The Global Subprime Crisis and State Attorney General ...



From PLI’s Course Handbook

The Global Subprime Crisis: Issues You Need to Know

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7

the global subprime crisis and

state attorneys general—The

“New” Regulators

Bernard Nash

Dickstein Shapiro LLP

The Global Subprime Crisis and State Attorneys General – The “New” Regulators

By Bernard Nash, Dickstein Shapiro LLP

Bernard Nash is the head of the State Attorneys General Practice of Dickstein Shapiro LLP, the largest in the country and has been recognized by Chambers USA as the “leading practitioner in the country” for State Attorney General issues.

The Global Subprime Crisis and State Attorneys General – The “New” Regulators

By Bernard Nash, Dickstein Shapiro LLP

Over the past two decades, State Attorneys General (AGs) have significantly increased the number of investigations and litigations they have brought against U.S. businesses. This increase is due to, among other things, a perceived lack of federal law enforcement motivating AGs to “fill the void,” as well as the increasing tendency of states to join together to coordinate activity through “multi-state” actions. AGs have used state and federal antitrust, securities, environmental, consumer protection, and predatory lending laws to bring high-profile cases against both small local companies and across a number of industries.

Many of the largest investigations and cases AGs have brought are aimed at affecting change in federally regulated industries previously thought to be within the sole province of federal regulators. There is little reason to believe that there will be a slowdown any time soon; to the contrary, there is every indication that AG activity will increase, particularly in light of the continuing subprime crisis.

Several high-profile cases – which have generated billions of dollars in settlement payments from the targeted industries – illustrate the breadth of AG enforcement efforts, including the 1998 $368 billion tobacco Master Settlement Agreement with major cigarette companies, $1.6 billion in settlements with mutual fund companies to resolve claims alleging fraud against investors, and a $156 million multi-state settlement over allegations of off-label marketing of prescription drugs.

Two of the major multi-state settlements, both in terms of value and the sweeping reforms agreed to, were the $484 million settlement with Household Finance in 2002 and the $325 million settlement with Ameriquest in 2006, both of which were among the largest subprime lenders at the time. These settlements were reached after extensive joint investigations by dozens of AGs pursuant to state predatory lending laws. The agreements required the companies to not only pay restitution to customers in all or nearly all fifty states, but also to substantially overhaul their business practices and loan provisions.

Building on the success of the Ameriquest and Household Finance settlements and in response to the global subprime crisis, AGs recently have focused on participants in both the subprime mortgage lending market and the mortgage backed securities market.

The subjects of AG inquiry, investigation, litigation and legislative proposals include subprime lenders, loan servicers, property appraisers, investment banks and financial rating agencies, among others. AGs, as elected officials, have concentrated on consumer protection and shielding their states’ citizens from the detrimental effects of the downturn in both the subprime lending market and the mortgage backed securities market. Not surprisingly, AGs’ highest priority has been to stem the tide of foreclosures. Also of concern to AGs is protecting investors in light of the large write-offs taken by many investment institutions.

AGs will continue to represent consumer interests in their investigations, and participants in all aspects of subprime lending will have to account to AGs as their “new” regulators, as well as to their federal regulators.

AGs’ Actions Against Subprime Lenders

Similar to their investigations of Ameriquest and Household, AGs are investigating and litigating against lenders using predatory lending laws. AGs are also using other laws which give them enforcement powers such as antitrust, fraud and consumer protection.[1] In addition, at least one AG is also investigating whether lenders violated civil rights laws after a published study found that minorities were given high-cost loans more often than other borrowers.[2] Despite these well-publicized efforts, many subprime lenders and the companies that support them initially resisted collaborating with AGs to ameliorate the subprime crisis, often to their detriment.

1 Litigation against Subprime Lenders and Appraisers

On the litigation front, at least seven AGs have issued subpoenas, and are investigating and litigating against subprime lenders, large and small, including such companies as Fremont General, Countrywide, and Wells Fargo.[3] In an effort to halt foreclosures in her state, Massachusetts AG Martha Coakley obtained an injunction in a Massachusetts circuit court against Fremont General that mandates that it give the AG thirty days notice before foreclosing on loans that are “presumptively unfair” and allows the AG to object to the foreclosure. Furthermore, if the property is also the borrower’s principal dwelling, the AG has forty-five days to object to the foreclosure. The lender may only foreclose on a loan that the AG objects to if a judge concludes that foreclosure is appropriate.[4] This injunction was recently upheld by the Massachusetts Appeals Court.[5]

