Financial firms have already been drenched by mortgage-related losses. Now a wave of litigation threatens to assail them. According to RiskMetrics, a consulting firm, between August and October federal securities class-action lawsuits were filed in America at an annualized pace of around 270—more than double last year’s total and well above the historical average. At this rate, claims could easily exceed those of the dotcom bust and options-backdating scandal combined.
At most risk are banks that peddled mortgages or mortgage-backed securities. Investors have handed several writs to Citigroup and Merrill Lynch. Bear Stearns has received dozens over the collapse of two leveraged hedge funds. A typical complaint accuses it of failing to make adequate reserves or to explain the risks of its subprime investments, and of dubious related-party transactions with the funds. Several firms, including E*Trade, a discount broker with a banking arm sitting on a radioactive pile of mortgage debt, are being sued for allegedly failing to disclose problems as they became apparent to managers.
But one thing that sets the subprime litigation wave apart from that of the 2001-03 bear market is its breadth. After the collapses of Enron and WorldCom, lawsuits were targeted at a fairly narrow range of parties: bust internet firms, their accountants, and some banks. This time, investors are aiming not only at mortgage lenders, brokers and investment banks but also insurers (American International Group), bond funds (State Street, Morgan Keegan), rating agencies (Moody’s and Standard & Poor’s) and homebuilders (Beazer Homes, Toll Brothers et al.).
Borrowers, too, are suing both their lenders and the Wall Street firms that wrapped up their loans. Several groups of employees and pension-fund participants have filed so-called ERISA/401(k) suits against their own firms. Local councils in Australia are threatening to sue a subsidiary of Lehman Brothers over the sale of collateralized-debt obligations (CDOs), the Financial Times has reported. Lenders are even turning on each other; Deutsche Bank has filed large numbers of lawsuits against mortgage firms, claiming they owe money for failing to buy back loans that soured within months of being made.
“It seems that everyone is suing everyone,” says Adam Savett of RiskMetrics’ securities-litigation group. “It surely can’t be long before we get the legal equivalent of man bites dog, where a lender sues its borrowers for some breach of contract.”
The authorities, too, are baring their teeth. Several Wall Street banks have received subpoenas from New York’s attorney-general, Andrew Cuomo, requesting information on their packaging of now-stricken securities. This comes on top of a deepening probe into possibly inflated home-price appraisals by brokers and lenders, including Washington Mutual and First American Corporation. Ohio’s attorney-general, Marc Dann, has been just as hyperactive, suing over a dozen lenders and brokers.
No less important is the spadework being done by the Securities and Exchange Commission, America’s main markets watchdog. It is conducting more than 20 investigations, including one into the arrangements banks entered into with hedge funds that may have been designed to hide or delay mark-to-market losses.
Such probes are even more important than they appear because they could encourage private litigation. Regulators and state prosecutors have more powers to demand information than private plaintiffs do. What they unearth, if they go public with it, can bolster investors’ claims or even lead to new ones. This is what happened following congressional investigations into the tobacco industry, and when Eliot Spitzer, Mr. Cuomo’s predecessor (and now New York’s governor), went looking for smoking guns at banks, insurers and mutual-fund managers after the 2001 stock market fall. The officials are likely to dig even harder this time since the issue touches poor homeowners, a more vulnerable group than day-traders.
In readiness, law firms have been rushing to set up dedicated subprime practices. These are working not only on disputes but also on helping clients to unwind leveraged transactions. “Securitization is the particle physics of finance, which makes it much richer legally than technology stocks,” says John Rosenthal, head of Nixon Peabody’s subprime team.
That complexity is a mixed blessing for plaintiffs. Showing that financial innovation got out of hand will not be hard. However, they have to prove not only incompetence, but fraud. Defendants will argue that, far from deceiving investors, they failed to understand the structured products they had bought (or created) and the speed with which those securities could deteriorate in value—in other words, that they were clueless but not conniving.
Banks that face lawsuits over mortgage debt they peddled have at least one strong argument in their favor: they themselves bought the stuff. Both Citi and Merrill, for instance, held on to the senior tranches of CDOs, which have since gone bad. Would they have done this knowing that the securities were potentially so toxic? On the other hand, plaintiffs’ lawyers say there are plenty of examples from recent months of banks and companies that have run aground even after stating in calls with investors that they had safeguards in place.
As busy as the lawyers are, they are only warming up. Scrutiny of the way banks account for tainted securities is just beginning, as is the task of poring through e-mails provided under subpoena. And as pain spreads to other securitized products, such as car and credit-card loans, they too will come under the spotlight.
The ultimate cost of the mortgage crisis in terms of settlements, awards and legal fees can only be guessed at. But the consensus view is that payouts will climb well above the billions stemming from the internet bubble.
Now, as then, many will settle for large sums rather than risk lengthy court proceedings that could end in even bigger payouts, even if their defenses have some merit. And it is not just those directly involved who will suffer. On one estimate, from Guy Carpenter, a reinsurance broker, insurers that underwrite directors and executives could end up shelling out more than $3 billion. For the plaintiffs’ bar, at least, the next boom is already at hand.