For the last year, the implosion of the subprime mortgage industry has dominated business page headlines. Many of our institutional clients have been asking questions about the ramifications for their funds and the potential for securities fraud litigation. The editors of the Securities Fraud Monitor asked Jeffrey Block, a partner in the firm’s Boston office, to put these cases into context. What follow are excerpts from our conversation.
The Genesis
The subprime crisis developed from an overheated real estate market. You had lots of lenders pushing loans and making lots of money. Subprime loans offered even higher payouts, at substantially higher risk.
In many ways, the debacle is reminiscent of the savings and loan crisis of the 1980s. In the recent meltdown, lenders were willing to lend 100% of the appraised value of the property. If I’m the homeowner and take a 100% loan, I have no equity. If I walk away, what do I care? I’m not losing anything.
At the same time, the mortgage industry engaged in a sort of financial alchemy to turn these dross loans into golden securities. First, the mortgage broker who initiates the loan – and gets a nice commission – hands it to a bank. The bank sells it to another bank, which sells it to another bank, which sells it to a giant like Citi or Countrywide, which bundles it with a bunch of other loans and securitizes it. In the end, these risky loans become part of a financial product sold to institutions as highly rated securities.
At the height of this craze, lenders were giving loans without any documentation to support the borrower’s income. And, to make matters worse, they crafted loans with adjustable rates that quickly soared out of reach for the borrower. Before long, the borrowers couldn’t make their payments.
These highly risky loans were issued under the premise that the real estate market would remain red-hot. Nobody bothered to consider what would happen if property prices didn’t continue to rise – or if they actually went down.
Eventually, the financial institutions that made tremendous amounts of money in 2004, 2005 and 2006 suddenly got hammered – with billions and billions in loans that were now worthless. Estimates of how much banks will eventually lose due to subprime mortgages range from hundreds of billions of dollars to more than $1 trillion.
Initial Cases
The first phase of securities cases, aimed at mortgage lenders, developed in late 2005 and early 2006 as the booming real estate market began its slowdown. Mortgage lenders couldn’t continue to hold onto the risky loans. Meanwhile, the underwriting firms that had been pushing subprime loans to anyone and everyone saw their financing begin to dry up.
In 2007, the subprime mortgages themselves began to deteriorate – only this time, there was no secondary market for these loans. Finance companies were no longer interested in buying them. This is where we began to see the emergence of cases against companies like American Home Mortgage Investment Corporation, one of the largest retail mortgage lenders in the country, which was sitting on enormous amounts of high-end subprime mortgages and bad loans. In the space of just a few weeks, American Home hemorrhaged and filed for bankruptcy protection.
In the American Home Mortgage case, our firm represents the Oklahoma Police Pension & Retirement System, which was recently named as co-lead plaintiff with the Oklahoma Teachers’ Retirement System.
Second Wave
The next wave of cases came against the financial services companies, particularly banks and underwriters such as Citigroup and Merrill Lynch. In the Citigroup case, we have filed a lead plaintiff petition on behalf of the State Universities Retirement System of Illinois.
These large banks had huge exposures to the subprime and residential mortgages – to the tune of billions of dollars – but never disclosed them to Wall Street. Only after the financial institutions began taking big charges and making big write-downs did investors realize just how large those exposures were.
At the same time, problems began to grow among companies like MBIA Inc. and Ambac, traditional insurers of municipal bonds that had turned to securities tied to riskier subprime mortgages to goose profits. In the third and fourth quarters of 2007, these insurers announced massive write-downs. And, once again, investors were shocked to learn of their exposure – especially since the companies had been publicly downplaying their involvement. The stock prices of these insurers fell so fast and so hard that the New York State Insurance Department developed a bailout plan.
Inadequate Disclosures
From an investor’s point of view, these lenders absolutely did not adequately disclose their risks. Given the real estate market’s relentless downward spiral over the last two years, one would have expected to see a slow and steady stock price decline for lenders, banks and insurers in 2006 and 2007.
Instead, we saw a dramatic crash only when the institutions finally came clean. It was as if they finally said: “Oops. We forgot to tell you. Things are a lot worse than we let on.”
We believe many of those involved were hiding information from their investors. When things began to sour in 2006, they simply crossed their fingers, held their breath and hoped for a turnaround. They clearly recognized that once they owned up, things would undoubtedly head south – fast. And indeed they did.
The Right to Legal Action
Shareholders have every right to expect that companies in which they invest will make full and fair disclosures about their operations. If I’m deciding whether to invest in a financial institution, I should be able to see which ones are heavily exposed in the subprime area, and which are not.
For example, Deutsche Bank and Bank of America (before it acquired Countrywide Financial) had little exposure. And Goldman Sachs was able to make money because a few employees made huge bets against Goldman’s position in the subprime market.
As an investor, am I supposed to start guessing which firm has exposure and which doesn’t? It is their obligation to state their exposures with certain detail; investors can then choose whether they want to accept any accompanying risks.
Here’s a good example. Berman DeValerio currently represents a number of pension plans in a case against State Street Bank that accuses the financial services firm of breaching its fiduciary duties in violation of the Employee Retirement Income Security Act, which is commonly known as ERISA.
As one of their investment options, participants in these pension plans chose what State Street described as a conservative bond fund. The fund measured its performance against a broad Lehman-Brothers bond index, which it was supposed to track roughly. But, somewhere along the line, State Street allegedly moved the investors’ money into the subprime market in an effort to juice returns without documenting the change in its materials. The pension plan participants lost millions as a result.
It was imprudent, or a breach of fiduciary duty as the lawsuit alleges, for State Street to put retirement funds that were to have been invested in a conservative bond fund into subprime securities in late 2006 and 2007.
Next Phase
Though the markets now know many of the companies that had massive exposure to subprime-based securities, I wouldn’t be surprised if Citigroup or Merrill Lynch or MBIA has another write-down.
What we will probably see next are lawsuits accusing companies of failing to properly value their securities in 2006 and 2007. American International Group, for example, recently took a $4.8 billion write-down after its auditors found material weaknesses in its credit portfolio valuation methods. (AIG later announced an $11.1 billion write-down on derivatives tied to the subprime market.)
The FBI and the SEC are each investigating at least two dozen companies for accounting issues. We believe many more investigations are on the horizon. Currently, our firm is investigating claims against Bear Stearns, MBIA, Ambac, Sallie Mae and First Marblehead, to name a few.
Institutional Reaction
Institutional investors are telling us that they want to take legal action against the industry to hold the companies and their executives accountable for hiding the truth. The heads of these companies made fortunes off these bad loans, while ordinary people sank into debt, lost their homes and watched their investments disappear.
Among our institutional clients, we’ve seen a wide range of losses over these issues – anywhere from $1 million to $50 million per fund.
Legal action may not be the answer for every institutional investor. But those that have suffered significant losses tied to the subprime crisis are meeting their fiduciary obligations to plan participants by exploring the merits of cases in which they had a large potential loss.
*In August 2017, our firm name changed to Berman Tabacco. Case references and content published before that date may refer to the firm under our prior name, Berman DeValerio.