New York AG Andrew Cuomo and former Ohio AG Marc Dann have taken a different tack and began investigations into whether lenders and appraisal companies pressured appraisers to inflate home values. At least one such case has been filed against an appraisal company.[6]

2 AGs’ Non-Litigation Efforts to Prevent Foreclosures

Not all AGs are litigating in the first instance. Many AGs are taking on the role of consumer counselor and are encouraging borrowers that are having trouble meeting their mortgage payments to call their lenders to modify their loans and, if necessary, enter mediation.[7] In Ohio, the State also attempted to reach an agreement with lenders that would prevent foreclosures and encourage loan modifications.[8] However, when the lenders declined to agree, former AG Dann issued subpoenas to those lenders and the investigation continues even though a number of lenders have now signed the agreement.[9]

Iowa AG Tom Miller, who led the investigations of Household Finance and Ameriquest, created a state task force to address the impact of subprime loans on homeowners that is comprised of the AGs from Arizona, California, Colorado, Illinois, Iowa, Massachusetts, Michigan, New York, North Carolina, Ohio and Texas, as well as bank regulators from North Carolina and New York. [10] The task force invited more than a dozen of the largest subprime mortgage servicing companies to a summit where they advocated loan modifications in lieu of foreclosures. The task force also has been meeting on a regular basis and actively lobbying Congress not to enact federal laws that would preempt state authority to establish future lending standards.[11]

On February 6, 2008 and April 22, 2008, the task force issued reports examining the restructuring practices of loan servicers. The reports concluded that the majority of seriously delinquent borrowers are not receiving assistance, lenders have increased loan modification options, and homeowners are catching up on back payments, preventing most foreclosures. In addition, the working group concluded that “serial refinancing” will not resolve the crisis because of the lack of loan products available and falling home prices. The working group also found that most foreclosures are not a result of the first adjustment on subprime hybrid ARMs, but that many of those loans are delinquent prior to the reset. [12] Despite its findings that certain lenders are working with borrowers to modify loans, the reports both concluded that further steps need to be taken by lenders to resolve the crisis.

It is apparent that AGs are and will continue to be a major force in the regulation of the global subprime crisis. This was reinforced by the U.S. Department of Justice’s recent announcement that it would not form a federal task force to investigate subprime lending fraud because it considers the crisis to be essentially local in character. U.S. Attorney General Michael Mukasey emphasized that he believes local jurisdictions are in the best position to litigate these matters.[13] Lenders, even those that are federally-regulated, and companies that support lending activities must include AGs in their litigation and government relations strategies going forward in order to secure a comprehensive resolution of the subprime crisis. Therefore, lenders must be prepared to deal with AGs.

AGs and the Mortgage Backed Securities Market

AGs also have stepped beyond predatory lending laws and are examining nearly every facet of the mortgage backed securities market, from the creation of the securities by underwriters to their sale to pension funds and other investors. To that end, AGs have subpoenaed participants in the mortgage backed securities market, such as credit rating agencies, firms that provide due diligence to investment banks and the investment banks themselves.[14]

1 AGs’ Power to Investigate Federally-Regulated Financial Institutions

AGs are asserting the right to investigate financial institutions who participated in the mortgage backed securities market under a number of state laws. In particular, New York AG Andrew Cuomo, like his predecessor Eliot Spitzer, is using his powers under the Martin Act, the broad and powerful New York financial fraud law, to gather information on all aspects of the mortgage backed securities market. For example, AG Cuomo subpoenaed the three major credit rating agencies, Moody’s Investor Service, Standard & Poor’s and Fitch, Inc., regarding how they rated certain mortgage backed securities. Recently, AG Cuomo reached a settlement with all three companies that alters how they are compensated by investment banks and requires that investment banks provide due diligence information on the underlying loans prior to the issuance of any ratings of mortgage backed securities.

