes recent developments in litigation and regulatory actions arising from the collapse of the auction rate securities market.
Bankruptcies, Buyouts and Bailouts
Lehman Files Largest Bankruptcy in U.S. History; Judge OKs Sale to Barclays
On September 15, 2008, Lehman Brothers Holdings Inc. filed a voluntary petition for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Southern District of New York. During September, Lehman suffered the largest losses in its 158-year history and was forced to file for bankruptcy after the federal government’s attempts to broker a sale of the company to Barclays and Bank of America failed. Both potential buyers reportedly pulled out of negotiations because they could not obtain guarantees to protect against potentially substantial losses on Lehman’s mortgage-related assets. Lehman, which was the largest U.S. underwriter of mortgage-backed securities, listed more than $613 billion of debt in its Chapter 11 petition. Lehman owes its bondholders, including Citigroup and Bank of New York, approximately $155 billion, and its largest creditor, Tokyo-based Aozora Bank, Ltd., $463 million. Analysts and other observers noted that the unprecedented liquidation of Lehman will likely cause a “broad-based decline in marks on asset values” and a chain reaction in markets worldwide. (“Lehman Files Biggest Bankruptcy After Suitors Balk,” Bloomberg.com, September 15, 2008)
Following a hearing on September 19, 2008, that lasted into the early morning on September 20, U.S. Bankruptcy Judge James Peck approved Lehman’s sale of its investment banking and trading business to Barclays in a deal worth an estimated $1.35 billion. Barclays will buy $47.4 billion of Lehman’s securities and assume $45.5 billion of the firm’s liabilities. Under the agreement, Barclays will purchase Lehman’s Manhattan headquarters and units that employ about 9,000 employees in the United States. Additionally, Barclays will acquire Lehman Brothers Canada Inc., Lehman Brothers Sudamerica SA and Lehman Brothers Uruguay SA. Bondholders’ counsel issued a statement expressing disappointment in the deal, which it believes benefits Barclays and the federal government, but not Lehman creditors. (“Judge OKs Lehman Unit Sale to Barclays,” CNN Money.com, September 20, 2008)
Bank of America Acquires Merrill Lynch for $50 Billion; Shareholders Could Reject Deal
Merrill Lynch entered into negotiations on September 12, 2008, to sell itself to Bank of America following declines in the firm’s share price. The two companies reached a deal on September 14, 2008, in which Bank of America would purchase Merrill Lynch for $50 billion, or about $29 per share. The all-stock deal remains subject to approval by Merrill Lynch’s shareholders. The sale price represents two-thirds of the company’s value a year ago. The firm’s decline in value and urgent negotiation for its sale demonstrate the severity of the credit crisis. Last year, Merrill attempted to protect itself from adverse market conditions by selling off large equity stakes and failing assets, steps that most other financial institutions failed to take. Despite these efforts, Merrill Lynch recently reported $900 billion of debt on its balance sheet due to its large holdings of presently illiquid mortgage-backed securities. (“Bank of America to Buy Merrill,” The Wall Street Journal, September 15, 2008)
After the federal government’s September 19, 2008, announcement that it would seek congressional approval of a proposal to rescue ailing Wall Street firms, commentators have speculated that Merrill Lynch’s shareholders might reject the hasty deal to sell the company. Commentators noted that the financial landscape that precipitated the deal between Merrill Lynch and Bank of America changed dramatically after the government announced its plan to buy up billions worth of mortgage-related securities. The deal between the two banks provides that Bank of America has the option to purchase up to 19.9 percent of Merrill Lynch at $17.05 per share (the closing price of the firm’s shares on September 12, 2008) in the event that Merrill Lynch’s shareholders reject the proposed acquisition. (“Merrill Lynch Investors May Now Balk at BofA Deal,” Associated Press, September 19, 2008)
U.S. Provides $85 Billion Loan to AIG to Stave Off Bankruptcy
The Federal Reserve announced its plan on September 16, 2008, to prevent American International Group (AIG), the nation’s largest insurer, from filing for bankruptcy. Although government officials stated that an eventual liquidation is likely, the plan is aimed at preventing a “tumultuous fire sale.” AIG faced almost certain bankruptcy after all of the major credit rating agencies lowered its rating on September 15, 2008. The credit rating downgrades could force AIG to increase the collateral on its outstanding debt by $13 billion. During 2008, AIG has lost more than $18 billion, and its stock price has fallen by more than 91 percent. AIG’s financial turmoil resulted from losses on its sales of credit default swaps and its holdings of subprime mortgage-backed securities. During the first two quarters of 2008, AIG was forced to write down the value of its credit default swaps, which are “insurance-like contracts” that guarantee companies’ debt, by $14.7 billion. Because it plays such a critical role in both the U.S. and international credit markets, the Federal Reserve stated that a “disorderly failure” of AIG could have led to the disruption of markets worldwide.
