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Financial Crisis Series: Causes and Effects
Practical Law Article 3-384-0309 (Approx. 14 pages)
Financial Crisis Series: Causes and Effects
by PLC Corporate & Securities and PLC Finance
| Published on 13 Feb 2009 • USA (National/Federal) |
This Article is part of a series on the causes and impact of the financial crisis and gives an overview of the causes and effects of the financial crisis.
Financial Crisis Series
This Article is part of a series on the causes and impact of the financial crisis. The other practice notes in the series are:
What Caused the Financial Crisis?
In early summer 2007, the US and Europe experienced a sudden reduction in the general availability of credit (variously described in the media as a credit squeeze or credit crunch). By October 2008, it had escalated to a full blown financial crisis.
The credit crunch was triggered by the bursting of the US housing bubble that had encouraged speculation by house builders, homebuyers and mortgage lenders (US house prices increased by 124% between 1997 and 2006). The decline in housing prices reduced the equity on which even risky borrowers could rely to help refinance their mortgages. Subprime mortgage borrowers faced with adjusted (higher) interest rates began to default on their payment obligations and this set the course for a chain of events that would lead to a downward spiral in the financial markets.
House price increases had been fuelled by cheap credit extended to risky borrowers on a massive scale as lenders competed against each other to achieve best available yield on their loans. This meant that loans were extended to these borrowers with low initial interest rates and little or no downpayments, on the assumption that housing prices would continue to increase. The US subprime mortgage market grew from $160 billion to $540 billion between 2001 and 2004, according to trade publication Inside Mortgage Finance.
Mortgage originators extended subprime mortgages. Financial institutions used securitization to pool these mortgages together in "bankruptcy remote" special purpose vehicles (SPVs) that issued mortgage-backed securities (MBSs) to investors. The MBSs were themselves repackaged and bundled together into other securities known as collateralized debt obligations (CDOs).
Credit rating agencies used statistical models to assign credit ratings to MBSs and CDOs. Investors such as hedge funds, investment banks, pension funds and insurance companies around the world relied on these ratings to invest in MBSs and CDOs, in some cases borrowing heavily to do so. Individuals within banks were effectively encouraged to make high risk investments which offered short term gains, because these gains drove their bonus payments. To protect themselves from the risk of borrower defaults, investors often bought credit default swaps (CDSs). In theory, CDSs should have insulated investors from the effects of defaults. However, it became clear that CDSs had actually helped spread the effects of defaults and created uncertainty about who had what credit exposure to whom.
As subprime borrowers began to default on their mortgages, the value of MBSs fell and the market for them became illiquid. Investors had to mark-to-market their investments and suffered huge paper losses.
The lack of transparency as to which financial institutions were exposed to subprime-related losses and the uncertainty over the size of the losses to which those exposures would give rise made financial institutions unwilling to lend to each other. The liquidity shortage exposed the underlying structural weaknesses within the banking system, including over-reliance by some banks on inter-bank lending.
By August 2008, financial institutions around the world had recognized subprime-related losses and write-downs exceeding $501 billion, according to figures from Bloomberg. September 2008 brought a series of market-transforming events, including:
- The federal government taking Fannie Mae and Freddie Mac into conservatorship.
- Lehman Brothers' bankruptcy.
- Bank of America's acquisition of investment bank Merrill Lynch.
- The federal government's 2-year bailout loan to insurance company AIG of up to $85 billion, in exchange for 80% ownership of the insurer (the terms for this loan were changed and the amount increased to $150 billion in November).
On September 19, 2008, the Treasury and Federal Reserve began discussions with Congress on a massive bailout plan to restore market confidence (see Has the Emergency Economic Stabilization Act Helped?). Similar measures were adopted internationally.
Subprime Borrowers
Subprime borrowers are those with impaired or low credit ratings who may find it difficult to obtain finance from traditional sources. Mortgage lending to subprime borrowers grew dramatically after 2001 and such was the appetite for lending that mortgages were even extended to borrowers with "No Income, No Job and No Assets" (so-called Ninja loans).
