Although there has been a recent slowdown in D&O claims, it appears that D&O insurers may soon be hit with a new wave of claims arising out of the subprime lending crisis. To date, twelve securities class actions have been filed against mortgage lenders. As the subprime lending crisis continues and potentially worsens, we anticipate that investors will also file securities class actions against companies who failed to adequately disclose the extent of their investments in the subprime lending market and, therefore, their vulnerability to the effects of the subprime lending crisis. Other actors – including government regulatory agencies, banks that financed subprime lenders, financial institutions that trade securitized subprime mortgages, auditors of corporations with investments in mortgage backed securities, and insurers of credit risk – will likely bring and/or defend litigation that may ultimately be noticed to D&O insurers.
The subprime lending crisis has its origins in the explosive growth in the national housing market. Aggressive mortgage lenders apparently predicted that such growth would continue unabated and, thus, greatly expanded their lending to so-called “subprime” borrowers – persons whose incomes and credit histories made them a relatively high default risk. Many of these loans included variable interest rate provisions, so although homeowners could make the first one or two years of payments at the lower interest rates, they defaulted when the interest rates increased, sometimes substantially, in subsequent years. Had housing prices continued to rise, lenders could have avoided any loss through foreclosure. However, with the correction in the real estate market, lenders took massive losses when foreclosure sales failed to cover the principal investment of the loan.
Shareholders of mortgage lenders have filed, and likely will continue to file, securities class actions where aggressive lending practices were not adequately disclosed – especially where those practices were directed at so-called “sub-prime” borrowers. It appears that mortgage lenders may also face litigation from credit insurers for alleged misrepresentations about the value of the underlying collateral.
Notably, the risk of subprime mortgages has been spread through the financial community through the use of financial instruments. Most commonly, the financial community has securitized mortgages – i.e., pooled mortgages and divided their income streams among investors. Often, these securities – known as mortgage backed securities (“MBS”) – are divided into tranches according to risk with any loss being applied first to the riskiest tranche. When an MBS is composed of subprime mortgages, the risk of loss among the riskier tranches is magnified.
Many public corporations have invested in MBSs. To the extent that they have not adequately accounted for and disclosed their MBS holdings, they will likely be the subjects of securities class actions.
Indeed, securities class actions are to be expected where the disclosure of MBS holdings leads to a large stock price drop. Even where such a disclosure leads to a minimal stock drop, however, the amount of shares outstanding (the “float”) may still be large enough that it creates sizable potential damages. That might be enough to attract plaintiffs to cases where the full extent of the wrongdoing, if any, is not yet known.
