Mortgage Meltdown

Treasury Issues New Rules on Executive Compensation for TARP Participants

Late last week, the Treasury department issued an interim final rule (somewhat of an oxymoron, but that is what it is called) entitled "TARP Standards for Compensation and Corporate Governance."  The Treasury Department was given this authority under the Emergency Economic Stabilization Act of 2008 passed last October in the deepest part of the crisis and amended by the American Recovery and Reinvestment Act of 2009, passed following the dust-up about retention bonuses provided to certain executives at AIG.  The full text of the regulation is available here (beware, it is 123 pages).  It supercedes the executive compensation interim rule issued after the EESA by incorporating the greater restrictions on executive comp in the Recovery Act.

The limits apply to those executives named in the company's proxy statements as well as a certain number of "the most highly compensated employees" at each firm.  The number of these employees that are subject to the regulations varies depending on how much financial support the firm has received under TARP.  For example, for those institutions receiving over $500 million in assistance, the five senior executive officers and the 20 most highly compensated employees are covered.

First, the regulation provides guidance to executive compensation committees at the TARP recipient to comply with the requirements of the EESA that it structure compensation to limit unnecessary short-term risk taking by management.  The committee must review, evaluate and report about the executive compensation of the named executives and highly compensated employes every six months.  The report, which must be filed with the SEC, has to include "a narrative description of how [executive compensation] plans do not encourage [executives] to take unnecessary and excessive risks that threaten the value of the TARP recipient." 

Second, the regulation provides for the recovery of any bonus, retention awards or other incentive compensation paid based on materially inaccurate earnings, revenues, gains or other performance criteria that caused the bonus to be paid.  The new rule requires that the TARP recipient actually exercise its clawback rights in such a case unless the TARP recipient can demonstrate that it would be unreasonable to do so (for example, if the expense of enforcing the clawback right exceeds the benefits of doing so).  It is still unclear how this gets enforced if the government disagrees either (1) with the company's decision that a bonus was not paid based on materially inaccurate information; or (2) does not exercise its clawback rights or determines it would be unreasonable to exercise them.

Third, it further curtails so-called "golden parachutes."  Aside from extending the restriction to a larger class of employees, the new rule also curtails payments made to executives leaving a company due to a change in control, such as an acquisition or merger with another company.

The rule also creates a "Special Master" to oversee executive compensation at firms receiving "exceptional assistance" under TARP.  Currently, the group deemed to have received exceptional assistance includes AIG, Citigroup, Bank of America, Chrysler, GM, GMAC and Chrysler Financial.  He will review compensation to named executives and the 100 most highly compensated individuals.    These company's must get compensation packages for these individuals approved by the Special Master, who may reject them if he deems them inconsistent with the goals of TARP.  However, compensation will automatically be approved -- a so-called safe harbor -- if the compensation does not exceed $500,000.

Finally, the rule sets forth a number of requirements that were not explicitly included in the EESA or the Recovery Act.  The rule prohibits the payment to senior executive officers and the 20 next most highly compensated employees of a tax "gross-up," or a payment to cover taxes due on compensation such as golden parachutes and perquisites.  TARP recipients will be required to disclose any perquisites provided to any employee subject to the Recovery Act's bonus limitations with total value exceeding $25,000.  TARP recipients will also be required to provide a nar rative description of, and justification for, the benefit.  The rule also requires financial institutions to disclose the use of compensation consultants and the methodology used by the consultant, such as "benchmarking" procedures in the consultants analysis. 

Catching Up

Well, it's good to be back writing this blog again.  Sorry to my readers for the long, unexplained absence.  I just returned from an almost month-long trial in Baltimore, Maryland (I am based in Reinhart's Milwaukee office).  A lot has happened in the interim, so let's get to it.  What follows is quick summary of some of the legal developments/stories from the mortgage meltdown:

(1)  Countrywide boss Anthony Mozilo was served with a "Wells notice" by the SEC.  As first reported by the Wall Street Journal and the L.A. Times, Countrywide's former CEO and other executives have been provided notice from the SEC that it intends to file formal civil charges for securities fraud and insider trading.  A Wells Notice is the name for this formal notification, and it provides the lawyers for Mozilo and the other executives to submit argument and evidence to try and persuade the Commission not to file the charges. Reuters June 2 story on the subject is here.  Although SEC may bring civil charges, criminal charges are also a possibility.

