What the Subprime Crisis Could Mean for Your Company

Loan Origination

Lenders

Earlier this year, the FBI announced that since the spring of 2007 it had been investigating 14 companies for possible accounting fraud, insider trading, and other violations in connection with subprime mortgages. According to the FBI's most recent Financial Crimes Report to the Public, each mortgage-based fraud contains some type of 'material misstatement, misrepresentation, or omission relating to the property or potential mortgage relied on by an underwriter or lender to fund, purchase or insure a loan.' Indeed, federal wire and mail fraud statutes, as well as most state larceny and fraud statutes, require a showing of a misrepresentation about something in the deal flow that is being offered. For example, misrepresenting interest rate increases or assisting lenders in exaggerating their income levels could constitute a lie for the purpose of supporting a criminal fraud charge. On the securities side, misrepresenting the risk involved in investment could support an element of a criminal charge.

An example of actions by individuals in a company that could give rise to criminal charges can be found in the investigation of New Century Financial Corporation. Prior to its collapse in the wake of restated financials in February 2007, New Century was the world's second-largest originator of subprime residential mortgage loans. This company presents a case study and blueprint for how any loan originator involved in subprime mortgages will be investigated by regulators and prosecutors in the coming months and years. A report by the trustee in New Century's bankruptcy case sheds light on areas where regulators and prosecutors will focus. The report states that New Century had a 'brazen obsession with increasing loan originations.' The company actively marketed and sold very risky loans with questionable features. These included adjustable-rate mortgages with extremely low initial 'teaser' rates; stated income loans, also known as 'liar loans,' which do not require verification of a borrower's income; loans allowing relaxed underwriting standards; no-down-payment loans offered at 100% of the value of the property; and the use of possibly phony real estate appraisals.

Clearly, if New Century staff and management did not actively convey the risks and downsides of these loan products to borrowers, these employees may be vulnerable to allegations of fraud. Such omissions can potentially be characterized as misrepresentations and lies. Prosecutors could charge individuals with larceny, theft, wire fraud, and mail fraud because they lied to borrowers to induce them to take on a mortgage obligation they could not handle, while the lender profited. Executives who never even met the loan customers could potentially be charged as conspirators.

Defenses to these types of charges would include an argument that the borrower agreed to an 'assumption of risk' which was adequately disclosed. The borrower was given the opportunity to own a home and took all the necessary steps to make his dream a reality. The fact that a booming market went bust cannot and should not result in honest, hard-working individual loan executives being branded as criminals.

However, according to the bankruptcy trustee, New Century management did nothing to limit these practices. Instead, it aggressively sold securitized loans in the secondary market, setting up the need to repurchase billions of dollars' worth of impaired and defaulted mortgages. The trustee's report states that New Century appeared to be profitable only because it engaged in 'at least seven wide-ranging improper accounting practices.' New Century's primary failure was the lack of
sufficient reserves to repurchase its obligations. Public financial filings significantly understated repurchase obligations, thereby allowing the company to appear to be in terrific financial health when it was really not profitable. There is no doubt that the potential for fraud charges exists with respect to statements made in public filings. Prosecutors may also consider prospective securities fraud charges based on misrepresentations made to investors and bank fraud charges based on misrepresentations to banks extending lines of credit.

Defenses could include arguments that highly technical accounting concepts were in play, that executives signed off on financial disclosures in good faith, and that there was no intent to mislead investors.

Mortgage Brokers

Brokers who recommend mortgage products to borrowers have the same concerns as lenders for the purposes of investigations by regulators and prosecutors. Certainly, stand-alone mortgage brokers need not worry about the securitization process and subsequent sales to investors of bundled debt obligations. The issues surrounding brokers will be what they told borrowers about the loan products. Were the disclosures made by brokers to their clients adequate, or were they misleading? Did the brokers do enough due diligence to insure the appropriateness of the loan, or did they simply avoid learning the unpleasant truth that the mortgage was virtually impossible for the borrower to maintain?

The appraisal process is also being scrutinized. In order to proceed to closing, a property must be appraised. Brokers may refer buyers to appraisers. Lenders may themselves provide appraisal services or make referrals. Finally, appraising companies themselves are being look at very closely. If appraisals were inflated and contain misrepresentations, the appraisers, their companies, and anyone else who knew that the appraisals were false and who participated in marketing subprime loans and closing on them could be faced with criminal fraud-related charges.

