6. Sub-Prime Securities Litigation in the USA

There are a number of different parties adversely affected by the losses created by the decline in the value of subprime mortgages that may bring legal claims in the USA seeking to recover some of these loses. This memo looks at the two basic categories of potential plaintiffs: CDO purchases and MBS purchasers.

I. Introduction

A. Loan originators

Mortgage-backed securities (MBS) are debt obligations whose cash flows are backed by the principal and interest payments of pools of mortgage loans, most commonly on residential property. Individuals with strong credit qualify for traditional mortgages, whereas those with weak credit histories quality for subprime loans. Subprime mortgages are an important part of the overall mortgage market, and the share of subprime mortgages in total mortgage originations have risen from 8.6% ($190 billion) in 2001 to 20,0% ($600 billion) in 2005.

Most subprime loans are made by mortgage banks and mortgage brokers, rather than by commercial banks or other depository institutions. Mortgage banks originate subprime residential mortgage loans and then sell them to investment banks, whereas mortgages brokers originate subprime residential mortgage loans on behalf of investment banks. Independent mortgaes companies sell loans for securitization to other financial service firms. Banks and thrifts, which are more highly regulated than mortgage banks and mortgage brokers, deal primarily in lower-priced prime mortgages, seliing to government sponsored enterprises such as Fannie Mae and Freddie Mac that securitize conventional conforming loans. 

B. Issuers

MBS sponsors or originators purchase the mortgage loans from loan originators, assemble them into asset pools, and structure them into mortgage-backed securities. After a large enough portfolio of mortgages is pooled, it is sold to a special purpose vehicle (SPV), which is an issuer of the MBS and formed for the specific purpose of funding the loans. 

The SPV issues securities to fund the purchase of the loans. Securities are generally split into tranches differentiated by maturity and credit risk. Tranches are categorized as either senior, mezzanine or subordinated/equity, according to their degree of credit risk. If there are defaults or the mortgages otherwise underperform, scheduled payments to senior tranches take priority over those of mezzanine tranches, and scheduled payments to mezzanine tranches take priority over those of subordinated/equity tranches.

The SPV has a trustee whose primary role is to hold all the loan documents and distribute payments received from the loan servicer to the bondholders. Although trustees are typically given broad authority with respect to certain aspects of loans under Pooling and Servicing Agreements, they may delegate authority to servicers.

Loans that do not conform to MBS requirements are often packaged into CDOs. Like an MBS, a CDO has a sponsoring organization, such as an investment bank, that establishes an SPV that issues securities, typically multiple tranches differentiated by maturity and credit risk, to invest in financial assets. The party that is entrusted with managing the CDO’s assets is the “collateral manager”. CDOs are often designed to meet specific investor needs. Investors can specify the desired maturity and credit risk characteristics of securities, which results in more highly-tailored, but less liquid securities than might overwise be available. The information exchange and time necessary to confer with investors in many instances precludes them from being publicly-tradable on registered exchanges or markets. Investors must therefore rely on dealers to execute trades.

C. Collateral appraisers

MBS and CDO sponsors typically hire firms, known as collateral appriasers or “due-diligence firms,” to review and verify the quality of loans sold to SPVs. These reviews evaluate the credit and collateral risks of the loans in the pool and verify the information provided by loan originators to MBS sponsors. Reviews include verifying a borrower’s identiy, place of residence, and employment status. They typically review note, mortgage riders, title, and mortgage insurance details and may include a property appraisal, as well as a review of the loan originators’ property and closing procedures. Collateral appraisers in 2007 included Clayton Holdings, First American, LandAmerica Financial Group, and Stewart Information Services Corporation.

D. Investors

Hedge funds, life insurers, pension funds, mutual funds, and wealthy individuals by MBS and CDOs. In certain instances, institutional bond buyers are subject ot legal limitations that permit them only to buy investment-grade or AAA-rated debt. For ERISA fiduciaries, who must “use care, skill, prudence, and diligence” in the course of investment plan assets, purchasing unrated MBS and CDO securities runs the legal risk that those investments will be deemed to be imprudent. The advent of investment grade MBS and CDOs dramatically changed the investment opportunities of many pension funds. Before investment grade MBS and CDOs, these institutions were largely precluded from investing in real estate. Investment grade MBS and CDOs allowed them to have real estate exposure in their portfolios while limiting credit risk.

II. Subprime mortage litigation in the United States

The residential subprime mortgage industry crisis is one of the foremost economic issues facing the world today. With US housing prices high and interest rates low through 2006, millions of American households with weak credit histories purchased homes or refinanced existing homes, using adjustable rate mortage loans designed for high-risk borrowers known as subprime residential mortgage loans. Investment banks securitized those loans into residential mortgage backed securities (RMBS) and collateralized debt obligations (CBOs), selling risk-differentiated tranches to investors. With the rise of interest rates and the decline in housing prices in 2007-2008, more than two million homeowners have faced or are facing interest-rate resets on loans that will increase their mortgage payment by as much as 30 percent. Some cannot or will not be able to pay their higher mortgage obligations and will default. The effect of these defaults and foreclosures are being felt by investors in the RMBS and CDO markets, loan originators, credit appraisers, underwriters, bond rating agencies, bond insurers, and others.