(2)  Subprime securities class action dismissal motions decided.  Several motions to dismiss were denied, as in the Moneygram, Inc. case involving allegations that the company failed to disclose risks of its own investments in mortgage backed securities (opinion here).  Similarly, a Florida District Court permitted claims to proceed against BankAtlantic Bankcorp., a Florida-based bank.  The court held that the amended complaint had cured prior deficiencies in pleading a strong inference of scienter (here).  Conversely, the case against Washington Mutual was dismissed with leave to amend (see here), and a securities fraud complaint against mortgage insurer Radian Group was dismissed with prejudice (here).  For more detail on these dismissals, go over to the D&O Diary blog which has consistent, in-depth analysis of the opinions and a running tally of the subprime securities motion to dismiss decisions.

(3)  Legislation Passed.  On May 20, President Obama signed two bills, the Helping Families Save Their Homes Act and the Fraud Enforcement and Recovery Act of 2009.  The first expands the mortgage foreclosure mitigation efforts, increased FDIC deposit insurance to $250,000 through 2013, and increases the borrowing authority for both the FDIC and the credit union deposit insurance counter-part.  The bankruptcy cramdown provision, which would have allowed bankruptcy judges to modify mortgages, was defeated and did not make it into the law.  The Fraud Enforcement and Recovery Act is intended to provide more resources and penalties for financial fraud, by extending the prohibition against making false statements in a mortgage application to employees and agents of a mortgage lending business; expanding the concept of monetary proceeds under federal anti-money laundering statutes to include gross receipts, a response to the Supreme Court’s June 2008 Santos decision; and expanding False Claims Act liability by, in part, overruling the Supreme Court's interpretation of the mental state required to prove a claim under the Act in Allison Engine Co. v. U.S. ex rel. Sanders, 128 S. Ct. 2123 (2008). 

(4)  More bank failures.  Throughout the first half of this year banks have failed at an accelerated rate, with the largest failure this year (the 34th) being Florida's BankUnited FSB, with $12.8 billion in assets.  The BankUnited closure was also notable because several private-equity firms, rather than another bank, purchased the deposits from the Office of Thrift Supervision and will operate the new BankUnited.  All of these bank closures have also substantially depleted the FDIC deposit insurance fund, so the FDIC approved a special assessment on banks to replenish the fund (the details are found here.)

(5)  Cleveland's Nuisance Suit Dismissed.  City of Cleveland's nuisance lawsuit against various investment banks and mortgage lenders was dismissed.  The district judge considering the case concluded that the nuisance claim was (1) barred by the economic loss doctrine, which prevents recovery in tort for purely economic damages (i.e. no personal injury or property damage); (2) preempted by Ohio law governing municipal regulations; (3) barred because a nuisance claim cannot be founded on subprime lending, which was lawful activity and heavily regulated; and (4) barred because the alleged damages were to remote.  The opinion is here. 

(6)  General Motors filed for bankruptcy protection this week at about the same time that another auto industry stalwart, Chrysler, was emerging from bankruptcy.  The United States government will own about 60% of the new GM.

New SEC Chair Weighs In On Ratings Agencies

The credit rating agencies that provided securities packaging subprime mortgages with investment grade ratings have been in the cross-hairs of regulators and plaintiffs since the mortgage meltdown first began in the spring and summer of 2007.  Yet very little has been done to change the way that they are regulated.

So last week new SEC Chairwoman Mary Schapiro hosted a round table on what more should be done.  Many see the fundamental problem with the current structure is that the rating agencies are generally paid by the issuer or underwriting of the security they are asked to rate.  This "issuer-paid model" accounts for 98% of all bond ratings.  There is an inherent conflict of interest in this model, where issuers will shop around for the highest rating.

Although the SEC has adopted some new regulations to address this conflict of interest problem (for example prohibiting any employee involved in rating a issue to also be involved in the fee negotiations), Ms. Schapiro acknowledged there was more to do.  Many of the proposals at the meeting focused on solving this conflict of interest dilemma.  Some participants suggested all firms should be required to switch to an investor based model, or have the rating fees paid out of a portion of the bonds' interest payments.  Others went further, suggesting that a new regulatory body, similar to the Public Accounting Oversight Board (PCAOB), should oversee rating agencies.

