The Subprime Crisis: Investigating and Defending Disputes

By Barrie L. Brejcha and Kimberly S. Richmond

Daily reports about the current subprime crisis intensified during the latter part of 2007, and many believe the greatest fallout is yet to come. It is currently estimated that global subprime losses could exceed $500 billion. [1] While reportedly more than 100 class action, derivative, fiduciary liability, and other lawsuits have already been filed against lenders, securitization participants, and rating agencies, [2] the litigation landscape is still evolving, and it remains to be seen how many different players will be implicated. In addition to private lawsuits, both state and federal regulators have initiated investigations into conduct related to subprime lending. As recently as December, the SEC reportedly was in the process of conducting approximately three dozen investigations into the subprime mortgage market, which may or may not result in enforcement actions. [3] In late January, the FBI announced that it was investigating 14 U.S. companies, focusing on accounting fraud, securitization of loans, and insider trading.

In this article, we first summarize the “perfect storm” in the mortgage lending, securitization, and real estate industries that culminated in the current subprime crisis. Next, we survey the various subprime-related claims that have been asserted and briefly assess the unfolding litigation landscape. Finally, we look at the issues to consider when investigating and defending these claims.

The Subprime Crisis

Subprime lending [4] is the practice of making loans to borrowers who do not qualify for the most favorable interest rates in the prime market, primarily because of credit history. During the past lending cycle, lenders offered many types of adjustable rate loans due to a combination of the steady increase in home values and interest rates that made adjustable rate mortgages much more attractive than fixed rate mortgages.

Underwriters appeared to move away from focusing on the borrower’s ability to repay the loan to assessing the value of the collateral (and the assumption that the collateral would continue to increase in value) in making lending decisions, reasoning that even if the borrower couldn’t make the payments on the mortgage, the lender could recover all (or substantially all) of its investment by foreclosing and selling the property. Borrowers were drawn to adjustable rate loans with low initial rates because they allowed borrowers to qualify for larger loans than they could receive if they borrowed at a fixed rate for 30 years. Rather than being concerned about increases in interest rates, borrowers assumed they would be able to refinance before those increases took effect, in part because of their belief that home values would continue to increase and interest rates would remain low.

However, when real estate values started to decline, subprime loans became the first to result in losses because there was little to no equity in the home in the first place.

When borrowers began defaulting, banks curtailed their lending as they sought to conserve capital eroding from losses caused by defaults at a time of declining real estate values, which contributed to a liquidity crisis. Mortgage defaults and market illiquidity led to a decline in the fair values of securities, including those previously thought to be “safe,” resulting in large write-downs.

Mortgage Instruments and Lending Practices

Issues relating to subprime lending provided the catalyst for a surge in securities class action filings in 2007—rising as much as 43 percent over 2006. [5] Reports attribute much of the increase to the subprime meltdown, prompting subprime-related lawsuits naming a variety of defendants. Most of the class actions have been filed against companies in the banking/mortgage lending business, although lawsuits have also been filed against residential home builders, real estate investment trusts, bond insurers, and credit rating agencies.

A growing number of these cases involve mortgage-backed securities (MBS) [6] and other structured financial products backed by subprime loans, with investors claiming that defendants failed to disclose the risks associated with complicated financial instruments into which subprime mortgage loans were packaged and then sold to investors. Given the number of parties potentially involved in a subprime loan transaction from origination to securitization, the subprime crisis encompasses a wide number of participants—including loan originators, firms that securitize loans, investors, credit agencies, and credit guarantors.

Loan Originators
Shareholders have criticized underwriting standards, whether the lenders made appropriate and adequate disclosures regarding the quality and sources of loans, whether the originators disclosed the ongoing conditions of subprime portfolios and related deterioration of loan quality therein, and lastly, whether reserves were adequate to accommodate loan repurchase obligations.

