Newsletter Sign-up

By MICHAEL ADLER, vice president of Ironshore Claims LLC

They say that those who do not know history are doomed to relive it. The current subprime mortgage crisis is in a number of ways reminiscent of the savings-and-loan crisis in the late 1980s and early 1990s. In many ways, the current credit crisis is the result of the failure to recall the lessons of the last credit crisis.

The crisis could well affect more classes of business than people expect.

THE BACKGROUND

The current subprime mortgage event, like the savings-and-loan crisis, arose out of dislocations in the real estate market. For several years, particularly from 2002 to 2005 and the first half of 2006, home prices increased substantially each year, driven by, among other things, historically low interest rates.

Subprime loans--loans offered by a commercial bank or other mortgage lender to a high risk borrower--increased substantially during this same period. Subprime loans grew from $173 billion in 2001 to a record $665 billion in 2005. As the real estate boom turned into a bust, many of these loans defaulted, creating a financial crisis.

THE FIRST WAVE

The first institutions to be effected by the downturn in the real estate market were the banks and other lenders who originated the mortgage loans. They face professional liability claims arising out of lending activity--wrongful foreclosure claims, predatory lending claims, and claims that the applicable loan terms were not described correctly or should have be explained or disclosed better.

Mortgage brokers will also face claims of a similar nature. The lawyers, appraisers and mortgage brokers who acted in connection with the loan originations and provided documentation and/or advice with respect to loan-to-value ratios will be subject to multiple lawsuits as well.

To the extent those suits involved disgruntled customers, as opposed to shareholders, these suits are more likely to trigger E&O policies than D&O policies. We have already seen many such claims, and talk of turning a corner or reaching a bottom appears premature.

In the first quarter of 2008, 170 subprime mortgage and related cases were filed in the federal courts, bringing the total of subprime cases in federal courts over a 15 month period to 448 new cases. Further, dozens of investigations have been launched by regulatory agencies, including at least 36 by the Securities and Exchange Commission and probes by attorneys general in New York, California, Illinois, Massachusetts, Connecticut and Ohio.

Therefore, the first wave of subprime litigation is already here, a second wave appears imminent, and companies need to prepare and make sure that they have adequate levels of E&O insurance now while the price of the coverage remains reasonable.

THE SECOND WAVE

The funding for the massive increase in mortgage lending and, in particular, subprime mortgage lending, was provided by the securitization process through which mortgages were sold by the original lenders to financial institutions, which repackaged the loans into mortgage-backed securities, known as collateralized debt obligations or CDOs.

As the real estate market turned and default rates rose, dramatic decreases in the market values of mortgage-backed CDOs followed. As a result of accounting rules, financial institutions valued their holdings of CDOs at "fair value." The sudden decrease in the value of CDOs resulted in massive mark-to-market write-downs by financial institutions, the extent to which is still not certain.

Total write-downs by the worlds largest financial institutions have increased to $274 billion as of the writing of this piece and is estimated by some commentators to reach as much as $1 trillion.

The second wave of claims, at least with regard to E&O coverage, involves hedge funds and other investment vehicles, brokers, investment advisors and related financial institutions that bought and sold CDOs. The key to understanding these claims is to understand how subprime mortgages, and more complex instruments based on derivatives linked to subprime mortgages, became part of the investment portfolio of many financial institutions.

The subprime crisis has not been solely confined to the subprime mortgage lenders and institutional investors of CDOs but has spread to other sectors of the credit market. In the first quarter of 2008, the effect on auction rate securities and write-downs caused by the collapse of the auction rate securities market became quite clear. Auction rate securities are long-term debt securities whose interest rates are periodically reset at auctions conducted by Wall Street investment banks.

There are four types of auction rate securities--municipal bonds, preferred stock, student loans and CDOs. On February 14, 2008, 87 percent of all auctions in the $330 billion market failed because there were not enough buyers willing to purchase all the obligations at sale.

While past practice would indicate that the major banks would usually purchase bonds to prevent failed auctions, write-downs by the banks in connection with their exposure to mortgage backed CDOs made them reluctant to add more debt to their balance sheets. Moreover, bond insurers that backed the securities were at risk of losing their triple-A ratings due to exposure to mortagage backed securities, further depressing the price of the securities.

We have begun to see, and we anticipate more, errors-and-omissions claims against firms that bought such securities and sold them to the public, as well as claims against those who recommended or sold interests in firms whose financials were negatively impacted by the declining value of CDOs or the increased cost of hedging against this risk.

THE RESULT?

There is a wave of claims coming as a result of the subprime crisis. More litigation is on the horizon for the rest of 2008 and beyond. As the market for E&O and other professional liability markets are more fragmented than the market for directors' and officers' insurance, it is difficult to estimate potential insured losses.

The classes that appear to have the most exposure are alternative investment funds (e.g., hedge funds and private-equity funds), investment advisors, real estate agents and mortgage brokers. While hedge funds historically have not been large purchasers of insurance (10 percent to 15 percent of 8,000+ funds do), their increased interest in buying E&O and/or D&O, as well as the significant rate hardening on existing funds, seems to indicate that attitudes are changing. They should.

According to a 2004 study by Wholesale Access Mortgage Research & Consulting Inc., there are approximately 53,000 mortgage brokerage companies that employ an estimated 418,700 employees and originate more than 50 percent of all U.S. residential loans.

Assuming an average insurance limit of $300,000 for each company (the minimum required by Fannie Mae/Freddie Mac), there would be almost $16 billion of insurance at stake. The nature of the parties initiating litigation will impact the outcomes, particularly for real estate-related classes like agents and mortgage brokers.

Actions by individuals would represent higher claim frequency, but lower ultimate insured losses, while class actions, in which plaintiff attorneys generally try to structure a party of multiple claimants with similar grievances, represent a much larger potential insured loss, despite a lower claim frequency.

Class actions are most likely to be limited to bigger firms who represent deep pockets to potential plaintiffs; however, any one firm can be targeted. These statistics suggest that insureds will find out that limits purchased historically are inadequate to cover their current exposure.

It seems safe to predict that rates will go up and insurance program configurations will change dramatically going forward. Companies should make sure they have adequate levels of both professional liability and directors' and officers' insurance to cover such "bet the company" litigation while the market for such insurance remains relatively stable. The scope of the current crisis has yet to be determined but the best advice would seem to be to prepare for the worst now rather than react after it is too late.

October 1, 2008

Copyright 2008© LRP Publications