Being that a domino fallout of predatory lending class-action lawsuits is likely to ensue if any one of them succeeds, most concerned parties, particularly the investment banks that underwrote the deals, are wondering if there is some basis for extending the liability for the abuses to the enabler of the loan.
Legally, for a case to be made that an underwriter is liable, the plaintiff would have to prove that the underwriter was fully aware of the predatory activities and the implications of the predatory activities, according to Dan Castro, head of real estate ABS research at Merrill Lynch.
On the radar screen is the recent class-action lawsuit filed against First Alliance Mortgage Corp. which names Lehman Brothers as a defendant for its role as underwriter. Filed in bankruptcy court on May 1 on behalf of subprime borrowers Jacqueline Bowser and Irene Huston, the suit alleges that First Alliance violated terms of the Truth in Lending Act (TILA), particularly those associated with the 1994 Home Ownership and Equity Protection Act (HOEPA), which amends TILA such that higher risk lending is subject to more stringent regulations.
Said Thomas Jenkins of San Francisco-based Jenkins & Mulligan, the law firm representing the plaintiffs, "The reason we named Lehman Brothers and not Prudential Securities [which also underwrote deals for First Alliance] is that Lehman Brothers took an equity stake in First Alliance... What we are convinced of is that no mortgage banker takes an equity stake in a company without undertaking substantial due diligence and review of the practices of the company it is taking a position in."
Though Lehman generally declines to comment on matters in litigation, spokesman William Ahearn did say, "It's one thing to receive a warrant position as compensation, which is very typical in the industry, but that doesn't indicate any kind of managerial control.
"The other point," he added, "is that the warrant position was never exercised. There's not even warrant position any longer."
What makes this case unusual, however, according to one source familiar with the situation, is that Lehman Brothers was not just underwriting First Alliance's deals, but was providing a warehouse line of credit.
"The argument would go that: as warehouse lender, Lehman would have reason to have a much greater level of knowledge about what the substance of those loans was actually like," the source said. "You're giving them money to basically go out and buy assets, as opposed to merely packaging them as an agent, and selling them as bonds on the Street."
The Loans in the Pool
Again, Lehman's liability is, on a legal basis, only at issue if First Alliance is found to have made loans illegally, which historically with predatory lending has been hard to prove on a class-action basis.
One reason is that predatory lending is often characterized by unquantifiable injustices: example, lending to a borrower with no real expectation that the borrower will be able to repay the debt.
"It's not likely that you'll win a legal case in many of these situations," said Tom Zimmerman, an analyst at PaineWebber. "It's more likely you'll win an ethical, public relations, moral case against them, but winning a legal battle is something else."
Ethical liability for predatory lending has already proved it can jump a rung however, from the broker to the funding entity. Unlike First Alliance, Delta Funding Corp., which over the last year has faced a barrage of political pressure associated with predatory lending, was not directly originating the loans but purchasing them from third party brokers who were charging fees found to be excessive by the New York Banking Department and the Department of Justice.
"These were not fees that were coming to us," said Delta's Chief Executive Officer Hugh Miller. "At the end of the day, we had a lot of things in place for monitoring ourselves. We were not monitoring the third party, because we did not feel we had any legal obligation to do so."
Delta settled out of court with what will amount to nearly $10 million over the life of the loans. Delta's underwriters - usually Lehman Brothers, Nations Bank Montgomery Brown (now Banc of America Securities) or Donaldson Lufkin and Jenrette - were never held accountable for the quality of the loans.
If legal cases do succeed in court, the victories will likely be associated with technical violations, and, as with the First Alliance case, many are pointing to part 226.32 (Section 32) of the HOEPA. Section 32 loans are second-lien mortgages flagged as high risk, and fall under certain regulatory disclosure requirements and restrictions.
A loan is considered a Section 32 loan if, at the time of close, the annual interest rate is more than 10% over the yield of a corresponding 30-year Treasury bond. Similarly, a loan is Section 32 if the total points and fees payable by the consumer exceed the greater of 8% of the total loan amount or $400 plus an index-adjusted annually for inflation.
Subsequently, when a loan falls under either of these criteria, certain disclosure forms must be given to the borrower three days before the close of the loan. Moreover, certain loan features are prohibited on Section 32 loans, such as prepayment penalties, balloon payments, and negative amortization.
With respect to the First Alliance case, the plaintiffs allege that the lender was purposely concealing the terms of the loans to the borrowers until after the loan had been consummated. Further, the plaintiffs are arguing that the lender failed to comply with the disclosure laws associated with Section 32 borrowers.
"In virtually every instance where we have interviewed borrowers, and I personally have reviewed over 60... virtually every borrower indicated that he or she did not receive the full package until after the loan was closed," said Jenkins.
