Wall Street faces fury over subprimes as
regulators and cities file lawsuits
Published: Monday, February 18, 2008 | 5:30 PM ET
Canadian Press: Mark Jewell, THE ASSOCIATED PRESS
BOSTON - Regulators are trying to punish Wall Street for mortgage finance practices that expanded home ownership
and spread risk among a host of new players - but also may have duped borrowers and investors who supplied cash to
fuel a housing boom that's turned bust.
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 behaviour 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 neighbourhood 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 middleincome
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.
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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 behaviour.
"What they can't enforce through regulation, they will try to accomplish through suing," said David Bizar, a Hartford,
Conn.-based lawyer 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 U.S. 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.
© The Canadian Press, 2008
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