In Michael Atlas v. Accredited Home Lenders Holding Co., No. 07-CV-488H (RBB) (S.D. Cal.), the plaintiff alleged that Accredited Home Lenders and certain director defendants concealed Accredited’s true financial condition and made materially false and misleading statements regarding the company’s operations and income—in particular, that Accredited’s underwriting procedures were better and more conservative that those of other subprime lenders. The lawsuit alleges that in addition to its public representations that the company was committed to credit quality, Accredited’s Form 10-Q for the quarter ending September 30, 2005, falsely stated that the company was in compliance with all covenant requirements for each of Accredited’s credit facilities. The complaint further charged that the defendants manipulated Accredited’s earnings by inadequately reserving for defaults on mortgage loans held for investment and repurchase losses on mortgage loans sold to third-party investors, and by not writing-down to fair value real estate acquired through foreclosure—causing Accredited’s reported income to be artificially inflated. On January 4, 2008, the court denied the defendants’ motion to dismiss, finding, among other things, that the facts alleged (e.g., the sizable impact on Accredited’s reported earnings of the alleged GAAP violations, the prior auditor’s refusal during the class period to approve the company’s 2006 financial statements before the deadline for filing its Form 10-K, and the new auditor requiring the company to restate to increase its allowance for loan losses by over $30 million) sufficiently supported an inference of scienter to survive a motion to dismiss.

However, in Claude A. Reese v. IndyMac Bancorp, No. 07-CV-01635 (C.D. Cal.), the court reached a different conclusion. As in Atlas, the plaintiffs alleged that the IndyMac defendants made public statements throughout the class period that touted the company’s business and financial performance but failed to fully disclose problems with internal controls and underwriting practices, and that the company maintained inadequate loan loss provisions—all of which effectively maintained IndyMac’s stock price at inflated levels, until news of its problems began seeping into the market. On November 29, 2007, the court dismissed the case without prejudice, finding, among other things—absent significant insider sales during the class period—that the complaint allegations did not satisfy the heightened scienter requirements of Tellabs. [7]

Loan originators are also the subject of regulatory scrutiny. For example, Countrywide Financial, the nation’s number one mortgage lender, is reportedly being investigated by the Attorneys General of Illinois and California for its loan origination activities.

Securitization Participants and Purchasers
Because of the extent of the involvement of many banks and securities firms in the securitization process, these players are receiving some of the greatest scrutiny in a number of areas. Purchasers of the securitized products are questioning prospectus disclosures of the initial loan portfolio, including asset pool characteristics, underwriting standards and quality of assets, source of loans, and credit enhancement arrangements. Regulators and others are questioning the procedures related to the valuation of the securities—a complex task compounded by challenges as the securities became less liquid and saleable on the open market. Further, questions have arisen concerning obligations to update ongoing disclosures as loan portfolios and associated risks changed (e.g., delinquency statistics that began to have a material effect on the portfolios).

Shareholders/investors have initiated class action securities fraud claims charging that banks failed to adequately disclose the risks related to investments in securities backed by subprime loans. These include allegations that investments were imprudent or unsuitable, standard risk management procedures were not followed, and due diligence related to the purchase of the investments was insufficient. For example:

An institutional investor sued Merrill Lynch for fraud, negligence and breach of fiduciary duty for investments of $133.9 million made by Merrill brokers in ten auction-rate securities, nine of which were backed by tranches of collateralized debt obligations ("CDOs”) [8] underwritten by Merrill and backed by pools of mortgages, in alleged violation of the investor’s stated goal of holding only low-risk, highly liquid assets. [9]

Shareholders sued UBS AG and certain of its directors and officers, charging false or misleading disclosures regarding valuations on subprime related assets. [10] The suit alleges that a hedge fund unit of UBS was slashing valuations on subprime-related assets at the same time that UBS was carrying similar assets at much higher valuations.

Through January 2008, five clients of State Street Corp. have sued the company for losses suffered by pension plans, claiming that they had lost tens of millions of dollars invested in a State Street fund they were told would be invested in risk-free debt securities (e.g., Treasuries) but were used to acquire “high risk” investments and mortgage-backed securities. [11]

While the initial wave of subprime shareholder class action lawsuits has targeted a number of firms for inadequate disclosures concerning their subprime mortgage-related positions—including Merrill Lynch, State Street, Bear Sterns, UBS, Goldman Sachs, Citibank, New Century Financial, and Credit Suisse—some experts anticipate that, for investment banks, the “worst is yet to come.” As one commentator has noted, the difficulty associated with valuing assets in a deteriorating environment results in piecemeal disclosures of subprime-related losses, potentially prompting further subprime-related litigation. [12]

