Unless one is Rip van Winkle, or suffers from his malady, anyone who cares to look is painfully aware of the massive spate of litigation arising out of the collapse of the subprime mortgage industry and the associated credit markets. These lawsuits run the gamut of claims, from faulty underwriting by lenders to faulty underwriting by those selling interests in the securitized pools. The identity of plaintiffs and defendants also runs the gamut, and, somewhat perversely, an industry participant might find itself as a plaintiff in one suit and a defendant in another, be they mortgage lenders, securitization trustees, investment advisors, bond underwriters, warehouse lenders, loan purchasers, and so on.
Like death and taxes, there are some essential realities that inexorably result from this spate of litigation: millions of dollars will be spent on lawyers, experts, accountants, and other consultants and most, if not all, of the litigations will be settled. As to the latter, the question is: how? Of course, each litigation stands on its own and presents peculiarities that prevent prognosticators from providing across-the-board commentary. In the context of the mortgage meltdown, however, there is a thread of consistency that legitimizes generalities. While there are bells and whistles unique to each case, very many of them revolve around a single question: what is the "proper" way to value these mortgage-related (as well as other asset-backed) assets? It is a difficult question, with, in my view, no currently known answer (or, much more importantly, a plethora of answers). Certainly the worst way of addressing - and by that I mean trying to answer - the question is through litigation, which is exactly what is happening, and will continue to happen, right before our very eyes.
My Loeb colleagues and I actually have been litigating these issues for years, starting well before it became fashionable to do so. In 2000 and 2001, the last time there was upheaval in the mortgage credit markets, my client, a subprime lender, found itself unable to service its $150 million of outstanding public debt. Given the lender's financial situation, the debt, naturally, was trading well below par - at about 20 to 30 percent of face. The lender offered to exchange the notes for its only remaining asset: the first risk, residual piece of its securitizations, referred to as the "residuals." As the name implies, this piece, conventionally retained by the lender, is the most risky and is the first to absorb losses resulting from non-performing loans. A majority of the notes were held by large, sophisticated investment banks, who were represented by competent counsel and advised by sophisticated and knowledgeable consultants.
Their choice was simple: either accept the package of assets offered by the lender or the lender would declare bankruptcy. Either way, the note holders would end up with an interest in the residuals. In the Exchange scenario, the note holders also would receive a newly-issued $15 million preferred, and the lender would retain one of the residuals.1In the bankruptcy scenario, the note holders, whose debt holdings were secured by most of the residuals, would have rights against those residuals, but their value would be diminished by the costs of the run-out of the business as well as the estimable costs of bankruptcy. Moreover, if there were a bankruptcy, residuals would be sold under "fire sale" circumstances and, based on similar experiences with these very assets, it was anticipated that purchasers would demand, and obtain, huge discounts of 70 percent or more.
The offering document for the Exchange set forth a "hold to maturity" projection of estimated cash flow from the offered residuals, indicating an estimate of $150 million of projected cash flow on a present value basis. The projections were heavily caveated, as one might expect, and the Exchange participants were repeatedly warned that projecting cash flow was a difficult and imprecise task, that the lender has utilized assumptions that might be wrong, and, in any event, that these residuals are highly sensitive to economic factors, particularly interest rate movements, and so changes in the economy can and will affect the projection.
Within two weeks of the Exchange, terrorists brought down the World Trade Center and the economy, which was already in an incipient decline, went down the toilet. More than two months after the Exchange, the lender issued its quarterly report and in it, it announced that, given changes in the economy, it had downgraded its assumptions and was projecting cash flow from the retained residual at levels far below the levels set forth in the Exchange offering document with regard to the exchanged residuals.
Notwithstanding all of the caveats and the inherent imprecision with which one projects cash flow for these residuals, plaintiff - an LLC created to facilitate the Exchange - brought suit claiming that the lender had promised to deliver an asset worth $150 million but delivered an asset that plaintiff now projects, based on the first year's actual cash flow, is worth only $40 million. The suit relies on a tortured breach of contract theory, since the lender had agreed to indemnify the LLC, which was a co-registrant on the S-4, against "loss" caused by a material misstatement in the S-4.
