Making sense of the subprime mortgage mess

The collapse of the subprime mortgage lending industry has dominated the headlines, led to turmoil in the credit and financial markets, and left the residential real estate marketplace in disarray. It also has already generated waves of litigation, with the lawsuits pointing in just about every possible direction. Borrowers have sued lenders, borrowers have sued financial institutions, regulators have sued lenders, financial institutions have sued lenders and investors have sued financial institutions.

In this flood of lawsuits, there are several growing waves of litigation of particular interest to the professional liability insurance industry. The most significant wave involves the growing number of subprime lending-related securities class action lawsuits. As of Sept. 7, 2007, 13 companies and their directors and officers had been sued in securities class action lawsuits related to subprime lending. In addition, two home construction companies have been sued in subprime related securities class lawsuits, and two lenders have been sued under the Employment Retirement Income Security Act (ERISA) by their employees in connection with company stock in the employees’ 401(k) plans.

In all likelihood, these litigation waves are likely to continue to grow and to spread outward. According to the Office of the Comptroller of the Currency, there is more than $1.08 trillion in securitized subprime mortgage debt that is being carried on the balance sheets of untold numbers of enterprises outside the lending industry itself. Those asset-backed securities are only as valuable as the performance of the underlying mortgages. Not only are mortgage foreclosures already running at historically high levels, they are likely to increase further as adjustable rate mortgages reset to higher interest rates.

According to the Bank of America, more than $1.3 trillion in adjustable rate mortgages — 70 percent of them subprime — will reset before the end of 2008. As borrowers face increased mortgage payments and an inability to refinance their mortgage debt, foreclosure rates will increase and the performance of mortgage-backed securities will continue to decline. As balance sheet losses show up (or are exposed) for the companies holding those assets, further litigation inevitably will ensue.

Aggrieved parties seeking to recoup their losses will look to supposedly deep pocket third-parties to try to hold them responsible. As litigants look to assign blame for the subprime lending mess, they can be expected to look to the gatekeepers — those who supposedly could have prevented the harm. Litigants are already attempting to assign gatekeeper blame to directors and officers; credit rating agencies; mortgage brokers; real estate brokers; and real estate appraisers. Investors also have already sought to establish the liability of auditors who gave mortgage lenders clean audit opinions shortly before the lenders failed. We undoubtedly also will have blame cast upon attorneys, investment advisors, hedge fund and pension fund managers, and many others whom plaintiffs will claim to have played some role.

All of those claims will be complicated by bankruptcy issues, as many of the lending institutions have filed for or will be filing for bankruptcy. There will also be potential coverage issues under conduct exclusions, particularly where there are allegations of fraudulent misconduct. As claims multiply and interests conflict and diverge, different individuals will seek separate counsel. That will both drive losses and potential losses into excess layers and even put pressure on limits adequacy.

The subprime lending mess also has had an impact on the directors and officers underwriting environment. Companies that are or that have been involved in the subprime lending industry face a D&O insurance marketplace that is far different than just a few months ago. Companies with subprime mortgage lending risk may find themselves in a “hard to place” category. Even other companies involved more generally in residential real estate lending, and other aspects of the residential real estate business, may find that they are facing heightened underwriting scrutiny.

D&O underwriters are also concerned about applicants’ possible balance sheet exposure to mortgage investment risk. Obvious places for underwriters to look for this risk include hedge funds and other alternative investment vehicles, mutual funds, investment banks, residential mortgage real estate investment trusts (REITs), and insurance companies. But the underwriting inquiry will likely not be limited just to companies in these sectors; given the sheer magnitude of the mortgage-backed investment risk dispersed in the economy, the mortgage investment risk may have wound up in some unexpected places. In addition, underwriters’ questions will likely not be limited to whether the applicant directly holds investments in mortgage-backed assets, but will also inquire whether the applicant has investments in hedge funds or other investment vehicles with significant exposure to mortgage-backed investments.

At least one leading D&O insurer has created a “three-page questionnaire” to be used to determine whether applicants “make home loans to the riskiest borrowers or invest in securities backed by them.” Other D&O insurers reportedly are inquiring about applicants’ vulnerability to subprime exposure without requiring a questionnaire.

While insurers are struggling to find the right underwriting response to the subprime risk, there is no doubt that the subprime lending mess could significantly impact the D&O insurance industry and the professional liability insurance industry generally. The quick emergence of claims frequency around subprime mortgage issues and the uncertainty of the eventual extent of the problem are likely making the managers at the D&O insurers (and their reinsurers) more than just a little bit uncomfortable right now. But whether that uneasiness alone is enough to reverse the current downward pricing trend remains to be seen.

The effects on the D&O marketplace likely will be uneven, with some predictable sectors constricting but most others remaining competitive, at least in the short term. Whether the constrictive impact will become more generalized will depend on how large and how widespread the subprime litigation wave becomes.

Topics Lawsuits Underwriting Market