In addition to private litigation, Wall Street firms, including Merrill Lynch, Morgan Stanley, and Deutsche Bank, have received subpoenas from New York Attorney General Andrew Cuomo seeking information about the packaging and selling of securities backed by subprime mortgages. Likewise, the Ohio Attorney General and the Mayor of Cleveland have filed respective subprime-related lawsuits against Freddie Mac, charging failure to disclose significant risk associated with subprime financing, [13] and 21 major investment banks and mortgage lenders alleged to have “financed and cultivated a subprime market.” [14]

Credit Rating Agencies and Bond Insurers
Credit Rating Agencies are being challenged for allegedly assigning excessively high ratings to MBS and CDOs backed by risky subprime mortgages. The SEC announced that it “is looking closely at the agencies' methodologies and procedures for determining ratings for residential mortgage-backed securities as well as their procedures for managing conflicts.” [15] State enforcement agencies have initiated investigations related to appraisals of the underlying real estate and the compensation of brokers, as well as the ratings assigned to MBS and other structured products by the ratings agencies. Shareholders have filed class action claims against Moody’s and Standard & Poors, challenging rating-related disclosures in their financial statements. [16]

Bond insurers—including MBIA, ACA Capital Holdings, Security Capital Assurance, and Radian Group—have also been named in subprime-related securities lawsuits for failing to account properly for their exposure to the complicated investment instruments. On January 11, 2008, MBIA was named in a class action lawsuit and related ERISA lawsuit in connection with its accounting for and disclosure of its exposure to CDOs comprised of other CDOs whose underlying collateral included securities backed by subprime loans. Reportedly, both the SEC and the New York Insurance Department are also conducting informal inquiries into MBIA’s recent financial disclosures.

Further subprime-related shareholder lawsuits alleging insufficient disclosures of balance sheet exposure to mortgage investment risk—especially where declining mortgage investment valuations are accompanied by declining share prices—may be expected against a variety of financial services and other companies as those companies report losses on subprime-related assets.

Litigation Outlook
Although the litigation battleground for subprime-related claims is only beginning to unfold, the viability of these cases likely will turn on three threshold pleading issues—including scienter, loss causation, and scheme liability—each of which has been the subject of recent U.S. Supreme Court scrutiny and each of which prominently factors into subprime-related lawsuits involving claims of false/misleading disclosures, often by multiple actors beyond the original lender and stock declines in shares of investing companies.

As a general proposition, given the likely fact patterns, plaintiffs asserting federal securities law claims in connection with subprime issues may have difficulty overcoming the heightened pleading requirements for securities fraud claims. Among other things, plaintiffs will be expected to plead with particularity facts giving rise to a “strong” inference of scienter. When weighed against “plausible nonculpable explanations,” the facts pled must be sufficient to give rise to an inference of scienter that is “cogent and compelling.” [17] Further, plaintiffs will need to identify the relevant economic loss they claim—and specify a causal connection between such loss and any alleged misrepresentation or omission (e.g., that the stock fell due to a particular revelation about this company, rather than a market-wide decline in similar stocks). [18]

Although it is unclear at this point whether or not “secondary” liability ultimately will attach to various individuals and entities involved to varying degrees in the securitization process, or to professionals (e.g., accountants and lawyers) who assisted in the transactions, the U.S. Supreme Court’s recent decision in Stoneridge casts doubt on the viability of such claims in private litigation. On January 15, 2008, the U.S. Supreme Court issued its highly anticipated decision in Stoneridge Investment Partners  v. Scientific Atlanta [19] —a case addressing the viability of scheme liability claims against third-party vendors and investment banks. By a 5–3 majority, the Court expressly rejected so-called “scheme liability” under Section 10(b) of the 1934 Securities Exchange Act and SEC Rule 10b-5. In so holding, the Court affirmed the Eighth Circuit Court of Appeals and held that liability did not reach the respondents because they were secondary actors and did not make any statements or representations upon which investors relied. The Court’s ruling does not affect the SEC’s ability to prosecute claims against aiders and abettors.

Given the recent Supreme Court’s pronouncements on what are likely to be the pivotal issues, lower courts will need to interpret and apply these rulings in the context of subprime-related litigation. Decisions issued in the coming year will define the securities pleading landscape and, in so doing, will determine the magnitude of exposure created by the subprime crisis.