Subprime mortgages were characterized by initial periods with attractive terms, such as low introductory (or teaser) interest rates that were adjustable (adjustable-rate mortgages), interest-only periods or terms permitting the borrower to capitalize interest payments for an initial period.
As these initial periods began to expire, many subprime borrowers could not afford increases in adjustable rates or capital repayments, and fell into arrears. This triggered foreclosures. When house prices began to fall, the value of the house that secured the loan was often less than the money owed, as subprime borrowers typically made little if any down payments on their homes (in 2005, for example, 43% of first-time buyers made no down payment at all according to figures from the National Association of Realtors).
Mortgage Originators
Mortgage originators are mortgage brokers or lenders that operate in the primary mortgage market, such as Countrywide Financial, which financed around 17% of all mortgages in the US in August 2007.
Large originators like Countrywide funded their mortgage lending by repackaging mortgages into securities to be sold to investors in the secondary market.
This "originate to distribute" model has been criticized, for removing the incentive to maintain high lending standards, as in practice it meant that originators did not retain the underlying risk on the loans they made.
Securitization
Securitization is a means of raising finance secured on the back of identifiable and predictable cash flows derived from a particular class of assets (generally receivables, such as rent or mortgage payments). Almost any assets that generate a predictable income stream can be securitized.
In a typical securitization:
- An SPV (typically a company) is established to raise funds by issuing debt securities (typically bonds) to investors.
- The proceeds of the securities issued are used by the SPV to purchase receivables. These are rights in respect of financial obligations arising from the obligation of a debtor to pay his creditor amounts in respect of a debt.
- Receivables may arise from payments owed on loans, monies owed for the purchase of goods or services, or any other circumstance creating a financial obligation.
- The receivables are generated and/or owned by an established business entity (typically a financial institution or a large company, here the mortgage originator).
- The SPV's obligations to the investors under the securities are normally secured by a security interest created by the SPV over the receivables purchased by the SPV from the originator.
- When amounts payable in respect of the receivables are received by the SPV, they are used to fund the payment obligations of the SPV under the issued securities, and to meet any other costs in the structure.
Mortgage-Backed Securities
When the securities issued by the SPV in a securitization are secured by mortgage loans, they are known as MBSs.
To optimize the risk profile of the securities and therefore maximize the range of investors to whom they can be sold, the securities are divided into different classes. These typically consist of several sequential tranches with differing priorities as to payment of principal and interest, and carrying differing rates of interest.
The more senior tranches have the right to priority of payment over more junior tranches, but the more junior tranches carry a higher rate of interest. More sophisticated transactions may include tranches of a combination of securities within the securitization structure (that is, tranches made up of a combination of separate tranches).
Each tranche is generally given a different rating by a credit rating agency, based in part on the relative priority of payment.
Collateralized Debt Obligations
The next step is re-securitizing, combining MBS tranches with other debt instruments into CDOs to create a re-packaged security that can be separately rated. In practice, this enabled a low-rated MBS to be repackaged and sold as a higher rated security.
Although the individual subprime mortgage loans were no less risky, this process of packaging, repackaging and rerating effectively turned them into highly-rated or investment grade debt.
Credit Default Swaps
A CDS is a contract between a buyer and seller where the buyer pays the seller a fee and the seller pays an agreed amount to the buyer if a certain event occurs. The event (known as a credit event) is usually:
- The bankruptcy, default or reorganization of an entity such as a company or government (known as a reference entity), and/or
- A default by the reference entity under a debt obligation (such as a security, loan agreement or bond).
The value of a CDS fluctuates according to the underlying obligation. Parties with credit exposures can use CDSs like insurance policies to cover those exposures, but CDSs can also be used to hedge or speculate on fluctuations in value.
Banks, as buyers and sellers of CDS protection, along with hedge funds as buyers and insurance companies as sellers, were heavily involved in the CDS market. Firms such as AIG and Bear Stearns ran into trouble because they did not expect the high volume of mortgage defaults for which they had sold protection. The fear that these institutions would default on their CDS obligations, spreading losses among parties who thought they had purchased adequate protection, was a key factor in the federal government's interventions with these firms.