Ms. Schapiro suggested that the structure the SEC set in place when it settled a 2003 enforcement action with ten of the largest investment banks could be applied to rating agencies as well.  The settlement, which resolved claims that the investment banks provided slanted research in companies in which they had a financial interest, required the banks to distribute independent research along with the firm's own research in certain circumstances.

Legislators are apparently getting involved as well.  According to a Wall Street Journal article (here), Senator Schumer is considering introducing a bill that would require rating agencies to separate any consulting business from the ratings business.  Another Senator, Jack Reed, would outsource the regulation to the class-action bar.  He supports passing legislation that would make it easier for investors to bring class action securities lawsuits against the rating agencies (rating agencies have traditionally had success asserting a first amendment privilege, claiming that, like a newspaper, they simply provide information to the public).

Putting the legislative proposals aside, I think that the PCAOB-like oversight structure may be worth pursuing, particularly if nothing is done about changing the issuer-paid model.  Moreover, the issuer-paid model does seem to support capital formation by allowing the most bonds to get ratings, so we may not want to do away with it entirely.

Coverage of the roundtable is available here, here and here.

New Century Financial Creditors Seek Over Billion Dollars From KPMG

In a what big four auditing firm KPMG would hope was just an April fools day prank, on April 1st a liquidating trust formed for the benefit of creditors in the New Century Financial bankruptcy has initiated a lawsuit against the company's auditor alleging damages in excess of $1 billion.  New Century was one of the largest subprime lenders, until it restated its financial statements in early 2007 which caused the flow of credit required to originate loans to dry up.  New Century filed for bankruptcy only a few months later, in April 2007.  The bankruptcy court appointed an examiner, who investigated the reasons for New Century's collapse.  The reportwas critical of KPMG's work.

KPMG is already a defendant in a securities class action lawsuit based largely on the bankruptcy examiner's report.  Now, New Century's creditors are taking a run at the auditors in two different lawsuits.  The first (here) was filed in California state court against KPMG LLP, the American audit partnership, that performed the audit work for New Century.  The second (here) was filed in federal court in New York against KPMG International, the parent entity of KPMG LLP.

Aside from any factual issues about the audit work, there are several interesting legal issues that should impact the case.  First, as the the California action, KPMG's agreement with New Century contained an arbitration clause.  The complaint alleges that the clause contains a prohibition on punitive damages, which are illegal under California law and which therefore invalidates the entire arbitration provision.  KPMG will certainly argue that even if the punitive damages clause in unenforceable, this should not invalidate the entire arbitration provision.  Next, the liquidating trust has asserted claims for aiding and abetting breaches of fiduciary duty by New Century management.  This claim may be barred by the legal doctrine of in pari delicto, which means that when two or more actors are at fault for the same damage one actor should not be able to sue the other.  Advisers to company's have successfully asserted this defense early on in similar litigation.  When a company's officers are alleged to have acted improperly, those actions typically get imputed to the corporation because it can only act through its managers.  Therefore, the argument provides that the liquidating trust, which stands in the shoes of the corporation, cannot sue an outside adviser for participating in the same wrong that the corporation knew about.  The argument has not been universally accepted, however.

The New York action is based on the legal theory that KPMG LLP is an agent of KPMG International.  It effectively seeks to pierce the corporate veil of KPMG International, which can be done under certain circumstances.  I think that the liquidating trust is fighting in uphill battle in this case.

Guidelines For Obama Loan Modification Program

Earlier this month the Treasury Department issued regulations governing President Obama's mortgage modification plan, dubbed the Home Affordable Modification Program, which is one aspect of Obama's more comprehensive Homeowner Affordability and Stability Plan, the intent of which is to reduce foreclosures and stabalize the real estate markets.  Since every government program needs a acronym (TARP, TALF, etc.), I will refer to the loan modification program, designed to assist homeowners who are at risk of default and foreclosure avoid it, as "HAMP."

Which mortgages are eligible for HAMP?

To qualify for the HAMP, mortgages must meet the following requirements:

• The mortgage must be a first mortgage encumbering a 1-4 unit residential property that serves as the borrower's current primary residence. 

