Trapped with Toxic Assets: Addressing Mortgage-Backed Securities and Other Mortgage-Related Securities Losses
The accelerated securitization of mortgage-backed securities ("MBS") and other mortgage-related assets has created some of the most significant problems of the ongoing economic crisis. When investment banks and other financial institutions pooled numerous different assets, including highly risky sub-prime and Alt-A mortgages, and used them as collateral to create new, securitized financial assets, these assets eventually devalued to such a degree that they became so-called "toxic assets."
While mortgage-related assets were rated by agencies at all levels (from AAA+ down) and sold like bonds, when the risky underlying assets began to default, the entire pool began to fall in value. The fall continued until investors were left with assets with such low value that they became essentially illiquid and untradeable, and thus left many financial institutions and individual investors holding MBS and mortgage-related securities suffering significant losses. Even as early as July 2008, major banks and financial institutions that had borrowed and invested heavily in MBS reported losses of approximately US$435 billion; now the number is even higher.
In response to the losses associated with these toxic assets, the U.S. Treasury proposed to purchase many of them through the so-called "Troubled Assets Relief Program" ("TARP") - a part of the Emergency Economic Stabilization Act of 2008. However, in October 2008 the program took another direction and its initial allotments were instead used to make direct equity investments in troubled banks. Nonetheless, as recently as January 2009, the central bank has pledged to buy $500 billion of the MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae.
Those MBS and other toxic assets not backed by the federal government (known as "private-label" MBS) also play an enormous part in MBS-associated losses. However, with no government backing or "bailout" in the private arena, private-label related losses are very real problems for those who have invested in them. Given the extremely complex nature of MBS and other toxic assets, and a lack of accurate information available to investors to self-assess credit quality, investors found themselves relying on underwriters of these products as well as the credit agencies. Where investors were misled by these entities into believing that these assets were relatively safe, liquid, and not backed by the incredibly high-risk subprime and other poor quality loans that they in fact were, investors may consider addressing their losses by way of litigation.
This article will briefly outline the different types of assets most commonly associated with "toxic assets," and will trace some instances of pending litigation which can provide examples of possible responses to toxic-asset-related losses for investors.
MBS and other Mortgage-Related Assets Overview
While, of course, not all MBS or mortgage-related securities are problematic, there are numerous different kinds of mortgage related securities that included assets associated with risky subprime and Alt-A loans. Some of the different types of mortgage-related securities that could include such risky investments and could thus be classified as "toxic" are outlined below.
- Asset-backed securities ("ABS") are a type of debt security based on a pool of assets, or collateralized by the cash flows from a specified pool of underlying assets. Such assets are pooled to make otherwise minor and uneconomical investments worthwhile, and also to reduce risk by diversifying the underlying assets. These pools can be made up of any type of receivable - credit card payments, auto loans, home mortgages, and even aircraft leases, royalty payments and movie revenues. Without such pooling the securitized assets might also be highly illiquid.
- Mortgage-backed securities ("MBS") are asset-backed securities whose cash flows are backed by the principal and interest payments of a set of home or other real estate mortgage loans, both first mortgages and second mortgages (fixed rate and home equity lines of credit). Mortgage-securities are created when issuers "pool" these loans for sale to investors. The majority of mortgage securities are issued and/or guaranteed by U.S. governmental agencies or enterprises. MBS include numerous sub-types:
- Pass-through MBS: The most simple form of MBS, which are essentially a securitization of the mortgage payments to the mortgage originators. Thus, purchasers have a direct ownership interest in a pool of mortgage loans. They can be further subdivided into Residential and Commercial. Residential MBS ("RMBS") are backed by mortgages on residential property and Commercial MBS ("CMBS") are secured by commercial and properties such as apartment buildings, retail or office properties, hotels, schools, or industrial properties.
- Collateralized mortgage obligations ("CMO"): CMOs are more complex MBS where the pass-through mortgages are pooled again, and are ordered into tranches based on a "quality" determination, and the tranches are sold as separate securities. They are made up of many pools of securities rather than the like-featured pool seen with pass-throughs. Each tranche includes its own set of rules by which interest and principal are distributed.
- Stripped MBS ("SMBS"): With SMBS each mortgage payment is partly used to pay down the principal and part is used to pay down the interest associated with it. SMBS are thus further broken down into two subtypes: interest-only SMBS ("IO-SMBS") and principal-only SMBS ("PO-SMBS"). IO-SMBS are a bond with cash flows backed by the interest component of the property owner's mortgage payments, and PO-SMBS are a bond backed by the cash flows associated with the principal repayment component of the property owner's mortgage.
- Collateralized Debt Obligations ("CDO") are a type of asset-backed security and structured credit product. They are structured from a portfolio of fixed-income assets, and are divided into tranches. The tranches are rated senior (AAA), mezzanine (AA-BB), and equity (unrated). CDOs are constructed where a special purpose entity ("SPV") acquires a portfolio of credit. The portfolio commonly includes MBS, commercial real estate debt ("CRE"), and high-yield corporate loans.
