Subprime Meltdown Leads To Wave Of Litigation

Feb 13 2008 | 6:00am ET

By Jacob Zamansky -- Following the subprime mortgage market collapse, there has been an unprecedented wave of related litigation.

The numbers are mind-blowing.  From 1994 to 2005, the subprime mortgage market grew from $35 billion to $665 billion.  At the end of 2006, subprime mortgages accounted for approximately 23% of the nation’s mortgages. 

Subprime mortgage lending grew as the housing “bubble” expanded with housing prices in the United States generally increasing between 2002 and 2005.  When the housing market peaked and began to decline in 2005, mortgage lenders and Wall Street firms who packaged and resold the mortgage loans into bonds and mortgage backed securities knew—or should have known—that the implosion of the housing market would lead directly and quickly to a collapse in the subprime mortgage, MBS and collateralized debt obligations markets, causing a ripple effect which would be felt by major Wall Street firms, investors, homeowners and other market participants.

As a result of the subprime mortgage collapse, it is predicted that 2.2 million U.S. homeowners will lose their homes to foreclosures.   In addition, the financial fall-out has staggered economists and investors alike.

A Litigation Tsunami

As of December, 32 class-action lawsuits have been filled by investors against the subprime mortgage lenders, Wall Street firms that underwrote MBS and CDOs, and investors who purchased shares of hedge funds, bond funds and other securities containing subprime mortgage exposure.  Numerous individual lawsuits have been commenced by various parties to the subprime mortgage lending and securitization markets, and many more such lawsuits are expected to be filed in this year and next.  These claims run the gamut, including fraudulent practices, failure to disclose information regarding loan packages sold to third parties, breach of contracts involving securitization and due diligence on mortgage loans prior to repackaging as CDOs and other securities.

Lawsuits have been filed against subprime originators, real estate agents, title companies and real estate appraisers alleging a variety of predatory lending practices and securities violations based on misrepresentation in the loan origination process.  Claims include charges that excessive fees were financed into loan principal amounts; loans were issued regardless of a homeowner’s ability to pay; and loans were made with higher interest rates than the lowest rate for which the homeowner might have been eligible.

Bears Stearns Hedge Fund Collapse And The Litigation Fallout

There is also the ongoing Bear Stearns litigation resulting from the collapse of its two hedge funds that invested in fixed income securities.  Many argue that failure led to the worldwide credit crunch. 

On Aug. 1, Zamansky & Associates filed the first arbitration case on behalf of a group of investors who claim that Bear Stearns misled them about the extent of subprime exposure in the hedge funds, misrepresented the “risk controls” which were in place, and misrepresented the performance of the fund during calls held with investors from January to June of last year, which were designed to keep investors in the fund and dissuade them from redeeming their shares.

On Nov. 14, the Massachusetts Securities Division filed an administrative complaint against Bear Stearns Asset Management alleging violations of securities laws based on BSAM’s failure to obtain approval by “unaffiliated directors” for numerous related party transactions with Bear Stearns and other entities controlled or managed by BSAM.  The Massachusetts complaint alleges that hundreds of so-called “principal transactions” were processed without prior approval by unaffiliated directors, and that Bear Stearns and BSAM used the hedge fund as a place to unload excessively risky or troubled assets that could not be sold to other investors at the prices paid by the hedge funds. 

In addition, the U.S. Attorney’s office for the Eastern District of New York has commenced a criminal investigation of Bear Stearns and the hedge funds’ managers, including portfolio manager Ralph Cioffi.  Cioffi allegedly engaged in insider trading by pulling his personal money out of the hedge fund prior to disclosure to investors that the subprime market turmoil had destroyed their value, resulting in a near total loss for all investors. 

The Brooklyn U.S. Attorney’s office is also working in conjunction with the Securities and Exchange Commission to probe various securities law violations regarding the marketing practices of the hedge funds, whether the “pricing” of the mortgage-backed securities was fraudulent and whether Bear Stearns and other financial firms should have told the public earlier about the declining value of such securities and how they priced them on their books.

The legal avalanche enveloping Bear is not limited to claims by investors and regulators. In December, Barclays Bank sued the firm to recover $400 million which Barclays lent to a Bear Stearns hedge fund which started operations in September 2006.  The suit alleges that Bear Stearns misled Barclays about the performance of the highly-leveraged fund.  Barclays claims that as the fund faltered, its desperate state was hidden by Bear Stearns from bank officials. Barclays also claims that Bear Stearns made false promises about savvy risk management to win loan money from the bank.

Regulatory Investigations

As usual, government regulators, who have been accused of being “asleep at the wheel” during the housing boom, are taking action after the fact.

The Federal Bureau of Investigation reported that it had opened criminal inquiries into 14 companies as part of a wide-ranging investigation of the troubled mortgage industry.  The Feds are looking into possible accounting fraud, insider trading and other violations in connection with loans made to borrowers with weak or subprime credit.

In addition, the Bureau is cooperating with the SEC, which is conducting about three dozen civil investigations into how subprime loans were made and packaged and how securities backed by them were valued.

New York State Attorney General Andrew Cuomo and prosecutors in Connecticut, Illinois, Massachusetts and Ohio are also investigating various aspects of the subprime mortgage industry.

Naturally, this is a fluid situation and more than likely even this compilation is the tip of the iceberg.  There are also myriad legislative proposals on the table that could further muddy the waters. It's a litigation tsunami, indeed.

Jacob Zamansky is a partner at Zamansky & Associates, a New York-based securities arbitration law firm. His firm focuses on helping victims of securities fraud recover money lost due to negligence or unscrupulous actions on the part of stockbrokers or other investment professionals. More of Zamansky’s musings can be found on his blog at www.zamansky.blogspot.com.


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