Over a year into the credit crunch, the hits just keep on coming. The first to take the hit were the front-line Main Street lenders, mortgage companies and financial-oriented REITS (lenders, for ease of reference), then came Wall Street underwriters and the Government Sponsored Enterprises Fannie Mae and Freddie Mac, and now the contagion appears likely to spread into other areas of the United States economy and possibly the world.
The severity of this storm and the speed with which it hit largely defies description, but words such as surreal, frightening and unprecedented come to mind. However, the storm waters eventually will recede and the dust will clear (and not a minute too soon). When it does, the more fortunate will be tasked with sorting out the cards. For better or worse, this means litigation in many cases. With the recent acquisitions, bankruptcies and government interventions, it is not clear who will be suing whom. However, whether it is borrowers, distressed asset funds, bankruptcy trustees, creditors committees or the modern day Resolution Trust Corporation, it appears likely that much of that litigation will be centered around the Main Street lenders and their directors and officers.
One area of particular concern for Main Street lenders engaged in an originate-to-sell model is repurchase agreements. Loans sold to Fannie Mae or other investors are typically subject to repurchase agreements that purport to obligate the originator or seller of the loan to buy back the loan in the event of early payment default, fraud or other underwriting irregularities. Whether the loan which the lender is being asked to repurchase meets the applicable criteria is, of course, subject to dispute. However, repurchase demands are high and increasing, and present a significant problem for large numbers of lenders.
In the beginning of August, Fannie Mae made a significant announcement concerning its Alt-A portfolio. Fannie Mae announced that its Alt-A book (estimated at approximately $330 billion, or 11% of its $3 trillion mortgage portfolio) accounted for 50% (approximately $2.675 billion) of the total second quarter losses. As a result of these losses, Fannie Mae announced its plans to exit the Alt-A business by the end of 2009. Further, Fannie Mae made the following announcement concerning Alt-A loss recoveries:
"Ramping up defaulted loan reviews to pursue recoveries from lenders, focusing especially on our Alt-A book. The objective is to expand loan reviews where the company incurred a loss or could incur a loss due to fraud or improper lending practices. To achieve this, we are increasing post-foreclosure loan reviews from 900 a month in January to 4,000 a month by the end of the year, expanding our quality-control reviews for targeted products and practices, and are on track to double our anti-fraud investigations this year. We expect this effort to increase our credit loss recoveries in 2008 and 2009. "
Given the size of Fannie Mae's Alt-A book, the default rate on those products, the projected increase in defaults associated with Alt-A loans set to recast in the coming years, and the concentration of Alt-A loans issued in high default states like California, Nevada, Arizona and Florida, lenders active in Alt-A products over the recent years (especially the more problematic 2005 through 2007 vintage loans) should expect to feel the impact of Fannie Mae's increased scrutiny.
I wrote in 2006 about preemptive measures lenders could have taken to ensure that their insurance portfolios were optimized for protecting against future mortgage–related losses. While it is a little too late for that, it is not too late to develop a coordinated plan to mitigate losses arising from repurchase obligations ("REPO Loss"). This article provides an overview of how insurance might help reduce the net risk of REPO Loss.
Direct Insurance
Many lenders carry, as relevant here, directors & officers liability insurance ("D&O), professional liability insurance ("E&O") and/or first party fidelity coverage (e.g., a financial institution bond), depending on the specific business model employed. These policies may, depending on the circumstances, provide lenders with a source of recovery for REPO Loss.
To the extent it does not involve securities suits for alleged accounting irregularities related to REPO Loss, coverage for REPO Loss under D&O policies (or D&O portions of blanket E&O policies) might be problematic. Primarily, D&O coverage for public companies typically provides Side C coverage (for the entity itself, not individual directors or officers) only for Securities Claims. Of course, if the policy provides broad entity coverage or the claim for REPO Loss implicates individual insureds, coverage under D&O Policies may very well be available. That coverage, however, likely will be subject to disputes concerning prior knowledge of allegedly wrongful conduct, prior related claims, whether the relief sought is restitutionary in nature, applicability of exclusions specific to mortgage securities, and conduct subject to characterization as intentionally wrongful.
