Subprime Mess Fuels Lawsuits

February 23, 2008
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GRAND RAPIDS — The subprime market meltdown has caused a surge in lawsuits against loan originators and nearly every player in the mortgage industry.

A new study by Navigant Consulting Inc. reveals that the number of subprime-related cases filed in federal courts is dramatically outpacing the savings-and-loan litigation of the early 1990s, which has been the benchmark in terms of litigation fallout from a major financial crisis, said Jeff Nielsen, managing director of Navigant Consulting and lead author of the study.

The number of subprime-related lawsuits doubled during the second half of 2007, from 97 to 181 cases: Some 43 percent of the cases were borrower class actions, 22 percent were securities cases, 22 percent were commercial contract disputes, in addition to bankruptcy employment and other cases.

Class action suits have been filed by investors against subprime mortgage lenders, Wall Street firms that underwrote mortgage-backed securities and collateralized debt obligations, and investors who purchased shares of hedge funds, bond funds and other securities that contained subprime mortgage exposure. Nielsen said there’s already evidence of a steady acceleration of continuing litigation into 2008.

Nielsen said the litigation throws a wet blanket on the mortgage industry as a whole because virtually every player in the industry is being named in lawsuits: Fortune 1000 companies are named in 56 percent of cases. Mortgage Bankers and loan correspondents represent the highest percentage — 32 percent of defendants — but defendants also include mortgage brokers, lenders, appraisers, title companies, homebuilders, loan servicers, issuers, underwriting firms, bond insurers, money managers, public accounting firms and company directors and officers, among others.

The industry in general has taken a black eye over the subprime mess, he acknowledged. The efforts to restore reputations and restore credibility in the market place are badges earned over time, and he believes that it’s going to be an uphill climb for a number of industry participants.

Business Litigation Attorney T.J. Ackert, a member of Miller Johnson, said the uptick in subprime litigation began last fall as more consumers sought to protect themselves from bankruptcy or sought to protect their credit by either bringing suits to bankruptcy court or bringing direct claims against their lenders for predatory lending practices. The consumer cases are typically filed in state courts, though some are filed in the federal courts. In most cases, consumers are looking to terminate their existing mortgage contract so they can replace it with a differently structured mortgage.

Consumers usually argue that their mortgage originator didn’t tell them enough about the risks of a certain mortgage, in particular that they had inadequate debt-to-income ratio, Ackert said. Common complaints are that the loan was originated without adequate underwriting criteria, without appropriate documentation or income verification, and in a way that would necessitate frequent refinancing.

“New claims are starting to be filed by protective classes, such as minorities, claiming that lenders came after them with refinancing offers when they couldn’t truly afford the refinancing and debt structure,” Ackert said.

“Another thing you’re going to start seeing in the consumer claim area is state attorney generals and state regulators filing administrative claims against mortgage originators or lenders for the same issues.”

Consumer suits of this nature are very fact-intensive, Ackert said. What happened? How did they document it? Did they follow regular procedures? If not, why not? Was there a legitimate business reason to support the change in procedure? Those are the issues the courts will be getting into, he said.

Then there’s the secondary market claims. As a way of funding their businesses, mortgage lenders bundle loans — pooling subprime, prime and prime-plus and selling them as a mortgage-backed security to different investors and banks

“As these subprime loans have been going into default, these investments are losing money, and investors aren’t getting their return on investment, so they’re bringing actions against those who sold the ‘pool’,” Ackert said. “Their argument is that the people who pooled the subprime mortgages misstated the value of these mortgages and failed to tell investors there were problems with the originations that made them much more risky investments.”

Some states and organized unions are bringing claims of misrepresentation and fraud because union pension funds that were invested in mortgage-backed securities lost 70 percent to 80 percent of their value in the subprime meltdown, Ackert noted.

“It’s a bit of a paradox,” Nielsen said. “The banks, specifically the large banks, have taken it on the chin in a couple of different ways: They have, to a large extent, been at the mercy of market conditions and have been hit with the resulting economic losses. Their massive write-downs have been well publicized, and at the same time, because some of them were so heavily involved in the securitization process, they also are shouldering a fair amount of the blame.”

Nielsen said the difference between this situation and the S&L crisis is that the model of securitizing mortgages and selling off interest to investors all over the world has greatly broadened the number of parties that play a role in that process and, likewise, greatly expanded the field of litigation as far as potential targets.

Subprime litigation is having a huge ripple affect, and everyone is pushing their liability downward, Ackert said. The big banks are going after the smaller lenders that pooled the mortgages. Since some of the subprime mortgage originators went out of business, the insurance companies have to cover the losses. Insurance companies will be impacted by the losses they’ll have to pay out, courts will be burdended with increasing caseloads, the mortgage industry will likely consolidate more, and many consumers will be left grappling with foreclosure and bad credit issues, he said. 

“Similar to the S&L crisis, in the end what this will do is reduce the amount of available credit to individuals and businesses, and that affects the economy,” Ackert said.

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