Valuation, Internal Controls, Accounting and Disclosure Issues
Understanding the relevant considerations in valuation, internal controls, and disclosure is critical to investigate and defend properly subprime-related activities and disputes.

Valuation and Internal Controls Considerations

Many financial products are highly customized to meet investor demand for various risk and reward profiles. Accordingly, those products are often not traded in an active market, resulting in the need to use models incorporating a number of inputs to estimate the fair value of the products. Because of the customized nature of many of the products, a careful analysis of facts underlying each securitization structure is critical to valuing properly the instruments. Furthermore, a careful analysis of facts supporting the valuation process is critical to defend or investigate allegations that a substantial write-down should have been recorded in an earlier period.

One of the critical inputs necessary to estimate the fair value of an MBS or CDO is the relationship, or correlation, among individual loans or securities backing the MBS or CDO. Typically, correlation is estimated based on industry-wide formulas and assumptions. For example, if an MBS were backed by mortgages from all 50 states, there would be an expectation that changes in real estate prices would not be highly correlated among the states. Stated differently, the estimate of the fair value of the MBS would assume that real estate prices in California and real estate prices in Florida would not react in the same way to economic conditions, and any significant declines in real estate prices would be localized.

Because CDOs issue multiple tranches with varying levels of subordination, the risks of the assets held by the CDO trust are not allocated equally to all bondholders. By creating senior tranches with more predictable cash flows, the junior tranches must necessarily have less predictable cash flows because they absorb most of the risk of the underlying assets. Consider, for example, a CDO comprised of a portfolio of BBB rated MBS. To create an AAA-rated senior tranche, the subordinated tranches would have to have ratings below BBB as they are absorbing a disproportionate amount of the risk presented by the BBB-rated MBS.

The underlying theory about this redistribution of risk is sound as long as the default correlation of the underlying securities is low. In other words, if the risk of defaults and losses on individual MBS in the portfolio of BBB-rated MBS in the example above are independent of each other, then the risk can be redistributed to create an AAA-rated investment. However, if the risk of default and loss on the underlying securities are highly correlated, the cash flows coming into the trust may fall considerably in a national downturn in the real estate market, and there may not be enough money to pay even the senior tranche. As the underlying assets in CDOs become more complex, the correlation of the underlying securities is a key assumption that becomes very difficult to estimate.

As the correlation of defaults and loss severities increases, the cash flows for the lower tranches of many CDOs become extremely difficult to predict. This significant increase in uncertainty has thinned the ranks of potential buyers, significantly reducing the liquidity of these investments and leaving the holders to rely on models to estimate fair values. However, these models can be very complex and, because of the subjective nature of many of the inputs, can be difficult to test, especially in rapidly changing market conditions.

Regulators have required, when available, the use of “market participant” (rather than “entity specific”) assumptions when estimating fair value. Standards-setters and the SEC have indicated a preference for maximizing the use of market data when estimating fair values. Given the current liquidity issues, there are questions over how much emphasis a company is supposed to place on trades that are occurring in estimating fair value. The SEC staff, in Financial Reporting Release Number 28, and then later in a 2004 enforcement proceeding, took the view that a market price, if available, should be used, even if a company thinks the market price reflects a liquidation price and has a strategy of holding for a market recovery. If a company uses a fair value other than the market price, it should be prepared to support the use of the different fair value estimate.

A number of internal control issues to consider relevant to valuations are as follows:

• Whether written valuation policies and procedures were updated on a timely basis
• Whether a valuation committee addressed market developments that created valuation concerns on a timely basis
• Whether secondary pricing services were used to obtain another view on the estimate of fair value
• Whether there was a periodic review of unusual or abnormal changes in fair value on a timely basis
• Whether there was an independent review of pricing information by individuals separate from the trading function
• Whether there were controls over model changes
• Whether model performance deterioration was tracked
  

Other areas of focus for companies will likely include the process used by the company to develop assumptions that drive fair value estimates, whether the assumptions could have been derived from transaction prices observable for similar financial instruments—whether valuation models utilized historicaldata that may be inconsistent with assumptions that market participants would have used, whether the company developed its own views of the potential credit risk and whether those views were different from the views of the rating agencies, and whether the reported fair value is consistent with management’s own estimates.