"Toxic Asset"-Related Litigation
Starting in the early 2000s, many agency and private-label MBS were increasingly issued based on pools of risky sub-prime and Alt-A mortgages. Again, those MBS known as "agency" mortgage securities are issued/guaranteed by the Government National Mortgage Association ("Ginnie Mae"), the Federal National Mortgage Association ("Fannie Mae"), and the Federal Home Loan Mortgage Corporation ("Freddie Mac"), and are explicitly or impliedly backed by the "full faith and credit" of the U.S. government. However, those MBS issued by private institutions such as investment banks and other financial institutions, known as "private-label" mortgage securities, are not guaranteed. Where investors in these private-label mortgage securities and other toxic assets have found themselves with great losses associated with the ultimate downgrading of their assets' value and lost liquidity, many are turning to litigation.
Litigation in these areas is rapidly increasing and has taken many forms. Complaints in this area of subprime litigation generally allege that investors were misled by the inaccurate information given to them regarding the true nature of these securitized assets. Some of the current litigation has included: cases where shareholders bring suit against mutual funds that invested in MBS and other mortgage-related securities, cases where institutional investors are suing underwriters and others, and cases where banks are looking to hold other banks accountable for inappropriately encouraging investment in MBS.
Mutual Fund Litigation
One example of MBS-based litigation is a class action filed on behalf of those who invested in Charles Schwab YieldPlus Funds. In In Re Schwab Corp. Securities Litigation (N.D. Cal.), the complaint alleges that the funds' underwriters, investment advisers, and officers and directors issued untrue and misleading statements regarding the diversification and make-up of the YieldPlus funds. The complaint alleges that the funds were marketed as a very safe alternative to money market funds, as being based on large and well-diversified portfolios, as having relative liquidity, as having only a marginally higher risk than cash, and as being "ultrashort." However, the funds were not diversified, and were instead concentrated mainly on highly risky subprime MBS. The suit seeks remedies under the Securities Act of 1933 (the "Securities Act"), and under various California laws.
Numerous other cases have been filed based on claims regarding false and/or misleading statements associated with the risks and quality of products which were in fact largely tied to high-risk mortgage-backed securities and other mortgage-related assets. In a case filed on behalf of those individual and institutional investors who acquired shares of State Street Global Advisors Yield Plus Fund, the complaint alleges that plaintiffs were misled by State Street's false Registration Statement, false advertising, and false sales materials. The complaint further alleges that the Funds were not diversified, high quality and liquid as defendants actively claimed, but instead were based on heavy investment in "high-risk mortgage-backed securities or had a vast exposure to the subprime lending industry." As a result of these false and misleading statements and omissions, which violated the Securities Act of 1933, plaintiffs sustained damages where their shares' values declined. Another case against Fidelity Management & Research Co. makes similar allegations for the sale of Fidelity's Ultra-Short Bond fund which was again marketed as safe, and as a fund which "allocates its assets across different market sectors and maturities," but which in fact had nearly two-thirds of its assets in high risk mortgage-related or mortgage-backed securities.
Institutional Investor Litigation
In NECA-IBEW Health & Welfare Fund v. Goldman Sachs et al.(S.D.N.Y.), plaintiffs allege strict liability and negligence claims brought pursuant to the Securities Act for issuance of various mortgage pass-through certificates and asset-backed certificates. The complaint alleges that the Registration Statements and Prospectus Supplement included false and misleading statements and/or omissions where they represented that the mortgage pools "would primarily consist of conventional, adjustable, and fixed-rate subprime mortgage loans," but instead, "were secured by assets that had a much greater risk profile than represented in the Registration Statement." Specifically, the complaint references misleading information about underwriting standards, loan-to-value ratios, underlying property appraisals, and debt-to-income ratios.
In a similar case involving New Mexico's State Investment Council, plaintiffs allege that state agencies were pressured into investing in a "complex array of risky mortgage-backed securities provided by Vanderbilt Financial and related firms." The investment products at issue contained various CDOs and ABSs that were backed by high-risk mortgages rather than the high-quality mortgages that defendants claimed they contained. The complaint seeks damages under state law totaling more than $300 million.
There has even been bank-on-bank litigation - all seeking recovery on losses associated with subprime investments, including subprime mortgage-backed securities and mortgage-related assets. For example, in M&T v. Gemstone CDO VII (a Deutsche Bank AG trust), the complaint alleges the Deutsche Bank fraudulently stated that the securities in the Fund were a sound and very safe investment, despite knowledge of unsound underwriting standards and information regarding the falling value of its fund which it did not disclose to both investors and ratings agencies. (See also, Barclays v. Bear Stearns and HSH Nordbank v. UBS).
MBS and other mortgage-related securities take many forms, and importantly not all of them are "toxic." However, litigation is being pursued for those securities whose value has precipitously declined where they were largely made up of risky MBS and mortgage-related securities and where investors were never informed of that fact (particularly those securities that are private-label, and thus are not being purchased by the federal government). Where institutional and individual investors have found themselves "trapped with toxic assets," we have seen such litigation in the areas of mutual fund investments, by institutional investors, and even by banks against other banks.
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