Payback Time

One thing you can be sure of as this unraveling unfolds is that those who have been agrieved in one way or another will be looking to punish the guilty (as well as anyone else they feel is responsible, whether justified or not).

Moreover, the media will redirect its sights towards blameworthy acts and characters they had previously ignored, regulators will become increasingly focused on the interests of angry citizens (instead of the coddled industries they allegedly oversee), and growing numbers of prosecutors will look to capitalize on the career-enhancing prospects associated with bringing about a steady parade of white-collar perp walks.

As far as the legal profession goes, all I can say is: I'm bullish.

Below are three recent articles that kind of sum up what we are likely to see a lot more of in future.

"Pricing Probes On Wall Street Gather Steam" (from The Wall Street Journal):

SEC-Led Investigations Focus on Public Notice, In-House Discrepancies

Regulatory investigations into mortgage-securities pricing are examining whether financial firms should have told the public earlier about the declining value of such securities and how they priced them on their books, people close to the matter say.

The regulators, led by the Securities and Exchange Commission, also are delving into whether Wall Street firms placed higher values on their own securities than those they placed on customer holdings, the people say.

During the past several months, financial firms have announced more than $80 billion in write-downs on mortgage-related assets. This includes a $9.4 billion write-down by Morgan Stanley on Wednesday stemming from bad bets on such securities. Last week, UBS AG took a $10 billion write-down bringing its total for the year to $13.7 billion; Merrill Lynch & Co. has had write-downs of $7.9 billion, and more are expected. In all three cases, the firms added to the write-downs they initially announced.

The existence of the investigations has been known, but few details previously had surfaced. Among the firms the SEC is examining for their mortgage-securities valuations and disclosures are UBS and Morgan Stanley, in addition to previously reported investigations of Merrill and Bear Stearns Cos. regarding their valuation methods, people close to the situation say.

The probes are among the roughly three dozen investigations opened by the SEC tied to the downturn of the subprime market, which primarily is tied to low-end borrowers.

The credit crunch that has hurt some homeowners and led to the Wall Street write-downs has highlighted an unnerving reality in the financial world: Investors increasingly have no way of knowing with any certainty the value of many of the securities now traded.

These days, far fewer than half of all securities trade on exchanges with readily available price information, according to Goldman Sachs Group Inc., while more securities than ever are priced by dealers who don't publish quotes.

The investigations will be complicated by the inherent difficulty in pricing such complicated securities, particularly when markets dry up. Financial firms often use mathematical models with built-in assumptions in determining value, or "marks," which might differ if they had to sell the securities.

The SEC has set up a working group that also is looking at whether firms adequately disclosed the risks of these investments and were timely in announcing stresses on the firms' financial statements. The probes are in early stages.

"The fact that we're investigating does not mean that we have uncovered wrongdoing," said Walter Ricciardi, deputy director of the SEC's enforcement division. "We don't know now that we will be recommending any enforcement actions in the subprime area."

To bring civil charges, the SEC likely would need specific evidence that a firm intended to make itself look better by misstating the value of its assets, says David Meister, a former federal prosecutor who now is a partner in New York at the law firm Clifford Chance LLP.

The SEC is asking questions specifically about whether financial firms were valuing mortgage-related securities differently on their own books compared to the valuations they applied to the holdings of customers such as hedge funds.

The SEC also is asking why securities firms would price the same or similar mortgage securities at higher prices for their in-house trading desks than for their asset-management groups, for instance, or the repurchase desk, where large slugs of securities are sold on a short term basis.

In one investigation, the SEC is examining a situation this year in which a trader at a now-defunct hedge fund of UBS's Dillon Read unit was confronted and then ousted after he valued mortgage securities at prices below the value assigned the same securities elsewhere at UBS. In late October, the SEC interviewed the Dillon Read trader following a front-page article in The Wall Street Journal detailing the incident, according to a person close the situation. A UBS spokesman declined to comment.

The SEC also contacted a trader from Royal Bank of Canada in recent weeks following assertions by the trader in the Journal that the bank had intentionally mis-marked government agency and corporate bonds. This week, the trader sought protection as a whistleblower under the Sarbanes-Oxley act, according to his lawyer, Jeffrey Liddle of Liddle & Robinson LLP. A spokesman for RBC declined to comment.

Regulators also are looking at how Wall Street firms account for off-balance-sheet entities holding mortgage securities and whether some of those entities should have been required to be placed back on the books of banks and securities firms earlier, people familiar with the situation say.

Some observers have compared this SEC investigation to an investigation of analyst research after the technology bubble burst. In 2003, regulators sanctioned several financial firms after discovering incriminating emails showing that the analysts' public pronouncements about stocks differed from what they said to colleagues. In that investigation, the issues came down to what was said publicly versus what they were saying internally, regulators and lawyers say.

