Among all the reports of downward trends – in sales of autos, homes, clothing and everything in between – it is possible to find one growth area: Subprime litigation.
Navigant Consulting, Inc. tallied more than 600 mortgage-related suits filed in the 18 months ending June 30 – a startling number, when you consider that the Resolution Trust Corporation dealt with only 569 suits in the five year period (1989-1995) during which it was cleaning up the savings and loan mess. And the litigation trend is pointing upward. The 170 suits filed in the first quarter of this year alone nearly equaled the 181 filed in the last half of 2007, according to the Navigant report, which noted, “It is perhaps of little surprise that as the current [financial] crisis takes an unprecedented scale, the related litigation would as well.”
The majority of the suits (46 percent) were borrower class actions, nearly half of which alleged inadequate or misleading disclosures by lenders or mortgage brokers. Although one-third of the suits targeted mortgage companies and loan correspondents, Navigant found, “virtually everyone in the subprime collapse is being sued,” a list that includes, in addition to brokers and lenders, appraisers, title companies, builders, loan servicers, underwriting firms, bond insurers, money managers, accounting firms, and corporate directors and officers.
“Like the credit crunch itself, the litigation is unrelenting,” Jeff Nielsen, managing director of Navigant noted in a press statement. Navigant began to see a surge in mortgage-related litigation in 20007, when nearly 300 suits were filed. But in the first quarter of this year, Nielsen said, the company saw a minimum of two filings daily, “including weekends. What we saw in 2007 was a breaking wave compared to the tsunami we’re witnessing now.”
Nearly 10 percent of the suits Navigant has tallied this year were securities class actions, some filed by shareholders of institutions damaged by their subprime loans or investments, and others filed by individual and institutional investors who purchased toxic securities, the risks of which, they now claim, were not fully disclosed.
A separate report by RiskMetrics Group identified 67 securities class action suits filed through April of this year. The report also noted indications that plaintiffs are targeting entities further removed from the subprime epicenter. “As the credit markets remain tight, more subprime-related companies may seek bankruptcy protection,” the report noted, “leaving class action plaintiffs to look to auditors, underwriters, and others for financial recoveries. The investor suits are somewhat surprising, analysts say, given recent Supreme Court decisions that have made it more difficult for plaintiffs to prevail in securities actions.
The statistics tracking suits filed by borrowers and investors tell only part of the litigation story; these reports don’t include the legal actions initiated by scores of federal, state, and local authorities. A few examples:
- The FBI said in April that it was actively investigating 26 companies in connection with their subprime activities, in addition to the 1,400 mortgage fraud investigations the agency is pursuing nationwide.
- A separate joint FBI-Internal Revenue Service task force is examining low- and no-documentation mortgages and the role of mortgage lenders and brokers in originating those loans.
- The Securities and Exchange Commission has said it has 50 subprime-related investigations pending, targeting lenders, mortgage banking companies, credit rating agencies “and others.”
- The Department of Justice (and just about everyone else in the country, it seems) is suing Countrywide Mortgage in several states.
- Federal prosecutor, citing “intense public interest” are investigating the circumstances surrounding the collapse of Washington Mutual.
- A long and growing list of cities (Cleveland, Baltimore, Buffalo, New York, and Minneapolis, among them) have sued lenders and developers in state and federal courts, seeking compensation for the damage widespread foreclosures have inflicted on neighborhoods and entire communities.
- All of this adds up to something of a boom for the law firms that will be representing the plaintiffs filing these suits and defending the companies and industry executives targeted by them. Law.com reported recently that many law firms are creating special teams in their litigation departments, with specialists in banking and financial regulation, bankruptcy, securities law and white collar crime, to handle the anticipated demand for legal services.
“The legal issues flowing from the financial crisis are staggering and multidimensional,” Thomas Hall, a partner in the New York law firm Chadbourne & Parke LLP, told Insurance Journal. Using what has become a popular adjective to describe the trend, Hall added, “We are clearly in the midst of a legal tsunami.”
For some law firms, that tsunami is, if not welcome, at least well-timed. Klayman & Toskes, a Florida litigation firm, is just completing work on the last of the suits filed for investors caught holding valueless dot.com stock when the high-tech bubble burst. “We expect to wrap up the last of [those] cases in the first quarter of next year,” Lawrence Klayman, a founding partner, told Law.com. Based on that experience, Klayman said, “I anticipate the [subprime litigation] will keep us busy for seven or eight years.”
FULL SPEED AHEAD
Despite continuing opposition from legislators and industry trade groups, HUD officials have sent the current version of the revised RESPA rules to the Office of Management and Budget for review – the final step in an approval process that the agency hopes to complete before the end of this year.
There has been no let-up in the criticism of the proposal, however. Industry executives blasted HUD’s plan again last month at a hearing before the House Financial Services Oversight and Investigations Subcommittee, repeating their demand that the agency withdraw the current proposal and enter into a joint rulemaking process with the Federal Reserve to reconcile differences between the RESPA rules and the Fed’s Truth-in-Lending Act regulations.
