The recent turmoil in capital and credit markets was caused by the US sub-prime crisis but its effects have been world-wide. Are there similar problems in the UK sub-prime market? In this special Financial Services Update we consider whether this could lead to increasing claims against UK professionals.
What is sub-prime lending?
Sub-prime mortgages are targeted at customers with impaired or low credit ratings who would otherwise struggle to obtain financing from traditional sources: often borrowers who wish to consolidate their existing debts. Because of the increased risk profile of sub-prime customers, mortgages are often more expensive, with high interest rates. This type of lending is highly controversial: there are many allegations of predatory lending practices, such as deliberately lending to borrowers who could never meet the terms of their loans, leading inevitably to default, seizure of collateral and foreclosure.
The problems in the US
Sub-prime lending took off in the US as a result of low interest rates and rapidly rising house prices between 2000 and 2005. Lenders were enticed into the riskier sub-prime market, largely attracted by higher yields, and began lending on a large scale to sub-prime borrowers.
To spread their risks, lenders rolled these sub-prime mortgages into bonds called Mortgage-Backed Securities (MBSs) which they subsequently sold into the secondary market. The MBSs are bought by investment institutions. As these institutions are not risk takers, they also look to sell the securities on as soon as possible. Since credit rating agencies, unsurprisingly, give the bonds a low credit score, the securities are carved into different Collaterized Debt Obligations (CDOs) to improve their credit rating. These are layered in a hierarchy of risk and are then distributed, through the issue of commercial paper, to pools of investors worldwide. Many of the riskier CDOs are sold to hedge funds.
Sub-prime borrowers, attracted by low intial terms, eventually found themselves unable to meet the normal rate repayments and large scale defaults loomed. It became immediately apparent that the credit analysis conducted by the original lenders was significantly flawed. Investors soon realised that much of the $300bn invested was not going to be repaid. Added to this, the US housing market crashed leaving enormous shortfalls from repossessions.
As a result, the US sub-prime market went into meltdown, causing more than 100 subprime mortgage lenders to fail or file for bankruptcy, most notably New Century Financial Corporation, previously the second largest sub-prime lender in the US. Since then, more subprime lenders and brokers have announced difficulties, whilst the larger financial institutions have suffered huge losses. The top 15 lenders have had $91bn slashed from their market value and there are concerns that the crisis may push the US into recession.
Observers of the crisis have cast blame on a number of different factors. Some have highlighted the predatory practices of subprime lenders, steering borrowers towards unaffordable loans, and the carelessness of Wall Street investors who backed sub-prime mortgage securities without verifying the strength of the underlying loans. Major rating agencies have come under fire for granting high ratings to the complex CDOs. The Securities Exchange Commission is currently investigating various institutions involved, including: investment banks, credit-rating agencies and mutual fund managers.
Consequences for the UK
The American sub-prime mortgage crisis caused financial markets around the world to seize up. Banks have been, and still are, nervous about lending to other banks, because they are not sure which entities are exposed to sub-prime debt. LIBOR (the rates at which banks lend money to one another in the London money market) has shot up and banks are charging a premium for loans over the shorter term, which they perceive as the riskier timeframe.
This caused the so called “credit crunch”, making it harder for banks to finance their activities. Northern Rock suffered in particular because it relies heavily on the money markets, rather than deposits to finance its mortgages. The world’s central banks including the US Federal Reserve and the Bank of England have made credit available, but the problems still linger.
Due to the poor credit conditions, banks are beginning to withdraw funding from sub-prime lending institutions. These institutions, many of which lend directly to borrowers, will not be able to complete mortgages they have arranged, and borrowers will have to rely on other institutions taking on the debts. If this trend continues, there will be an even greater rise in sub-prime mortgage rates, and subsequently more defaults and claims.
