Subprime Meltdown

September 25, 2007
Corporate Governance Newsletter

Hedge funds are collapsing, lenders are being sued, companies are filing for bankruptcy, the government is looking into accounting irregularities and insider stock trades, and many Americans are losing their homes – all as a result of the subprime loan crisis.  The subprime meltdown threatens investors and borrowers, businesses and markets.

Subprime loans are expensive loans made to borrowers who are deemed a high risk based on a poor credit history or a high debt-to-income ratio.  These loans were relatively rare until the mid-1990s, when there was an upsurge in the practice of selling mortgage-backed securities to investors.  Essentially, the mortgages are pooled together and resold as bonds, vastly increasing the amount of credit available.

The securitization of mortgages led to a rapid increase in the number and amount of subprime loans.  By 2005, it was estimated that one out of every five loans issued was subprime.

The securitization process also introduced a number of new layers into a process which previously had been a relatively straightforward transaction between a lender and a borrower.  Frequently the same party filled many of these intermediary roles – building conflicts of interest into the loan process.

For example, the investment banks that issue the mortgage-backed securities to investors also pay credit agencies to grade the assets they are selling.  Perhaps unsurprisingly, the credit agencies consistently advised investors that mortgage-backed securities were safe investments.

In the midst of the superheated housing markets, many borrowers decided it was worth the risk to obtain a loan by any means necessary – based on the assumption that rising housing prices would outweigh the cost of an expensive loan.  Built upon this precarious foundation, the market was unable to prevent a confluence of events, including a rise in short-term interest rates and a slowing housing market, from triggering a domino effect that led to widespread delinquencies, defaults and foreclosures.

Advocates for corporate reform, clean markets, and corporate transparency are now urging a thorough examination of the root causes that created the subprime crisis and new protections to prevent future fiascos.  “Investors deserve independent analysis, uncorrupted by conflicts of interest,” affirmed Patrick Coughlin, chief trial counsel in the Enron case.

The inherent conflict of interest that exists when credit agencies grade their clients’ securities is all too reminiscent of the conflicts that led to the debacles of Enron and WorldCom,” said Coughlin, noting the disturbing similarities between the roots of the subprime meltdown and previous corporate looting.  Coughlin and his firm have launched a task force to investigate the subprime disaster and have filed suit against the nation’s largest lender, Countrywide Financial Corp.

However, shareholders in the various loan originators are not the only victims of this scandal.  Most subprime loans were packaged into Mortgage Backed Securities, which were then in turn packaged into Collateralized Debt Obligations (CDOs).  The CDOs were then sold to institutional investors, including public pension plans, Taft-Hartley Funds, and European and Asian Banks.  These investors were willing to purchase the CDOs because many of them had investment-grade ratings, making them seem as safe as highly rated Corporate Debt.  Because the CDOs are still not publicly traded, many institutional investors are not yet aware of the losses they have incurred on the investments, although many CDOs have been downgraded.  Coughlin Stoia is working with experts in this area to be uniquely prepared to help institutional investors recover losses from those involved in packaging, promoting and selling these CDOs, based on their deception, breach of fiduciary duties and unjust enrichment.

In addition to numerous lawsuits brought by victimized investors, the subprime crisis is also the focus of government inquiries.  At a recent House hearing on the subject, Congressman Gary Ackerman was sharply critical of the cozy relationship between the credit agencies and the banks: “Essentially, the originators and credit raters shoved enough pigs and laying hens in with the beef herd that investors expecting prime ribs on their silver platter and money in their pocket ended up with pork ribs on their paper plate and egg on their face.”

Abrams v. Countrywide Financial Corp., et al., No. CV07-05432-ODW (MANx) (C.D. Cal. 2007).

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