Is there a legal defense to the mortgage mess?
Anthony Lendez and David Hille / Special to The National Law Journal
April 21, 2008
Securities class actions continue to mount against subprime mortgage lenders and Wall Street
firms that packaged and resold subprime mortgage loans as mortgage-backed securities. The
U.S. Securities and Exchange Commission (SEC) and other regulatory bodies are investigating a
number of companies that operate (or operated) in the market for subprime mortgage loans. In
reaction to this wave of litigation, law firms have formed subprime task forces and teams to deal
with the onslaught of litigation and governmental investigations, as well as corporate
restructurings, bankruptcy filings and asset sales resulting from the subprime mortgage market
A number of these lawsuits are directed at the accounting practices of mortgage lenders. For
example, in some of these lawsuits, plaintiffs allege that the mortgage lenders issued financial
statements that were materially misleading, in violation of the federal securities laws, because
their results were based on defective estimates and assumptions due to a lack of proper internal
controls. Among the relevant accounting practices, the plaintiffs focus on establishing estimates
for allowances for loan losses, mortgage servicing rights, residual interests and loan repurchase
Many of the accounting practices at issue in these lawsuits involve traditional accounting
estimates, which, because they are estimates, will almost always differ from actual results. These
differences can be significant if future events vary sharply from the assumptions used to arrive at
the estimates. Accounting estimates also are based on subjective as well as objective factors and,
as a result, involve considerable judgment.
Generally Accepted Accounting Principles (GAAP) recognize that changes to accounting
estimates are a necessary component of producing financial statements and that subsequent
changes to estimates do not necessarily mean a company's previously issued financial statements
were not properly stated. In particular, the Financial Accounting Standards Board (FASB) has
specified that, "[a] change in accounting estimate is a necessary consequence of the assessment,
in conjunction with the periodic presentation of financial statements, of the present status and
expected future benefits and obligations associated with assets and liabilities. Changes in
accounting estimates result from new information." FASB Statement No. 154, Accounting
Changes and Error Corrections, FAS 154 ¶2(d).
In contrast, errors in previously issued financial statements result "from mathematical mistakes,
mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the
financial statements were prepared." FAS 154 ¶2(h).
A number of the recent subprime lawsuits have alleged federal securities law fraud claims
against mortgage lenders and their managers and directors under §§ 10(b) and 20(a) of the
Securities Exchange Act of 1934 and §§ 11 and 15 of the Securities Act of 1933.
To show a violation of 10(b), the plaintiff must show that it was damaged by a material
misstatement or omission made by the defendant in connection with a securities transaction with
"scienter," or fraudulent intent. Although violations of GAAP may provide evidence of scienter
when the violation resulted in "widespread and significant inflation of revenue" — see In re
Daou Sys. Inc. Sec. Litig., 411 F.3d 1006 (9th Cir. 2006) — GAAP violations and accounting
irregularities must be coupled with evidence of "corresponding fraudulent intent" to state a
securities fraud claim. Novak v. Kaskas, 216 F.3d 300 (2d Cir. 2000).
The fact that accounting estimates prove to be inaccurate does not necessarily establish
fraudulent intent. One recent case involving accounting-based allegations against a subprime
mortgage lender was dismissed without prejudice because the facts as alleged implied that the
defendants "were simply unable to shield themselves as effectively as they anticipated from the
drastic change in the housing and mortgage markets." See Order, Tripp v. IndyMac Bancorp Inc.,
No. CV 07-1635, 2007 WL 4591930, at *6 (C.D. Calif. Nov. 29, 2007).
Put another way, the fact that the mortgage lenders' loan-loss reserves and other accounting
estimates proved inaccurate did not give rise to a sufficient inference that the defendants had
fraudulent intent in preparing their accounting estimates. The court ruled that an inference of
fraud also was unwarranted because the defendants amended their financial statements "once that
inability became evident" (id.), which is consistent with the principles underlying FAS 154.
If a 10(b) claim is established against a mortgage lender, its managers and directors may face
liability under § 20(a) of the 1934 act, which applies to anyone who "controls" a party that has
committed securities fraud. However, § 20(a) explicitly provides that "control persons" can avoid
liability by proving that they acted in good faith (generally interpreted to mean acting without
recklessness) with regard to the securities violation.
