Insurance Coverage Available For The Subprime Mortgage Collapse: Current Developments

Reprinted with permission from the Volume 18, Number 3,

May/June 2008 edition of Coverage magazine. @2008 American Bar

Association Section of Litigation. This information or any

portion thereof may not be copied or disseminated in any form

or by any means or downloaded or stored in an electronic

database or retrieval system without the express written

consent of the American Bar Association.

When facing a loss, the first rule of insurance recovery is

"think insurance." Daily headlines describe

the collapse of the subprime mortgage market, the impact on the

financial markets and investment community, as well as the

hardships suffered by individual borrowers. Investments in

mortgage-backed securities, particularly subprime mortgages,

have dominated the financial news because of the: (1) stunning

losses reported by institutional investors; (2) growing

multitude of lawsuits filed by borrowers alleging predatory

lending and shareholders alleging securities fraud; (3)

government investigations, and (4) collapse of Bear Stearns. In

recent months, Merrill Lynch, UBS, and Citigroup each has

reported losses of more than $3 billion, while Morgan Stanley

and JPMorgan have reported losses of more than $2

billion.1 According to Standard & Poor's,

the estimated losses and write-downs related to investments in

mortgage securities and subprime-related investments amounts to

$285 billion.2 Other analysts estimate that the

total losses tied to subprime mortgages are as high as $400

billion.3

Insurance will be part of the solution for some. The claims

against investment banks, mortgage companies, and virtually

everyone involved in the securitization chain implicate

coverage under a variety of insurance policies. The most

obvious coverage will be found in directors and officers

("D&O"), professional liability

("E&O"), Fiduciary liability insurance and

Financial Institution Bond ("FI Bond") insurance

coverage. D&O, E&O and Fiduciary liability insurance

policies protect the policyholder and its managers, officers or

general partners against losses due to an unintentional

(negligent) act, error, omission, and/or breach of duty that

could give rise to a claim. D&O insurance typically covers

directors and officers and the corporate policyholder (where

entity coverage is present).

Similarly, standard form E&O insurance policies protect

the corporate policyholder and its various directors, officers,

employees and affiliates, including securities brokers and

dealers working for financial institutions and investment

banks, for loss arising from their alleged wrongful acts

committed in their capacities as managers, representatives or

agents. Finally, the Fiduciary liability policy and the FI Bond

coverage fills the void left by D&O and E&O insurance,

covering policyholders experiencing loss in an employee

retirement or similar fund, or for their employee's fraud

and dishonesty, as well as losses caused by forgery, false

pretenses and the like. All these lines of coverage may respond

to subprime litigation against a corporate policyholder and the

individuals impacted.

More and more litigation arising out of the subprime crisis

has been filed and is gaining speed and momentum. To date,

almost 300 lawsuits have been filed relating to investments in

subprime loans. This is almost half the total number of

lawsuits that were filed during the entire period of the

savings and loan crisis. With the losses mounting daily, the

number of lawsuits against investment banks, lenders, and

others involved in the subprime market is virtually certain to

continue to increase.

Investment Banks Are Looking For Help

Given the catastrophic losses reported by investment banks,

it should be no surprise that even the largest investment banks

have turned to investors, including foreign governments, for

help.

In November 2007, Charles Prince, the chairman and chief

executive of one of the world's biggest banks, Citigroup,

resigned shortly after Citigroup reported record losses. Since

then, Citigroup has turned to foreign investors, including

Dubai International, Abu Dhabi and Kuwait, and raised more than

$30 billion to stabilize its finances.4

In early 2008, just months after reporting its first-ever

loss, Bear Stearns sought - and received - a

federal bailout to help avert a total collapse.5

However, the bailout was evidently insufficient and, in March

2008, JPMorgan, with the help of the Federal Reserve, made an

offer to buy the 85 year old investment bank for 10% of its

market value in the prior week, or approximately one quarter of

the value of Bear Stearns' headquarters in New

York.6

Will Regulators Step In?

Given the reach of the subprime crisis, regulators in the

United States and Europe are evaluating underwriting standards

and other risk management practices employed by investment

banks.7 In the United States, regulators have been

evaluating deficiencies in securitization8 and are

expected to release a report that addresses various

deficiencies in securitization.9

Recently, United States Treasury Assistant Secretary Anthony

Ryan called upon banks and brokerages to address weaknesses in

risk-management policies and said regulators are working to

ensure financial products are not so complicated. According to

Mr. Ryan, "[w]e need to see global financial institutions

promptly identify and address any weaknesses in risk-management

practices that the current turmoil has

revealed."10 Regulators are reviewing the

assumptions and inherent weaknesses in the securitization

process, as well as reviewing lending practices.11

Additionally, he said that banks should improve their balance

sheets to minimize risk and better understand what they're

investing in: "looking ahead, we expect practices will be

different . . . Financial products will be less complex and

more transparent, then mechanisms for dealing with complexity

will be improved.''12

In response to the wave of defaults on subprime mortgages,

regulators of mortgage insurance companies are also considering

splitting the firms into two parts: one for safe municipal debt

and the other for riskier mortgage-related

securities.13 Some insurance companies are eager to

restructure. In fact, the Financial Guaranty Insurance Company

has reported that it would like to create a...