Upstreaming Subprime Losses
Posted on October 6, 2008 by Kevin LaCroix
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Trackbacks According to news reports (here), MBIA has filed a lawsuit breach of contract lawsuit in New York state court against Countrywide Financial Corp. (now part of Bank of America) alleging that Countywide made fraudulent misrepresentations about is loan underwriting standards in connection with the securitization of over $14 billion of securities for which MBIA provided default insurance and that were backed by mortgages and home equity loans that Countrywide originated.
MBIA alleges that based on Countrywide’s representations about its mortgage lending practices and lending guidelines, MBIA provided "credit enhancements" in connection with the mortgage backed securities, in the form of billions of dollars of trust obligation guarantees.
The complaint alleges that contrary to Countrywide’s representations in connection with the transactions, during the period 2005 to 2007 Countrywide engaged in a "systemic pattern and practice of abandoning its own guidelines for loan origination" as part of the company’s attempt to expand its market share, as a result of which the risk profile of Countrywide’s mortgage portfolio "fundamentally changed." The complaint further alleges that "Countrywide deliberately abandoned its own guidelines to drive up revenues from increased origination fees, securitization fees and origination fees – no matter what the cost to borrowers, investors or guarantors like MBIA."
The complaint further alleges that MBIA has already paid out more than $459 million on it guarantees of the securitized loans and "is exposed to claims in excess of several hundred million dollars more."
The Seeking Alpha blog notes (here) that this lawsuit "may be the beginning of what may be a long battle by bond insurers MBIA and AMBAC to recover losses from those responsible, a process they refer to as remediation." Both insurers have said they expect substantial recoveries "due to misrepresentations and breaches of warranty with respect to securities that they have insured."
The Seeking Alpha blog further notes that these kinds of efforts may be a "painful and necessary" part of the process of putting responsibility where it belongs: "Every fraudulent transaction needs to be pushed back along the chain of perpetrators to its original source, if that person or entity can be located. As much as possible, those whose dishonesty caused the losses must bear them."
There have been multiple other recent attempts to by other litigants to assign blame, as part of the process that seeks to upstream losses back to their source. I discuss a couple of additional examples below.
Special thanks to a loyal reader for links concerning the MBIA lawsuit.
Wisconsin Schools Sue Over CDO Losses: On September 29, 2008, five Wisconsin school districts filed a lawsuit (here) in Wisconsin state court seeking to rescind and to recoup their losses on the $200 million the school districts invested in three synthetic CDOs. The lawsuit alleges that Stifel Nicholaus & Co. and Royal Bank of Canada and their respective related entities omitted or misrepresented the true nature of the investment and of the risks involved.
In 2006, the school districts invested largely borrowed funds into the CDOs to help pay their non-pension retiree benefits. Stifel Nicolaus & Co. and affiliated entities allegedly brokered the deal, while Royal Bank of Canada devised the instruments and determined their value.
The investments have lost approximately $150 million, or three quarters of their value. The lawsuit alleges that the investment was "complex, convoluted, and opaque, and as Stifel and RBC then well knew, beyond the investment knowledge or experience of the School Districts, their school board members, and their administrators."
The complaint also alleges that contrary to the defendants’ representations, the CDOs were collateralized by subprime mortgage loans. The CDOs also allegedly issue credit default swap protection as an additional source of income, which increased the CDOs credit default risk, which risk the lawsuit alleges was not fully disclosed.
The school districts seek rescission of the CDO transaction plus damages.
As losses accumulate, more and more aggrieved persons will join in this process of upstreaming losses back to their source. As I have noted many times, the litigation arising the subprime meltdown is likely to take years to unfold. As these cases illustrate, the litigation is also likely to involve an ever broader array of litigants, asserting an ever more diverse range of claims.
The SEC Pursues a Subprime Related Claim: Private litigants are not the only ones that will participate in this process of assigning blame. The SEC also clearly intends to get into the act, as reflected in its October 3, 2008 filing (refer here) of an enforcement action against five representatives of World Group Securities. The action alleges that the defendants fraudulently sold unsuitable securities to persons whose acquisitions were financed by mortgage refinancings.
The SEC’s complaint alleges that the defendants moved the customers, many of whom had little education and spoke little English, from fixed-rate mortgages to "subprime adjustable-rate negative amortization mortgages." The refinancing proceeds were then invested in variable universal life insurance and other unsuitable securities.
The defendants are alleged to have "misrepresented the expected returns from the securities, the liquidity of the securities, and the nature of the securities and the terms of the new mortgages while failing to disclose material facts about the products."
At one level this new SEC enforcement proceeding may seem unrepresentative of the larger subprime meltdown owing to its particular facts. The SEC action does share several common elements with the cases described above. Like the Wisconsin school suit, the SEC action contains both disclosure and suitability allegations, and like the MBIA lawsuit, the SEC action alleges misrepresentation of the true conditions.
Many of the subprime-related losses are on a much larger scale than that involved in the SEC action, but the SEC action underscores how widespread and diverse the losses are. Because of the degree of excesses involved and the overall magnitude of the losses involved, the blame assigning process yet to come will be complex and protracted. The lawsuits will continue to arise and the losses continue to emerge.
Tags: Subprime Litigation, credit crisis, credit crisis litigation |
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