The RESPA plan would generally overhaul the Good Faith Estimate and other closing documents, expand and simplify the disclosure of loan rates, terms, and costs. Newly required or expanded disclosures would include the “yield spread premium” paid to mortgage brokers, which would have to be described clearly and up-front in the closing documents.
That is one of many provisions that have drawn opposition from various industry participants. A requirement that closing agents read a final “script” to borrowers before they sign the purchase documents has also proven to be wildly unpopular. Opponents say the new rules will confuse consumers, reduce competition and increase borrowing costs. HUD officials, for their part, continue to insist that the revamped disclosure requirements will increase transparency, enable borrowers to compare loans and settlement services and reduce settlement costs by an average of $668 per loan.
The subprime crisis underscores the need for the protections HUD is proposing, HUD Secretary Steve Preston told executives attending the Mortgage Bankers Association’s (MBA’s) annual conference held recently in San Francisco. Many of the borrowers struggling with under water loans today are in trouble because they didn’t understand the loans they obtained, Preston said. “Our goal is to make sure that never happens again. We must make mortgages more understandable and the process more transparent.”
Addressing the same topic in an earlier speech to the Exchequer Club in Washington, Preston said the agency hopes to complete the RESPA rules by year-end “and then provide the industry with a full year to implement [the changes]. I firmly believe this will be a big step forward for restoring trust and transparency between the industry and the homeowner,” Preston stated.
DUAL BANKING DEBATE
The value of and need for the dual banking system took center stage at a recent Congressional hearing on the direction of regulatory reform. Although they differed on other issues, the American Bankers Association and the Independent Community bankers Association agreed that preserving the currents bifurcated system of state and federal regulation – and the state and federal chartering option – should be preserved. The Financial Services Roundtable, representing larger financial institutions exclusively, disagreed.
Highlighting a fault line that is likely to run through the financial services sector during the coming regulatory reform debate, Steve Bartlett, president and chief executive officer of the Roundtable, Bartlett said the fragmented regulatory system, with separate, overlapping and sometimes conflicting priorities, was unable to identify or prevent excesses, especially in the mortgage finance sector.
“At a time when the system of mortgage origination and financing was undergoing fundamental change, no single regulatory body had a clear purview or supervisory authority over the entirety of the primary mortgage market,” Bartlett argued at the House Financial Services Committee hearing. The state/federal regulatory divide also impaired oversight, he said, because regulators in the two sectors “lack a common set of regulatory objectives; they do not share a common vision or operate under common principles that balance consumer and investor protection, market integrity and stability, and competition. This has resulted in gaps in regulation and even conflicts in regulation.” The lack of coordination between state and federal regulators compounded those problems, Bartlett said, becoming more problematic “as the lines between the different segments of the financial services industry have crossed and blurred.”
Lining up on the other side of that question, ABA President and CEO Ed Yingling and banker Michael Washburn, representing the ICBA, cited preservation of charter choice and the dual banking system as one of the principles that should guide regulatory reform proposals. “While the lines of distinction between state and federally chartered banks have blurred in the last 20 years,” Washburn said, “community banks continue to value the productive tension between state and federal regulators.” In many cases, he said, the state system “has worked better than the federal system.”
Both bank trade groups also questioned the idea the Roundtable and have endorsed of a ‘super-regulator’ with broad authority over all segments of the financial markets, and they agreed that regulatory reforms should target the unregulated market players that, they said, were primarily responsible for the subprime abuses that triggered broader financial and economic problems. “There is a strong line of reasoning, which we believe is correct, that the basic system of bank regulation has worked – despite severe strains – while the problems built up outside this regulated system,” Yingling said. “Clearly,” he added, “major changes are coming and major changes are needed. But time after time, bankers have seen regulatory changes aimed at others result in massive new regulations for banks.”
But they parted company noticeably on the question of precisely where regulations should be tightened, and for whom. Washburn agreed that regulators should target “nonbank providers of financial services,” but he also suggested that policy makers examine “excessive concentration” of financial assets,” and rethink the assumption that some institutions are “too big to fail…. “Congress should seriously debate whether it is in the public interest to have so much power and concentrated wealth in the hands of so few,” Washburn suggested, noting that the ICBA proposes “down-sizing these super mega-sized institutions.”
UNMARKING TO MARKET
As the search for culprits in the financial market meltdown continues, fair value accounting has emerged as a leading target for the banking industry. Industry executives testifying at the regulatory reform hearing (see related news item) branded the accounting rules as misguided, misleading, and counterproductive in a troubled economic environment. “The current application of fair value accounting is neither clear-minded nor fair,” Steve Bartlett, president and chief executive officer of The Financial Services Roundtable,” stated. “It is causing significant damage to individual institutions and the economy as a whole.”