For more on CDSs, see Article, Financial Crisis Series: Impact on Capital Markets.
Investors
From 2003-2006 trading in MBSs, CDOs and CDSs exploded. Investment banks, along with hedge funds, insurance companies, pension funds and other institutions and authorities were large investors in this market, worldwide. This meant that the effects of subprime mortgage defaults spread around the globe.
Investment banks
Banks invested in some of the riskiest loans packaged in securities. The MBSs and CDOs with the lowest ratings also yielded the highest rate of return.
Hedge funds
Hedge funds, also highly leveraged as well as unregulated, were large investors in MBSs, CDOs and CDSs. When these investments soured, hedge funds stopped providing liquidity to this secondary securities market. This contributed to illiquidity in the financial system.
Fannie Mae, Freddie Mac
In September 2008 the government bailed out Fannie Mae and Freddie Mac. Fannie Mae, the Federal National Mortgage Association, was created by the federal government in 1938 to create a secondary market for mortgages (to buy mortgages from lenders) and was later converted into a publicly traded corporation. Freddie Mac, the Federal Home Loan and Mortgage Corporation was created in 1970 as a publicly traded corporation to compete with Fannie Mae. These entities buy mortgage loans from originators and then securitize them to sell to investors. They also earn profits for their shareholders by purchasing in mortgage backed securities issued by other institutions.
Eager to increase home ownership, the government encouraged these entities to invest in the subprime and Alt-A markets. Alt-A mortgage loans are less risky than subprime but not as safe as prime. They are usually given to borrowers with better credit histories and income than subprime, but made with less documentation than prime loans. Both Fannie Mae and Freddie Mac purchased securities backed by subprime mortgages. Losses on these investments ultimately led to the government bailout.
In February 2008, the Office of Federal Housing Enterprise Overshight (OFHEO) encouraged Fannie Mae and Freddie Mac to invest in even more of these higher risk loans and securities to bolster the weakening housing market. In March 2008, OFHEO decreased Fannie and Freddie's capital requirements (amount of capital they are required to hold to give loans), which were already lower than those for investment banks.
Credit Rating Agencies
Significant blame for the financial crisis has been directed at credit rating agencies.
Many investors relied on credit ratings assigned to MBSs and CDOs without doing any independent risk analysis or, in fact, understanding that credit ratings measure credit quality only and do not capture the risk of a decline in the market value or liquidity of an instrument. When credit rating agencies started downgrading instruments in summer 2007, many investors lost faith in ratings and stopped buying complex instruments altogether.
Credit rating agencies argue that their ratings are expressions of opinion protected by the First Amendment, but in practice they work closely with issuers to develop structured products that achieve the desired rating. In addition credit rating agencies have been criticized for:
- Using inadequate statistical models to rate complex MBSs and CDOs that did not capture the risks of those securities, particularly where an underlying subprime mortgage loan went through multiple securitizations.
- Having conflicts of interest which encouraged over-rating. Agencies are paid by the issuers of securities that they rate and compete against other agencies for this business.
The US Congress passed the Credit Rating Agency Reform Act in April 2006 (see Credit Rating Agency Reform Act). Under the 2006 Act, the SEC is required to establish clear guidelines for determining which credit rating agencies qualify as Nationally Recognized Statistical Rating Organizations (NRSROs). The 2006 Act also gives the SEC the power to regulate the NRSRO's record-keeping processes and their methods of dealing with conflicts of interest. However, the law specifically prohibits the SEC from regulating an NRSRO's rating methodologies.
On June 11, 2007, the SEC voted to formally propose rules to increase transparency and avoid conflicts of interest in the credit rating process (SEC Release No. 34-57967: Proposed Rules for Nationally Recognized Statistical Rating Organizations). On December 3, 2008, the SEC voted to adopt rules imposing disclosure, recordkeeping and other obligations on credit rating agencies and proposed additional rules for comment. See Legal Update, SEC Publishes Final Amended and Reproposed Rules for Nationally Recognized Statistical Rating Organizations.