• The borrower must have had a change in circumstances that causes financial hardship, or be facing a recent or imminent increase in the amount of the borrower's monthly payment that is likely to create a financial hardship.

• The unpaid principal balance of the mortgage must be no more than $729,750 (this
  amount increases proportionately for multiple unit properties.)

• The mortgage can not have been previously modified under the HAMP.

• The mortgage must have been originated on or before January 1, 2009 (mortgages
  are eligible to be modified until December 31, 2012)

Which eligible mortgages must be modified?

After determining that the mortgage is eligible based on the requirements set forth above, a net present value test must be performed on the mortgage. This test determines whether the estimated net present value of the mortgage, as modified, is greater than the estimated net present value of the mortgage absent modification. Relevant parameters for the net present value test include the estimated value of the property upon foreclosure, cure and redefault rates, the amount of any incentive payments made under the HAMP and other information affecting the potential future value of the mortgage. If the net present value test determines that the modified loan is more valuable, as modified, participating servicers are required to offer the borrower a modification. However, servicers have the option of offering borrowers a loan modification even if the modified loan is estimated to be less valuable. The Treasury will release further parameters for the net present value calculation at a later date.

How are loans modified pursuant to the HAMP?

1. Interest rate reduction. First, a servicer must attempt to reduce the interest rate for the mortgage in increments of 0.125% (subject to a floor of 2%) until a mortgage debt-to-income ratio (Front-End DTI Ratio) of 31% is reached. For purposes of calculating Front-End DTI Ratio, mortgage debt includes principal, interest, taxes, insurance, homeowners association and/or condominium fees and certain arrearages. Mortgage insurance premiums and debt service on subordinate liens are not included. If the interest rate required to reach a Front-End DTI Ratio of 31% is above an interest rate cap (set at the lesser of: (a) the original contractual rate, or, (b) the current Freddie Mac Primary Mortgage
Market Survey rate) the modified rate will become the interest rate for the remainder of the term of the mortgage. If the modified interest rate is below the cap set forth above, the modified rate will remain in effect for the first five years and then increase by 1% per year until it reaches the level of the cap, at which time it will be fixed.

2. Extension of term or amortization. If a Front-End DTI Ratio of 31% cannot be reached by lowering the interest rate to 2%, servicers may extend the term of the mortgage to up to 40 years. If loan terms prohibit extending the term, the amortization period can be increased to up to 40 years, which will result in a balloon payment that will be due upon the maturity or other termination of the
loan. 

3. Forbearance of principal. If the above steps still do not result in a Front-End DTI Ratio of less than 31%, servicers may forbear principal, which would then become due upon the maturity or other dermination of the loan. The guidelines mandate that interest cannot accrue on the forbearance amount.

4. Trial period. After the modified interest rate is determined, the borrower engages in a trial period lasting 90 days, or 3 payment periods, during which the borrower must make payments at the modified terms. If the borrower is current at the end of the trial period, the modification is then effective.

What incentives are available in connection with the HAMP?

Acknowledging the failure of prior loan modification programs, the Obama plan provides a variety of incentives to lenders and servicers to gain their participation on more loan modifications.

Lenders (or whoever owns the mortgage in this era of securitization) are eligible for the following incentive payments from the government:

• A payment in the amount of one-half of the difference between the borrower's monthly payment, as modified, and the lesser of: (a) the monthly payment of the loan at a 38% Front-End DTI Ratio, or, (b) the borrower's current monthly payment. This compensation will be paid for up to five years. 

• A bonus incentive of $1,500 for any loan modified while the borrower is still current (including less than 30 days delinquent), subject to de minimis restraints.

• Compensation to partially offset probable losses from home price declines for loans that have already been modified.

2. Servicers. Servicers, including lenders that service their own loans, are eligible for the following incentive payments:

• An initial payment of $1,000 for each successful modification. 

• Annual payments of up to $1,000 for the first three years following successful modification, provided the borrower stays in the program.

• A bonus incentive of $500 for any loan modified while the borrower is still current (including less than 30 days delinquent), subject to de minimis restraints.

Even borrowers, who have already obtained the benefit of having their loans modified, get sweeteners from the governent.  For example, if the borrower makes mortgage payments on time during the first five years after the modification, the principal on the loan will be reduced by an additional $1,000 each year. 