There will also be increasing scrutiny as to how frequently companies updated their models to reflect recent transactions in the capital or primary markets. If the company utilizes models to estimate fair value, areas of focus likely will include whether the valuation models were recalibrated as the market evolved so that the model output agrees to the most recent transaction price, whether the model results were benchmarked to transactions in other markets (e.g., in the derivatives market) in situations where there are no capital market transactions, whether the drivers of critical estimates in the valuation models were updated to ensure they reflect recent trades, the extent of any differences between recent trades and the model results using assumptions developed prior to considering those transactions, whether there were indications that the model performance had deteriorated, the extent to which using historical data produced a model result that was not representative of current environment, and whether changes to the model or methodology were tested.

When multiple information sources exist, it is important to understand how the company selects the point in a range of possible fair values in an illiquid market. For example, the company may have access to multiple sources to estimate the fair value of a financial instrument in an illiquid market. This information may result in a range of fair value estimates. A critical understanding of how the company selected the methodology it uses, how it applied that methodology over time, and whether it has documented reasons for any changes in how it applied the methodology from period to period are all critical points to understand.

Potential Accounting and Disclosure Issues
The pace of developments in the mortgage market has prompted questions about the accounting and disclosures by those companies who made significant investments in structured instruments backed by subprime mortgages, were engaged in subprime lending, or were involved in structuring instruments backed by subprime loans. A careful analysis of facts supporting the disclosure process is critical to investigate or defend allegations that a defendant knowingly did not disclose information earlier.

Questions in the accounting and disclosures area will likely focus on whether a company’s estimates of the fair value of structured investments are supportable, whether recent events require a company that provides support to structured financial instruments to consolidate the trusts used in those arrangements, whether a company’s MDA identified the risks associated with investments in subprime mortgage-backed instruments in light of reports of increased defaults reported in the summer of 2007, and whether changes in a company’s loss reserves for mortgages held are consistent with changes in economic conditions (i.e., did the company recognize additional provisions as defaults began to increase?).

Responses to the following questions may be helpful in investigating or defending issues arising from a company’s involvement with structured financial instruments that has resulted in significant losses.

• With respect to a company’s most recent Management Discussion and Analysis (MD&A), what did it tell investors about the risk of investments in subprime asset-backed securities? How did the disclosed information compare to the information available to management? To the extent that there are any differences, how did the company conclude that the omitted disclosures were not material?
• How did the company incorporate current market information (in particular, declining home prices and increasing default rates) into their fair value estimates? Did the company’s models mitigate the potential impact of declining prices and increasing defaults by using averages determined over an extended period?
• Did the company’s models incorporate credit default and recovery information for asset-backed securities or for corporate bonds? If information for corporate bonds was used, what was the rationale for that decision?
• What changes in economic factors subsequent to June 2007 resulted in changes to model inputs that are the significant drivers of fair value estimates? How do the inputs at the end of the prior reporting periods correlate to the economic factors that existed then? Were there delays in updating the models for changes in those drivers?
• Has the company utilized information from market transactions to evaluate the performance of valuation models? To the extent there have been no market transactions in a particular instrument, have the valuation models been compared to transactions involving similar instruments or derivatives (e.g., prices of credit derivatives that may identify a greater expected level of defaults than the level a company incorporated into its models)?
• Given the market competition to acquire subprime loans because of their greater yields, has the company considered the impact of differences in its credit, underwriting, valuation, trading, and risk management processes for loans originated in or acquired during 2006 and 2007, versus earlier periods, in determining the fair value of securities backed by loans or loss reserves?

Conclusion

Subprime has replaced options backdating as the next litigation crisis. Investigations and lawsuits relating to subprime mortgage exposure will continue to be initiated against an increasing number of institutions involved in subprime loan transactions and a variety of industry players. The practices associated with packaging and selling securitized subprime loans will continue to draw the scrutiny of federal and state regulators. While the litigation and regulatory landscape unfolds, understanding the valuation, internal control, accounting and disclosure issues implicated is integral to the investigation of subprime activities and the defense of subprime-related disputes.