Editor: Would each of you tell our readers something about your professional experience?
Stutzman: I have an engineering background but went to law school with the idea of representing financial services companies and lenders. Stradley has a considerable focus in this arena, and its practice groups include a variety of practitioners engaged in banking transactions, asset-based lending, structured finance and SEC investigations with a full range of legal services for this type of client. I chair the Mortgage and Lending Litigation Practice, which handles litigation arising from consumer or commercial loans.
Rentezelas: I joined Stradley at the beginning of this year after about five years as in-house counsel with a financial services entity that was involved in the non-prime and alternative lending markets. Prior to that, I was in the financial services department of a large Philadelphia law firm, so my entire legal career has involved working with banks, mortgage lenders, credit unions and the like, and this has given me something of a head start with respect to the subprime mortgage crisis.
One of the principal reasons I was attracted to the firm was its approach to industry concerns - bringing together a full measure of experience and expertise in contrast to a compartmentalized or specialized approach. The subprime crisis is a good example: people are drawn from across the firm's various practice groups and from many different professional backgrounds to focus on the clients' needs. I have found this very compelling.
Editor: You have both been following the subprime mortgage crisis for some time. For starters, can you give us an overview of the problem?
Stutzman: The problem is really a convergence of a number of forces. The American government has long tried to foster home ownership, and a number of legislative initiatives came into play in an effort to encourage the development of new products resulting in more people being brought into home ownership. This effort has been largely successful.
At the same time there has been a change in how home ownership is accomplished. Most of your readers will be familiar with the film It's A Wonderful Life , which depicts a model whereby both borrower and lender are known to each other and the loan is carried on the bank's books. Today, that model is the exception. Most of the time, today's lender is going to sell the loan in the marketplace, which has the benefit of dispersing the risk of loss and passing at least some of the reduced costs resulting from increased volume and efficiency on to the borrower.
As a consequence of these factors, as well as the Fed's lowering of interest rates to their lowest rates in decades, together with the expansion of alternative mortgage products and increasing loan-to-value ratios, including the wider use of "piggy-back" or second loans to reduce or eliminate downpayments, a greater number of people were brought into the home ownership market than ever before. Many of these people would not have qualified for a mortgage just a few years ago, but the combination of factors permitted them to participate without undue risk provided the housing market continued to appreciate. When the housing market stalled - and even began to decline in some areas - the ability of the owner to refinance an adjustable-rate mortgage or to sell the property became a formidable challenge. Much, if not all, of the equity built up in the property over time simply evaporated as a result.
When values finally started to decline, many real estate speculators, who may have put little down on their investment, began to walk away. This further stimulated default rates, which eventually started to draw press, and Wall Street investors became more wary. As default rates began to climb, the rating agencies started to revisit and downgrade different types of securitized loan packages that earlier had been given high ratings. As write-downs were announced, including reports from two Bear Stearns hedge funds that lost substantially all of their value, an undercurrent of panic began to develop. This process continues to run its course today.
Rentezelas: From my perspective, the growth in the subprime lending market was simply too aggressive and too fast. Some of the new products had never been tested in the prime credit market and were being offered to borrowers with, in some cases, no credit history at all. The combination - new products, some not well grounded; new markets, encompassing borrowers who would not have qualified for credit in the past; and an unbroken rise in real estate values over a long period of time, together with an influx of new credit liquidity into the real estate market - resulted in what constitutes almost perfect storm conditions for the implosion of the market.
Editor: Despite the fact that most of us think of real estate as essentially a local investment, the subprime mortgage crisis has global implications.
Rentezelas: The subprime mortgage crisis in the United States is having a tremendous impact globally. In addition to the effect on foreign investors seeking a return in U.S. markets, any downturn in the U.S. economy has a ripple effect across the global economy as Americans buy less from abroad. The U.S. crisis is, at the same time, reflective of trends occurring all across the world. The United States has not been alone in attempting to expand credit availability for home ownership. The run on Northern Rock - which was heavily into the subprime lending market in the UK - is but one example of what is happening elsewhere. In that instance the Bank of England was forced to issue a guarantee of Northern Rock's funds to stem fears of a credit collapse.
Stutzman: The American consumer has driven much of the growth of the global economy. So much of the world's economy is derived from the American consumer. And so much of the American consumer's purchasing power is derived from debt, including the debt options that were created by our homes' appreciation. However, with house prices declining, and with the resultant tightening of available credit, that engine, if you will, of the global economy will obviously lose some of its buying power and result in lowered or negative growth.
Editor: What about domestically? Are there lenders who have managed to weather the storm better than others?