Victoria Mortgages was the first victim of this trend, and went into administration soon after its funding was pulled by its banks. The sub-prime lender had an outstanding loan book of about £300m, but was able to sell the majority of its existing mortgage liabilities onto other banks and financial institutions. It left some 400 borrowers with pending applications, hoping that other institutions will agree to the same terms before they lose their homes. Should the sector continue to decline, there will be fewer volunteers to take on subprime loans, and brokers could be left high and dry as borrowers are unable to complete purchases.
The fallout of the sub-prime crisis has been widespread. Evidence of sectoral decline is building; hedge funds have collapsed, mergers and acquisitions have been cancelled and job losses have occurred across the subprime institutions. The general economic downturn caused by the sub-prime crisis and now in evidence could have an indirect effect on the UK mortgage market. Lower City bonuses and increased unemployment generally will quickly have a knock-on effect on house prices. In already unstable times, there is a real prospect of yet greater downward pressure on the housing market from national and international economic conditions.
Sub-prime lending in the UK - similar problems?
The US problem has also drawn attention to the lending practices within the UK sub-prime sector. There is now concern that not only will the UK suffer the economic fall-out from the US crisis, but that there could be identical problems underlying our own sub-prime sector and mortgages more generally. The FSA has regulated the mortgage industry in the UK since October 2004. It sees it as essential that firms implement and maintain robust processes to ensure they recommend suitable mortgage contracts, and treat their customers fairly.
Since January this year, the FSA has focused on the sub-prime market and is now clamping down on mortgage brokers who have shown significant failings. It is mainly small firms that are currently under pressure, but even larger firms, which have adequate processes in place will have to demonstrate that they are using them. More recently, in December, the FSA warned lenders of the very real prospect that conditions may worsen next year, in terms of both liquidity and credit risks, and urged lenders to take steps to protect themselves. It also announced that it will be taking an urgent look at whether lenders are complying with FSA rules and the treating customers fairly principle in their practices for dealing with the handling of mortgage arrears and repossessions.
Mortgage brokers can only recommend a mortgage if it is appropriate for the client, based on full information regarding suitability. The FSA has found that many firms do not conduct proper credit checks on clients and few can justify why a particular mortgage was chosen. These poor standards may allow borrowers to claim against the brokers for the substandard advice they were given. Lending institutions who operate via a direct sales force will also be liable to the borrowers. See the box (right) for details of firms fined recently for a combination of bad practices, including unsuitable recommendations, poor record keeping and sub-standard credit checks of customers.
Sub-prime mortgages are the main concern, as many of the over-stretched UK sub-prime borrowers are likely to start defaulting when their initial low or fixed rate introductory offer periods end. Should the anticipated cuts in interest rates be too late to reduce the costs of unaffordable mortgages, the situation could escalate to mirror that which is unfolding in the US. For those emerging from discount periods, quarter point reductions in rates will not be enough to avert personal financial crises.
Self-certification mortgages target the self-employed and contract workers, allowing borrowers to state their income and sign to confirm their ability to repay the loan, without having to provide any supporting evidence such as accounts, pay slips or bank statements. The mortgage lenders charge higher fees and interest rates to account for the increased risk of defaults.
The main problem that has arisen, as can be seen from the FSA enforcement actions, is that some brokers and lenders have apparently become careless in their administration of the mortgages. Recent investigations by the BBC found evidence of serious mis-selling of selfcertification mortgages. Brokers have encouraged mortgage applicants to overstate their income in order to get larger loans, preferential rates and the deals passed quicker. Some borrowers have been told to double their salary on the mortgage applications, resulting in them receiving unaffordable loans of over eight times their salary.
During the aftermath of the last property crash, self-certification mortgages were described as a ‘fraudster’s charter’. The FSA thoroughly investigated mortgage fraud, and over the last year has banned several mortgage brokers who have been fraudulent in the administration of their applications. One example of this is the case of John Adebayo Adepoju, who was prohibited from carrying on any function relating to any regulated activity for knowingly submitting false financial statements to mortgage lenders in support of 25 different mortgage applications. One customer’s £10k salary was submitted as around £40k. The FSA has announced that four further brokers are to be held accountable for mis-selling mortgages.