Triggers
Leverage
In 2004, the SEC exempted the five largest investment banks, including Bear Stearns and Lehman Brothers, from the Net Capital Rule. Under the rule, banks must hold a certain amount of capital to loan money. The rule was intended to place a check on banks from trying to earn greater profits by lending more (profiting from the interest payments on the loans) and thereby increasing leverage levels (ratio of debt to equity/capital).
As expected, banks began to dramatically increase corporate lending, so the amount that they were owed in debt far outweighed the amount they held in capital. Leverage levels increased dramatically, in some cases to a ratio of 30:1, exposing them to severe risk if their revenues decreased or corporate borrowers defaulted on loans.
Liquidity
When the stream of payments from MBSs and CDOs fell off and payouts on CDS contracts increased due to mortgage defaults, banks' liquidity problem, the ability to convert capital to cash, was exposed. Banks did not have sufficient capital to make up for the loss of revenue because they were so highly leveraged. They began to sell off assets, which drove drown the price of those assets, forcing them to sell more and causing more declines.
Until the credit crunch hit, these potential liquidity problems were hidden because the trades in securities were off-balance sheet transactions.
Mark-to-Market Accounting
Mark-to-market accounting is a method of accounting that determines the current market value of a security or derivative contract. The current market value is what a buyer for an asset would pay at that moment. For example, traders record their positions in a security at the end of each trading day at the closing price of the security. Since the valuation is done on a daily basis, the fair value is more transparent than if valued over longer intervals of time.
Mark-to-market accounting exacerbated the effects of the credit crunch because firms were forced to write down the value of MBSs and CDOs to reflect market value at a time when the only trades were distressed sales. This weakened their capital position, triggering further sales and creating a vicious downward spiral in value.
Remuneration Structures of Investment Banks
Bonus structures at investment banks encouraged high risk-taking investments. Short-term returns from high-risk investments resulted in large bonuses. Eventual losses on those same investments were not reflected in the bonus payments based on those shorter-term gains.
This behavior was pro-cyclical: making high-risk investments led to high bonuses, which encouraged higher-risk investments. In a bull market, bankers were not rewarded for being cautious, driving a "follow the herd" mentality. As a result, investment banks invested too heavily in high-risk investments at the same time that their leverage ratios soared.
Has the Emergency Economic Stabilization Act Helped?
As a result of the financial crisis:
- Financial institutions in need of liquidity were unable to borrow money and held a large number of assets of deteriorating value for which there was no market.
- Borrowers and investors were uncertain whether banks would be able to fulfill their funding commitments, and even whether banks were still safe places to keep their money.
- Homeowners were worried about losing their homes if they were unable to pay their mortgage debts.
The Emergency Economic Stabilization Act (EESA) was enacted on October 3, 2008 (H.R. 1424; Public Law No. 110-343). EESA put in place a rescue package for troubled financial institutions, with the intention of restoring stability and confidence to the financial markets. Since then, the US Treasury Department has expanded its plan under EESA and other measures have been introduced by the Treasury and the Federal Reserve to help restore confidence in the US banking system.
Financial Institutions
For financial institutions, the key aspects of the relief package under EESA are:
- A capital purchase program, under which the Treasury decided to use the initial $250 billion available to it under the Troubled Asset Relief Program (TARP) to purchase equity or subordinated debt from eligible financial institutions. The Treasury has allotted $125 billion to the nine largest US banks; the other $125 billion will go to regional and small banks. The Treasury has reassured the institutions that its investment generally will not cause negative tax consequences.
- A troubled asset guarantee/insurance program, under which institutions pay a premium and in return the Treasury guarantees the principal plus interest due on troubled assets.
The Treasury initially focused on a plan to purchase up to $700 billion of "troubled assets" (including mortgage-related assets) from eligible financial institutions. However, the focus shifted to the capital purchase program as it became clear that more drastic and immediate action was required (HP-1265: Remarks by Secretary Henry M. Paulson, Jr. on Financial Rescue Package and Economic Update). Now TARP is also being used to provide funds to the automobile industry (see Practice Note, Government Bailout Programs) and targeted financing to certain banks (see Treasury TARP Transactions Report, January 16, 2009).
