The subprime scapegoating process has resulted in a round up of the usual suspects, including directors and officers of publicly traded companies. But among other targets many aggrieved parties seem particularly keen to blame in the subprime debacle are the rating agencies.


In prior posts (most recently here), I have noted the securities claims that some investors are trying to assert against the rating agencies, notwithstanding the substantial legal barriers (about which refer here) that may exist to the rating agencies’ liability.


The urge to try to hold the rating agencies responsible has reached a creative new level in the action filed on November 17, 2008 by the National Community Reinvestment Coalition, a national coalition of over 600 community-based housing advocacy organizations, against Fitch’s and Moody’s. The complaint was filed with the Department of Housing and Urban Development’s (HUD) fair housing and equal opportunity unit.


The complaint, which can be found here, purports to be brought under the Fair Housing Act of 1968 and alleges that the defendants "facilitated, encouraged and profited from subprime loans that were designed to fail, due to unfair payment terms and borrower income levels that could not sustain home ownership based on those payment terms."


The complaint further alleges that the defendants "unlawful actions caused a disproportionate adverse impact on African Americans and Latinos." The defendants are alleged to have "facilitated…predatory real-estate transactions" through their "unwarranted ratings, which fueled and sustained subprime lending."


The defendants are also alleged to have "facilitated discriminatory conduct" because their "inflated ratings…allowed discriminatory securitized subprime loans to be originated, brokered and serviced." The defendants’ alleged role was "central" because "investors purchased securities based on their ratings," as a result of which the defendants "profited significantly." Further, the defendants "knew or should have known that the predatory practices permeated the subprime securitization market."


The complaint seeks a declaratory judgment that the rating agencies violated the FHAA, a permanent injunction requiring the agencies to "take all affirmative steps necessary to remedy the effect of the illegal, discriminatory conduct"; and to award NCRC compensatory damages "for the frustration of mission and diversion of resources" the defendants’ conduct allegedly caused.


In its November 18, 2008 press release announcing the complaint (here), NCRC states that if HUD "does not adequately address the issues in the complaint," then the NCRC "will consider civil litigation."


According to a November 29, 2008 Washington Post article describing the complaint (here), the complaint did not name S&P as a third defendant, because the NCRC is "in discussions" with S&P. However, the article also quotes an NCRC source as saying that if discussions with S&P are "unsatisfactory," the NCRC could institute a separate proceeding against S&P.


The NCRC complaint belongs in a category with the nuisance lawsuit the City of Cleveland filed against the major investment banks (about which refer here). Both actions involve novel legal theories, and both attempt to scapegoat downstream deep pockets for the consequences of upstream transactions. Both depend entirely on simplistic causation analyses that disregard the multitude of causes that contributed to the subprime mess.


These blame casting exercises may gratify claimants or even provide catharsis, but these exercises in creative lawyering (and I do not mean that as a compliment) will do little, other than contributing friction costs, to affect the current deplorable conditions in the housing market. To be sure, there are no easy solutions in these circumstances, but simplistic litigation definitely does not help.


Where Were the Auditors?:  A December 1, 2008 article entitled "Subprime Suspects" (here) takes a look at the likelihood that litigants will seek to blame auditors for the financial meltdown. The article notes that while claimants undoubtedly will pursue the auditors, "it’s far from clear what burden they will bear – or even what they did wrong."


One school of thought claims the auditors "are at fault for overlooking inflated asset valuations during the mortgage bubble." The other camp says that the "auditors were doing fine until they forced banks to take overly severe write-downs on assets, based on fears that they would face punishment from regulators."


The article suggests that the audit firms "may yet prove bulletproof" because of the difficulty even proving misconduct at their financial institution clients. The firms, however, are likely to face further litigation and are in any event facing their own challenges as a result of the disruptions in the financial and economic marketplace.


Investors Sue Over Mortgage Loan Workouts: In an earlier post (here), I noted the objections investors have raised to the various mortgage modification proposals designed to provide relief to distressed homeowners. I specifically noted concerns investors had raised about the Bank of America’s regulatory settlement in which the bank proposed to restructure over 400,000 mortgages the Countrywide Financial Corporation had originated prior to being acquired by BoA.


As discussed in a December 1, 2008 Business Week article (here), mortgage investors have now initiated a purported class action lawsuit alleging that the proposed modification of the Countrywide mortgages is illegal. The article quotes the lawsuit plaintiff as saying "while these loan adjustments may help to keep struggling borrowers in their homes," the alterations "run the risk of permanently damaging the secondary market for housing finance."


The investor ‘s lawsuit in New York (New York County) Supreme Court seeks a judicial declaration that under the terms governing the mortgage trust holding the securitized mortgages, "Countrywide is required to purchase any loans on which it agrees to reduce the payments." A copy of the state court complaint can be found here.


Special thanks to David Grais of the Grais & Ellsworth firm (which represents the plaintiff in the declaratory judgment action) for providing a copy of the state court complaint.


The investors clearly are committed to having their concerns about the mortgage modifications heard. The political pressure to provide mortgage relief is substantial. However, there does seem to be reason to be concerned whether future investors will be interested in investing in this class of assets if the investment agreements can be unilaterally altered.


Lehman Excavation: The November 30, 2008 issue of New York Magazine has a cover article entitled "Burning Down His House" (here) about the fall of Lehman Brothers and the role of Lehman CEO Richard Fuld in the firm’s collapse. The article raises the question whether Fuld is a dupe or a victim; the article says:


He held on to 10 million shares of Lehman stock until the end and lost almost $1 billion – "He drank the Kool Aid," said one executive. And consensus grows that the Lehman fall was one of Treasury Secretary Henry Paulson’s and Fed chairman Ben Bernanke’s biggest mistakes.


Professor Ribstein, on his Ideoblog (here), citing the article’s statement that Lehman was "in a financial condition that was even worse than critics suspected," interprets the article as suggesting that Fuld may be the "next loser in the corporate crime lottery."


Hat tip to the Securities Docket blog (here) for the link to the New York Magazine article.