Whether or not First Alliance was deliberately withholding the terms of its loans from its borrowers, even in honest lending, adhering to the Section 32 requirements can be difficult, which is why some fear the issue might be subject to "Rodash-style litigation" - as one source termed it - where the right to rescission is granted on technicalities unrelated to the intent of the lender.
The source was referring to a mid-90s lawsuit where a Florida judge ruled in favor of defendant Martha Rodash in part because, though all fees were disclosed, certain fees, namely the Federal Express charge and intangible tax charge, were disclosed as "part of the amount financed' rather than the finance charge,'" according to published reports.
Rodash was granted the right to rescission. The case spawned a wave of "Rodash copycats." Generally, the right to rescission is available to the borrower until the third day after the close of the loan, explained a source at the Federal Reserve Bank. However, there are provisions extending the right to rescission when there are material errors on the disclosures.
"Part of the problem too is that there can be very technical violations that result despite the best intentions," said an attorney who works on subprime transactions. "You disclose the fee but you disclose it in the wrong place, and because you disclose it in the wrong place, you're over the limit, and now you're a Section 32 loan. And by the way, you can't have a prepayment penalty if you have a section 32 loan, and yours has got one. And it's like, See you later.'"
Perhaps one of the more disquieting notions is that no one really knows the concentration of section 32 loans in the outstanding mortgage pools, though most speculate the number is insignificant. William Apgar, assistant secretary to the HUD, who has argued that the Section 32 blanket should be more inclusive, estimated that of all subprime loans, less than 1% fall under Section 32.
However, a mortgage banker who worked on the pre-securitization side of the market, purchasing and trafficking subprime loans in the secondary market, said that companies who he had worked with, including Delta Funding and ContiMortgage, were securitizing portfolios with Section 32 loan concentrations as high as 30%.
What's most frightening, perhaps, is that predatory lenders, who have already demonstrated a willingness to commit fraud, could have originated loans that qualify for Section 32 treatment without ever informing their borrowers, or recording the loans as such.
Said Michael Youngblood, real estate analyst at Banc of America Securities, "And if they're lying to the company that buys their loans, and saying there's been no more than five points, or no more than ten points associated with a given loan, when in reality the total number of points is much higher, it's very difficult to uncover fraud until it's too late."
Again, if by further investigation, lawyers and regulators uncover loans that should have been dealt with differently, the securities backed by those loans could theoretically suffer.
"If it's one out of a thousand loans in a trust, it doesn't matter, it's not going to be a problem," said Peter Rubinstein, a real estate fixed-income strategist at Prudential Securities. "Any trust can withstand one or two of the loans going bad. If it's ten percent of the market, than it's a problem, but I don't think it is."
If Rescission, Who Pays
Under the terms of the securitization, if a trust is found to contain loans that violate Truth in Lending Act disclosure requirements, the originator is usually required to buy the loan back from the trust. Such recourse would not be possible if the originator has long since declared bankruptcy, as is the case with many of the subprime residential issuers who were originating loans in the mid-90s, and whose bonds are outstanding.
"I think this opens up an area that has not been tested," said Rubinstein.
According to a number of industry sources, it's possible that the trust itself could be hit, specifically the residuals or excess interest/spread which is typically held by the servicer. In some cases, because of the servicing transfer that usually happens at or near a bankruptcy, often the residuals on these deals are already in bad shape.
"It even gets more complicated," said an attorney who works on subprime transactions. "Just because the originator is bankrupt doesn't mean that the bankrupt estate is not obligated for that. Does the bankrupt estate disavow the servicing contract and lose all that, or do they suck it up and say Yeah, it's our obligation but you're an unsecured creditor, and get in line with everyone else?'"
According to Keith Wofford of Moody's Investors Service, the vast majority of the subprime securitizations that could be exposed to predatory lending litigation were wrapped, which would protect those bonds against any sort of credit loss.
"For most of the bonds there should not be a significant effect," Wofford said. "Maybe in the senior/subordinate deals where the originator is hit by a significant amount of litigation, then there might be some effect upon the bonds, but generally there should not be a widespread effect."
However, one source who agreed that credit loss is fairly unlikely said that trading and liquidity problems are likely nonetheless.
"Liquidity, from what I've heard, is a real issue with a lot of these bonds," the source said. "There's a relatively limited pool of buyers in the sub bonds, so there's not a whole lot of buyers out there when these things trade wide, so I think people would be more likely to hold than to take a bath."
Currently, a First Alliance bond trades about 15 to 20 basis points behind a comparable subprime security from another issuer, according to a trader. Though the trader admitted those numbers reflect First Alliance's bankruptcy, as much as they do any other issues the lender is facing.