In the current environment, investigators will be looking at whether a firm changed its valuation methodology to one that was more favorable in order to avoid or forestall taking big losses.

"It is likely that regulators will focus on whether people within the firms knew or had reason to be concerned about valuations while telling the marketplace something different," said Richard Grime, a former SEC enforcement attorney who now is at O'Melveny & Myers in Washington.

"The Finger of Suspicion" (from The Economist):

In America and elsewhere trial lawyers, state prosecutors and regulators look for the crime in subprime

FINANCIAL firms have already been drenched by mortgage-related losses. Now a wave of litigation threatens to assail them. According to RiskMetrics, a consulting firm, between August and October federal securities class-action lawsuits were filed in America at an annualised pace of around 270—more than double last year's total and well above the historical average. At this rate, claims could easily exceed those of the dotcom bust and options-backdating scandal combined.

At most risk are banks that peddled mortgages or mortgage-backed securities. Investors have handed several writs to Citigroup and Merrill Lynch. Bear Stearns has received dozens over the collapse of two leveraged hedge funds. A typical complaint accuses it of failing to make adequate reserves or to explain the risks of its subprime investments, and of dubious related-party transactions with the funds. Several firms, including E*Trade, a discount broker with a banking arm sitting on a radioactive pile of mortgage debt, are being sued for allegedly failing to disclose problems as they became apparent to managers.

But one thing that sets the subprime litigation wave apart from that of the 2001-03 bear market is its breadth. After the collapses of Enron and WorldCom, lawsuits were targeted at a fairly narrow range of parties: bust internet firms, their accountants and some banks. This time, investors are aiming not only at mortgage lenders, brokers and investment banks but also insurers (American International Group), bond funds (State Street, Morgan Keegan), rating agencies (Moody's and Standard & Poor's) and homebuilders (Beazer Homes, Toll Brothers et al).

Borrowers, too, are suing both their lenders and the Wall Street firms that wrapped up their loans. Several groups of employees and pension-fund participants have filed so-called ERISA/401(k) suits against their own firms. Local councils in Australia are threatening to sue a subsidiary of Lehman Brothers over the sale of collateralised-debt obligations (CDOs), the Financial Times has reported. Lenders are even turning on each other; Deutsche Bank has filed large numbers of lawsuits against mortgage firms, claiming they owe money for failing to buy back loans that soured within months of being made.

“It seems that everyone is suing everyone,” says Adam Savett of RiskMetrics' securities-litigation group. “It surely can't be long before we get the legal equivalent of man bites dog, where a lender sues its borrowers for some breach of contract.”

The authorities, too, are baring their teeth. Several Wall Street banks have received subpoenas from New York's attorney-general, Andrew Cuomo, requesting information on their packaging of now-stricken securities. This comes on top of a deepening probe into possibly inflated home-price appraisals by brokers and lenders, including Washington Mutual and First American Corporation. Ohio's attorney-general, Marc Dann, has been just as hyperactive, suing over a dozen lenders and brokers.

No less important is the spadework being done by the Securities and Exchange Commission, America's main markets watchdog. It is conducting more than 20 investigations, including one into the arrangements banks entered into with hedge funds that may have been designed to hide or delay mark-to-market losses.

Such probes are even more important than they appear because they could encourage private litigation. Regulators and state prosecutors have more powers to demand information than private plaintiffs do. What they unearth, if they go public with it, can bolster investors' claims or even lead to new ones. This is what happened following congressional investigations into the tobacco industry, and when Eliot Spitzer, Mr Cuomo's predecessor (and now New York's governor), went looking for smoking guns at banks, insurers and mutual-fund managers after the 2001 stockmarket fall. The officials are likely to dig even harder this time since the issue touches poor homeowners, a more vulnerable group than day-traders.

In readiness, law firms have been rushing to set up dedicated subprime practices. These are working not only on disputes but also on helping clients to unwind leveraged transactions. “Securitisation is the particle physics of finance, which makes it much richer legally than technology stocks,” says John Rosenthal, head of Nixon Peabody's subprime team.

That complexity is a mixed blessing for plaintiffs. Showing that financial innovation got out of hand will not be hard. However, they have to prove not only incompetence, but fraud. Defendants will argue that, far from deceiving investors, they failed to understand the structured products they had bought (or created) and the speed with which those securities could deteriorate in value—in other words, that they were clueless but not conniving.

