The Blame Game and the Subprime Mortgage Lending Meltdown

By | August 22, 2007

The subprime mortgage lending blame game is in full swing — with people arguing about who’s at fault for mortgage defaults, bond losses and lender failures — but “we’re only in the very top of the first inning,” when it comes to how far and wide the lawsuits will reach and how severe the impact will be on the insurance industry, according to one industry expert.

“Already general litigation in the subprime arena is pointing in about every possible direction. Borrowers have sued lenders. Lenders have sued financial institutions. Financial institutions have sued lenders. Regulators have sued just about everybody,” noted Kevin M. LaCroix, an attorney and a director of OakBridge Insurance Services, a specialized insurance intermediary that focuses on executive liability coverages.

Currently, American Home Mortgage Investment Corp. (which has filed for bankruptcy), Countrywide Financial Corp. (which recently began laying off staff, according to media reports), Fremont General Corp., IndyMac Financial Group, New Century Financial and Radian Group Inc. are among the many financial entities that have been hit with class action lawsuits stemming from the subprime mortgage lending crisis. (For a more extensive list of filed litigation visit LaCroix’s “D&O Diary” at http://dandodiary.blogspot.com/2007/08/all-subprime-all-time.html.)

Whether the effect of such litigation spreads beyond financial institution directors and officers and errors and omissions lines of coverage remains to be seen, LaCroix said. However, questions are arising about whether auditors, lawyers and even credit rating agencies should bear some of the burden for investors’ loss of capital. Allegations against corporate gatekeepers question whether they sufficiently scrutinized the exposures of some of the subprime lenders and other mortgage-related facilities.

Dave Kodama, director of Policy Analysis for the Property Casualty Insurers Association of America (PCI), agreed that it’s too early to tell how far-reaching the ripple effect of litigation will be. However, Kodama said, with criticisms being leveled against securities rating agencies such as Moody’s and Standard & Poor’s, others will likely be brought into the fray.

“Pension funds are going to have to step back and look at their portfolio and see what is their exposure,” as individuals will want to hold the funds’ directors and officers accountable.

“Definitely insurance companies, including our members, are having to address this with their shareholders — address what is their exposure in their investment portfolio [with] these types of securities,” Kodama said.

Moody’s reported that U.S. property and casualty insurers’ exposure to subprime mortgage-backed securities is minimal. The ratings agency issued a report, “Most U.S. Property and Casualty Insurers Have Little Subprime Mortgage Exposure,” August 2007, www.moodys.com, indicating P/C insurance companies tend to invest conservatively and that overall the industry’s exposure subprime-related investments is less than $15 billion.

What’s it all about?
In the simplest of terms, subprime mortgages are offered to high risk borrowers with less than stellar credit histories. They generally are offered at higher rates of interest than those presented to more financially stable customers and carry a greater risk for both borrowers and lenders. However, over the past few years, many such loans were offered as adjustable rate mortgages with low interest rates at the outset and no money down. Apparently in some cases, little or no documentation was required to determine whether or not the borrower could afford to make the payments, especially as interest rates adjusted to higher levels.

Through a series of financial transactions, the mortgages are sold by the original lenders to other financial institutions. In many cases, the loans were packaged as mortgaged-backed securities and sold on the bond market.

The double whammy of rising interest rates and a cooling housing market caused the house of cards to come tumbling down. As interest rates rose, customers were unable to continue making their loan payments. Mortgage defaults and foreclosures soared, lenders were forced out of business, and bond funds were rendered worthless. Lawsuits ensued, with companies and individuals hoping to recover from some of their losses.

Impact on claims
The lawsuits filed so far have “clearly had a material impact on claims,” LaCroix said. While the price declines in the D&O sector over the past three to four years are not going to reverse overnight “there have been a number of claims in this area,” LaCroix explained. “And certainly that’s going to affect underwriting and perhaps even pricing in the financial institutions area.”

He said it’s uncertain whether the domino effect will cause claims to spread broadly across many business sectors. “But certainly I think it’s something that the heads of the D&O underwriting facilities can’t ignore, and it’s clearly a concern for them. I think it will lead to conservatism and possibly, if the claims trends continue, the prices will be tightening.”

PCI’s Kodama emphasized, however, that the primary purpose of the D&O insurance product is to protect and defend the corporation and its directors and officers, not to protect the investments of individuals.

“The primary loss incurred by that product is mainly for defense costs for protecting the interests of the corporation, as well as its directors and officers,” Kodama said. “That’s the primary issue.”

He also noted that typically an exclusion in the D&O policy negates coverage if the adjudication process reveals intentional acts of fraud, such as defrauding the public, the Securities and Exchange Commission or investors by intentionally withholding information.

“The defense is not there for intentional acts of criminal activity found through the adjudication process,” Kodama said.

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