EESA also includes provisions aimed at supporting this process and addressing political concerns arising from what amounts to a government bailout. The principal supporting provisions are:
- Curbs on executive pay. Compensation structures should no longer encourage executives to make unnecessarily high-risk investments. Institutions participating in EESA programs may be required to limit top executive pay including "golden parachutes" (that is, lucrative severance benefits). Performance-based pay (such as bonuses) may be required to include clawback provisions, allowing the employer to recoup performance-based pay based on investments that later lose money. In addition, EESA introduces new limits on tax deductions for executive compensation. On January 16, 2009, Treasury issued an interim final rule which provided additional provisions and further guidance relating to executive compensation requirements (see Legal Update, Additional Executive Compensation Rules Issued Under TARP). On February 4, 2009, the government announced further restrictions on executive compensation for those companies receiving government assistance, including a cap on total cash compensation for senior executives of $500,000 (see Legal Update, New Executive Compensation Restrictions for Companies Receiving Government Assistance).
- Tax relief for losses. EESA includes a relief provision that treats gain or loss recognized by banks and certain other financial institutions on the sale or exchange of preferred stock of Fannie Mae and Freddie Mac as ordinary income or loss. This means that these financial institutions will be able to set the gain or loss on such sale or exchange against ordinary trading profits.
- Suspending mark-to-market. The SEC is authorized under EESA to suspend Mark-to-Market accounting rules for any institution. On December 30, 2008, however, the SEC delivered its EESA-mandated report to Congress recommending against the suspension of fair value accounting standards (see Practice Note, Financial Crisis Series: Long-Term Implications: Scrutiny of Mark-to-Market Accounting).
- Reports on reform of the regulatory system. EESA commissioned several reports on the US financial regulatory system and allocated various oversight responsibilities to new and existing entities. On January 29, 2009, the Congressional Oversight Panel (COP) published a report discussing how regulation would have averted the current financial crisis (see Legal Update, Congressional Oversight Panel Publishes Special Report on Regulatory Reform).
Another key measure included in EESA means individuals (such as US fund managers) who are compensated under deferred compensation programs of certain offshore investment vehicles may be subject to current taxation.
On January 27, 2009, Treasury Secretary Timothy Geithner announced new rules to encourage transparency and limit the influence of lobbyists in investment decisions made under EESA (see Legal Update, Treasury Outlines New Rules on Transparency and Limiting Lobbyist Influence in EESA Investment Decisions).
Borrowers and Homeowners
To address the concerns of financial consumers, under EESA the FDIC increased the maximum limit for deposit insurance for financial consumers to $250,000 until 2009. For a discussion of other FDIC programs, see Articles, Financial Crisis Series: Impact on Loans and Credit Markets and Government Bailout Programs.
EESA also addresses homeowner concerns. To the extent the Treasury Secretary acquires mortgages or assets secured by mortgages, EESA requires the Secretary to implement a plan to maximize assistance to homeowners and encourage financial institutions to prevent avoidable foreclosures, facilitate loan modifications and, where possible, allow tenants to stay in their homes. Other government institutions are expected to cooperate with Treasury in extending these benefits. Despite no longer planning to purchase illiquid mortgage assets, the Treasury Secretary announced they were still committed to strategies to mitigate mortgage foreclosures.
In addition to initiatives under EESA, the US Senate has proposed legislation, the Helping Families Save Their Homes in Bankruptcy Act of 2009, to allow judges to modify the terms of mortgage loans for borrowers in bankruptcy court to prevent foreclosures. This so-called mortgage cram down legislation has not yet been finalized, but is supported by certain lenders (including Citigroup) and opposed by other interested parties (for example, the American Bankers Association). Parties opposed highlight the increased authority given to bankruptcy judges and the increased cost of home loans. For further information, see Legal Updates, Legislation to Change Bankruptcy Laws is Reintroduced, Citigroup Reaches Agreement with US Senators on Legislation to Allow Bankruptcy Courts to Modify Mortgage Terms and ABA Makes Statement Opposing Mortgage Cram Down Legislation.