Securitization Investment Banks and Broker-Dealers

Companies like New Century and Countrywide Financial not only offered loan origination, but also bundled mortgage obligations into securities instruments and resold them on the secondary market. Larger investment banks, such as Merrill Lynch, UBS, and Bear Stearns, all operated at the investment-banking level and arranged for packages of mortgages to be securitized and valued. The SEC and the U.S. Attorney's Offices for the Southern and Eastern Districts of New York have initiated investigations into the activities of all three banks. In general, these investigations focus on the manner in which subprime securities were valued. In addition, the New York State Attorney General's Office is looking into how various securities firms priced individual home loans for purchase and sale on secondary securities markets.

The former Bear Stearns suffered the collapse of two internal hedge funds, which contributed to its failure. A fund manager is being investigated by the SEC. Among the potential crimes and regulatory violations being probed is the manager having expressed 'cautious optimism' about the financial viability of Bear's subprime holdings while simultaneously moving $2 million of his own holdings from one of the funds (which later failed) into a less risky internal fund. Merrill Lynch and UBS are being investigated by the SEC as well for what they knew about the financial viability of their subprime holding and about the disclosures made to investors.

Broker-dealers that sold the investments to customers will face inquiry into the degree to which they performed due diligence on the securitized subprime loans and precisely what they told customers.

Whether there were misrepresentations, cover-ups, and crimes committed will turn largely upon complex valuation procedures and their subsequent disclosure in public financial filings. Market failure on a massive scale provides a compelling explanation that may negate concerns about fraud. It may be very difficult for prosecutors to prove intent, and certainly the widespread nature of the failures could not have been anticipated.

Accounting Firms

Accounting firms have provided complex and involved advice and service on the valuation of subprime securities and how to describe this value in public filings. Lenders and investment banks that securitize loans make money on the difference between interest paid by borrowers on their mortgages and rates paid out to investors on mortgage-backed securities. This creates value known as 'residual assets,' which must be accounted for in public filings. Announcing these assets up front by way of so-called gain-on-sale accounting has been criticized. Although it is a highly technical area, both FAS and FASB rules exist to direct accounting firms in their work in this area.

Accounting firms will have provided both advice and services in setting up procedures and reviewing public filings. The widespread failure of subprime loans has created powerful incentives for regulators and prosecutors to closely review the accounting advice given, the procedures set up, and the public filings themselves, much in the way the accounting process for options backdating was suddenly questioned, investigated, and prosecuted. Indeed, in the report by the New Century bankruptcy trustee the accounting unit of KPMG is strongly criticized and accused of accounting malpractice.

However, here again, the question of an intent to mislead will be a very real and viable avenue of explanation and may provide a strong defense for accountants and their firms. The technical nature of complex GAAP rules, and the unexpected and sudden collapse of the market for subprime securities, will provide a compelling explanation and defense.

Ratings Agencies

Agencies such as Moody's, Standard & Poor's and Fitch, which value and rate securities offerings, including bond offerings of bundled subprime mortgage packages, are among the companies being investigated in connection with this massive debt failure. Indeed, the SEC and various state attorneys general have focused on these groups and are probing to discover whether they colluded to overvalue the worth of these securities. Were ratings standards intentionally relaxed in order to promote the value of these offerings in return for compensation from the investment banks and originators that put together the offering in question?

These companies' consistently positive ratings supported the expansion of the global market for investment opportunity in high-risk subprime loans. Those marketing subprime mortgage securities needed investment-grade ratings from the agencies in order to sell offerings on a broad scale. Were the offerings intentionally overvalued?

Criminal prosecutors could bring charges of conspiracy to commit securities fraud, wire fraud, and mail fraud if they find proof of intentional, collusive overrating. However, the agencies are private, profit-driven companies that will compellingly argue that they maintain objective standards of review and are paid for their objectivity. Individual executives will in all likelihood be in a position to demonstrate that there is no proof of any quid pro quo or of positive ratings being tied to compensation.

