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The fault lines that led

John Bruce, a senior solicitor at City law firm Reynolds Porter Chamberlain, looks at the chain of events that led from the US sub-prime crisis to lines of anxious savers queuing outside Northern Rock branches this month

The fallout from the US sub-prime mortgage meltdown continues and could have an impact in unexpected places.

Up to six million people in the US have borrowed 100 per cent of the value of their home and many are now having difficulties. These are the sub-prime borrowers.

They have been charged higher interest rates to reflect the higher risk of default. Uncommonly for the US, the rates are variable and not fixed. The US housing market has now fallen and interest rates have increased. The result? Many sub-prime borrowers have not kept up with repayments and the cash from the sale of their homes has not been enough to repay the money borrowed.

However, what would otherwise have been an issue for US domestic mortgage lenders has spread across the globe. Sub-prime lenders have rolled the sub-prime mortgages into bonds called mortgage-backed securities which they have then sold into the secondary market. The sub-prime lenders have used the money received to lend more cash to more sub-prime borrowers to buy more houses.

The mortgage-backed securities are bought from the sub-prime lenders by investment institutions but these institutions are deal-makers rather than risk-takers and want to sell on the securities as quickly as possible. Since credit rating agencies give the bonds a low credit score, the securities have been sliced and diced into different collaterised debt obligations to improve the credit rating.

The higher-rated, investment-grade CDOs are relatively easily sold on but what about the riskier CDOs or the “toxic waste”?

Much of it is sold to hedge funds, which are possibly created and owned by the selling investment institution itself. When the housing market is rising, the investments appear to be making huge profits. The toxic waste is priced up more quickly than the underlying house prices because it contains all the price volatility. Success leads to leveraging to enable the hedge fund to purchase more and more of these star investments. Then the housing market collapses and these CDOs drop in value as quickly as they rose. The hedge funds can be left owing lenders billions.

That is a brief description of the simpler derivatives created from the mortgage-backed securities. These risks have also been passed on via more complex instruments such as credit default swaps or synthetic CDOs. The investment institution uses these products to effectively pass the risk of default to another institution.

The institution taking the risk receives a steady premium income stream and, while the market is on the rise, they pay out no money. This is obviously attractive to fund managers who have been investing in what they might have considered a safe investment. These are products which have been assessed by the credit rating agencies.

All these products have been further repackaged and sold on to the world’s investment institutions so when the sub-prime market began to crater in, every major financial institution started checking their exposure, leading to the credit crunch and intervention by world central banks. It was the credit crunch that caused Northern Rock’s recent woes.

Nobody knows the true value at stake but it could easily be hundreds of billions of dollars. Whatever the true sum, it is likely to dwarf the sum involved in the 1998 failure of Long-Term Capital Management.

Of course, we still have the fallout from all the legal claims to come. The class action juggernaut has already got under way. Various class actions have been issued by shareholders against a number of US sub-prime lenders, alleging securities fraud, essentially for failing to disclose that their sub-prime portfolios were not performing as well as had previously been stated. But what other claims might be made?

Bank claims

HSBC revealed bad debt provisions of $10.5bn, largely as a result of mortgage default, and other institutions have suffered similar losses. However, being trading losses, these are unlikely to translate into claims. Investor class actions are another matter.

The stock value of institutions involved in the sector seems to have stayed relatively stable. However, if banks start issuing profit warnings, class actions will surely follow soon.

Prospectus liability

Investment banks may face claims where the mortgage-backed securities they have repackaged and issued have collapsed in value. Just as disgruntled equity investors have launched claims over failed IPOs, so purchasers of mortgage-backed securities may seek to sue investment banks on the basis that they issued flawed prospectuses.

The Court of Appeal ruling in Goldman Sach’s favour (IFE Fund SA v GSI, July 31, 2007) brings comfort that properly drafted limitation of liability provisions should protect the issuer. Provided the issuer has no basis to believe that the prospectus is misleading, that is. But that is not to say that claims will not be made and substantial defence costs incurred.

Fund managers

Investors in failed hedge funds may bring claims against the fund manager for investing in these securities. Pension funds and other institutional investors may feel that their fiduciary duty to their investors lies in pursuing litigation.

Pension fund managers

If pension funds drop in value, claims against the pension scheme trustees will no doubt be brought by policyholders for poor investment strategies. Those trustees may seek a contribution from their actuaries who advised on asset allocation.

Rating agencies

Many of these securities have been given a favourable grading by the credit rating agencies. These ratings now seem to have been too high although hindsight is a wonderful thing. Some agencies have been slow to downgrade.

Criticism has also been levelled that the agencies are in too cosy relationships with company management. Conflict of interests have also been alleged as a result of some agencies charging issuers rather than investors for their rating. Therefore, although a difficult case to bring, if the losses are big enough, claims against the agencies may be attempted.

Failed mergers and acquisitions

The credit crunch has led to a cooling of the M&A market. It is said that this has led to litigation, in some instances.

One pertinent example is that of Accredited Home Lenders. AHL is a failing sub-prime lender and is suing Lone Star over the private equity company’s decision to withdraw its agreed takeover.

IFAs

The retail market has not invested in hedge funds in the UK but retail investors have done so in Australia and US. Claims against the implicated IFAs for bad investment advice are already being notified.

These are some of the potential claims that might be made. For the time being, professionals must wait and see if claims are made and from what quarter.

Of course, there is the impact on the UK housing market. So far, this is a US problem which has the potential to affect the UK.

One obvious indirect casualty has been Northern Rock which has suffered because of its inability to raise funds in the short-term money markets.

A sub-prime market does exist here although the main players are withdrawing products and increasing rates. If rates continue to rise and a housing crash follows, the UK may follow the US’s lead.

A housing crash seemed unlikely in the UK. However, with mortgages being harder to obtain by those entering the market and with falls in City bonuses havaing an impact at the top of the market, perhaps the seemingly inexorable rise of property prices is about to end.

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