|The Snowball Effect|
A Brief Review of Subprime Securities Litigation
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by Faten Sabry, Anmol Sinha
& Sungi Lee
The International Monetary Fund estimates that the credit
crisis will cost about $945 billion dollars. No one knows
the ultimate cost of the crisis, but it will certainly exceed
the costs of the last major financial crisis of the savings
and loans industry. The problem started in the subprime
mortgage market and then quickly spilled over into other
areas of the mortgage industry and corporate world,
culminating in a liquidity and credit crisis that we are still
in the process of sorting out. Unsurprisingly, litigation has
quickly started to accumulate.
This article briefly examines the subprime securities
litigation to assess the trends, major players and issues.
Some allegations are familiar from other types of disputes,
yet others are somewhat novel. This is not meant to be
a comprehensive account of all the cases and we do not
report on commercial disputes or borrowers’ predatory
lending suits. We report the types of allegations brought
by and against the various market players. We searched for
suits alleging wrongdoings associated with subprime assets
– mortgages, mortgage-backed securities, collateralized
debt obligations (CDOs), etc. We compiled the data from
various news sources including Bloomberg, Factiva, Business
Week, The Wall Street Journal, and others from January 2007
to April 2008.
Just like the credit crisis, the lawsuits initially started in
the mortgage industry. Subprime borrowers – those with
poor credit history – were at the forefront of the meltdown
as several economic factors, including the decline in
national housing prices, caused the credit boom to stop
and a reversal to begin. Lawsuits began against mortgage
lenders, then moved to issuers and underwriters of
securities backed by subprime mortgage payments, and
then to investors who either purchased these securities or
packaged them into other securities. As the liquidity crisis
intensified, sectors not directly related to subprime started
to suffer losses, including commercial paper, leveraged
buyouts and auction-rate securities. Lawsuits followed
The 2007 fourth-quarter delinquency rate for subprime
loans is 17.31%, the highest in the last eight years,
and prime loans and credit cards have also started
experiencing delinquencies. Not surprisingly, the value
of asset-backed securities (ABS) backed by subprime
products has fallen as the performance of the subprime
loans has continued to worsen. Exhibit 1 shows the value
of two indices tracking BBB rated and BBB(-) rated subprime
home equity deals based on loans from the last six months
of 2006. An initial investment of $100 (on January 19, 2007)
in the BBB index would have been worth only $5.46 by
May 8, 2008; both indices show a decline of almost 95%
as of May 8, 2008.
Almost every market participant in the securitization
process – the process of turning illiquid financial assets
such as mortgages, auto loans and student loans into
securities – has been named a defendant. The list of
defendants includes lenders, issuers, underwriters, rating
agencies, accounting firms, bond insurers, hedge funds,
collateralized debt obligation trusts and many more.
As of April 2008, there have been more than 132 securities
lawsuits related to subprime and credit issues, of which
56 lawsuits were filed since January 2008. New York has
the most filings – 48% – while California follows with 14%
and Florida wraps up the top three with 7%. Filings in
other states range between 1% and 5%. This is consistent
with recent trends in shareholder class actions.
The majority of the early lawsuits have been against
mortgage lenders. As various participants revealed
the extent of their exposure and losses, securities
defendants began to include others. The plaintiffs include
shareholders, investors, issuers and underwriters of
securities, plan participants and others. See the breakdown
in exhibit 2.
Subprime mortgage lenders face securities lawsuits from
shareholders, borrowers, and issuers/underwriters. What
complicates matters is that many of the lenders have filed
for bankruptcy or have closed down. The allegations are
mostly similar to suits filed in previous crises.
One of the earliest subprime shareholder class action cases
was filed in February 2007 against New Century Financial
and alleged a failure to disclose and properly account
for the surge in forced repurchases of subprime loans.
Other cases allege that the lenders concealed the size of,
and failed to adequately reserve for, their subprime risk
exposure. Shareholder class actions comprise almost
half of the lawsuits thus far and the allegations are all
Various mortgage lenders, such as Countrywide and
Fremont Mortgage Corp., also face Employee Retirement
Income Security Act (“ERISA”) lawsuits where plaintiffs
allege that management’s fraudulent actions caused
the company’s stock to collapse and thereby negatively
affected employee contribution plans. There are also
ERISA/401(k) lawsuits pending against asset management
firms, home builders, and securities issuers.
