Emerging Trends

Subprime Worries Still Looming

7/26/2007

In this month's Q&A, New York partners Rick Antonoff and Maria Galeno, both members of Pillsbury's Subprime Industry Group, discuss the ramifications of the subprime meltdown on lenders and other financial services entities.

Ben Bernanke, Chairman of the Federal Reserve, recently testified before Congress that the U.S. should expect "significant losses" as a result of the collapse of the subprime mortgage industry.

In the following Q&A, Pillsbury Winthrop Shaw Pittman insolvency partner Rick Antonoff and white-collar litigation partner Maria Galeno discuss developments in the subprime mortgage industry and possible changes to come. Antonoff and Galeno, both partners in Pillsbury’s New York office, are members of the firm’s Subprime Industry Group, a multidisciplinary group that advises clients and prospects affected by the collapse of the subprime mortgage market. Pillsbury was the first AmLaw 50 firm to announce the creation of a formal group to specifically address this issue.

Q: The collapse of the subprime mortgage industry began close to a year ago and there seems to be no end in sight to the repercussions. What’s happening?

Antonoff: There are significant downside risks still to come. Loss estimates range from $50 billion to $100 billion, and more than 60 mortgage lenders have already closed shop, gone bankrupt or sought buyers. On the regulatory side, more than 30 states have pending legislation that would further regulate those making risky, high-interest rate loans. Add to that increasing scrutiny by Congress and dozens of lawsuits targeting many of the players in this troubled industry, including mortgage brokers, investment banks, underwriters, warehouse lenders, mortgage loan wholesalers, credit rating agencies, credit default counterparties and the borrowers themselves.

Q: How did this happen?

Antonoff: The crisis began partly as a result of lower home prices and higher short-term interest rates in 2006, which led to lower demand for new loans and fewer refinancings. It also resulted from higher payments triggered by adjustable rate mortgages, leading to higher default rates among homeowners. That, in turn, caused investment banks that fund subprime lenders to cut off funding and many subprime lenders to stagnate, unable to originate new loans, and ultimately go bankrupt.

Q: What’s going to happen to those lenders?

Antonoff: When the subprime industry last collapsed in the late 1990s, many mortgage lenders simply ceased to exist. The difference today is that the market is much bigger, at an estimated $3 trillion compared to $500 billion in 1998. Also, there are more players in the industry and investment liquidity around, so more opportunities to sell assets and businesses and more opportunities for private equity and hedge fund investors exist to scoop up these distressed companies and get into this business at a relatively low entrance cost. Hedge funds and private equity funds are buying entire lending operations, including originating, servicing and sales programs.
 
Still, investors in mortgage-backed securities are wary. Recently, several large hedge funds trading in the riskier end of these securities found themselves essentially worthless. That news rattled investors and the stock market. So did recent ratings cuts for dozens of collateralized debt obligations, or bonds backed by subprime loans and other risky debts.

Q: Are we seeing any lawsuits related to the subprime meltdown?

Galeno: A number of different types of lawsuits have already been filed. In one case, borrowers brought a class action against the warehouse lender to the mortgage company for aiding and abetting deceptive sales practices by the mortgage company. A jury verdict against the warehouse lender was sustained. In another proceeding, a trustee for a bankrupt mortgage company sued the warehouse lender to subordinate the lender’s bankruptcy claims and to rescind payments to the lender on a fraudulent conveyance theory. There, the trustee was denied relief because the lender was not an insider (and so not in a fiduciary relationship) and was fully secured. In a recently-filed action, a large purchaser of mortgage-backed securities sued an investment bank and its affiliates who purchased the loans, serviced the loans, and was underwriter and issuer of the mortgage-backed securities, alleging claims of negligent misrepresentation, fraud, breach of fiduciary duty, and state and federal securities law violations. That case is at the stage of motions addressed to the pleadings. More recently, a CFO of a rating agency was sued for false and misleading statements in connection with a bond issuance.

Q: How is the Government responding in the wake of the collapse of the subprime industry?

Galeno: Many state Attorneys General, including California, Massachusetts, New York and Ohio, have announced investigations of the subprime mortgage industry, and are issuing subpoenas. If you are a player in this space, it is a good time to revisit your company’s guidelines and procedures as to what to do if a subpoena arrives at the company—such as how to route the subpoena quickly to the appropriate person in the organization, the necessity for a document preservation memorandum and possible suspension of otherwise routine document destruction policies (including electronic documents), and other relevant information concerning communicating with law enforcement.

Q: Why do we expect so many more loan delinquencies in the coming months?

Antonoff: Many subprime borrowers got favorable, fixed interest rates at the outset of their loans, particularly in the first two or three years. As those interest rates reset at higher adjustable rates once those initial terms expire, we expect more borrowers will have trouble making their monthly loan payments. Many of the loans in question were made in 2005 and 2006, so that’s happening and increasing as we speak and will soon affect the securities that are backed by these loans as well as parties on the wrong side of credit default arrangements.

With lower home prices, many borrowers are finding their loans now worth more than their homes, so they can’t simply refinance or sell their homes to pay off their debts. The fact that there are so many properties in foreclosure on the market has contributed to lower home prices. With many consumers facing higher loan payments, consumer spending may lag as well. The effects of that drop in spending could be felt across the economy, particularly in the retail sector which may see the effects on consumer spending sooner than other segments. The problems could be exasperated as home builders tamp down their development activities, as well, as a result of sluggish home sales.

Q: What could regulators do to "adjust" the industry as Bernanke suggested?

Antonoff: Because of a recent Supreme Court ruling denying state governments the power to regulate subsidiaries of federally chartered institutions, the federal Government may be the only authority in a position to do anything meaningful. But there are limits on what the Government can do. A mortgage is recognized under the law as a property interest and Congress can’t simply compel lenders to stand down and not exercise their rights when a borrower defaults.

On the other hand, Congress and the federal regulators can mandate more transparent disclosure to borrowers of the terms and risks associated with the mortgage loan, they can implement consumer education laws and better enforce laws against predatory lending practices. But I would be concerned if they go too far and, in effect, try to manage the mortgage lending business. For example, if Congress imposed unrealistic credit limits and unduly burdensome underwriting standards, or worse, requiring a "Sarbanes-Oxley" type of reporting and certification, it would dramatically increase transaction costs and make it more expensive for even the most creditworthy consumers to borrow money to buy homes.

Finally, some states are setting up bailout funds that will help prevent borrowers from going into default and losing their homes. While many fear broad economic ramifications as a result of this mess, Bernanke optimistically calls this crisis a "bump" in the road. We shall see.

---

"Emerging Trends" is a monthly feature produced by Pillsbury Winthrop Shaw Pittman, highlighting key legal issues impacting businesses today. To schedule an interview with any of our lawyers or to receive a copy of "Emerging Trends" on a regular basis, please contact Sandi Sonnenfeld, Director of Public Relations, at 212.858.1741 or at sandi.sonnenfeld@pillsburylaw.com.