Law Firms and In-House Counsel

Once again, the spotlight will be on lawyers and law firms in the finger-pointing game. As we have seen, and will continue to see, in the option-backdating investigations, prosecutors and regulators do not hesitate to criminally charge attorneys. Lawyers involved in the option-compensation and public-disclosure process at various companies have been charged with serious federal crimes, and a number of guilty pleas have been obtained. Lawyers and law firms were involved in providing advice and services in the marketing and securitization of subprime mortgages at every step of the process. Here again, the issue will be what lawyers knew and what the intention was in providing the advice and legal services.

Given the massive nature of the collapse and its widespread effect, closing attorneys and in-house counsel to originators, investment banks, and ratings agencies all need to be concerned that regulators and prosecutors will play the blame game.

Conclusion

The investigations into the subprime mortgage collapse are in their early stages. Companies may resolve issues with compliance agreements, settlements that include fine and restitution payments, increased corporate governance structure, and deferred prosecution arrangements. However, as was the case in the large corporate scandals earlier in this decade, and to a lesser degree in the options-backdating inquiries, it is individual executives and employees who face the real threat of criminal prosecution and jail time. Any individual involved in decision making with respect to the marketing and securitization of subprime mortgages would do well to seek the advice of experienced white-collar defense counsel as to possible exposure and potential explanation and defense.

Charles A. Ross is the principal of Charles A. Ross and Associates, and focuses his practice on white-collar criminal defense. The firm represents clients in complex criminal matters in cases involving public corruption, the RICO Act, bank fraud, bribery, government procurement fraud, antitrust, healthcare fraud, and tax and securities fraud. Ross may be reached at [email protected].

The continuing economic crisis, driven in large measure by the subprime mortgage meltdown, is affecting major segments of the economy. Not a day goes by that there is not something in the press regarding the effects of billions of dollars of mortgage failures. Criminal investigations into all industries involved in the process are underway. The Department of Justice is considering creating a task force, much in the same way the Bush Administration created the Corporate Fraud Task Force in the aftermath of the Enron failure. Indeed, in a recent Business Week article, investigators stated that probes are looking at the 'full gamut' of participants in the process of originating and securitizing subprime mortgages. The FBI has predicted a landslide of mortgage fraud cases.

Citing the opportunities for fraud created by the increasing reliance on third-party brokers, it consolidated all of its mortgage fraud programs within its Financial Institution Fraud Unit in fiscal year 2006. Local regulators and prosecutors have issued subpoenas to probe allegations of malfeasance and deception. These potentially sweeping and wide-ranging investigations will likely include probes into the lending industry, including mortgage lenders, brokers, and bankers, as well as a thorough look at the securitization side, which includes investment banks, broker-dealers, and ratings agencies. Accounting firms and law firms will be scrutinized as well.

The purpose of this article is to examine what industries are likely to be affected by ongoing criminal and regulatory investigations. It will also examine what types of individual criminal charges may be considered, and what defenses may be available for people unlucky enough to be caught in the sights of the government.

Loan Origination

Lenders

Earlier this year, the FBI announced that since the spring of 2007 it had been investigating 14 companies for possible accounting fraud, insider trading, and other violations in connection with subprime mortgages. According to the FBI's most recent Financial Crimes Report to the Public, each mortgage-based fraud contains some type of 'material misstatement, misrepresentation, or omission relating to the property or potential mortgage relied on by an underwriter or lender to fund, purchase or insure a loan.' Indeed, federal wire and mail fraud statutes, as well as most state larceny and fraud statutes, require a showing of a misrepresentation about something in the deal flow that is being offered. For example, misrepresenting interest rate increases or assisting lenders in exaggerating their income levels could constitute a lie for the purpose of supporting a criminal fraud charge. On the securities side, misrepresenting the risk involved in investment could support an element of a criminal charge.

An example of actions by individuals in a company that could give rise to criminal charges can be found in the investigation of New Century Financial Corporation. Prior to its collapse in the wake of restated financials in February 2007, New Century was the world's second-largest originator of subprime residential mortgage loans. This company presents a case study and blueprint for how any loan originator involved in subprime mortgages will be investigated by regulators and prosecutors in the coming months and years. A report by the trustee in New Century's bankruptcy case sheds light on areas where regulators and prosecutors will focus. The report states that New Century had a 'brazen obsession with increasing loan originations.' The company actively marketed and sold very risky loans with questionable features. These included adjustable-rate mortgages with extremely low initial 'teaser' rates; stated income loans, also known as 'liar loans,' which do not require verification of a borrower's income; loans allowing relaxed underwriting standards; no-down-payment loans offered at 100% of the value of the property; and the use of possibly phony real estate appraisals.