Stutzman: Since 2006 about 225 mortgage lenders have closed, which creates an opportunity for other lenders to pick up market share. There is a further chance for some of the traditional savings banks, or "balance sheet lenders," to recapture some of the business that had been lost to new products before this crisis. I see community banks and credit unions as potential winners in being able to pick up market share.
Rentezelas: From a more general viewpoint, in light of the subprime loans that have already defaulted, and the continued spotlight on this market segment, virtually all subprime loans, including those which are good performers, have been devalued as a consequence. There is an investment void, and a loss of liquidity in this market that may offer a few savvy investors an opportunity to acquire loans, even failing companies, at a dramatic discount. It could be a profitable gamble if investors choose their targets carefully and perform appropriate due diligence.
Editor: How has the subprime mortgage crisis affected your practice over the past year or so?
Stutzman: At the litigation end, there has been a substantial increase, reflective, I think, of the approximately 75 percent increase in the number of foreclosures from 2006 to 2007. Bankruptcy filings have similarly increased by about 50 percent over the same period. There are always grounds for contested actions or counterclaims here, so litigators are increasingly busy. And, class actions are also on the upswing, including in securities litigation as a result of write-downs and related matters.
In light of the various statutes of limitation, together with consumer fraud statutes which might give up to six years for the substantiation of litigation, I see these actions playing out over a long period of time.
Rentezelas: My focus is on regulatory compliance, and that is in the process of change as well. New product development has been in decline as lenders have retrenched. However, loan modification and other loss mitigation strategies are receiving a great deal of attention, and, of course, new legislation and regulations are being adopted, triggering questions from industry participants.
Editor: Do you anticipate any legislative enactment, perhaps along the lines of Sarbanes-Oxley, that might provide some sort of regulatory structure to prevent this type of crisis from occurring in the future?
Stutzman: This is an election year, so there is considerable discussion concerning anything that can be seen as a safeguard. There is even some talk of "suitability standards" - various objective assessments placed on the lender concerning, in effect, whether a borrower is creditworthy - or of successor liability, which would, if enacted, constitute very significant and problematic changes. How all of this will play out between now and November - and after - remains to be seen, although I think it's likely that some form of legislation will pass that does increase regulation in this market - and possibly result in more litigation for the industry.
Rentezelas: Going into the subprime crisis, I think the regulators did have an opportunity to scrutinize the credit risk potential of many of the loans. They did not point out that many of the first-time borrowers were likely to run into trouble when the rates on their loans changed. I am not too sure many would have listened if they had, particularly in the early going when everyone seemed to be doing well.
There has already been some guidance issued, at both the state and federal levels, on subprime and non-traditional mortgage products. The regulators must understand, however, that if the regulatory language does not set clear and objective standards for lenders, every loan originated can be a potential law suit. That is in no one's interests.
There is likely to be a push for more risk transparency for investors in subprime commodities, as well.
Editor: Are we past the worst of the crisis, or is there more to come?
Stutzman: There are many schools of thought on this. The resetting of the adjustable rate mortgages is one rational gauge of how the crisis is playing out. October 2007 saw the largest dollar amount - about $50 billion - in resets. The current monthly number is closer to $30 billion, and this appears to be the number anticipated through September 2008. However, as we've seen, we may be past the stage where we can rationally analyze the market. Thus, its current state of essential panic makes it difficult if not impossible to very accurately predict the length or depth of the crisis.
With the changes in the residential lending market, we are also seeing some tightening of other credit, which may suggest that the situation is spreading. This includes corporate lending to highly leveraged companies, which default rate is expected to increase, and which can impact a variety of deals and M&A transactions. Likewise, the commercial real estate finance market recently experienced its worst delinquency rate in a decade and is expected to continue. We've also seen similar movement in credit cards, auto finance and even student loans. Obviously, anyone who has such securitized products in their asset portfolio may also be impacted. Moreover, some insurers will be affected from D&O payouts from the securities litigation and from bond defaults.
Editor: Would you share with us the lessons learned from this crisis?
Rentezelas: I believe that expansion of credit into the subprime market took place too quickly and with too little forethought. What was necessary at the time was better economic forecasting to enable borrowers, lenders and investors to understand what might occur if the real estate market cooled or the overall economy faltered.
As a result, I think we are going to see a return to basics on the part of the lending community and a much greater emphasis on sound underwriting practices. That means, among other things, a return to full documentation loans with verification of borrower-supplied information. I think we will also see an increase in more traditional mortgage products, including fixed rate and fully amortizing loans. And, to be sure, enhanced disclosure obligations for lenders and a push for greater financial literacy on the part of the borrowing public.
Published March 1, 2008.