E&O policies issued financial institutions (e.g., Chubb Bankers Professional Liability Insurance is a common policy) is the type of liability policy most likely to respond to claims for REPO Loss. Coverage available under these types of policy will likely be subject to disputes concerning general exclusions for contractual liability and other exclusions specifically keyed to mortgage-related businesses. Additionally, insureds should expect insurers to raise many of the coverage issues mentioned above in the D&O section (prior knowledge of allegedly wrongful conduct, prior related claims, whether the relief sought is restitutionary in nature, applicability of exclusions specific to mortgage securities, and conduct subject to characterization as intentionally wrongful).
Fidelity policies are first-party indemnity policies that provide coverage for loss sustained by the insured. For this reason, these policies are unlikely to directly respond to loss caused by a third party bringing suit against a lender. That said, the distinction between what is a covered first-party loss and a noncovered loss caused by a third-party suit is not clear in many situations, and insureds should pay careful consideration of the facts underlying loan losses to ascertain whether facts supporting a claim exist. Insureds should keep in mind, however, that these policies often contain reporting requirements that purport to require prompt notice to the carrier upon discovery of a loss and specified time periods within which to provide full information concerning the loss. For this reason, prompt notice and a thorough investigation of loan losses should be performed promptly upon discovery of facts which might support a claim under a fidelity policy.
Lenders should expect significant push back from the carriers in response to claims submitted for REPO Loss. That disputes may arise concerning coverage issues does not necessarily mean that the carrier advancing the position is correct. It merely reflects the hot-button issues that insurers frequently raise with respect to most complex claims. Preparing for the issues likely to be disputed and proper presentation of claims is critical in maximizing the potential for recovery under these policies.
Counterparty Insurance
Lenders facing significant REPO Loss often have other third parties to whom risk can be shifted. For example, lenders might have claims against brokers or mortgage companies from which the lender purchased loans. Claims might exist against former directors and officers of entities acquired by a lender in recent years. Other sources, which are pursued more frequently in the insolvency context, are former directors, officers, lawyers, accountants, and auditors.
Many of these third parties have insurance potentially applicable to a claim made by the lender. As with direct insurance, D&O and E&O policies are the most likely to respond to claims for REPO Loss. For example, the tail purchased by a merged-out entity for its former directors and officers might provide coverage for claims based on those directors and officers' failure to disclose during due diligence material facts concerning their pre-acquisition lending practices.
Whatever the context, a lender must – in its capacity as a plaintiff – identify those parties with insurance and properly structure and execute the claim against those parties to maximize the REPO Loss shifted to these third parties, especially when the recovery source may not be sufficiently solvent to fund an adverse judgment or settlement. Understanding the coverage available to potential recovery sources is critical to employing a successful third-party insurance recovery strategy. Equally important is understanding the types of claims and allegations that create coverage and the types of claims and allegations that may provide the carrier with a coverage defense. Those, however, are only two of the factors that must be considered when pursuing coverage available to a third party. Other factors and strategies must be considered, both before making a claim and during the course of litigation, to maximize the insurance recovery.
Conclusion
Over a year into the current crisis, squeezed between increased loan losses and very hard capital markets, many lenders are facing unprecedented challenges. For those that have already succumbed to the cycle, insolvency players are working to maximize the value of the remaining assets. The woes currently faced by many lenders will be compounded when, as appears imminent, Fannie Mae ramps up its efforts to mitigate its own losses by increased pursuit of REPO claims. Finding ways to offload that risk will be critical to the future viability of many lenders and the preservation of value in lender bankruptcies. Insurance should not be overlooked as a potential source of funding for REPO Loss.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