While the theory of the case is tortured, and of course in my view entirely specious (ill-motivated, and several adjectives inappropriate for publication), the plaintiff was, clearly, ahead of its time. The propriety, accuracy, reasonableness, and/or honesty of cash flow projections or open market valuations for these interests in securitizations underlies, or will underlie or at least be implicated, in just about every one of the hundreds, if not thousands, of litigations arising out of the mortgage credit crunch. Those holding interests in securitizations inevitably will claim that a plethora of professionals and others - underwriters, bond insurers, accountants, rating agencies, due diligence firms, investment advisors, broker/dealers, fund managers, loan servicers, lenders - failed to accurately asses the value of the securities that they purchased. Each of that long list of potential litigants (and many others) will claim that they relied on one or more others, and everyone will claim that the lender made ill-advised loans to persons whom they knew, or should have known, could not repay the loan. Fair lending laws will come into play, as market participants try to argue that proof of violations of HOEPA, TILA, ECOA, and even RESPA make out per se cases against the lender. Borrowers will (as they already are) seek to leverage off of the confusion to argue that the members of the mortgage lending diaspora (all those on the list above other than the lender) are somehow liable for fair lending violations on a vicarious liability, assignee liability, or aiding and abetting theory.
As the reverberations of the mortgage credit crisis spread, so will litigation based on valuation issues. For example, as we all know, Bear Sterns was sold just this week for a very small fraction of its recent market price. Most commentators ascribe that result to Bear Stern's prominent participation in the mortgage lending market. The day after the Bear Sterns acquisition by J.P. Morgan, the New York Times reported that:
Throughout much of its history, Bear Stearns has masterfully persuaded the market that its business - narrowly focused on mortgage finance - was worth more than it actually was. To some degree this trick has been a testament to the coy gamesmanship of two of its past leaders, Alan Greenberg and Mr. [James] Cayne.
"Fears That Bear Stearns's Downfall May Spread," New York Times , March 17, 2008.
It doesn't take a crystal ball to predict the inevitable: before the ink dried on the J.P. Morgan deal, several class actions were commenced against a wide array of defendants growing out of the transaction and the steep decline in stock price.
Predicting that lawsuits will be filed is easy. Litigating them is also easy. Resolving them is not. Our experience in the suit involving the Exchange offer puts these matters in stark perspective. Our experts, all of whom are nationally recognized, experienced, sophisticated people, support the valuation performed by our client. Our adversaries retained experts in whom they have great faith. Those experts issued reports that tick off numerous alleged shortcomings in our client's methodologies, assumptions, and practices. These adverse experts base their analyses on models that were produced in discovery. Of course, these projections were the subject of much modeling, and no single model was the one relied upon, in isolation, for the projections set forth in the S-4.
Most importantly, none of the individual strengths or flaws in the models is outcome determinative. The most important inputs are the economic assumptions - projected prepayment rates, projected delinquencies and defaults, projected losses, and discount rate. Small changes in any of these metrics can produce fairly dramatic changes in "value." Who is to say that a set of assumptions is "wrong?" Indeed, "wrongness" most likely is not the measure. Lenders (and those who diligenced them) who employ reasonable assumptions should be protected. Lenders (and those who blindly relied on them) who use dart boards should be liable. As for the in-between, who knows?
Yet these issues will have to be resolved. Unless something remarkable happens, and jurists across the nation decide to employ a sort of caveat emptor approach to valuing these interests, litigants are going to have to come to some negotiated agreement about value. And that is a scary proposition. The accounting standards provide some broad guidance, but by and large these matters are not really regulated. As a result, while the art of valuation spreads across a wide spectrum of practices, there is no recognized right way of doing it. In order to resolve litigations, however, the parties are going to have to come to some apportionment of responsibility for failing to do the impossible - correctly predict what these assets will generate by way of cash flow or what they will fetch on the open market. Whatever these market participants do in order to resolve these lawsuits, it will likely have a lasting effect on the market.
Inevitably, the result will be regulation by litigation - in my view the least stable and most random type of regulation there can be. Hopefully, calmer heads will prevail and a more rational means of dealing with this situation will emerge. Frankly, I am not optimistic. Whatever happens, one thing is clear: these lawsuits will start or have started, and once they do they have to be resolved. The question is: how?
1Each securitization creates a separate residual. Because the lender would be stripped of all assets by virtue of the Exchange, it had to retain a single residual in order to fund operations.
Published April 1, 2008.