The Impact of the Government Rescue Efforts
Lending between banks appears to have shown some improvement since the relief package was introduced. However, lending rates remain high showing that banks are still nervous (see Article, Financial Crisis Series: Impact on Loans and Credit Markets: What Effect has the Financial Crisis had on the Pricing of Loans?).
EESA brought with it intense and unwelcome scrutiny to past and future executive compensation at banks, especially at the nine largest US banks that received amounts under the capital purchase program.
The TARP capital purchase program does not require institutions receiving assistance to increase lending and banks seem reluctant to do so. Fears of further devaluing of their assets and the impact of a severe recession are driving banks to hoard capital from the TARP.
There is some indication that banks may use the money obtained through the TARP program to acquire other banks. On October 24, 2008, PNC Bank announced a $5.58 billion takeover of National City Bank at the same time as they announced they were issuing $7.7 billion in preferred shares to the Treasury Department under TARP.
One wider effect has been the "me too" factor: non-financial companies such as automobile manufacturers are now also receiving assistance under EESA. Arguably the biggest task now facing the government is deciding where to draw the bailout line.
It is too early to say whether EESA will substantially improve matters for mortgage borrowers. However the recent historic settlement reached by the Attorney Generals of Washington and other states with subprime lender Countrywide Financial Corporation looks promising. Under that settlement, Countrywide is required to provide loan modifications for as many as 395,000 borrowers nationwide, giving them payment relief under their mortgages. Other lenders are also taking heed: on November 12, 2008, Citigroup announced that it would to reach out to a half a million homeowners who are behind on their mortgage payments.
In addition, the FDIC insurance program seems to have spread enough calm to consumers that most again consider a bank a safer place for their money than their mattress.
For a discussion of individual government programs, see Articles, Financial Crisis Series: Impact on Loans and Credit Markets and Government Bailout Programs.
On February 10, 2009, Treasury Secretary Geithner announced the Financial Stability Plan, a wide ranging plan aimed at the financial system which is still suffering as a result of the financial crisis (see Legal Update, New Bank Rescue Plan Announced by the Treasury Department). In addition, on February 13, 2009, Congress approved the American Recovery and Reinvestment Act of 2009 (ARRA). The ARRA contains an estimated $787 billion in new spending measures and tax cuts designed to jump start the economy (see Legal Update, House Approves Compromise Stimulus Bill). As a result of these new initiatives, further government programs are expected.
What Litigation will come out of the Financial Crisis?
The turmoil in the credit markets and the losses suffered by banks, mutual funds, companies and ordinary investors resulted in a number of high-profile lawsuits.
The initial litigation concentrated on acquisitions affected by market events (see Article, Financial Crisis Series: Impact on M&A and Private Equity).
In 2009, the focus will likely shift to financially distressed companies (see Article, Financial Crisis Series: Impact on Companies). In particular, the scarcity of DIP financing may result in more liquidations rather than successful reorganizations (see Article, Financial Crisis Series: Impact on Loans and Credit Markets: What Impact has the Financial Crisis Had on DIP Financing?).
The focus will also move to parties that have suffered losses as a consequence of the financial crisis, and the market participants to whom they attribute the blame.
Possible Litigation Parties
Potential Plaintiffs
Potential plaintiffs include:
- Stockholders. In the past year, stockholders have seen their investments lose a significant percentage of their value as companies and the stock market continue to suffer significant losses. In some cases (for example, the bankruptcy of Lehman Brothers Holdings, Inc., the failure of Bear Stearns, and the effective nationalization of AIG, Freddie Mac and Fannie Mae), their investments have been virtually wiped out. The scale of the losses even resulted in preferred stockholders (institutional investors not typically involved in these types of cases) initiating securities class action lawsuits.