Under the bailout plan, the U.S. government will extend an $85 billion line of credit to AIG for two years with interest accruing at a rate of the three-month Libor plus 8.5 percent. In return, the government will receive a 79.9 percent stake in the company, and AIG’s management will be replaced. Edward Libby, former head of Allstate Corp., will lead the company, but the current board will remain in place. The government believes that taxpayers are protected under the bailout plan because the loan is secured by the assets of AIG and its subsidiaries. In a statement released after the government’s announcement, AIG said that it believes that the plan “will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis.” (“Fed in AIG Rescue - $85B Loan,” CNN Money.com, September 17, 2008)
U.S. Treasury Seeks Authority to Buy $700 Billion of Distressed Mortgage-Related Assets
On September 20, 2008, the Treasury Department sent Congress a proposal, which, if approved, would give the Treasury broad authority to buy troubled assets from U.S. financial institutions. In the two-and-a-half page proposal, the Treasury outlined the fundamental aspects of its plan to salvage the U.S. credit markets. Under the proposal, the federal government would buy, sell and hold residential and commercial mortgages and “any securities, obligations or other instruments that are based on or related to such mortgages,” as long as all assets purchased are tied to mortgages originated before September 17, 2008. The plan would authorize the government to spend up to $700 billion to acquire the mortgages and securities and to employ asset managers to oversee the acquisition process. Under the proposal, the authorization would expire after two years, but the Treasury would be allowed to hold the purchased assets for as long as it deemed necessary. The plan, which states that decisions by the secretary of the Treasury are non-reviewable, provides legal immunity to the Treasury. The plan also asks Congress to raise the public debt limit to $11.3 trillion from the $10.6 trillion limit, which Congress approved earlier this year as part of legislation that allowed the government to take control of Fannie Mae and Freddie Mac. (“U.S. Bailout Plan Calms Markets, But Struggle Looms Over Details,” The Wall Street Journal, September 20, 2008; “$700 Billion Is Sought for Wall Street in Massive Bailout,” New York Times, September 21, 2008)
Goldman Sachs and Morgan Stanley Become Bank Holding Companies
On September 21, 2008, the Federal Reserve granted Goldman Sachs and Morgan Stanley permission to become bank holding companies, which will allow both firms to seek stable funding by creating commercial banks that can take deposits. The bankruptcy filing of Lehman and the forced sale of Merrill Lynch to Bank of America put pressure on the shares of both Goldman Sachs and Morgan Stanley as investors feared that independent investment banks could not survive under current market conditions. As commercial banks directly overseen by the Federal Reserve, the firms will be forced to comply with stricter regulations than they faced as investment banks under the regulation of the Securities and Exchange Commission. However, the two banks will have access to the Federal Reserve’s emergency loan program, and during a transition period, the banks can obtain short-term loans from the Federal Reserve Bank of New York. After the announcement, shares of Morgan Stanley and Goldman Sachs fell 3.3 percent and 2.8 percent, respectively, in pre-market electronic trading on September 22, 2008. (“Last Major Investment Banks Change Status,” The Associated Press, September 22, 2008)
Litigation and Regulatory Investigations
Pace for Subprime-Related Lawsuit Filings Increases During 2008
