The Credit Crisis and Subprime Litigation: How Fraud Without Motive ?Makes Little Economic Sense'
| Autor | Peter H. Hamner |
| Cargo | New York and New Jersey State Bar Candidate |
| Páginas | 103-136 |
103
THE CREDIT CRISIS AND SUBPRIME LITIGATION: HOW FRAUD
WITHOUT MOTIVE ‘MAKES LITTLE ECONOMIC SENSE’*
ARTICLE
PETER H. HAMNER**
I. Introduction ........................................................................................................ 103
II. Securitization: Financi al Innovation or Financial Frankenstein? ................ 105
A. The Subprime Mortgage Market and Housing Prices ............................. 105
B. The Securitization Proces s ......................................................................... 108
C. Subprime Mortgage Backed Securities ....................................................... 111
D. The Derivatives Market ............................................................................... 112
III. Relevant Securities Law ...................................................................................... 115
IV. Subprime Lending and Fr aud: Examining the Allege d Relationship ............ 116
A. Originate-to-Distribute an d the Subprime Lawsuit Narrative ................ 116
B. A ‘Fusillade’ of Cautionary Statements ...................................................... 118
C. Economic Research on Le nding Standards ............................................... 121
D. Misplaced Anger: What Really Happened ............................................... 124
1. The Role of Securitization..................................................................... 124
2. The Housing Bubble and M onetary Policy ......................................... 125
3. The Black Swan ...................................................................................... 128
E. Economic Sense ........................................................................................... 130
V. Conclusion ........................................................................................................... 135
I. INTRO DUCTION
N SEPTEMBER 29, 2008, THE DOW JONES INDUSTRIAL AVERAGE DROPPED
777 points, the greatest sing le day point drop ever.1 The precipitous
drop illustrated the vola tile state of the marke t during the recent
* Luminent Mortg. Capital, Inc. v. Merrill Lynch & Co., 652 F. Supp. 2d 576 (E.D. Pa. Aug.20,
2009).
** New York and New Jersey State Bar Candidate; J.D., Villanova University School of Law, May
2010; B.A., University of Delaware, May 2007. I would like to thank Professor Robert T. Miller of
Villanova University School of Law for his help with understanding and tackling the difficult issues of
this article. I would also like to thank my family and friends for their love and support. Special
thanks to my mother for everything.
1 See Eric Martin, U.S. Stocks Drop as Recession Concern Outweighs Bailout Passage,
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aeuIcK0ruEHs (last visited Aug. 4,
2010). (Reporting losses sustained in U.S. market).
O
104 U.P.R. BUSINESS LAW JOURNAL Vol. 1
Credit Crisis.2 The Credit Crisis3 began with a complex chain of events.4 Falling
housing prices and subprime mortgages are generally considered the s tarting
blocks of the Crisis.5 Subprime mortgage ori gination accounted for $ 1.2 trillion
in 2005 and 2006.6 Ten percent of subprime mortgages, however, were more
than sixty days delinquen t or in foreclosure by the end of 2006, well above no r-
mal levels.7 These deteriorating loans sent shoc kwaves through the financi al
system because the loans wer e held by several financial ma rket participants.8
The credit market subsequently halted as lenders became wary of borrower cre-
dit.9
The global economy suffere d and continues to suffer e normous losses from
the Credit Crisis.10 With financial los ses came lawsuits.11 The majority of sub-
prime plaintiffs follow comparable narratives to their claims.12 Plaintiffs blame
their economic losses duri ng the Credit Crisis on banks or iginating faulty sub-
prime loans for distribution.13 According to the originat e-to-distribute narrative,
2 See id. (stating market conditions).
3 See Catherine Rampell, ‘Great Recession’: A Brief Etymology, NYTimes.com, Mar. 11, 2009,
available at http://economix.blogs.nytimes.com/2009/03/11/great-recession-a-brief-etymology/ (dis-
cussing naming of the “Credit Crisis”). This paper will refer to the 2007-2008 financial disruption as
the “Credit Crisis.”
4 See JOHN B. TAYLOR, GETTING OFF TRACK: HOW GOVERNMENT ACTIONS AND INT ERVENTIONS
CAUSE, PROLONGED, AND WORSENED THE FINANCIAL CRISIS 15 (Hoover Institution Press 2009) (noting
importance of August 9th, 2007).
5 See id. at 1 (describing falling housing prices role in Credit Crisis).
6 See Gary Gorton, The Panic of 2007 at 3 (Yale ICF, Working Paper No. 08-24, 2008), available at
http://ssrn.com/abstract=1255362 (conveying economic importance of subprime mortgage origina-
tion).