Interest-only mortgages are usually tied with investment plans to pay off the capital borrowed at the end of the mortgage term. They are increasingly popular: during 2005, 24% of all new mortgages were interest-only.
The problem lies again in the mis-selling of these products. Many brokers are failing to ensure that there is an adequate capital repayment plan, or are not giving borrowers enough information to understand how the payment plan works. Firms have also been poor at assessing the customers’ financial position and ability to repay, meaning that often even correctly administered interest-only mortgages are not suitable for the customer. This can be seen from the FSA enforcement action against Select Mortgage Services, who were fined for not giving appropriate information to customers and not recommending suitable mortgages. The FSA has specifically criticised brokers and lenders for recommending interest-only mortgages on affordability grounds only, rather than suitability.
The FSA rules oblige firms to protect themselves from fraud and to assist in preventing financial crime.
Rule SYSC3.2.6 says that :
“A firm must take reasonable care to establish and maintain effective systems and controls …for countering the risk that the firm might be used to further financial crime.”
Rule SUP15.3.17 states:
“A firm must notify the FSA immediately … of the following events ...:
(1) it becomes aware that an employee may have committed a fraud …; or
(2) it becomes aware that a person … may have committed a fraud against it; or
(3) it considers that any person … is acting with intent to commit a fraud against it; or …
(5) it suspects that one of its employees may be guilty of serious misconduct concerning his honesty or integrity…. “
All regulated firms are therefore under a duty to prevent and report fraud. The FSA Financial Crime Newsletter of October 2007 identified two forms of residential property fraud - one-off income inflation fraud perpetrated by individuals (those trying to buy a larger home, for example), and organised fraud using a network of complicit individuals in a systematic criminal attack on the financial sector. The FSA Mortgage Advisers Newsletter of October 2007 restated the reporting requirements agreed in April 2006 by the FSA and the Council for Mortgage Lenders (CML). See the box (right) for examples of matters which should be reported.
Anecdotal evidence and the emergence of specific findings by the FSA suggests fraud is rife within the mortgage sector. Whilst borrowers cannot claim for losses arising out of their own fraud, they may be able to claim if it can be shown that they were encouraged by their broker to believe what they were doing was legitimate. In any event, fraud will lead to claims by lenders against brokers for conspiracy and to FSA enforcement action against both lenders and brokers whose systems and controls fail adequately to protect them.
Who’s lost out if prices continue to rise?
Even in cases involving fraud, for so long as house price rises exceed the mortgage repayment costs (ie interest), there will be no substantial losses from mis-sold mortgages. Even if a mortgage proves unaffordable, forcing the borrower to default and the lender to repossess his home, in a rising market the sale proceeds should meet the outstanding mortgage loan. It is likely that neither the lender nor the borrower will end up out of pocket (unless, of course, the property was over-valued by the surveyor).
Lenders who advanced high loan to value ratios or even more than 100% may suffer a shortfall on repossession and borrowers faced with the anguish of an unaffordable mortgage might complain to the Financial Ombudsman Service (FOS) for compensation for the distress and inconvenience or the unaffordable portion of their repayment costs. However, these losses (even if they materialise) are unlikely to place a heavy burden on the industry as a whole.
And if prices fall?
The recent news from the Royal Institution of Chartered Surveyors (RICS) that house prices across the UK have fallen in the last three months raises the prospect of shortfalls for borrowers and lenders when homes are repossessed. Although London still defies the national trend, most now believe that prices will fall or at least stabilise for the foreseeable future. This will leave over-stretched borrowers in negative equity or still owing their lenders money after defaulting and losing their homes.
Although the FSA has started to take enforcement action relating to the dangers arising in the UK’s own sub-prime sector, the problems have by no means been contained. Whilst house prices rose and the subprime sector boomed, little attention was paid to the emerging bad practices of the lenders and brokers. These are now being scrutinised and claims are likely to arise due to the negligent and even fraudulent selling of sub-prime, self-certification and interestonly mortgages.