Clearly, if New Century staff and management did not actively convey the risks and downsides of these loan products to borrowers, these employees may be vulnerable to allegations of fraud. Such omissions can potentially be characterized as misrepresentations and lies. Prosecutors could charge individuals with larceny, theft, wire fraud, and mail fraud because they lied to borrowers to induce them to take on a mortgage obligation they could not handle, while the lender profited. Executives who never even met the loan customers could potentially be charged as conspirators.

Defenses to these types of charges would include an argument that the borrower agreed to an 'assumption of risk' which was adequately disclosed. The borrower was given the opportunity to own a home and took all the necessary steps to make his dream a reality. The fact that a booming market went bust cannot and should not result in honest, hard-working individual loan executives being branded as criminals.

However, according to the bankruptcy trustee, New Century management did nothing to limit these practices. Instead, it aggressively sold securitized loans in the secondary market, setting up the need to repurchase billions of dollars' worth of impaired and defaulted mortgages. The trustee's report states that New Century appeared to be profitable only because it engaged in 'at least seven wide-ranging improper accounting practices.' New Century's primary failure was the lack of
sufficient reserves to repurchase its obligations. Public financial filings significantly understated repurchase obligations, thereby allowing the company to appear to be in terrific financial health when it was really not profitable. There is no doubt that the potential for fraud charges exists with respect to statements made in public filings. Prosecutors may also consider prospective securities fraud charges based on misrepresentations made to investors and bank fraud charges based on misrepresentations to banks extending lines of credit.

Defenses could include arguments that highly technical accounting concepts were in play, that executives signed off on financial disclosures in good faith, and that there was no intent to mislead investors.

Mortgage Brokers

Brokers who recommend mortgage products to borrowers have the same concerns as lenders for the purposes of investigations by regulators and prosecutors. Certainly, stand-alone mortgage brokers need not worry about the securitization process and subsequent sales to investors of bundled debt obligations. The issues surrounding brokers will be what they told borrowers about the loan products. Were the disclosures made by brokers to their clients adequate, or were they misleading? Did the brokers do enough due diligence to insure the appropriateness of the loan, or did they simply avoid learning the unpleasant truth that the mortgage was virtually impossible for the borrower to maintain?

The appraisal process is also being scrutinized. In order to proceed to closing, a property must be appraised. Brokers may refer buyers to appraisers. Lenders may themselves provide appraisal services or make referrals. Finally, appraising companies themselves are being look at very closely. If appraisals were inflated and contain misrepresentations, the appraisers, their companies, and anyone else who knew that the appraisals were false and who participated in marketing subprime loans and closing on them could be faced with criminal fraud-related charges.

Securitization Investment Banks and Broker-Dealers

Companies like New Century and Countrywide Financial not only offered loan origination, but also bundled mortgage obligations into securities instruments and resold them on the secondary market. Larger investment banks, such as Merrill Lynch, UBS, and Bear Stearns, all operated at the investment-banking level and arranged for packages of mortgages to be securitized and valued. The SEC and the U.S. Attorney's Offices for the Southern and Eastern Districts of New York have initiated investigations into the activities of all three banks. In general, these investigations focus on the manner in which subprime securities were valued. In addition, the New York State Attorney General's Office is looking into how various securities firms priced individual home loans for purchase and sale on secondary securities markets.

The former Bear Stearns suffered the collapse of two internal hedge funds, which contributed to its failure. A fund manager is being investigated by the SEC. Among the potential crimes and regulatory violations being probed is the manager having expressed 'cautious optimism' about the financial viability of Bear's subprime holdings while simultaneously moving $2 million of his own holdings from one of the funds (which later failed) into a less risky internal fund. Merrill Lynch and UBS are being investigated by the SEC as well for what they knew about the financial viability of their subprime holding and about the disclosures made to investors.

Broker-dealers that sold the investments to customers will face inquiry into the degree to which they performed due diligence on the securitized subprime loans and precisely what they told customers.