In addition, lenders are facing lawsuits from issuers for
failure to buyback loans. The plaintiffs allege negligence
as well as lack of due diligence on, and misrepresentations
about, the quality of the underlying mortgages.
Securities issuers have also begun receiving an
increasing number of securities lawsuits filed by lenders,
shareholders, mortgage-backed securities investors, and
their own employees. The list of issuers who are named
defendants include Credit Suisse, HSBC, Lehman Brothers,
Merrill Lynch, Citigroup, Washington Mutual, Bear Stearns,
UBS, Morgan Stanley, Bank of America, and others.
In suits by lenders against issuers and underwriters,
allegations include “exploiting an aberrational market as
a pretext to unreasonably mark down the purported value
of the bonds.”
Shareholder lawsuits again comprise the majority of cases
against issuers. Cases such as the suit against Citigroup
focus on charges of misrepresentation of exposure to the
subprime sector and allegations of failure to write
down impaired securities backed by subprime loans.
As companies disclose their losses, derivative products
such as CDOs have become the centerpiece in many
cases. CDOs highlight the pending suit against Merrill
Lynch, as well.
Along with shareholders, investors have pursued litigation
against issuers, as well. Banker’s Life Insurance Company
filed suit in April 2007 regarding asset-backed securities
purchased from Credit Suisse. It alleges that Credit Suisse
misrepresented the true value of some of its investment
products and the underlying collateral, the majority of
which were allegedly “shoddy, inferior mortgage loans.”
Ratings agencies are being accused of assigning excessively
high ratings to bonds backed by risky subprime mortgages.
Both Moody’s and Standard & Poor’s (McGraw-Hill is
the parent company) face lawsuits alleging that despite
worsening conditions, the ratings agencies maintained the
high ratings on subprime-backed instruments and failed
to disclose key information regarding the market
conditions and their effects on company profitability.
Charges of failure to disclose subprime exposure are not
limited to lenders and issuers. Separate class action suits
were brought against bond insurers MBIA and Ambac in
January 2008. The allegations include misrepresentation
of purported risk exposure and inadequate internal
underwriting and ratings systems for products such
With complex derivatives securities like CDOs in the midst
of the crisis, several asset management companies are
now facing lawsuits after experiencing losses in subprimerelated
securities. One example is the suit by the German
state-owned HSH Nordbank, which is suing UBS over
its investment in a UBS-managed CDO. HSH Nordbank
alleges that UBS misrepresented the credit quality of the
investment and its underlying pool, causing a loss in excess
of $275 million on its investment.
Other lawsuits are calling upon the courts to determine
the respective interests of the defendants and other
related parties in the distribution of interest and principal
proceeds of a CDO.
In an ERISA lawsuit, State Street faces allegations that
it violated its fiduciary duties and “abandoned [its bond]
funds’ conservative investment profile to speculate
in high-risk mortgage backed investments,” including
As the losses mount and markets for products such
as CDOs continue to unravel, some expect more suits
involving these complex securities.
So far, the lawsuits described above focus on market
participants who are somewhat related to the subprime
mortgage industry. Events started to happen fast as
investors fled to quality and write-downs spiked.
July 2007 started with an increase in spreads on the
iTraxx Crossover index, which measures the cost of
credit derivatives and is often regarded as a “barometer
of investor appetite for corporate credit crisis.” The index
crossed 3%; in mid-June, it was below 2%. Signs of concern
over credit quality became apparent as buyout firm KKR’s
banks failed to find investors for $10 billion worth of loans
and banks for the Chrysler Group decided to delay the sale
of $12 billion in debt due to the strained markets.
Various hedge funds began reporting losses due to the
subprime meltdown and the ensuing turmoil in the credit
markets. In August 2007, Sowood Capital Management
announced that it was facing heavy losses of about 50%
of its value and would shut down.