The CML forecast in October predicted 45,000 repossessions in 2008. The figure for 2006 was 22,700. It is inevitable that many of these cases will result in complaints and of those a significant proportion will involve mis-sold mortgages and/or fraud.
Implications for lenders and mortgage brokers
Claims - by lenders
Mortgage lender claims were big news in the last housing market crash in the early 1990s. When acting as agent of the lender, the mortgage broker owes a duty of care not to pass on bad business. Where brokers have colluded with borrowers in fraudulent mortgage applications, lenders will be entitled to claim against the broker for the resulting losses.
Lenders’ losses will consist largely of irrecoverable shortfalls from sale proceeds on repossession plus the costs of repossession. Legal authorities established after the last crash will apply in the same way to the next wave of claims.
Claims - by borrowers
Brokers who arrange these deals, and lenders who operate through a direct sales force, will be at risk of claims from borrowers who were negligently or fraudulently advised (unless the borrower was complicit in the fraud). Some fraudsters will succeed with claims against their brokers on the basis that the ‘broker knows best’. In hindsight, many will claim that they were persuaded to inflate their income, for example, and did not realise it was fraudulent to do so. We fear the Financial Ombudsman Service (FOS) may have sympathy with this line of argument.
Rising repossessions will inevitably lead to borrowers seeking to blame the brokers and advisers that recommended unsuitable mortgages. After the previous housing market crash claims were dealt with in the courts. Now borrowers can go to the FOS where complaints are determined by reference to what is, in the opinion of the individual Ombudsman, fair and reasonable in all the circumstances of the case.
Brokers may be precluded from relying on traditional defences, such as the legal argument that it is not within the scope of a broker’s specific duty to advise on house price risk. It is likely that the FOS would simply find that the mortgage was not suitable given the risk of house prices falling. Also, in court it could be argued that borrowers cannot complain about having a bigger mortgage as it will have afforded them a better house. It is unlikely that the FOS will accept this view.
If the endowments experience is anything to go by, the claims management firms will stir up complaints. After all, they get paid even if the complainant only gets a small award of compensation for distress and inconvenience. At £400 per case, the FOS fees alone could be a significant cost to the industry.
FSA action or the threat of it will have a significant impact. Although it is unlikely that a formal s404 review (akin to the Pensions Review) would be ordered under the Financial Services and Markets Act 2000, FSA enforcement action often results in pro-active file reviews by individual firms. Homebuyer Securities Limited, among others, were required to do this, and will have to pay redress to customers who have suffered loss. This power of the FSA is likely to be widely used and could be very costly to firms. In addition the increasing emphasis on the treating customers (and complainants) fairly principle, means that the FSA is likely to expect firms to take more seriously their existing regulatory obligation to remedy systemic failings in their systems and controls or sales practices. Recently amended, FSA guidance DISP1.3.5 provides:
“A firm should have regard to principle 6 (customers’ interests) when it identifies problems, root causes or compliance failures and consider whether it ought to act on its own initiative with regard to the position of customers who may have suffered detriment from, or been potentially disadvantaged by such factors, but who have not complained”. It is noteworthy that the FSA’s final notices to date have been against smaller firms. We doubt this is because there are no bad practices amongst larger firms and their direct sales forces. It is possible that the mere mention of FSA enforcement action and the bad publicity it generates will prompt (or may have already prompted) larger firms to undertake their own reviews. The result for them and possibly their insurers will be the same - huge costs and liabilities.
Borrowers and lenders are likely to bring complaints about the negligent practices of brokers. Should the current down-turn in the housing market be combined with more public criticisms from the FSA, then the floodgates are bound to open. If the legal principles applicable in court fail to provide the usual defences, the liabilities could be enormous.
Implications for lawyers
The potential for claims against solicitors ranges from the leading city and international firms to high street practices.