What are the potential problems with HAMP?

In addition to obvious moral hazard seemingly present in all of the government bailouts, loan modifications create problems for investors in mortgage-backed securities.  Most of the mortgages in this country are owned in some way or another by investors who have already taken huge losses on their investments in these securities.  Loan modifications may be opposed by investors, and may result in litigation as it did when Countrywide (now owned by Bank of America) settled predatory lending charges by various State Attorneys General by agreeing to modify thousands of mortgages.  Investors in the mortgage-backed securities containing these Countrywide loans banded together and brought litigation to prevent the modifications.  The Treasury guidelines do not really address this, but state that servicers must comply with the terms contained in servicing agreements (including pooling and servicing agreements) for eligible mortgages, or make reasonable efforts to remove any prohibitions or obtain waivers from any necessary party.

The plan also presents additional problems for lenders and servicers.  The guidelines prohibit servicers from passing along most charges in connection with loan modifications. For instance, while notary fees, property valuation and other required fees may be reimbursable from a lender or investor, servicers cannot pass these costs to borrowers. In addition, servicers cannot require a borrower to contribute cash to the closing of a loan modification, and must waive any unpaid late fees.  Servicers participating in the HAMP are required to enter into service contracts with Treasury's financial agent prior to December 31, 2009. These service contracts are likely to require servicers to offer loan modifications to all eligible mortgages in a servicer's loan portfolio. Treasury expects to circulate examples of these contracts in April 2009.  Servicers performing loan modifications will also be subject to detailed data gathering and recordkeeping requirements. Treasury will issue details on these requirements at a later date.

Additional information is available on the Treasury Department's website here, here and here.

Mortgage Modification By Bankruptcy Passes House

On March 5, the House of Representatives passed a bill that permits bankruptcy judges to modify mortgages on primary residences (referred to as a "cramdown" provision) in personal bankruptcy cases.  Last week the House delayed a vote on the legislation due to some unexpected opposition from moderate House Democrats.  Republicans, as well as those in the financial services industry, generally oppose the measure.

As a concession to get approval of some House members, provisions were added to the bill to narrow the circumstances in which a mortgage can be modified.  For example, the new bill requires the judge to consider whether the homeowner has previously received a "qualified loan modification," such as when the lender has offered to modify the loan such that monthly payments on the loan are less than 31% of his monthly income.  Under such circumstances, the person filing bankruptcy could not get a mortgage modification through the bankruptcy.  This provision seems to dovetail with the Obama mortage modification plan (here), which seeks to encourage lenders to modify more mortgages.

In addition, the amended bill would require judges to first look to extending the length of the loan or decreasing the loan interest rate before actually lowering the principle amount of the loan.

The legislation faces sterner opposition in the Senate.  Interestingly, Reuters has interviewed several federal judges and looked at the history of bankruptcy judges use of similar tools in the 1980s.  The judges quoted in the article claim that fears of the widespread use of the cramdown provision, and therefore the feared consequences of bankruptcy modification tool, are overblown (here).

Whatever the consequences of the bill if it gets passed by the Senate, it is clear that new mortgage modification legislation and regulation will present lenders and mortgage servicers with new legal challenges.

Additional coverage of the bill is available here, here and here.

Financial Crisis Creates Wave Of FINRA Broker Litigation

The mortgage meltdown, and the ensuing financial crisis has resulted in a wave of new FINRA arbitrations by investors against their brokers and financial advisors.  Although it is easier to track new securities class action filings arising out of the financial crisis, FINRA arbitrations are much harder to follow.

However, a recent Associated Press article (here) sheds light upon the huge increase in new FINRA filings.  In 2008, new arbitration filings with FINRA increased by 54% over 2007 (which I suspect were also higher than 2006) to 4,982.  Much of these are no-doubt directly related to the subprime lending and the credit crisis; many are the result of the Madoff scandal, the Stanford fraud, and the significant general decline in the stock market.