Section 11 of the 1933 act applies only to statements made in or omitted from securities
registration statements, but imposes liability on a wide range of defendants, including the
company, its officers, directors, accountants, underwriters and anyone else who signed the
registration statement. Scienter is not an element of a claim under § 11 and "good faith" is not a
defense for issuers, which essentially are subject to strict liability. In general, however, a
director, officer or outside experts may avoid liability if he or she conducted "reasonable" due
diligence on the portion of the statement he or she helped prepare. Section 11 provides the
standard for reasonable due diligence as that "required of a prudent man in the management of
his own property."
Thus, key issues in these mortgage-lender lawsuits will be whether certain defendants made a
good-faith and reasonable effort to arrive at the accounting estimates used to account for the
company's assets and liabilities, taking into consideration information that existed at the time the
estimates were made.
The significant changes in market conditions that occurred during 2007 will be the lens through
which many of the mortgage lenders' accounting estimates are viewed in these cases. Take, for
example, the allowance for loan losses and the effect that changes in the trend of real estate
values and foreclosures in 2007 may have had on the level of allowances previously established
by a given lender.
Allowances for loan losses are established for loans that were maintained on the mortgage
lenders' books and classified on their balance sheets as "loans held for investment." These are
loans that were not sold to investors either through whole-loan sales or securitizations that
qualified for sale treatment. For loans held for investment, mortgage lenders are required to
establish an allowance for loan losses based on their estimate of losses inherent and probable in
their loan portfolios at the balance sheet date. Lenders attempt to project expected loan losses by
estimating how many of the loans will default and how much of the loan balances will be lost in
the event of default. Lenders consider a number of factors in arriving at these estimates,
including, for example, the current performance of the loans (current, delinquent, in default, in
foreclosure), the characteristics of the loans, the value of the underlying collateral and general
economic conditions. Analysis of this information typically is based on the lender's historical
experience, taking into consideration factors not yet reflected in the historical data, such as trends
in real estate values, economic trends and changes in underwriting standards, among other
Accounting for the market
Real estate values can have a significant influence on the level of the allowance for loan losses
established by mortgage lenders. If a lender forecloses on a home during a period when real
estate values are rising or are fairly stable, it may be able to sell that home for a price that
reasonably approximates the amount owed on the mortgage. This environment suggests that a
lower (or perhaps no) allowance for loan losses would be necessary. In contrast, if real estate
prices are declining, the lender ultimately may sell the home in foreclosure for less than the
amount owed on the mortgage, thereby suggesting the need for a higher allowance for loan
losses. Consequently, consideration of the changes in the trend of real estate values is important
because many of the accounting estimates reflected in the financial statements of mortgage
lenders are affected by such trends, including the allowance for loan losses.
The S&P/Case-Shiller U.S. National Home Price Index from 2000 through the end of 2006
shows that, generally speaking, real estate values either increased or remained relatively stable
during this period, declining slightly in the latter half of 2006. In estimating allowances for loan
losses, mortgage lenders likely would have considered their own historical experience and
adjusted those data for trends in economic conditions, including real estate values. Because real
estate values had been increasing or relatively stable for years and did not demonstrate any
significant deviations from past trends, mortgage lenders likely will assert that it would have
been difficult to justify allowances for loan losses that were inconsistent with these trends. In
fact, if mortgage lenders had established allowances for loan losses that were higher than deemed
necessary based on known market conditions and trends, they could have been accused of
creating "cookie jar reserves" (i.e., reserves recorded in good periods to offset potential future
bad periods), which have been criticized by the SEC as potentially misleading.
Real estate values did show some sign of weakening in late 2006, but it was in 2007 that values
really began their persistent and ultimately precipitous decline, as reflected in the S&P/Case-
Shiller U.S. National Home Price Index. Id. This change in trend contributed to the significant
increases in allowances for loan losses established by mortgage lenders throughout 2007.
