Subprime Contagion: Where Will the Litigation Wave Spread Next?

The subprime mortgage meltdown has been a leading story on the front pages of newspapers around the country for the past few months. The uproar also has led to a flood of new lawsuits and to concerns about how much further the litigation wave will spread. But as a result of growing turmoil in the credit marketplace, the meltdown story is no longer just about subprime.

There are increasing fears that the problems could engulf other types of debt — credit cards, car finance and unsecured loans. For example, in a recent column, former Treasury Secretary Lawrence Summers commented on “the dangers of a deepening crisis,” noting that most estimates about the ultimate losses in the financial sector from the subprime meltdown “take no account of the likelihood that losses will spread to credit card, auto and commercial property sectors.”

To the extent the turmoil spreads to other parts of the credit marketplace, the question about the extent of the subprime litigation wave leads to the question about how much further beyond subprime will the litigation wave spread?

In just the first five months of 2007, late credit card payments rose 30 percent. Further delinquencies are almost certain because of problems arising from subprime mortgages. Homeowners struggling to make mortgage payments are more likely to give house payments a priority over credit card payments. As interest payments due on adjustable mortgages reset upward, that tension with house payments will only increase. Tightened credit requirements will foreclose the ability of many consumers to tap into home equity lines of credit or to refinance to retire consumer debt. All of those circumstances could contribute to further deterioration in credit card debt repayments.

There are also concerns that problems in the subprime mortgage industry could spread to vehicle loans. Major auto and truck lenders are already experiencing rising delinquency levels. The American Bankers Association reported that the auto loan delinquency rate for nonbank auto lenders during the second quarter of 2007 was at its highest level since 1991. The same concerns regarding credit card debt increase the likelihood that mortgage woes will spill into car and truck financing.

In addition to consumer-related loans, another segment of the credit marketplace that may be affected is the commercial property mortgage sector. According to a Dec. 2, 2007, Financial Times article, the aftershocks from the subprime meltdown could “hit lenders with a second real estate-related punch, if the highly leveraged commercial property market succumbs to the contagion.” Banks are holding tens of billions of dollars worth of unsold commercial mortgages. According to the article, “U.S. banks could see $11 billion to $78 billion of commercial real estate losses if the lending crisis spreads.”

Like subprime mortgage loans, many of the loans from those other areas of the credit marketplace were repackaged into asset-backed securities. And just like the subprime mortgage-backed securities, the securities backed by those other types of loans are also facing a significant valuation slump — not only because of concerns about borrower defaults, but also out of concern that constrained banks and investment funds will be forced to sell the securities, pushing prices lower.

The growing turmoil in the larger credit marketplace may hit some unexpected companies. Many manufacturers have in recent years become increasingly involved in financial services. There are a host of companies that are not classified as financial that have financial arms and could suffer along with banks if borrowers stop paying their bills.

According to recent media reports, General Electric attributes 34 percent of its pretax earnings to financial services. Deere & Co., Caterpillar and Pitney Bowes all get at least 12 percent of their earnings from financing. Other unexpected companies with significant financing operations include Sony and Harley-Davidson. In addition, companies such as Boeing and tractor truck manufacturer Paccar carry significant customer leases or other significant interest-bearing receivables on their balance sheets.

Whether any of those companies, or other financing companies outside the subprime mortgage lending arena, get drawn into securities litigation as a result of the broader credit marketplace turmoil remains to be seen. But if the deterioration of those other sectors continues, as seems probable, then the possibility that aggrieved investors will initiate securities litigation contending that they were not fully apprised of the credit or default risk is just as likely.

A deeper concern may be the vulnerability of the companies and investment funds that are carrying significant amounts of securities backed by those other credit assets on their balance sheets. Those companies will face many of the same kinds of well-publicized valuation and disclosure issues that have troubled companies invested in mortgage-backed securities.

The subprime-related valuation and disclosure challenges have led to securities litigation. The challenges ahead involving valuation and disclosure of those other asset-backed investments could also lead to litigation.

For directors and officers underwriters and others whose job it is to identify and locate risk, the evolving exposures represent an enormous new challenge. D&O underwriters are still struggling to get a handle on risk segmentation issues related to subprime lending. But just as underwriters have quickly learned that it cannot be assumed that subprime-related risk is restricted only to a narrow category of companies, so they must face the challenge of identifying an evolving risk that is threatening to spread throughout much of the economy.

Topics Lawsuits Auto Property