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Mortgage woes spark D&O suits

Posted On: Mar. 18, 2007 12:00 AM CST

Mortgage woes spark D&O suits

The securities litigation against subprime mortgage lenders and even lawsuits that some observers predict eventually will ensnare other organizations involved in risky home loans are not expected to tighten the competitive executive and professional liability insurance markets.

Subprime mortgage lenders, which extend home loans to buyers with subpar credit histories, have been credited for fueling the real estate market surge that began early this decade and ended abruptly in mid-2005.

But many of those risky loans have come back to haunt subprime lenders.

According to a report that the Washington-based Mortgage Bankers Assn. issued last week, foreclosures on subprime loans during the fourth quarter of 2006 outpaced foreclosures on other types of loans, jumping to 2% from 1.82% during the third quarter. Among all types of loans, 1.19% were in foreclosure at year-end 2006, compared with 1.05% during the previous quarter and 0.99% at year-end 2005, according to the MBA

The foreclosures have forced numerous subprime lenders out of business and have caused financial problems for many others, the MBA noted in its report, which rattled the U.S. securities market last week.

Nationwide, there were 210 subprime lenders at year-end 2005, the latest date for which information is available, according to the U.S. Department of Housing and Urban Development. That number includes independent lenders as well as subprime units of banks and financial institutions.

One of the nation's largest subprime lenders, Irvine, Calif.-based New Century Financial, also faces investigations from state and federal authorities over its financial reporting (see story, page 22).

The industry's financial woes have angered investors, who have filed securities class action lawsuits against New Century and other subprime lenders. Investors claim the lenders issued misleading financial statements and failed to exercise internal controls that would have minimized lenders' losses.

Among others, leading class action plaintiffs attorney firms Lerach Coughlin Stoia Geller Rudman & Robbins L.L.P. of San Diego and Milberg Weiss & Bershad L.L.P. of New York have filed lawsuits against the lenders.

Making a case

D&O insurer defense attorney Dan A. Bailey said plaintiffs could face a stiffer challenge recovering losses against subprime lenders than they have met in cases against companies in less volatile industries.

Subprime lenders are involved in a risky business, and the securities market understands that, noted Mr. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio. As a result, investor losses in such businesses are not easily recoverable under securities law, Mr. Bailey said.

For that reason, investors might concentrate on allegations that the lenders used business models that not only failed to protect them from the riskiest loans but also may have encouraged the lender to accept them, Mr. Bailey said.

While expensive, such claims typically are less costly than those that allege the defendants filed misleading financial statements.

But plaintiffs attorney Gerald H. Silk said a defense that investors knew that the subprime lending business is risky "kind of misses the point."

"When you know facts that render other statements inaccurate, you need to alert investors," said Mr. Silk, a partner with Bernstein Litowitz Berger & Grossman L.L.P. of New York.

He said executives for subprime lenders issued financial statements that failed to disclose that loan defaults were increasing and that their earnings-sapping bad debt reserves would have to be boosted.

"Just because you're in a risky business, that's not an excuse for not telling the truth," Mr. Silk said.

He said clients plan to file securities claims against at least four subprime lenders and will take "a hard look" at filing claims against the auditors that signed off on those defendants' financial statements.

But Mr. Bailey said claims against auditors would be even tougher, because securities law would require plaintiffs to show the auditors had issued a misleading statement to investors or were directly involved in a scheme to defraud them.

Still, Mr. Bailey and insurance market experts said they would not be surprised to see plaintiffs of various stripes file litigation against numerous other types of organizations involved in subprime loans.

For example, investors in subprime mortgage-backed securities sold in the secondary market might file suit against investment banks that packaged the securities or stock brokers that marketed them, said Gary Dubois, a New York-based senior executive with Bermuda-based Ariel Reinsurance Co. Ltd.

In addition, real estate brokers involved in arranging the loans may face lawsuits, said Mr. Dubois, who is working on setting up a U.S. operation for Ariel.

In any of those cases, Mr. Dubois said he would expect the defendants to file cross-claims against the subprime lenders.

As a result, the professional liability insurance market likely will be in play far more than the D&O market, he said.

Market impact

But even if professional liability losses are substantially greater than D&O losses, they would be spread among far more insurers, Mr. Dubois said.

"So the net effect will be about the same" in the professional liability and D&O markets, he predicted. "I hope it will scare people enough to bring back at least some degree of stability" in pricing in both markets, he said.

The D&O market would be affected only "moderately" because of the relatively limited number of D&O defendants that likely will be drawn into the litigation, he said. In addition, some of those lenders are units of large banks and financial institutions, so their subprime loan losses likely will not hurt their share prices materially, he said.

Mr. Dubois predicted that any market reaction to the lawsuits would dissipate within six months and will not be evident by the January 2008 renewal season.

Jacqueline Urban, a senior vp-legal and claims with Aon Corp. unit Aon Financial Services Group in Chicago, said she expects that only the industry segments that are pulled into the subprime lending litigation would see rates affected this year. Those segments would likely experience a smaller reduction in rates than they had anticipated, she said.

How the rates of the defendants might be affected is "too early to tell," Ms. Urban said.

A spokesman for New York-based American International Group Inc. said "it is premature for us to decide what, if any, impact this could have" in the D&O and professional liability markets.