Banks that face lawsuits over mortgage debt they peddled have at least one strong argument in their favour: they themselves bought the stuff. Both Citi and Merrill, for instance, held on to the senior tranches of CDOs, which have since gone bad. Would they have done this knowing that the securities were potentially so toxic? On the other hand, plaintiffs' lawyers say there are plenty of examples from recent months of banks and companies that have run aground even after stating in calls with investors that they had safeguards in place.

As busy as the lawyers are, they are only warming up. Scrutiny of the way banks account for tainted securities is just beginning, as is the task of poring through e-mails provided under subpoena. And as pain spreads to other securitised products, such as car and credit-card loans, they too will come under the spotlight.

The ultimate cost of the mortgage crisis in terms of settlements, awards and legal fees can only be guessed at. But the consensus view is that payouts will climb well above the billions stemming from the internet bubble.

Now, as then, many will settle for large sums rather than risk lengthy court proceedings that could end in even bigger payouts, even if their defences have some merit. And it is not just those directly involved who will suffer. On one estimate, from Guy Carpenter, a reinsurance broker, insurers that underwrite directors and executives could end up shelling out more than $3 billion. For the plaintiffs' bar, at least, the next boom is already at hand.

"A Crisis Long Foretold" (from The New York Times):

A truism of crisis management is that most seemingly out-of-the-blue disasters could have been prevented if someone had paid attention.

An article in The Times on Tuesday by Edmund L. Andrews leaves no doubt that the twin crises of the subprime lending mess — mass foreclosures at one end of the economic scale and a credit squeeze afflicting the financial system — are rooted in the willful failure of federal regulators to heed numerous warnings.

The Federal Reserve is especially blameworthy. Starting as early as 2000, former Fed Chairman Alan Greenspan brushed aside warnings from another Fed governor, Edward M. Gramlich, about subprime lenders who were luring borrowers into risky loans. Mr. Greenspan’s insistence, to this day, that the Fed did not have the power to rein in such lending is nonsense.

In 1994, Congress passed a law requiring the Fed to regulate all mortgage lending. The language is crystal clear: the Fed “by regulation or order, shall prohibit acts or practices in connection with A) mortgage loans that the board finds to be unfair, deceptive, or designed to evade the provisions of this section; and B) refinancing of mortgage loans that the board finds to be associated with abusive lending practices, or that are otherwise not in the interest of the borrower.”

Yet, the Fed did nothing as junk lending proliferated — including loans that were unsustainable unless house prices rose in perpetuity, riddled with hidden fees and made to borrowers who could not repay. Mr. Greenspan has said that the law was too vague about the meaning of “unfair” and “deceptive” to warrant action.

The Fed has also disappointed since the current chairman, Ben Bernanke, took over in early 2006. It was not until the end of June 2007 — after the damage was done — that the Fed and other federal regulators issued official subprime guidance. On Tuesday, the Fed issued another set of proposals. Among those, subprime lenders would have to verify a borrower’s ability to repay and include mandatory tax and insurance costs in the monthly payment. In at least one key respect — enforcing the ability-to-repay standard — the proposal is weaker than earlier Fed guidance. Congress is considering other protections that are stronger in many ways.

When all the truth is out, the Fed will have company in the hall of shame. The Office of the Comptroller of the Currency, for example, blocked states from investigating local affiliates of national banks for abusive lending.

If the regulators had done their jobs, there might have been no lending boom and no extraordinary riches for the lenders and investors who profited from unfettered subprime lending. Neither would there be mass foreclosures, a credit crunch and a looming recession.

This crisis didn’t appear unexpectedly. And it won’t go quickly away. Congress and the next administration will have a lot of work ahead to clean up the subprime mess — once and for all.

Comments

[Sackerson]

I agree. It's fear of the blame/false compensation claim phase that led me to look for a salaried, non-financial job in 1999. The continued failure to address fundamentals since then, and the use of inflation to diguise the problems, mean there will be a vindictive caterwauling from the public soon.

[farang]

And on the flip side of this coin: Will anyone focus on how Goldman Sachs managed to avoid this mess, and post profits?

[dearieme]

"— once and for all": why did they pass the writing of the final phrase to a foolish sixteen year old?

[aiden]

So -- once the banks get bailed out, they'll be set to pay it all to lawyers and possibly plaintiffs. Sounds like this mess will have the half-life of plutonium.

How the H did we get so many greedy halfwit MBAs who are paid so much with so little real oversight?

I may be wrong, but it seems to me that this is the biggest boondoggle of the century, and possibly of the country's history. I mean, these people were supposed to know finance. Instead, these bombastic Masters of the Universe are possibly bringing the entire nation to it's knees. They are selling us all out to sovereign wealth funds so they can buy absurdly priced apartments overlooking Central Park. The shallowness of those in charge of our country's finances is absolutely staggering.