FINRA recently reached a significant decision in a case directly related to the credit crisis.  In that case, the agency awarded over $400 million to an investor in Auction Rate Securities, who lost money when the ARS market froze up in February 2008.  The award included compensatory damages, interest and $3 million in attorneys' fees.  The investor, a European microchip maker, claimed that its investment advisor caused it to invest in ARS rather than safer federally guaranteed student loan securities it had asked to invest in.  An article with more detail about the decision is available here and the award is available through the investor's press release here.

I expect that the volume of FINRA arbitrations and the announcement of other significant decisions will increase again in 2009.

Obama's Mortgage Foreclosure Mitigation Plan

As this blog has noted in the past (here, here, here and here), the federal government has made several attempts at stemming the tide of foreclosures in the United States.  Most of them have relied on the industry to take the lead as in the HOPE Now Alliance, and the FDIC's loan modification "in a box" program.  Now, the Obama Administration takes its shot with the Homeowner Affordability and Stability Plan, announced on February 18th by President Obama.

The Obama plan also relies on lenders actively pursuing modifications, but now offers government incentives (i.e. money) to encourage lenders to modify more mortgages on primary residences, and thereby reduce foreclosures.  The plan, which will take effect on March 4, 2009, consists of the following aspects:

(1) A loan modification plan for homeowners who are at risk of default and foreclosure:

The plan offers financial incentives to lenders to modify first mortgages for primary residences for borrowers whose mortgage payments exceed 31% of current household gross income, if the amount of the loans does not exceed the current limits for Fannie Mae and Freddie Mac. Lenders will be first required to reduce monthly payments to no more than 38% of borrowers' gross monthly income. This reduction is to be made primarily by an adjustment of the interest rate, although the plan offers incentives to lenders for principal reductions. Lenders and the government will share the cost of reducing monthly payments to 31% of gross income. If homeowners pay on time for five years, by the end of that time they can receive up to $5,000 to reduce their principal balances. Bonuses will be given to mortgage servicers and lenders if they complete modifications when homeowners are still current with payments. 

(2) A refinancing program for homeowners who are current with mortgage payments but
owe more than their homes are currently worth:

Fannie Mae and Freddie Mac will be permitted to purchase new first mortgage loans of up to 105% of the current market value of properties, allowing homeowners to take advantage of historically low interest rates by refinancing existing debt, thus reducing monthly payments.

(3) Additional capitalization of Fannie Mae and Freddie Mac to keep money available for new mortgages:

Using money authorized in the Housing and Economic Recovery Act, the Treasury Department will increase its Preferred Stock Purchase Agreements with Fannie Mae and Freddie Mac to $200 billion each and will continue to purchase Fannie Mae and Freddie Mac mortgage-backed securities. The administration believes this move will stabilize markets and keep mortgage rates low.

(4) Some additional provisions:

• The administration is developing uniform guidelines for loan modifications (using guidelines developed by FDIC as a starting point), which will be used by all lenders receiving financial assistance under the financial stability plan and Fannie Mae and Freddie Mac. The guidelines are expected to be released on or before March 4.

• The administration will seek changes in bankruptcy laws to allow judges to reduce the mortgage principal of homeownersin bankruptcy. To encourage lenders to modify loans (rather than foreclosing now out of fear that the values of properties will continue to decline), the Treasury Department will establish a $10 billion insurance fund. The fund will partially compensate lenders if housing values fall further, and there is a subsequent default.

Experts forecast that, when the Homeowner Affordability and Stability Plan goes into effect on March 4, financial institutions may become deluged with requests to restructure loans.  The problem is made more daunting when the homeowner desiring a loan modification is in foreclosure because the lender's foreclosure department is typically different from the department charged with modifying loans.

Lenders may find it more manageable to contract out this loan modification work.  Several firms, including my firm (Reinhart Boerner Van Deuren) have formed teams to assist with issues arising from the President's stimulus bill and the Homeowner Affordability and Stability Plan.