Mark-to-market accounting, as currently applied “is simply incompatible with the banking system as we have come to know it,” Ed Yingling, president and CEO of the American Bankers Association (ABA), agreed. If banks are to provide loans and make investments with a long-term perspective, Yingling said, they “must not have their loans and investments marked to prices set in panicked markets.”
But the push to eliminate or suspend market-to-market requirements is encountering strong resistance from several sectors as the Securities and Exchange Commission (SEC) begins to consider demands to rethink the rules. The argument against the rules: They require arbitrary and unnecessary reductions in asset values that make financial institutions look weaker than they are. The argument for them: They provide an accurate picture of the financial health of institutions, preventing them from claiming to be stronger than they are.
The resolution of this debate, analysts predict, probably lies somewhere in between – retaining the transparency MTM provides, but permitting interpretations that ease the impact in an illiquid market. The consensus seems to be that while the SEC and the Financial Accounting Standards Board (FASB), which also has jurisdiction in this area, may issue new guidance they are unlikely to revoke the accounting rules. “Investors have been clear – they want to see the current fair values of a company’s financial assets,” Robert Herz, chairman of the FASSSSB, said in a recent speech.
Washington Post columnist Alan Sloane echoed that view in a recent article, in which he argued that revoking MTM – which he opposes – would not solve the financial market problems. “There are problems with MTM,” Sloane agreed, among them, “it is relatively new and parts of it seem arbitrary. It is easier to blame accountants for your problems than to admit you made your institution vulnerable by overleveraging its balance sheet and buying securities you didn’t understand,” he added. The credit markets have been frozen, Sloan concluded, “largely because banks haven’t trusted the balance sheets of other banks and have thus been afraid to lend to them. I can’t imagine that confidence problem being resolved by changing MTM.”
PAYDAY PUSH BACK
State legislatures all over the country have been adopting laws designed to push payday lenders out of their markets. Now, payday lenders are pushing back. The Wall Street Journal reported recently that payday companies are spending more than $30 million to promote ballot initiatives in Arizona and Ohio to revoke laws capping payday interest rates at 36 percent (Arizona) and 28 percent (Ohio). The Arizona initiative is being financed by a local affiliate of the Community Financial Service Association, the national trade association representing the payday lending industry, according to the WSJ.
“The payday lending industry realizes that in some ways, this is the beach of Normandy,” Joe Cimperman, a city councilman in Cleveland, OH, told the Journal Cimberman was a sponsor of city ordinance that caps the number of payday lenders in Cleveland, using a ratio based on the city’s population.
Payday lending opponents argue that the loans, which carry effective interest rates averaging more than 390 percent, are usurious and deadly, trapping borrows in an endless cycle of escalating debt. Proponents insist that the loans offer a necessary emergency financing alternative to consumers who do not have access to mainstream sources of credit.
“Simply ending payday lending by itself is not a terribly productive activity,” Rebecca Blank, a senior fellow at the Brookings Institution, said in the Journal article.
A study published earlier this year by the Federal Reserve Bank of New York made the same point, concluding that the elimination of payday lending has adverse consequences for consumers. The study’s authors, economist Donald Morgan and Michael Strain, compared the experience of consumers in Georgia and North Carolina, which have barred payday lending, with consumers in states where that option is available. They found that consumers “do not seem better off since their states outlawed payday credit. They have bounced more checks, complained more about lenders and debt collectors, and have filed for Chapter 7 bankruptcy protection at a higher rate.” That “negative correlation” between educed access to payday loans and increased credit problems “contradicts the debt trap critique of payday lending,” Morgan and Strain conclude, ‘but it is consistent with the hypothesis that payday credit is preferable to substitutes, such as bounced check protection sold by credit unions and banks, or loans from pawnshops.”
Criticism to the contrary notwithstanding, this study contends, “payday credit can be profoundly beneficial, even lifesaving in extraordinary events,…helping to avoid more quotidian disasters, like bouncing a mess of checks, or getting hassled by debt collectors….Progressives may call for something better than either payday credit and bounced check protection,” the study concludes. “And we are all for that. But banning payday loans is not the way to motivate competitors to lower prices or invent new products.”
A competing study by the University of North Carolina’s Center for Community Capital, reached a different conclusion. This study, undertaken at the request of the North Carolina Commissioner of banks, also analyzed the impact of eliminating payday lending as an option for consumers, but it found that the results were “positive” rather than negative on most households.
“Hard-working North Carolinians have not missed payday lenders,” the study asserts. “This study shows that people have many options to get through financial distress.” Consumers interviewed for the study said they had used payday loans in the past primarily because of the “speed and ease” with which they could obtain that financing, but the majority also agreed that the costs were “excessive” and that they were better off without this financing option. “The themes of speed, ease and convenience resound throughout the research and our focus groups,” the study says, “which may partly explain why payday lending appeals to certain consumers, and why, at the same time, it is not sorely missed.”