A recent report by Navigant Consulting Inc. found that 607 lawsuits related to the fallout from the subprime lending debacle have been filed in U.S. federal courts since June 30, 2007. About half of those cases were filed during the first six months of 2008. Subprime-related lawsuit filings have overtaken the total number of lawsuits filed following the savings-and-loan crisis of the late 1980s and early 1990s, and show no sign of slowing in the near future. During the second quarter of 2008, three new subprime-related cases were filed for every one case that was dismissed. The report warns that “new waves of litigation” will likely occur because the “credit crisis remains fluid.” The report notes, however, that borrower class action lawsuits have fallen 60 percent from the first quarter to the second quarter of 2008. (“U.S. Subprime Lawsuits Outpace S&L Cases, Study Finds,” Reuters, September 11, 2008; “Subprime Mortgage Litigation Filings Surpass S&L,” Business Wire, September 11, 2008; “Subprime Crisis Spurs Private Lawsuits,” Financial Times, September 10, 2008)
Auction Rate Securities
Credit Suisse Settles With State Regulators
In a settlement with state regulators, who have been investigating Credit Suisse and other banks involved in selling auction rate securities (ARS) since late February 2008, Credit Suisse agreed to repurchase $550 million of ARS from investors and pay a $15 million fine. Credit Suisse’s September 16, 2008, settlement came only a week after Fidelity Investments’ agreement to repurchase $300 million of ARS from its investors. Regulators alleged that Credit Suisse misrepresented to investors that ARS were liquid investments. Under the terms of the settlement, Credit Suisse agreed to repurchase ARS at par from retail investors “as soon as practicable” and to develop “liquidity solutions” for institutional investors with account values of more than $10 million. Additionally, the bank consented to a public arbitration process to resolve claims by investors who purchased ARS from Credit Suisse and subsequently sold them at a loss. (“Credit Suisse Settles in ARS Case,” Financial Times, September 16, 2008)
UBS Motion to Dismiss Denied in ARS Lawsuit
On September 17, 2008, a federal judge in the Northern District of New York denied UBS’ motion to dismiss, allowing a lawsuit alleging that the firm fraudulently misrepresented that ARS were liquid investments to move forward. The lawsuit also asserts claims under the Investment Advisors Act, alleging that UBS violated the plaintiff’s investment policy, and a breach of fiduciary duty claim, alleging that USB sold off its own ARS when it realized that the market was becoming illiquid but failed to warn its clients of the liquidity problem. Counsel for the plaintiff believes that this is the first ARS claim to survive a motion to dismiss. Legal analysts had speculated that ARS claims might not be viable because the notes do not mature for 20 to 30 years, allowing defendants to argue that investors have suffered no loss to date. UBS expressed disappointment in the ruling and said it has offered its clients “multiple liquidity options” since the breakdown of the ARS market. (“New York Judge Denies UBS Motion to Dismiss ARS Case,” The AM Law Daily, September 18, 2008)
SunTrust and WaMu Settle FINRA’s ARS Investigation
On September 18, 2008, the Financial Industry Regulatory Authority (FINRA) announced it had reached separate settlements with SunTrust Investment Services, Inc. and SunTrust Robinson Humphrey, Inc., WaMu Investments, Inc. and two other firms related to their sales of ARS. Under the settlements, each firm will offer to repurchase, at par, ARS purchased between May 31, 2006 and February 28, 2008, make whole individual investors who sold ARS below par after February 28, 2008, and allow an arbitrator to resolve investor claims for any consequential damages. The SunTrust entities and WaMu agreed to pay fines totaling $1.95 million and $250,000, respectively. (“FINRA Announces Agreements in Principle with Five Firms to Settle Auction Rate Securities Violations,” www.finra.org, September 18, 2008)
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