For the official documentation supporting this plan, click on the following government links:

http://www.treas.gov/initiatives/eesa/homeowner-affordability-plan/ExecutiveSummary.pdf
http://www.ustreas.gov/news/index2.html
http://www.ustreas.gov/news/index3.html

New Litigation Round-Up

New cases arising from the ashes of the mortgage meltdown continue a-plenty and take many forms.  A sampling of recent cases:

ERISA  According to an article here, on January 29 the ERISA retirement plan for a Minneapolis glass-ware manufacturer called Apogee sued State Street Bank alleging that State Street breached its fiduciary duties to the plan.  State Street is alleged to have been an investment adviser to the fund.  According to the suit, State Street touted the Daily Bond Market Fund as a conservative, stable, risk-controlled, well-diversified option for Apogee's 401(k) plan, but changed the fund's strategy during 2006 to take on significantly more risk. Apogee alleged that State Street applied leverage in making the investments in subprime mortgage-backed securities, which had the effect of adding greater risk to the fund.  The fund also alleged that State Street prevented it from exiting the bond fund, while it allowed others to get out.  The fund alleges it lost $5 million.

Title Insurer Sued Over 1031 Exchange Program.  When the large title insurance company LandAmerica Financial Group, Inc. filed for bankruptcy last November, people who sold real estate in the months prior to the bankruptcy intending to reinvest the proceeds of the sale into new real estate through an IRS 1031 exchange (the benefit is deferring capital gains) had their money tied up in the bankruptcy.  For some it appears the money was tied up too long, and they lost their ability to make the exchange.  Several lawsuits have been filed against LandAmerica related to these issues, including a $300 million class-action lawsuit claiming breach of contract, fraud and theft of property filed in LandAmerica's bankruptcy case in Virginia.  A separate class action, raising similar issues, was filed in federal court in California.  As reported here, the cases are similar, and allege that the 1031 Exchange customers were misled about the financial health of LandAmerica.

Hedge Fund Sues Over Mortgage Bond Investments.  As reported by Bloomberg (here), Ellington Management Group LLC, the hedge-fund firm focused on mortgage bonds, sued Ameriquest Mortgage Co. and other ACC Capital Holdings units over soured subprime home loans.  Ellington alleges that its $354 million investment in certain bonds backed by subprime loans was virtually lost in its entiretly.  Ellington claims it was misled about the risk and the loans' potential for default.

Another Securities Class Action Filed.  This time the company in the cross-hairs is mortgage insurer Triad Guaranty, Inc.  The plaintiff's lawyers press release (here and here) from earlier today states that they allege that Triad misled investors about its underwriting practices for insuring Alt-A and pay-option mortgage and failed to adequately disclose to investors its weakening financial position as the financial crisis deepened throughout 2008. 

Tranche Warfare

Although securitized residential mortgages have been at the forefront of the credit crisis, commercial real estate debt has also been securitized, sliced, diced and sold to investors.  Some estimate that over $700 billion in commercial mortgage-backed securities are held by investors.  Now it seems a new front may be opening in the mortgage meltdown litigation - legal battles among holders of different tranches of securities backed by troubled commercial real estate.  What some have dubbed "tranche warfare."

Last week several outlets reported on the dispute among holders of various tranches of debt secured by the John Hancock Tower in Boston.  In 2006, a real estate investment firm called Broadway Real Estate Partners bought the building and a portfolio of other commercial real estate for $3.3 billion.  Back then, the Hancock Tower was valued at $1.3 billion.  Almost all of the purchase price was funded with debt.  There is a $650 million senior loan, and then about $450 million in a "mezzanine" loan that was split up amongh 9 investors.  This mezzanine debt was essentially a bridge loan which had to be paid within two years. 

In times of easy credit and soaring real estate values, it would have been easy for Broadway to refinance the debt at the end of the two-year period.  But now credit has become scarce, and in the sagging economy the Tower has gone from fully occupied to only 85% full, causing cash flow problems.  Thus, Broadway recently defaulted on a payment for the mezzanine loan.

That has touched off a battle among the holders of the various tranches of the mezzanine debt secured by the Tower.  Some estimate that the building is now worth only $700 to $900 million.  The terms of the mezzanine agreement provide that the most junior creditor still in the money (i.e. it would be paid off in a liquidation) based on an appraisal of the property would become the "controlling holder" and determine whether to foreclose on the mortgage.  The current skirmish is over which investor is "still in the money" should therefore be in control of decisions about foreclosure.

If the holders of the various tranches of the mezzanine funding cannot agree, one holder would likely file a foreclosure action and the other investors would then intervene to block the foreclosure or stay it pending a declaration from the court about who should be in charge.

To read more about the dispute, click here, here, and here.