Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

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 As I have previously observed, the current credit crisis is about more than subprime loans. Among the other kinds of credit are so-called Option ARMs, which frequently involve prime borrowers. These loans are adjustable rate mortgages where the borrower has the option of paying less than the full amount of interest due, with the unpaid balance added to the principle (that is, the loan can negatively amortize). My prior post describing and discussing the nature of Option ARM loans can be found here.

This negative amortization payment feature of Option ARMs only makes sense (if at all) at a time of rising home prices. At a time of declining home values, it can quickly put the borrower in a position where they owe more than the value of their home. As unattractive as this position is, it can get worse when the interest rate adjusts upwards, leaving the borrower in a position of paying even more to stay in a home that is worth less than the mortgage debt.

Unsurprisingly, borrowers are having difficulties with Option ARM loans, which in turn is leading to problems for lenders with Option ARM portfolios. These problems in turn are leading to litigation.

The latest company to be sued in a securities class action lawsuit arising out of problems with Option ARM loans is Wachovia Corporation, which was sued, together with certain of its directors and officers, on June 6, 2008 in the United States District Court for the Central District of California. The plaintiffs’ lawyers’ June 9, 2008 press release about the lawsuit can be found here. The complaint can be found here. UPDATE: As correctly noted in the reader comment, this case is actually pending in the Northern District of California, rather than the Central District as original text incorrectly stated.

According to the press release, the complaint alleges that:

Defendants misled investors by falsely representing that Wachovia had strict and selective underwriting and loan origination practices and a conservative lending approach that set it apart from other lenders. Such reassurances were repeated by defendants throughout the Class Period in order to artificially support Wachovia's stock price in the midst of a weakening mortgage market. In response to increased market concern with the mortgage lending industry, and Wachovia's option ARMs in particular, Wachovia falsely represented that its loan underwriting practices were much better than at other banks and that this would allow it to prosper while lenders with less exacting standards and procedures would fare much worse. In reality, Wachovia's actual lending practices differed materially from the description of those practices in statements made to investors. The Company's ability to weather the deterioration in the real estate and credit markets was grossly exaggerated by Defendants, at precisely the worst time, when analysts began to ask tough questions. The Company, moreover, had inadequate loan loss reserves and falsely represented that its capital position was sufficient to fund its dividend.

Shortly after last assuring the market of its liquidity, the strength of its underwriting practices, and the adequacy of its reserves, Wachovia reported a surprise quarterly loss, undertook emergency measures to increase capital, and cut its dividend. On April 14, 2008, before the open of ordinary trading, Wachovia reported a loss of $350 million, or $0.20 per share, for the first quarter of 2008. The Company attributed the results to: (1) a $2.8 billion increase credit loss reserves, including $1.1 billion specifically for ``Pick-A-Pay'' reserve build, the lending program highly touted by the Company during the Class Period. The need to increase Pick-A-Pay reserves was attributed to Wachovia's adoption of a ``refined reserve modeling'' that resulted in ``higher than expected loss factors on Pick-a-Pay''; and (2) $2 billion in mark-to-market losses for mortgage backed securities, including a ``$729 million loss on unfunded leveraged finance commitments.'' In order to shore-up its capital, Wachovia announced the following steps: (1) reduce the dividend 41% to $0.375; and (2) plan to raise capital by $7-8 billion through public offerings.

Wachovia is only the latest company to become embroiled in securities litigation arising out of Option ARM problems. Companies previously sued in securities lawsuits involving Option ARM allegations include Washington Mutual (about which refer here) and Downey Financial (refer here). It seems highly unlikely that these companies will be the only ones to become involved in lawsuits involving these concerns.

Indeed, as bad as the situation involving Options ARMs may now appear, circumstances are likely to deteriorate in the months ahead. As discussed in the June 5, 2008 Business Week article entitled “The Next Real Estate Crisis” (here), foreclosures on Options ARMs have already tripled in the last year, but could further hasten as “monthly options recasts are expected to accelerate starting in April 2009, from $5 billion to a peak of about $10 billion in January 2010.” The Option ARM loan defaults “could accelerate next year even if subprime defaults subside.”

The possibility of further Option ARM related securities litigation seems likely.

In any event, I have added the new Wachovia case to my running tally of subprime and credit-crisis related securities class action lawsuits, which can be accessed here. The current tally now stands at 89, of which 49 have been filed in 2008.

It is probably worth noting that this new case is the third in which Wachovia has become involved as part of the current credit-crisis related litigation wave. In addition to the new lawsuit, Wachovia was previously sued in an auction rate securities lawsuit (refer here), and in a Prospectus Liability case arising out of the company’s offering of certain Trust Preferred Securities (about which refer here).