Whether there were misrepresentations, cover-ups, and crimes committed will turn largely upon complex valuation procedures and their subsequent disclosure in public financial filings. Market failure on a massive scale provides a compelling explanation that may negate concerns about fraud. It may be very difficult for prosecutors to prove intent, and certainly the widespread nature of the failures could not have been anticipated.

Accounting Firms

Accounting firms have provided complex and involved advice and service on the valuation of subprime securities and how to describe this value in public filings. Lenders and investment banks that securitize loans make money on the difference between interest paid by borrowers on their mortgages and rates paid out to investors on mortgage-backed securities. This creates value known as 'residual assets,' which must be accounted for in public filings. Announcing these assets up front by way of so-called gain-on-sale accounting has been criticized. Although it is a highly technical area, both FAS and FASB rules exist to direct accounting firms in their work in this area.

Accounting firms will have provided both advice and services in setting up procedures and reviewing public filings. The widespread failure of subprime loans has created powerful incentives for regulators and prosecutors to closely review the accounting advice given, the procedures set up, and the public filings themselves, much in the way the accounting process for options backdating was suddenly questioned, investigated, and prosecuted. Indeed, in the report by the New Century bankruptcy trustee the accounting unit of KPMG is strongly criticized and accused of accounting malpractice.

However, here again, the question of an intent to mislead will be a very real and viable avenue of explanation and may provide a strong defense for accountants and their firms. The technical nature of complex GAAP rules, and the unexpected and sudden collapse of the market for subprime securities, will provide a compelling explanation and defense.

Ratings Agencies

Agencies such as Moody's, Standard & Poor's and Fitch, which value and rate securities offerings, including bond offerings of bundled subprime mortgage packages, are among the companies being investigated in connection with this massive debt failure. Indeed, the SEC and various state attorneys general have focused on these groups and are probing to discover whether they colluded to overvalue the worth of these securities. Were ratings standards intentionally relaxed in order to promote the value of these offerings in return for compensation from the investment banks and originators that put together the offering in question?

These companies' consistently positive ratings supported the expansion of the global market for investment opportunity in high-risk subprime loans. Those marketing subprime mortgage securities needed investment-grade ratings from the agencies in order to sell offerings on a broad scale. Were the offerings intentionally overvalued?

Criminal prosecutors could bring charges of conspiracy to commit securities fraud, wire fraud, and mail fraud if they find proof of intentional, collusive overrating. However, the agencies are private, profit-driven companies that will compellingly argue that they maintain objective standards of review and are paid for their objectivity. Individual executives will in all likelihood be in a position to demonstrate that there is no proof of any quid pro quo or of positive ratings being tied to compensation.

Law Firms and In-House Counsel

Once again, the spotlight will be on lawyers and law firms in the finger-pointing game. As we have seen, and will continue to see, in the option-backdating investigations, prosecutors and regulators do not hesitate to criminally charge attorneys. Lawyers involved in the option-compensation and public-disclosure process at various companies have been charged with serious federal crimes, and a number of guilty pleas have been obtained. Lawyers and law firms were involved in providing advice and services in the marketing and securitization of subprime mortgages at every step of the process. Here again, the issue will be what lawyers knew and what the intention was in providing the advice and legal services.

Given the massive nature of the collapse and its widespread effect, closing attorneys and in-house counsel to originators, investment banks, and ratings agencies all need to be concerned that regulators and prosecutors will play the blame game.

Conclusion

The investigations into the subprime mortgage collapse are in their early stages. Companies may resolve issues with compliance agreements, settlements that include fine and restitution payments, increased corporate governance structure, and deferred prosecution arrangements. However, as was the case in the large corporate scandals earlier in this decade, and to a lesser degree in the options-backdating inquiries, it is individual executives and employees who face the real threat of criminal prosecution and jail time. Any individual involved in decision making with respect to the marketing and securitization of subprime mortgages would do well to seek the advice of experienced white-collar defense counsel as to possible exposure and potential explanation and defense.

Charles A. Ross is the principal of Charles A. Ross and Associates, and focuses his practice on white-collar criminal defense. The firm represents clients in complex criminal matters in cases involving public corruption, the RICO Act, bank fraud, bribery, government procurement fraud, antitrust, healthcare fraud, and tax and securities fraud. Ross may be reached at [email protected].