The crunch was not just a U.S. phenomenon. In the first
week of August, Australia’s Macquarie Bank announced
that two of its funds may lose as much as 25% of their
value due to subprime loans. In Germany, banks banded
together to provide €3.5 billion to cover potential subprimerelated
losses for German lender IKB. News also broke of
the collapse of two Bear Stearns hedge funds. In the days
following, alarm over BNP Paribas halting withdrawals
from three investment funds, and a disclosure from
Countrywide regarding short-term liquidity concerns
due to “unprecedented” conditions in the credit markets,
culminated in a 3% drop in the U.S. markets on August 9.
The market for commercial paper and commercial paper
backed by securities seized up in that same week. Investors
became increasingly nervous about the financial viability
of their counterparties and lending almost came to a halt.
By August 10, the Federal Reserve had announced
that it was “providing liquidity to facilitate the orderly
functioning of financial markets.” In the two-day period
of August 9 and 10, the Federal Reserve and other central
banks injected $290 billion into the financial markets as
a stabilizing measure. The subprime issue had evolved
into a credit crunch affecting the larger, global economy.
As deleverageing continued, other sectors began to
experience losses and receive lawsuits.
A Canadian unit of HSBC Holdings is facing a lawsuit by
Aastra Technologies in Ontario. Aastra is alleging that
HSBC gave bad investment recommendations in suggesting
asset-backed commercial paper investments that were
frozen soon after. HSBC is the first financial adviser to
face a lawsuit over investments in asset-backed
As investors’ aversion to risk continued, the cost of
borrowing increased and several merger deals fell
through due to lack of funding. For example, in New York,
Bain Capital and Thomas Lee Partners sued a group of
banks including Citigroup, Morgan Stanley and Credit
Suisse that were to finance the plaintiffs’ buyout of Clear
Channel. The plaintiffs allege that the banks “balked” at
their obligations due to the worsening credit conditions in
mid-2007 even though the commitment was not subject
to market conditions.
Various investors have even experienced losses on
corporate debt and were sued. For example, iStar Financial
is being sued for allegedly failing to recognize more than
$200 million in losses on its corporate loan and debt
portfolio in its registration statement for its secondary
offering. The complaint alleges that the company’s
continuing operations were negatively impacted by the
adverse conditions in the credit markets at the time of
the secondary offering.
Auction-rate securities (ARS) – long-term variable-rate
instruments (usually municipal or corporate bonds)
whose interest rates are reset through auctions – were
also affected. ARS are generally a main source of funding
for municipalities. As a result of the credit crisis, many
auctions have begun to fail. These failures are causing
serious repercussions for municipalities like Jefferson
County, Alabama, which is now facing rising interest
rates on its bonds and demands for penalty payments
as it struggles to avoid what would be the largest-ever
bankruptcy of a U.S. county.
The ARS market problems have led to various lawsuits
against broker-dealers such as Wachovia, Goldman
Sachs, Wells Fargo, UBS, JP Morgan, Merrill Lynch,
Morgan Stanley, TD Ameritrade and others. They all face
allegations that they misrepresented the risk-level and
liquidity of ARS they sold. In addition, plaintiffs claim
that defendants “failed to disclose that auction-rate
securities were only liquid at the time of sale because
the auction market was artificially supported and
manipulated by various broker-dealers to maintain
the appearance of liquidity and stability.”
There are now up to 15 lawsuits related to auction-rate
securities filed mostly in March and April 2008.
Most of the lawsuits are still in the first stages and it is too
early to tell the outcomes. The first class-action subprimerelated
lawsuit against New Century Financial Corporation
was dismissed in January 2008 without prejudice. Earlier in
November 2007, IndyMac Bank’s motion for dismissal, from
the second amended complaint, was granted but with leave
to amend after the judge ruled against a “strong inference”
of scienter. Given the continuing turmoil in the financial
markets, the mounting losses, and the growing list of
lawsuits, this story is far from over.
Faten Sabry, Ph.D. is a vice president at NERA Economic Consulting. She has
directed projects in securities, complex damages disputes, product liability, and
mass torts. She can be reached at
Anmol Sinha is an analyst at NERA Economic Consulting.
Sungi Lee is a research associate at NERA Economic Consulting.