The subprime mortage industry crisis has had not only an economic effect, but has proven to be a legal phenomonon as well. The substantial decrease in the value of asset-backed securities held by investment banks and other purchasers will generate substantial, “perhaps unprecedented,” levels of litigation. According to a 2008 Harvard University John M. Olin Center for Law, Economics, and Business study.The facts so far have been sobering. The percentage of securities class action suit filings has increased by almost 50 percent year over year. The threat of private litgation and its settlement value have been heightened by recent revelations that the FBI is investigating several major investment banks with respect to the accounting and pricing of various pools of securities in addition to civil investigations already underway by the Securities and Exchange Commission (SEC) and the Attorney Generals of Connecticut and New York.1

That study anticipates three substantial sources of additional litigation: (i) litigation against companies other than those directly involved in the structured finance market due to losses as a result of subprime mortgage exposure; (ii) non-class action brought by MBS and CDO purchasers and investment banks; and (iii) governmental action against various participants in the structure finance process. For this memo, we shall focus on the first two types of subprime litigaiton.

An example of the first type of subprime litigation would be litigation brought against and by operating companies that invested corporate cash in subprime mortgages as investments and suffered substantial losses as a result. 

The second category of non-class litigation includes litigation brought by the investment banks against mortgage originators (for example, a subsidiary of Deutsche Bank has already filed 15 lawsuits against mortgage originators for violation of repurchase agreements); registered Mortgage Backed Securities purchasers bringing claims under the 1933 Securities Act against underwriters for misleading statements in the offering process; and disputes between different Collateralized Debt Obligation tranche holders as to how to distribute assets of liquidating Collateralized Debt Obligations.

A. Claims by Collateralized Debt Obligation (CDO) purchasers

Much of the substantial losses suffered by investors were purchasers of collateralized debt obligations (CDOs) in which the underlying asset were Mortgage Backed Securities (MBS) for which the collateral in the Special Purpose Vehicle was, in turn, subprime mortgages. 

Purchasers of CDOs may have a cause of action under the indenture agreement[2] which governs the collection and distribution of the CDO’s funds among the various CDO tranches.3] The CDO trustee is the party that is responsible under the indenture agreement for ensuring compliance with the terms of the indenture agreement. It is quite possible that holders of the more junior or mezzanine tranches (perhaps hedge funds that wish to limit their losses) have an argument that some of the proceeds of the CDO under the terms of the indenture agreement belong to them; an interpretation that would be resisted by the holders of the more senior CDO tranches.4] According to a Harvard Law School discussion paper, these disputes will rise “when, according to the terms of the CDO indenture agreement, there is a “default” that triggers an obligation on the part of the trustee to distribute whatever assets are held by the CDO to the CDO tranche holders.”[5]

Another potential cause of action is a claim that the pricing of the CDO assets or interests therein was inflated relative to the assets’ or interests’ “true” value. Even if the CDO purchase agreement does not contain representations or warranties, there might well be a contractual obligation to provide pricing information on an on-going basis that would give rise to a contractual claim. A related legal basis for bringing a pricing claim is a long line of cases that have held that, absent adequate disclosure, when the price charged an investor bears to reasonable relationship to the “prevailing price” this operates as a fraud on the purchasers.6]

B. Claims by Mortgage-Backed Securities (MBS) purchasers.

Although the most dramatic losses in value occurred for purchasers of CDOs with subprime exposure, there were nevertheless substantial losses suffered by MBS purchasers. The most likely claim is under Section 11 the 1933 Securities Act: “a false or misleading statement in the registration statement”. The issuer of the security, the SPV, underwriters, and auditors will all be subject to potential Section 11 liability (with the latter two groups having due-diligence defenses). Finally, there are a number of possible state causes of action, including breach of contract, fraud, and negligent misrepresentation that might be brought by MBS purchasers.

At least four likely candidates for misleading disclosures in the registration statement or offering communications for registered MBS present themselves, all relating in some way to the underwriting quality of the underlying mortgages themselves:

i. outright fraud with respect to the documentation surrounding the mortgage origination rendering statements in the offering process false;

ii. lack of adequate disclosure of underwriting standards for the underlying mortgages;

iii. the extent to which exceptions were made to whatever the underwriting standards were; and

iv. the pricing of the various MBS tranches.

Plaintiffs may be able to rely upon information that is being uncovered by the on-going investigations of the New York and Connecticut Attorney Generals, as well as by the SEC in terms of what was actually known by the due-diligence firms concerning mortgage underwriting quality and the extent to which that information was shared with the investment banks.

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[1] Jennifer Bethel, Allen Ferrell, Gang Hu, “Legal and Economic Issues in Subprime Litigation,” Harvard Law School Discussion Paper Series (Feburary 21, 2008).

[2] Indenture agreements are usually governed by either New York or UK contract law.

[3] The securities issued by the SPV are generally split into tranches differentiated by maturity and credit risk. Tranches are categorized as either senior, mezzanine, or subordinated/equity, according to their degree of credit risk.

[4] Indeed, litigation of this type has already been filed by Deutsche Bank, as trustee of a CDO indenture agreement, seeking judicial resolution of a dispute between various CDO tranche holders over how CDO proceeds should be distributed. See e.g., Deutsche Bank Trust Company v. Lacrosse Financial Products LLC, Supreme Court of the State of New York County of New York (December 3, 2007).

[5] Jennifer Bethel, Allen Ferrell, Gang Hu, “Legal and Economic Issues in Subprime Litigation,” Harvard Law School Discussion Paper Series (Feburary 21, 2008).

[6] See Allen Ferrell, “The Law and Finance of Broker-Dealer Markups” (FINRA commissioned study).
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