Regulators want Wall Street to pay
BOSTON (AP) - February 18, 2008 A handful of state securities regulators and a couple
foreclosure-blighted cities have fired the opening shots with
lawsuits trying to prove that investment banks and big lenders are
guilty of more than just bad business decisions and failing to
foresee looming mortgage troubles. Some regulators say greed and
fraud underlie much of the subprime mortgage mess that has spread
across the broader housing market, triggering a spike in
foreclosures.
Aside from the civil cases, the FBI is looking at possible
criminal action, focusing on what Wall Street firms knew about the
risks of mortgage securities backed by subprime loans, and whether
they hid risks from investors.
Observers don't expect the financial penalties that regulators
extract in the civil cases to be massive. But the cases could turn
up evidence that forces Wall Street to defend itself amid growing
talk of government help to ease subprime-related financial strains
on bond insurers. Revelations of bad behavior turned up by the
government also could spur private investors to file even more
lawsuits than the hundreds they've already brought to recover
losses.
"This could get a lot nastier, for many reasons," said John
Akula, a business law lecturer at the Massachusetts Institute of
Technology's Sloan School of Management. "Prolonged close scrutiny
often turns up all kinds of dubious practices that in normal times
are under the radar.
"If the government sponsors any kind of bailout with public
funds, this may be coupled with an aggressive prosecutorial agenda
in support of efforts to get private parties to kick in."
Although the foreclosure-blighted cities of Cleveland and
Baltimore have sued seeking to recover damages from mortgage
lenders, most of the cases filed so far are from regulators
alleging violations of state securities laws.
Attorneys general in New York and Ohio are targeting alleged
systematic inflation of home appraisals by major lenders and
appraisal firms. Litigation in Massachusetts and other states seeks
to demonstrate that investment banks failed to disclose risks to
investors who bought mortgage-related securities and weren't up
front about conflicts of interest across their far-flung financial
operations, including trading of subprime investments.
"Over the years, the relationship between lender and borrower
and a particular piece of property has been severed," said
Massachusetts Secretary of State William Galvin. "It's clear that
it's become a runaway train."
Gone are the days when most borrowers simply got loans from the
neighborhood bank, which used to hold the bulk of mortgage risk.
Now that risk is spread further - mortgages are bundled together
and sold to investors. Behind the scenes, credit-rating agencies
offer advice on whether the investments are secure.
Until recently, cash from Wall Street banks and investors
extended growing amounts of credit to low- and middle-income
Americans enticed to enter a market when home prices appeared
headed nowhere but up.
Lenders wrote $625 billion in subprime mortgages in 2005, nearly
four times the total in 2001. The boom brought in big fees to
mortgage brokers, lenders, banks and ratings agencies.
But now that prices are dropping, those players are hurting.
Global banks have ousted executives and have written off nearly
$150 billion since mortgage securities began collapsing last
summer.
Given the losses, "It's doubtful some of these entities will
repeat their performance," Galvin said. "But I think there needs
to be an understanding of how we got where we are, whether that is
through regulatory action, or through Congress."
States have responded by tightening rules governing how lenders
and brokers arrange mortgages and are compensated. But lawsuits and
administrative complaints are the main tools regulators use to seek
fines against companies accused of wrongdoing, or to set examples
to deter bad behavior.
"What they can't enforce through regulation, they will try to
accomplish through suing," said David Bizar, a Hartford,
Conn.-based attorney with the firm McCarter & English who defends
against subprime mortgage lawsuits brought by consumers and
regulators.
Already, the number of subprime-related cases filed in federal
courts is outpacing the rate of litigation that emerged from the
savings and loan meltdown in the late 1980s and early '90s,
according to a study released Thursday.
The 278 subprime cases filed in federal courts in 2007 already
equals half of the total 559 S&L cases handled over multiple years,
according to the findings from Navigant Consulting Inc.
Criminal action also could be looming. The FBI said last month
it was investigating 14 companies for possible accounting fraud,
insider trading or other violations that could result in criminal
charges. The FBI didn't identify companies but said the probe
involves firms across the financial services industry.
The FBI is working with the Securities and Exchange Commission,
which has civil enforcement powers. The SEC said in January that it
had about three dozen active investigations under way.
In the rush to sue big business, there's plenty of blame to go
around in the subprime meltdown, said Bizar, the lawyer who has
represented lenders in subprime cases. Those include everyone from
investors buying mortgage-related investments without understanding
the risks, to credit-rating agencies that failed to alert investors
to lenders' precarious positions as mortgage delinquencies spiked.
But the mess can be blamed more on unrealistic expectations than
fraud, he said.
"You had a lot of people reaching to get into homes they
couldn't afford, on the theory that it would go up in value,"
Bizar said.