Taking A Lesson From History In Viewing The Subprime Crisis

Saturday, March 1, 2008 - 00:00

Editor: I understand that Saul Ewing is currently setting up a subprime practice group. How will this group differ from the firm's bankruptcy practice?

Pippett: It will be different in that it is to be a broad-based, cooperative effort among practice groups, made up of attorneys from our litigation, insurance, bankruptcy, financial services and education practice groups as well as the white collar crime and real estate groups. The person spearheading the setting up of the group is Jim Gkonos from our Insurance Practice Group. The new practice is intended to cover the majority of issues that we anticipate may arise as a result of the credit crisis and to aid clients and potential clients in coping with the ripple effects from the overall crisis. We believe that there are many industries and service groups that will be affected with a far-reaching impact.

Editor: Whom will you be representing - investors who have been harmed or institutions threatened with lawsuits owing to their investment policies or lending practices?

Pippett: I expect our clients will fall into both categories. I think we will have clients who may want to pursue claims as a result of bad investments and sustained losses and we may also have institutions that are being challenged by shareholders or regulators for making such investments.

Editor: Do you expect to also be defending class action law suits against financial institutions?

Pippett: I don't think we'll be involved in class actions because as a firm we don't have many clients among the large money center banks that probably have the biggest exposure in this area.

Editor: What has the history of investor law suits over the subprime debacle been to date?

Pippett: There's no significant history to date. I think people are rattling sabers but most are waiting to strike when they see how the matters come to a head. After the annual reports for the year 2007 start getting into people's hands, when more information becomes available in order to evaluate the scope of the damage as well as determine where the deep pockets are - then I expect we will see litigation activity.

Editor: What role do you expect the SEC to play in terms of setting forth guidelines for securitizations in the future?

Pippett: They may play a role similar to the one played in the more recent securities industry crisis involving Enron and WorldCom in providing more refinements as to disclosure in regard to securitization transactions. It is difficult for the SEC to scrutinize each of the transactions other than to require much more disclosure. The underwriters should be required to look at every transaction - describe it as it really is, not what it purports to be. It seems that responsibility was overlooked on the theory that someone else would buy the paper. The same is true of the rating agencies in accepting the guidance of the investment bankers. They apparently failed to do the proper due diligence. If you look at a transaction and don't understand it, rather than rubberstamping the investment banker's endorsement, there should have been more push back.

Editor: Most of these CLO's and CDO's were not registered securities so they did not come under the purview of the SEC?

Pippett: In fact, the SEC has acknowledged that as part of the problem - not being able to monitor and supervise these activities. They could not address the individual transactions but only the entities that were doing the buying or the selling who fell under their jurisdiction.

Editor: What "best practices" do you see being adopted in loan origination as well as in loan securitization?

Pippett: I think in this respect loan brokers and banks should stick to the basics: look at the true value of the loan vis--vis the creditworthiness of the borrower and the asset that supports it as against what it can be bundled up for and sold. In many cases it would be hard to prove outright fraud. Mortgage brokers might put a slight spin on their presentation regarding a C credit's ability to perform when approaching a lending institution, but fraud would be difficult to prove. In loan origination, I would expect some changes in how loan brokers are compensated for originations - not the present system where they are paid x dollars upon closing the loan regardless of whether the loan is made to a creditworthy borrower. For instance, in the insurance industry brokers do not get paid the full fee upfront but over a longer period - say, five years. I think what you're going to see is a little more scrutiny on the front end and a change in the origination basis whereby the mortgage broker might wait for his payment over time to make sure the loan is going to perform. Also, lenders may terminate brokers who have a history of bringing them bad paper. This will eliminate the scenario where a broker has no incentive to see to it that a loan performs once it closes.

The same approach applies to securitizations. There should be a whole lot more scrutiny on both sides of the table as to what a party is selling or buying because the better the bundle of products at the beginning, the finer result at the end.

Editor: How much can quasi-governmental institutions, such as the Federal Home Loan Bank, Fannie Mae and Freddie Mac, be helpful in salvaging some loans and relieving the balance sheets of financial firms?

Pippett: Some take the view that governmental institutions should not help with any bailout because then there's no lesson learned. There should be repercussions owing to irresponsible behavior both on the borrower's side and on the lender's side. If I'm a borrower and I'm buying something that I really can't afford just because somebody will lend me the money and my sole intent is to sell it to somebody else, I must take responsibility for any shortcomings. Similarly with a lender, if I'm lending money to someone whom I don't think can afford to pay me back but I'm willing to lend because I don't think this person is going to own the property for very long, then I should take the downside of the risk. Who should bear the burden of the two risk-takers? Should it be those two parties or should it be some other party who really was not involved or will never benefit from the transactions? My own view is that it probably should not be the uninterested parties.

The third parties' role may be to step in to assist people who were not speculating but were being taken advantage of in instances where predatory lending or other similar activity took place. I see that as part of their function as opposed to being the ultimate guarantor of people's bad investment decisions.

Editor: What changes should be made in the way in which the rating agencies review and rate securities in the future?

Pippett: Their job is to rate the security based on its true value. If the appraiser has a financial interest in the outcome, it is going to skew the way he views a transaction. The rating agency should be totally without bias in the way in which it analyzes the instrument. If the analyst at the rating agency doesn't fully understand a complex structure or the security does not appear as represented, then the analyst should remember what his first duty is, push back and ask hard questions. If the right answers are not forthcoming, he or she should respond accordingly and follow his moral compass. Some are saying the rating agencies were simply rubberstamping what they were told by the investment banks that were requesting and paying for the ratings. The insurance industry has had this seeming conflict for years but has been steadfast in evaluating claims and evaluating risks before ever issuing a policy. To prevent this from happening again, there should be more transparency and disclosure about the underlying security, a little more independence and due diligence, and a more careful examination of the underlying transaction.

Editor: The agencies did change their ratings but that was after the horse was out of the barn.

Pippett: Changing the ratings after the fact is like bayoneting the wounded. While it protects possible furure investors, there is a credibility issue at that point.

Editor: How far do you see the subprime infection spreading - both geographically and in terms of various financial institutions and their investors?

Pippett: The discussions that we have had internally lead us to believe the effects will be widespread and that everyone will be affected in the sense that federal assistance will have some fallout on the entire country in terms of a possible increase in taxes. It will affect interest rates which, although currently most favorable for mortgage and commercial rates, are not for credit cards. It has affected and will affect market fluctuations in that investors are trying to anticipate the impact of tightened credit without any guideposts. In addition, because of the tightened credit, transactions that might have happened otherwise have not happened because there is no funding available.

This issue arose in the last couple of years in the credit union industry. My previous experience in assisting a creditor had to do with an originator of subprime auto loans who packaged the loans and sold them to credit unions. The subprime auto loan originator subsequently went bankrupt and the credit unions were left with collateral of questionable value. Our job was to sort out what exactly the credit unions had as well as what the value was.

One interesting fact is that some of the smaller regional and local banks will be less impacted since they stuck to traditional lending and underwriting policies and kept mortgages on their books. They had the benefit of experiencing the bailout crisis of the savings & loan industry. Only if they invested their own portfolios in the CDOs and CLOs will they have losses resulting from this crisis. Again, this goes back to performing careful due diligence and knowing what you're buying.

Please email the interviewee at cpippett@saul.com with questions about this interview.