Shifting Sands: The Illusion Of An Ever-Rising Residential Real Estate Market And The Subprime Mortgage Crisis

Saturday, March 1, 2008 - 01:00

Editor: Mr. Hayes, would you tell us something about your professional experience?

Hayes: I have 28 years of trial experience in commercial litigation. My primary focus has been on handling complex breach of contract, business tort and other unfair competition matters, including intellectual property and antitrust cases. In this practice area, I have litigated a substantial number of cases in which securities and common law fraud, misappropriation of trade secrets and embezzlement claims have been asserted.

Editor: How did you come to Cozen O'Connor? What were the things that attracted you to the firm?

Hayes: I joined Cozen O'Connor in 1990 at a time when the firm was just beginning to organize a commercial litigation group. I was attracted to the unique opportunity to help build a new practice within an environment that provided all of the resources of a large firm. I was impressed with Stephen A. Cozen's and Patrick J. O'Connor's vision for the firm.

Editor: Have you seen an increase in any area of your practice?

Hayes: Yes, in the area of intellectual property and antitrust. Of course, we have seen a dramatic increase in litigation arising out of the so-called subprime crisis.

Editor: Is this reflective of trends in the industry?

Hayes: Well, that is certainly the case with respect to intellectual property. With the increasing focus in our global economy on the development of IP, there is a greater effort to secure and enforce copyright and patent protection. Companies have paid more attention to branding in marketing their products and services, and this, in turn, has driven the efforts to protect their trademarks. The increase in subprime litigation is events-driven.

Editor: You have been following the subprime mortgage crisis for some time. For starters, can you give us an overview of the problem?

Hayes: For me, the term 'subprime crisis' - and I concede that everyone is using it - is something of a misnomer. I think we are facing a challenging financial environment precipitated by the high rate of defaults on mortgages characterized as subprime. Of course, that description is not a catchy buzz word. In any event, these defaults have had a significant effect on the overall economy, and it has extended far beyond the subprime lending area to impact a wide segment of our economy. For instance, the subprime mortgage defaults have threatened the liquidity of bond insurers that play an instrumental role in facilitating other types of financing. On a broader basis, the enormous losses the financial community is suffering has certainly affected liquidity in the credit markets for all borrowers.

Editor: Lending institutions are supposed to be pretty sophisticated when it comes to assessing the risk of default. What went wrong here?

Hayes: While this is open to debate, in my view, most financial institutions accurately assessed the risk of default. I believe that what they failed to do was accurately assess the consequences of default. With the substantial increase in the pooling of mortgages, securitization of mortgage pools and skyrocketing housing prices, lenders and investors apparently felt that they could easily recoup the principal balance of the mortgages through foreclosure in the event of a default and, if they did suffer losses, cover them through the favorable interest rates generated on the entire pool of subprime mortgages. At the same time, the rising home prices fueled a thirst for interest only, balloon and adjustable rate mortgages, which lenders were happy to accommodate. As a result, the number of subprime mortgages skyrocketed from 1994 through 2005.

In order for the lenders to protect themselves effectively, the residential real estate market needed to continue to rise and remain hot. It did not. The market went flat and, in some areas of the country, it went into decline. The economy hit what others have analogized to the "perfect storm." Borrowers began to default in droves and the lenders, trusts and investors involved in this market, unable to resell these properties for the appraised values, were stuck with non-performing loans. As many borrowers had no equity in their homes, they were disinclined to endure the pain of workout agreements and simply walked away from their houses. At the same time, many of the trusts holding pools of mortgages were not as inclined to work out troubled loans as traditional banks have previously been and have sought simply to liquidate the security on defaulting loans. With mortgages having been securitized and sold, the value of the investment plummeted.

Everything would have continued to work if the value of the real estate had continued to increase. Regrettably, however, home values dropped. At that point, it was not too difficult for the borrower to determine that it made sense to walk away from the loan. By way of contrast, had the borrower put a couple hundred thousand dollars of equity into the house, preventing foreclosure might have been something of an imperative.

Editor: What products turned out to be the most egregious in a market where residential real estate prices either stagnated or declined?

Hayes: Problematic is probably a better word. Loans where the mortgage was close to the total value of the home, as well as those where the borrower was making interest only payments, were certainly problematic. There was also extensive use of balloon mortgages. People with good credit who had bought a balloon mortgage at 80 percent of the market discovered that they were unable to find lenders willing to refinance their mortgages when the balloon kicked in.

Editor: How did the lenders fail to assess the consequences of default?

Hayes: Well, there has been a plethora of litigation attempting to assign blame. I just saw a survey reporting that the number of cases filed with respect to the so-called subprime crisis far exceeds the number of cases filed at the relatively same point of the savings and loan crisis.

There have been allegations that rating agencies did not accurately rate the mortgage pools amid concerns that these pools were given a higher rating than the individual mortgages within the pools. The concept, to take a simple example, that "A" rated and "B" rated mortgages could be combined into a pool and rated B+ is being questioned. There have been claims that real estate appraisers intentionally or recklessly overvalued the mortgaged properties. Subprime mortgage lenders and the Wall Street firms that underwrote the securitization of the mortgages have been the subject of breach of contract, lack of due diligence and fraud claims.

Some homeowners are not willing to walk away from their homes and are filing predatory lending practices claims against subprime originators, real estate agents, title companies and appraisers.

Investors have filed numerous securities law actions against subprime lenders and Wall Street firms alleging that the companies failed to disclose the increasing default rates in the subprime mortgages which, according to the plaintiffs, artificially inflated the value of the lenders' stock. We might expect claims against the trustees and managers of pension and other funds asserting breach of fiduciary duty claims based upon the investment in subprime mortgage pools or failure to divest these investments.

Of course, law enforcement and regulatory agencies have been spurred into action. It has been reported that the FBI has opened criminal inquiries into a number of companies.

I believe we will find that each transaction was fact specific and there will be no overarching conclusion as to why the players in this market failed to realize it could not continue unabated.

Editor: Are we past the worst of the crisis, or is there more to come?

Hayes: I do not know the answer to that, and I am not sure anyone does. In the fourth quarter of 2007, the Federal Reserve Board assumed that the economic slow down resulting from the subprime crises had peaked, but it apparently had not. Even if the crisis has peaked, given the impact it has had across our economy and the people who have been affected by it, the resulting litigation is going to be with us for a time.

In addition to the influx of litigation, corporate and individual bankruptcy filings are increasing significantly. Individual bankruptcy filings are increasing despite the recent changes in the law making it harder for individual creditors to obtain a discharge.

Editor: Would you share with us your thoughts on the lessons we should have learned from this event?

Hayes: Well, I am not an economist. With that said, I do not believe that this event, as traumatic as it has been for a great many people, heralds a fundamental shift in the way our markets function. We are not, in my view, going to see the end of the pooling and securitization of mortgages. This practice will likely continue on sounder structural underpinnings, and perhaps with greater transparency and regulation.

The financial markets will recover. In the interim, it is my understanding that companies are returning more to venture capital firms to meet their funding requirements.

As Isay, litigation will likely continue to be filed over the short term, perhaps even to a greater extent. These cases may well have a significant effect on individual entities, but I do not foresee these cases continuing to be filed for years to come.

Please email the interviewee at rhayes@cozen.com with questions about this interview.