Font Size:

Everyone knew that the subprime mortgage crisis would lead to a ton of litigation, but few expected it to be this bad. Hundreds of subprime-related suits have been filed already, and by the end of the year the total will almost certainly exceed the number of suits filed during the entire savings and loan crisis.

A new study by Navigant Consulting Inc. offers the most detailed statistical portrait of subprime litigation yet. The Chicago-based firm reports that 448 subprime-related cases had been filed in federal court from January 1, 2007, to March 31, 2008. By comparison, the Resolution Trust Corp., which was created to deal with problems spawned by the savings and loan crisis, handled a total of 559 suits from 1989 to 1995.

And while subprime litigation steadily increased last year, filings really soared during the first quarter of 2008. "What we saw in 2007 was a mild breaking wave compared to the tsunami we're witnessing now," says Navigant managing director Jeff Nielsen. "In the most recent quarter, we're looking at approximately two filings per day, including weekends." Nielsen adds that 86 percent of all subprime cases that Navigant tracked in its study were still active.

Though the subprime crisis appeared to explode overnight, these mortgages are nothing new. For years, borrowers with checkered credit histories have been able to get home loans that don't use the same underwriting, appraisal, and credit standards as prime mortgages. However, the number of subprime loans began to rise starting in 2001, with the bulk being issued in the past three years. Many have been adjustable-rate mortgages that feature a low-interest teaser rate for the first two years and higher rates thereafter.

In an effort to get a quicker return, many issuers sold their mortgages to companies who then packaged the loans into collateralized debt obligations and other mortgage-backed securities. These instruments were then sold to investors looking for a high-yield, fixed-income security. The trouble began when some homeowners were unable to make even the lower interest payments at the start of their mortgages.

"Everybody knows there will be defaults on subprime mortgages," says George Oldfield, a principal at The Brattle Group, a Cambridge, Mass.-based consulting firm. "The problem for investors occurs when the defaults far exceed expectations."

According to Navigant, the largest portion of subprime suits -- 45 percent -- have been borrower class actions. But observers say that these cases aren't likely to have a major impact on companies' bottom lines, because the plaintiffs won't be eligible for large damages.

Securities cases appear to be another matter. Navigant found 105 such suits over the course of last year and the first quarter of this year. And within this category, slightly more than half, or 58, are securities fraud class actions.

"These are all going to be very complex, expensive cases to litigate," says Julie Caggiano, an associate general counsel at Houston-based Sterling Bank. Caggiano, who spoke at a recent conference on subprime litigation, adds that these suits "have the potential for huge judgments, given the magnitude of the losses involved."

There are two distinct types of subprime-related securities actions. The first consists of traditional stock-drop cases. In these cases, the financial institutions who issued subprime mortgages are being sued by their shareholders. The claim is that the defendants failed to adequately or properly disclose the risks inherent in their mortgages (such as lax underwriting standards).

A second category of subprime securities suits have been brought against businesses that issued, underwrote, or advised on mortgage-backed securities. The purchasers of these instruments -- generally, large institutional investors -- are claiming that the defendants failed to adequately disclose the risks of the underlying mortgages, or conducted insufficient due diligence. Some of these suits are alleging fraud on the part of the defendants, while others merely claim negligence.

Despite the explosion of subprime-related securities litigation, experts say at least some of the suits will be dismissed. "The only viable cases will be those in which the plaintiff alleges misrepresentation or false statements at the moment of purchase or leading up to the purchase of the securities," says Duke University law professor James Cox, who specializes in corporate and securities law.

One of the first class actions to come out of the subprime meltdown was brought by New York State Teachers' Retirement System and other shareholders of New Century Financial Corp., an Irvine, Calif.-based mortgage issuer that filed for bankruptcy protection last year. The plaintiffs claim that New Century and its officers, underwriters, and auditor made material misstatements in the company's stock offerings in 2005 and 2006. The plaintiffs have also leveled various fraud claims against former officers of New Century.

A federal district court judge dismissed the suit on January 31, stating that the complaint lacked "clarity in articulating the grounds for its claims." The plaintiffs refiled on March 24. Salvatore Graziano, a partner at Bernstein, Litowitz Berger & Grossmann, which is representing the New York pension plan, declined to comment on the suit, as did attorneys for most of the defendants. Manny Abascal, a Latham & Watkins partner who is representing former New Century chairman and CEO Robert Cole, did say, "We plan to vigorously defend the case."

In another big subprime case, Massachusetts-based Plumbers' Union Local No. 12 Pension Fund and others are pursuing a class action against Nomura Asset Acceptance Corp. The plaintiffs, who purchased mortgage pass-through certificates issued by Nomura, claim that they were not properly warned about the risks of the mortgages behind the certificates. Stephen Poss, a Goodwin Procter partner who is representing the nonunderwriter defendants, refused to comment. Attorneys representing other parties in the case did not respond to requests for comment.

Though the issuance of subprime loans has slowed down considerably, that doesn't mean companies will see the end of the lawsuits. "I think we're in the intermediate stage of the crisis," says Brattle Group consultant Oldfield. "We haven't seen most of the litigation yet." In particular, Oldfield thinks that "institutional investors are looking at how much they've been damaged, and talking with counsel about how they can make a claim that will stick against the parties in the securitization process."

Subscribe to Corporate Counsel