Foreclosure rates are another factor that can have a significant effect on the level of allowances
for loan losses established by mortgage lenders. During 2007, foreclosure rates were at historic
high levels in many areas in the United States. According to a report released by RealtyTrac in
January 2008, foreclosure filings during 2007 (for example, default notices, auction sale notices
and bank repossessions) were up by 75% from 2006, with more than 1% of all U.S. households
in some stage of foreclosure during the year — up from 0.58% in 2006. This trend also likely
contributed to the substantial increases in allowances for loan losses established by lenders
Some of the subprime mortgage lender lawsuits assert that the aggressive underwriting standards
applied to subprime mortgage loans should have put the mortgage lenders on notice that they
needed to establish higher allowances for loan losses because they knew subprime borrowers
with questionable credit histories would default on their loans. Mortgage lenders are likely to
argue in response that changing market conditions in 2007 significantly altered the mix of data
that would have been used by mortgage lenders to estimate their allowances for loan losses.
Before 2007, actual loan losses had been unusually low in most U.S. real estate markets for an
extended period of time. As a result, mortgage lenders projected lower losses for their loans —
even for their risky loans. Given their historical experience with subprime loans, the mortgage
lenders are likely to argue that they could not have reasonably anticipated the events that
unfolded during 2007.
Before 2007, the subprime mortgage market appeared to have been working fine as long as real
estate values continued to increase. When subprime borrowers needed to refinance their
adjustable-rate mortgages to avoid higher monthly payments, they had no difficulty finding
suitable loan programs, particularly since the appraised value of the real estate typically
exceeded the loan amount. Moreover, mortgage lenders had little difficultly selling subprime
loans for packaging in mortgage-backed securities, generally at a net premium, because they
carried higher interest rates. Because a number of the subprime loans were sold shortly after they
were underwritten, mortgage lenders did not retain these loans on their balance sheets for
investment purposes, thereby obviating the need for any loan-loss allowance.
However, the economic environment began to change radically in 2007. First, many subprime
borrowers could no longer refinance their adjustable-rate loans because they were unable to find
suitable loan programs and/or their mortgages had high loan-to-value ratios due to declining real
estate values. Unable to afford the higher monthly payments when the adjustable-rate mortgages
reset to a higher interest rate, many subprime borrowers defaulted on their loans or simply
walked away from their homes, placing further pressure on real estate values.
The market for mortgage-backed securities also contracted sharply in 2007. As a result,
mortgage lenders were no longer able to readily sell their loans to Wall Street, prompting many
lenders to retain their loans as investments and requiring them to establish allowances for loan
losses. Given the state of the real estate market and growing rate of foreclosures at this time,
significant provisions for loan losses often were made.
The effects of the foregoing changes in market conditions were not just isolated to the level of
allowances for loan losses. They also affected the estimated value of other assets and liabilities
on the mortgage lenders' balance sheets, such as mortgage services rights and residual interests,
the values of which are based on cash flow assumptions that are tied into estimates relating to the
loans' expected losses and prepayment speeds (in this instance, influenced by a greater number of
foreclosures relative to refinancings). These market conditions, in turn, affected the values of
mortgage-backed securities that were collateralized with subprime loans, prompting investors to
significantly write down their values. Those write-downs could reach $300 billion to $400
billion, according to Deutsche Bank A.G. analysts, as reported last year.
Subprime litigation is still in its relatively early stages, and the cases no doubt will unfold in
some unexpected ways. In cases involving challenges to loan-loss reserves and other accounting
estimates, however, it seems very likely that a key battle will be over when and to what extent
mortgage lenders should have identified and built into their accounting estimates the market
changes that have recently rocked the U.S. housing market.
The parties will need capable experts to analyze and explain the S&P/Case-Shiller and other
statistical indices and market data, as well as accounting and other industry experts to help
interpret the relevant accounting estimates. Courts around the country will need to sort out
whether mortgage lenders dropped the ball or whether their only sin was not having one made of
Anthony Lendez, a certified public accountant and certified fraud examiner, is a partner at BDO
Consulting, a division of BDO Seidman LLP. David Hille is a litigation partner in the New York
office of White & Case. White & Case associate Adam Burton contributed to this article.