7 See TECHNICAL COMMITTEE OF TH E INTERNATIONAL ORGANIZATION OF SECURITI ES COMMISSIONS,
IOSCO, REPORT ON THE SUBPRIME CRISIS 4 (May 2008), available at
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD273.pdf (reporting on subprime mortgage
delinquencies).
8 See Gorton, supra note 6, at 34 (“If this was the end of the story, it is not clear whether there
would have been a systemic problem when the house price bubble burst.”).
9 See TAYLOR, supra note 4, at 16 (describing credit freeze).
10 See generally, CHARLES R. MORRIS , THE TWO TRILLION DOLLAR MELTDOWN 64 (2008) (detaili ng
losses suffered in global economies).
11 See Jennifer Bethel, Allen Farrell & Gang Hu, Law and Economic Issues in Subprime Litigation
2-3, (Harvard John M. Olin Discussion Paper Series, No. 612, 2008), available at
http://www.law.harvard.edu/programs/olin_center/papers/pdf/Ferrell_et_al_612.pdf (stating in-
crease in securities fraud cases following crisis).
12 See, e.g., Plumbers’ Union Local No. 12 Pension Fund v. Nomura Asset Acceptance Corp., 658 F.
Supp. 2d 299, 303 (D.Mass. 2009) (discussing plaintiffs’ allegations); Atlas , 556 F.Supp.2d at 1149
(S.D.Cal. 2008) (blaming inflated stock price on misrepresentations regarding companies’ core busi-
ness); New York State Teachers’ Retirement Systems v. Fremont General Corp., 2009 U.S. Dist. LEXIS
94241, *3-4 (C.D. Cal. 2009) (arguing poor lending standards contributed to common stock devalua-
tion).
13 See Bethel, et. al., supra note 11, at 33-34 (describing claims by MBS purchasers).
No. 1 (2010) THE CREDIT CRISIS AND SUBPRIME LITIGATION 105
lenders originated poor quality loans and passed the risk onto investors through
securitization.14 The risks associated with the loans wer e allegedly not disclosed
to investors.15 Therefore, according to this narrative, originators committed se-
curities fraud to their inve stors by not disclosing.16
This article argues that the majority of securities fraud claims arising out of
the Credit Crisis are ill founded. Section I I presents backgroun d information on
the subprime mortgage securiti zation process. Section III dis cusses the relevant
securities law. Section IV ana lyzes the validity of secur ities fraud claims in light
of what we know about the caus es of the Credit Crisis. Fi nally, Section V con-
cludes the paper with fi nal remarks on the Cre dit Crisis and securi ties fraud
claims connected with the Credit Crisis.
II. S ECURITIZATION: FINANCI AL INNOVATION OR FIN ANCIAL
FRANKENSTEIN?
A. The Subprime Mortgage Market and Housing Prices
From 2000-2007, the subprime mortgage market grew 800 percent, whereas
overall mortgages merely doubled.17 Lenders categorize borrowers by the risk
associated with their ability for loan repayment.18 Borrowers are defined as
“prime” and “nonprime.” 19 Prime borrowers are the traditional borrower and
exhibit great credit characte ristics.20 A standard prime mortgage is set at a fixed-
interest rate for thirty years.21 The borrower has the right to default or prepay
the mortgage.22
14 See Frederic S. Mishkin, Governor, Bd. Of Governors Federal Reserve System, Speech at the
Wharton Financial Institutions Center and Oliver Wyman Institute’s Annual Financial Risk Roundt-
able: How Should We Respond to Asset Price Bubbles? (May 15, 2008),
http://www.federalreserve.gov/newsevents/speech/mishkin20080515a.htm (discussing misaligned
incentives of originators and investors in originate-to-distribute banking) (last visited Aug. 11, 2010).
15 Nomura Asset Acceptance Corp., 658 F. Supp. 2d 299, 303 (stating that lender misrepresented
loan quality).
16 See id. (providing plaintiffs’ argument that lender committed securities fraud).
17 See Gorton, supra note 6, at 8 (reporting growth of subprime market).
18 See Sumit Agarwal & Calvin T. Ho, The Federal Reserve Bank of Chicago, Comparing the Prime
and Subprime Mortgage Markets, Chicago Fed Letter No. 241, August 2007, available at
http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2007/cflaugust2007_241.p
df (stating varying risk characteristics in borrowers).
19 See id. (discussing differences between prime and nonprime borrowers).
20 See id.
21 See Gorton, supra note 6, at 13 (describing standard prime mortgage operation).
22 See id. (“The usual way of thinking of mortgage design and pricing is to recognize the embed-
ded optionality in these mortgages: the borrower has the right to prepay the mortgage (a call option
to refinance) and the right to default (a put option).”).
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