In addition, AG Cuomo subpoenaed investment banks such as Bear Stearns, Deutsche Bank, Merrill Lynch, Morgan Stanley, and Lehman Brothers among others, seeking information about whether the investment banks adequately assessed the risk of mortgages packaged and sold to investors. AG Cuomo has secured the cooperation of Clayton Holdings, a company that provides due diligence on mortgage pools for investment banks, in the investigation. [15]

In Ohio, the AG brought a derivative class action against Freddie Mac on behalf of the state pension fund, which owned stock in Freddie Mac. New York state authorities have also brought a derivative action against Countrywide on behalf of New York’s pension fund, as well as two accounting firms for allegedly enabling Countrywide to release false statements regarding its financial health.[16]

Because AGs’ powers to bring suit against federally-regulated investment banks are not unfettered,[17] many are finding creative ways to institute reforms, such as investigating and reaching settlements with companies that provide support to the investment banks. These settlements, such as the New York agreement with the credit rating agencies mentioned above, may contain provisions that substantially affect banks’ business practices and indirectly force them to make sweeping changes in how they conduct business.

2 The “New Home Valuation Protection Code”

Among the more well-publicized and contentious investigations brought by AGs against financial institutions was New York AG Cuomo’s investigation of Fannie Mae and Freddie Mac. AG Cuomo subpoenaed Fannie Mae and Freddie Mac for information on what they “might have known about possible home value inflation.” In a letter accompanying the subpoena, AG Cuomo strongly suggested that both entities suspend all business with one of the largest subprime lenders in the country.[18] Initially, there were numerous heated exchanges in the press between the Office of Federal Housing Enterprise Oversight (OFHEO), Fannie Mae’s and Freddie Mac’s regulator, and AG Cuomo which questioned the AGs’ authority to investigate the two institutions.

Despite the contentious nature of the investigation, it eventually ended after both entities agreed to establish the “New Home Valuation Protection Code” that sets standards for appraisers and eliminates conflicts of interest in the relationship between home appraisers and lenders. Fannie Mae and Freddie Mac agreed that they will not purchase loans from lenders who do not abide by these standards. In addition, the settlement creates an independent organization that will implement the Code.[19]

This agreement has been criticized by federal bank and thrift regulators because they believe it may have unintended adverse consequences. Namely, federal regulators are concerned that the Code will undermine instead of enhance the quality and reliability of appraisals, raise origination costs, disrupt the mortgage appraisal process, and interfere with federal efforts to restore credit availability and confidence in the mortgage and housing markets.[20] A number of groups also have called for a lawsuit to be filed blocking the Code from taking effect because it has not been subject to public scrutiny and comment. Neither AG Cuomo nor OFHEO has responded to these criticisms.

Regardless of the controversies surrounding their investigations into the mortgage backed securities market, AGs are expected to continue their regulatory efforts. AGs likely will aggressively pursue many avenues to protect their citizens from investor fraud and foreclosures including issuing subpoenas and investigating banks and other entities. Therefore, similar to lenders, investment banks need to account for AGs in their assessments of both potential private litigation (states as stockholders) and enforcement and regulation efforts.

Working with State Attorneys General

As they did with respect to the tobacco, securities, mutual fund, and pharmaceutical industries, AGs are now at the forefront of regulating the subprime mortgage industry, including the mortgage backed securities market. As a result of AGs’ increasing aggressiveness, many businesses have recognized that they must have an AG strategy and that working with AGs requires different strategies than those employed in commercial or federal government investigations or litigations. Those that have been most successful in dealing with AGs have taken proactive steps to incorporate AG relationship-building into their government relations and legal agendas. Working proactively with AGs can help a company (or an industry) avoid becoming a target of an AG or a group of AGs, can help respond to AG concerns before negative headlines or litigation, and can facilitate solutions before, during, and after litigation.

The most effective way for a company to avoid becoming a target of an AG or a multi-state AG coalition, or to resolve a dispute before litigation, is to engage in AG outreach. For example, there are a number of AG-related organizations that facilitate interactions among AGs and private industry. The four principal AG organizations are the bipartisan National Association of Attorneys General, the bipartisan Conference of Western Attorneys General, the Republican Attorneys General Association, and the Democratic Attorneys General Association. Each of these organizations has meetings throughout the year, and each provide the opportunity to interact with AGs.

An effective AG outreach program is significantly different from a federal government relations strategy because, unlike investigations by federal regulators, there are political and policy aspects to some AG investigations. If your company has received an inquiry, sensitivity to those issues as well as open and direct communication and quick and accurate responses to AG concerns can resolve an investigation before it progresses to litigation. A successful AG strategy should involve awareness of political and policy concerns of both the inquiring AG and the AGs of other states that may have an interest in the issue. Cooperating with AGs and being responsive and straightforward will build trust and respect that will serve a company well in the long term.