Asset Backed Securities transactions have not historically generated a large number of claims against solicitors. However, when they are made they are usually very large. Solicitors are commonly instructed for each of the parties in a securitisation and with thousands of issues and three or four times more tranches there is significant potential for the number of claims to increase.
While the assets backing these securities have been performing well, the distress provisions within the transaction documents have remained untested and any potential negligence may have been left undiscovered. If the underlying assets fail and the distress provisions are triggered then the offering circular and other transaction documents will be scrutinised to see how the lawyers who drafted them provided for the repayment of sums. If the lawyers failed to provide for the repayment of sums in the order or way anticipated by purchasers of these securities then they may be susceptible to a claim in negligence from the issuer. Lawyers may also find themselves joined into actions against rating agencies who relied on the intended structure of the transaction.
Securitisations of residential MBSs are clearly going to be vulnerable to defaulting home owners at the lower end of the market. RMBSs tend to be the larger issues in terms of both money and the number of tranches and more complexity. When the securities are repackaged into CDOs they are typically only slightly smaller and less complex. In each case, the complexity of the transaction gives rise to a greater potential for things to go wrong; in particular, in accurately translating the commercial intention into the documentation.
In each case, the solicitor is also likely to be heavily involved in the structuring of the initial assignment from the asset producing entity to the SPV (special purpose vehicle) or other issuer. This part of the transaction has its own dangers. If the transfer falls short of a true sale then the securities may not be properly insulated from the performance and solvency of the producing entity. It may be difficult for investors to bring third party claims in tort direct against the solicitors but the solicitor may face claims for an indemnity from the SPV or the underwriter in relation to their own liability to investors. Equally, a rating agency might seek an indemnity in relation to any legal opinion provided to it as to the bankruptcy remoteness of the SPV.
Defects in the initial sale to the issuer can also give rise to direct claims where the tax treatment of the producing entity or the SPV is not achieved or is challenged. This type of claim is not common and is not likely to increase as a result of the current problems. It will typically emerge when the entity submits its returns to the relevant taxing authority.
At the retail end of the market, conveyancing lawyers will also face claims. The 1990s saw a plethora of claims by lenders against solicitors. Many of these related to information that the solicitor had obtained in the course of acting for both the borrower and the lender and which cast doubt on the value of the security provided or the covenant of the borrower. This information included details of back to back sales, direct payments of deposits and purchase price, and bad credit histories of borrowers. The case law developed through the 1990s defined the parameters of these types of claim and particularly restricted claims arising from the solicitor's knowledge of matters going to the strength of the covenant. One of the concerns about more recent lending is that borrowers may have been encouraged by brokers to misstate their income in order to obtain higher mortgages and properties they could not afford. These cases may well be difficult to pursue because the solicitor is unlikely to have had that information. However, where the solicitor was aware of bad faith on the part of the borrower the lender may argue that a duty of care was owed to pass on that information. Lawyers instructed to consider the adequacy of security may also face claims in cases where they were aware that properties were being overvalued.
Implications for valuers
The magnification of risk for valuers during housing market instability is well known. In the recent benign economic conditions, instances of loan defaults, even within the UK sub-prime market, have been relatively low and any negligence on the part of valuers has been masked. As long as any losses caused to the lenders were mitigated by house price increases, the number of claims against valuers was not significant.
However, if higher interest rates and an increase in borrower defaults lead to a fall in general demand for housing and a subsequent fall in prices, there will be more claims. In these circumstances, the lenders will look to mitigate their losses. As was the case in the 1990s, valuers provide an obvious target.
An important characteristic of claims against valuers in the 1990s was the courts’ willingness to reduce awards as wide-ranging evidence of lax lending procedures came to the fore. As a result, major players in the mortgage market improved their procedures. However, the prevalence of smaller lenders in the sub-prime market, combined with the apparent failure of the sub-prime business model, suggests that the courts will again see arguments that losses should be apportioned to the lenders where fault lies with them.
