D&O underwriters assess the subprime meltdown

When defaults in U.S. mortgages reached record levels in the second quarter of 2007, forcing a large number of subprime mortgage lenders to shut down or file for bankruptcy, the fallout spread quickly throughout the financial markets. Securities backed by subprime mortgages plummeted in value, leading to losses for investors in those instruments, including commercial banks, pension funds, mutual funds, residential real estate REITs, insurance companies and hedge funds.

Not surprisingly, the meltdown has led to securities class action suits and other types of suits that may be covered by directors and officers liability insurance (D&O) policies. While there has not been an avalanche of suits to date, D&O underwriters are cautiously eyeing the situation — attempting to assess not only how many and what types of suits are likely to be filed, but also the probability that those suits will produce insured losses and the potential magnitude of the settlements.

The subprime mortgage crisis

Subprime adjustable-rate mortgages originated in 2005 and 2006 to enable customers with less-than-perfect credit histories to obtain home loans. Although over the course of the mortgage subprime borrowers would pay higher interest rates reflective of their credit histories, to attract more customers, lenders lowered initial monthly payments through loans that charged only interest or set a lower rate for the first few years. The expectation was that borrowers would refinance and head off increases in monthly payments down the road. However, falling housing prices made refinancing difficult, leading many borrowers to default as the low initial rates on the loans expired.

Mortgage lenders found themselves in deepening trouble as the result of buyback provisions that permit investors to sell back loans that go bad within a specified period of time. As an increasing number of borrowers fell behind on their payments, investors forced lenders to buy back hundreds of millions of dollars in bad loans. In addition, investors in securities backed by subprime mortgages, which include commercial banks, pension funds and insurance companies, may take hits in the performance of their investment portfolios. However, few if any are exposed to the solvency risks of mortgage lenders subject to loan buyback provisions.

The magnitude of the crisis

According to survey data compiled by the Mortgage Bankers Association (MBA), the rate of loans entering the foreclosure process during the second quarter of 2007 was the highest in the history of the MBA’s survey. The MBA’s chief economist, Douglas Duncan, predicts that the delinquency rate will peak some time between the end of 2007 and the middle of 2008, with the foreclosure rate peaking one to two quarters after that.

D&O analyst Kevin LaCroix has pointed out that, according to the Comptroller of the Currency, there is $1.08 trillion in subprime mortgages packaged into securities that are not being held by banks, thrifts, credit unions or finance companies — in other words on the balance sheets of pension funds, mutual funds, residential real estate REITs, insurance companies, hedge funds and others. In some cases, companies have made best-guess estimates of their potential liabilities and have disclosed them. In other cases, companies have acknowledged the exposure, but have not been able to quantify their potential liabilities. However, according to LaCroix, there are still hundreds of billions of dollars of subprime mortgage-backed securities sitting on companies’ balance sheets, largely unaccounted for.

D&O exposure

Depending on the entity involved and the nature of the allegations, many lawsuits are likely to trigger coverage under errors and omissions (E&O) policies. D&O insurers also are potentially exposed to losses from the subprime fallout on several fronts.

Subprime lenders are the most obvious targets for securities class action suits and, to date, shareholders have filed suits against 11 mortgage lenders. Among the most common allegations are: (1) lenders lacked requisite internal controls, and, as a result, projections and reported results were based upon defective assumptions or manipulated facts; and (2) financial statements were materially misstated due to the failure to properly account for allowances for loan repurchases or to properly write down impaired assets. Lenders also are targets of class action suits by borrowers, as well as suits by regulators, alleging “predatory” lending practices as regards subprime mortgages. Those suits may or may not trigger coverage under a D&O policy depending on the allegations.

Attention is increasingly focused on the rating agencies that, in many cases, assigned favorable ratings to securities backed by subprime mortgages up to the moment that the market began to collapse. At least one suit filed thus far targets a mortgage insurer, though not in its capacity as an insurer, but rather as a co-owner of a loan servicing company.

For the most part, these suits are far from a slam-dunk. Companies and their directors and officers typically have not been held liable for bad business decisions or even for lack of diligence unless they are grossly negligent. For most securities class action suits, the core issue will be when the company knew it had a problem relative to when and how that problem was disclosed to investors. Companies and their directors and officers that delayed reporting problems to investors — and worse yet, those that actively concealed them — certainly may be found liable, but in many cases allegations will be difficult to prove. It can be tough to pinpoint when a problem first became known to directors and officers, and to investors.

Impact on the D&O market

Forecasts concerning the impact of the subprime crisis on the D&O market at this early date are murky due to the complexity of the issues involved. The fact that there are numerous classes of stakeholders who are potential plaintiffs — borrowers, shareholders, investors in mortgage-backed securities, etc. — makes projections especially difficult. At the very least, this may increase the complexity and the cost of the litigation process.

In addition, a plaintiff in one case may very well be a defendant in a related case, which raises the possibility that in some cases insurers may be on the hook for multiple policies covering the same loss event, while in other cases there may be significant potential for subrogation.

Multiple categories of potential plaintiffs also poses interesting questions as to whether class action suits by different types of plaintiffs can be consolidated. It seems likely that there will be a push for early settlements of suits by plaintiffs, and perhaps by insured directors and officers if there are allegations of fraud that might void D&O coverage if adjudicated. This may not be to the benefit of insurers, who are likely to conclude in many cases that a vigorous defense is warranted.

The D&O market has seen steadily falling prices since about the beginning of 2004, due to abundant capacity and favorable accident year loss experience. While it is still too early to tell whether the subprime mortgage crisis will have a material impact on rapidly eroding rate levels, it is most likely that rate corrections will be localized — affecting principally companies in the mortgage lending business and others with significant exposure to residential mortgage risk.

It is nearly certain that companies involved with mortgage lending, and perhaps companies throughout the financial services sector, will be subject to more restrictive policy terms. Some companies will have difficulty finding coverage at any terms.

Insurance companies and other large investors with balance sheet exposure to mortgage investment risk — including investments in hedge funds or other vehicles with significant exposure to mortgage-backed investments — are likely to come under underwriters’ scrutiny.

One challenge for underwriters is that the story is still unfolding, and they may be underwriting “burning buildings.” While some potential targets are fairly self-evident — mortgage lenders and those companies financing their activities, for example — other companies that may be sucked into the maelstrom are more difficult to identify. This is especially the case for companies with significant undisclosed or underdisclosed balance sheet exposures to subprime mortgage losses, either through direct investments in mortgage-backed securities, or through investments in hedge funds or other vehicles with subprime mortgage exposures.

Undoubtedly there are many companies carrying securities backed by subprime mortgages at acquisition cost, and are counting on the marketplace to right itself before having to face the moment of truth.

Conclusions

While it is still too early in the subprime mortgage crisis to predict the impact on the D&O market, it is clear that lawsuits are being filed which likely will trigger coverage under D&O policies, and similar suits are almost certain to follow. Bear Stearns predicts a worst case scenario to the D&O insurance sector of $3 billion in losses, relative to 2007 earned premium for public company D&O estimated by Advisen to be roughly $5 billion.

Undoubtedly, subprime mortgage lenders will bear the brunt of the litigation, but other companies also may be targeted. It seems probable that defendants will have strong defenses in many of these cases and the actual toll may fall short of this worst-case projection. The fact that there have not been more cases filed to date may be an indication that plaintiffs’ attorneys recognize that these will be difficult cases to win, and are carefully choosing their targets.

Topics Lawsuits Carriers Underwriting