AGs are poised to again make their mark as the new regulators that “reform” the subprime lending and mortgage backed securities markets. AGs likely will reach agreements with companies that include provisions to change common practices and institute codes of conduct. AGs also likely will pursue significant monetary settlements and the reformation of large numbers of loans on behalf of the citizens of their states.

Subprime lenders, those who have worked with subprime lenders, financial institutions that participated in the mortgage backed securities market and companies that supported those financial institutions would be well advised to prioritize an AG strategy and AG outreach. Not to do so would be akin to allowing a default judgment in a “bet your company” litigation.

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[1] See e.g. Press Release, Attorney General Dann to File Subpoenas as Sub-Prime Investigation Continues, November 8, 2007, available at .

[2] Ruth Simon, Illinois Probes Mortgage Firms – State Asks Whether Minority Borrowers Were Bias Victims, WSJ, March 7, 2008; Press Release, Illinois Attorney General Madigan Issues New Subpoenas to Countrywide and Wells Fargo, March 6, 2008.

[3] Paul Menchaca, States Weigh Legal Action Against Lenders: Ohio, Massachusetts Among States Accusing Lenders of Deception, Asset Securitization Report, October 22, 2007.

[4] Press Release, Attorney General Martha Coakley Obtains Preliminary Injunction Against Subprime Lender Fremont Investment and Loan, February 26, 2008.

[5] Mass. Upholds Ruling to Halt Fremont Foreclosures, Reuters, May 5, 2008.

[6] New York v. First American Corp., No. 406796-2007 (N.Y. Supreme Ct. November 1, 2007) (removed to Federal District Court, New York v. First American Corp., 07-CV-10397 (SDNY)); see also Press Release, NY Attorney General Sues First American and Its Subsidiaries for Conspiring with Washington Mutual to Inflate Real Estate Appraisals, November 1, 2007; Regulators’ Subprime Mortgage Cases, Birmingham News, February 19, 2008.

[7] See e.g., Press Release, Miller Organizes Foreclosure Project to Prevent Flood of Foreclosures, September 11, 2007.

[8] Stephen Majors, Ohio to Issue Subpoenas to Subprime Lenders Friday, November 9, 2007.

[9] Id.

[10] Ruth Simon, Task Force Will Seek More Loan Revisions, WSJ, September 8, 2007.

[11] Id.

[12] State Foreclosure Prevention Working Group, Analysis of Subprime Mortgage Servicing Performance: Data Report 1, February 2008; State Foreclosure Prevention Working Group, Analysis of Subprime Mortgage Servicing Performance: Data Report 2, April 2008.

[13] Eric Lichtblau, Mukasey Declines to Create a U.S. Task Force to Investigate Mortgage Fraud, N.Y. Times, June 6, 2008.

[14] Regulators’ Subprime Mortgage Cases, Birmingham News, February 19, 2008.

[15] Kate Kelly, Amir Efrati, Ruth Simon, State Subprime Probe Takes Another Look, WSJ, January 31, 2008; Kara Scannell, Credit Crunch: Wall Street Firms are Subpoenaed – New York Examines Treatment of Debt Tied to Risky Mortgages, WSJ at C2, December 5, 2007.

[16] Joan Gralla, NY Expands Countrywide Suit with more Defendants, Reuters, January 25, 2008.

[17] OCC v. Spitzer, 396 F. Supp. 2d 838 (S.D.N.Y. 2005) aff’d The Clearing House Assoc. & OCC v. Cuomo, No. 05-5996-cv & No. 05-6001-cv, slip op. (2d Cir. Dec. 4, 2007) (holding that AGs are preempted from using state law to prosecute national banks). This follows the Supreme Court’s April 2007 decision that state bank regulators may not subject federally chartered banks and their wholly owned subsidiaries to state laws and regulations. Watters v. Wachovia Bank, N.A., 127 S.Ct. 1559 (2007).

[18] GSE Regulator Raps Cuomo Over Investigation, Reuters, November 8, 2007.

[19] Press Release, New York Attorney General Cuomo Announces Agreement with Fannie Mae, Freddie Mac, and OFHEO, March 3, 2008.

[20] Marcy Gordon, Regulator Protests Fannie, Freddie Appraisal Deal, Associated Press, May 27, 2008.

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