Already this year the FSA has expressed its view that loans have been given to borrowers with poor credit histories, who should not have been given them. Following a review of 11 lenders and 34 brokers the FSA found that in almost a third of cases there was an inadequate assessment of the borrower’s ability to repay the mortgage and that more than half of borrowers had self-certified their income. Valuers may therefore have robust arguments that sub-prime lenders are, at least in part, to blame for their own losses.
Whilst these arguments will be a powerful weapon should claims materialise, it must be remembered that, although a court may find a lender 25-50% (rarely more) to blame for their loss, it does not necessarily mean that there will be a corresponding discount in the damages payable by a negligent valuer.
The discount will be applied to the full extent of the lender’s actual loss rather than to any damages awarded against the valuer. The damages are capped at the difference between the negligent valuation and the actual market value at the time of the negligent valuation. In a falling market, the lenders’ losses are likely significantly to exceed this amount.
Of course, valuers instructed by sub-prime lenders will owe a tortious duty of care to the subprime borrowers. These borrowers are precisely the class of purchaser that the courts set out to protect when establishing the principle in the early 1990s that valuers instructed by lenders owed a duty of care to purchasers of modest, inexpensive properties, who the valuers knew were unlikely to obtain independent valuations. Therefore, whilst the primary risk for valuers comes from financial institutions, there is potentially a further tier of claimants with wholly separate causes of action. If this sector is galvanised into action by enterprising “no win no fee” lawyers, there may be greater liabilities, notwithstanding the basis of any settlements reached with the lenders. The only consolation for valuers is they are not subject to a quasi-judicial complaints service like the FOS or Legal Complaints Service
Implications for accountants
Class-action claims have already been brought in the US against the original sub-prime lenders. More claims are predicted against the investment managers of the hedge funds and structured investment vehicles (the SIVs) which have had such a keen appetite for the MBSs and also the rating agencies. Will accountants and auditors become embroiled?
We are not yet aware of any claims having been made or intimated against the auditors or accountants involved. However, it seems likely that if the losses keep increasing, then the auditors and accountants will face claims along with the investment banks, perhaps as secondary targets by way of claims for contribution.
So what might the claims against the auditors and accountants look like? Clearly, wherever an auditor has given an unqualified opinion on the value of a particular asset or company, which opinion has since been shown to be inaccurate, there is the possibility of a claim. The fact the opinion has subsequently been shown to be wrong does not mean it was negligent at the time it was given, but claims are often brought with the wisdom of hindsight. Unfortunately for auditors, they could be vulnerable in respect of work carried out at every stage of the lending and securitisation cycle. Sub-prime lenders are already facing class actions in the US premised on the overstating of the value of sub-prime books of business. Might auditors be complicit in the over-valuations? What about the role of the accountants in calculating the likely flow of income coming through to the holders of the asset backed securities when the securities are created? Again, over-valuations seem likely.
We see the biggest potential for liability to be against the auditors who, before the sub-prime crisis, were involved in the valuation of the hedge funds and SIVs that have had such a keen appetite for the MBSs. Many of those valuations seem certain to have been massively overstated.
Auditors’ current role today in valuing such MBSs is particularly difficult now that the market for such instruments has collapsed. Banks would prefer not to ‘markto- market’ as a result of the near complete illiquidity in the market with auditors being forced instead to construct complicated models in order to conduct ‘markto- model’ valuations. But it may be the controversial nature of such ‘mark-to-model’ valuations that has caused the US Financial Accounting Standards Board to issue FASB regulation 157 compelling banks to value assets at market prices rather than against controversial models. Whether or not the approach is adopted on this side of the Atlantic, the current financial crisis is likely to test the auditor’s judgement, in turn increasing the risk of liability exposure.
It is worth emphasising that this is somewhat of a doomsday prophesy: of course defences for auditors and accountants will exist and the limitation of liability provisions which should be in retainers will provide some comfort. But unfortunately, whatever the defences available and however innocent the auditors and accountants may be, the size of the losses being reported means that it seems inevitable that accountants and auditors will be targets along with the other professionals involved.