- Borrowers. Lenders, facing their own liquidity problems, may be unable or unwilling to meet their funding obligations to borrowers under their credit facilities or their commitment letters. With alternative sources of finance likely to be in short supply, borrowers may sue lenders who fail to fulfil their lending commitments (see Article, Financial Crisis Series: Impact on Loans and Credit Markets: What Impact has the Financial Crisis had on the Terms of New Debt Commitment Letters and New Loans?).
- Employees. Employees who have seen the value of their pension and other retirement plans plummet in value may seek to sue their employers.
- US Government. As a result of EESA, the government has become an equity holder in a number of financial institutions. The government may seek to hold the persons they consider responsible for the market collapse financially or criminally liable for their actions.
Potential Defendants
Potential defendants include:
- Rating Agencies. Many investors are wondering whether credit rating agencies that assigned high credit ratings to mortgage-backed securities properly managed their conflicting interests or even understood the securities they were rating.
- Mortgage Lenders. Mortgage lenders are being accused of lax lending practices resulting in mortgages being issued to risky or unqualified borrowers. Countrywide Financial Corporation, one of the largest mortgage lenders in the US, has already settled some claims with the Attorneys General of Washington and other states. Some of these lenders may also be subject to lawsuits from investors who bought securities backed by these mortgages. On December 1, 2008, a hedge fund sued Countrywide demanding that they be compensated if Countrywide changes the terms of the loans underlying the securities (see Legal Update, Hedge Funds Sue Countrywide Financial over Mortgage Loan Modifications).
- Directors and Officers. The management of failed or troubled companies have been accused of not disclosing material information about their companies' financial condition and exposure to subprime mortgages and mortgage-backed securities. These claims (except for claims brought by regulatory agencies such as the FDIC) may be covered by directors and officers' liability insurance. Officers and directors may also be subject to criminal liability. Criminal charges have already been filed against managers of two Bear Stearns funds that failed in early 2008.
- Investment Banks. Investment banks are accused of creating risky securities with complicated structures that even they did not fully understand.
Types of Claims
There are a number of claims that plaintiffs may assert.
Inadequate Disclosure
Many plaintiffs are accusing officers, directors and underwriters of Bear Stearns, Freddy Mac, Fannie Mae and Countrywide Financial of failing to disclose material facts such as:
- The extent of their mortgage-related losses.
- The strength of their finances.
Conflicts of Interest
Many investors are accusing credit rating agencies of being too close to the banks and issuers who paid for their ratings and not issuing independent and untainted ratings on which the market in practice relied.
The credit rating agencies maintain that their ratings are opinions and protected by the First Amendment and, historically, the courts have agreed with this view.
However, many investors argue that the role the credit rating agencies played in structuring the mortgage-backed securities went beyond merely stating an opinion and puts them at the heart of the financial crisis. In practice, credit rating agencies consulted repeatedly with banks and issuers to structure securities that would receive the desired credit rating.
Breach of Fiduciary Duties
Employees whose retirement savings were heavily invested in a failed company's stocks may sue that company's management for breaching its fiduciary duties by allowing these savings to be so invested at a time when they knew the company was in trouble. Such a claim has already been filed against Bear Stearns and its management.
Breach of Contract
Borrowers have sought to force lenders to comply with their lending obligations under various financing documents. Some borrowers initiated lawsuits against lenders who failed to fund because of changing conditions in the market (for example, see In Dispute: Clear Channel Communications, Inc./Bain Capital Partners, LLC & Thomas H. Lee Partners, L.P.).
If a lender modifies mortgage terms to reduce interest rates or the principal amount, investors who bought securities backed by these mortgages (and are therefore expecting a return based on specific mortgage terms) may claim that the lender does not have the right to do so under the relevant documents and is in violation of the applicable documents. A hedge fund has asserted such a claim against Countrywide Financial, but it is too soon to tell whether the claim will be successful or whether other investors will initiate their own claims against Countrywide Financial or any other lender or loan originator.
What is Happening in Markets Outside the US?
For information on the impact of the financial crisis in the UK, see Practice Note, Financial crisis: Q&A (UK).