Subprime Mortgages and Theories of Liability - Deja Vu? - Part One

Michael Clark
August 8, 2008 — 1,285 views  

In preparing for two speaking engagements about the Subprime Mortgage crisis (one for the “White Collar Practice for the Business Lawyer and In House Counsel Conference” (South Texas College of Law on August 1, 2008), and the other for the ABA Annual Meeting in New York City entitled “Regulatory and Criminal Investigations of the Subprime Mortgage Meltdown” (Section of Business Law on August 9, 2008)), I have had the benefit of reading many excellent articles and working drafts analyzing different aspects of the subject, as well as reflecting on my prior experience as a Chief of a Financial Institutions Fraud Section at the U.S. Attorney’s Office in the Southern District of Texas during the 1990s (near the epicenter of activity during the Savings & Loan Crisis) and also on my more recent experience in defending an individual in one of the Enron cases.

Parallels Between the S&L Crisis and the Subprime Mortgage Crisis
Clear parallels and differences can be drawn between the Subprime Mortgage investigations and litigation with both the S&L crisis and the more recent corporate fraud crisis after Enron, which led to the DOJ’s hardened approach toward corporations and their officers and directors. A clear and common thread is that the government bears a lot of blame for helping these events get out of control.

Leading up to the S&L crisis, Congress hoped to avoid accountability for the deepening financial problems that traditional mortgage lenders—the savings and loan (S&Ls)— were experiencing since they were losing money on each longterm fixed rate mortgage loan they made simply because their borrowing costs were far higher than what they got in return from their customers on mortgage payments.

Part of Congress’s solution was to let the S&Ls replace Generally Accepted Accounting Principles (GAAP) with Regulatory Accounting Principles (RAP) which were unique accounting rules that let the nowunderwater savings institutions book good will as an asset. This accounting slightofhand appeared to magically erase billions in losses. By also letting the institutions make loans they previously were not allowed to make,
Congress permitted S&Ls to compete with banks and others, such as mutual funds, who promised customers higher returns on their funds. But the investing public was not allowed to know that those S&Ls (which offered increasingly higher returns on deposits) were the sickest of the lot and desperately needed the deposits to leverage their lending activities.

For a while, Congress ’s highrisk gamble seemed to work. In fact, soon it seemed to work far too well to the regulators because of the growing bubble of lending activities by the S&Ls funding real estate development. But, within a few years, the tax laws were overhauled in a major way which move negatively affected savings and loans. Soon, the depth of the S&L’s losses grew considerably deeper. This is due to other parts of our government’s illadvised efforts, such as letting land developers take control of such institutions.

At bottom, for too many of the new breed of owners who were encouraged to buy savings and loans, the historic value of prudential loan underwriting was not considered to be a core concern, but a hassle that was either ignored or considered as an afterthought. I learned from investigating and prosecuting several of these cases that a large part of the owners being referred for prosecution were decent people who made bad choices when confronted with situations that appeared to have no good options. The sarcastic explanation for such behavior that I learned was “a rolling loan gathers no loss. ” This viewpoint appears to be something that seems to apply to too many subprime mortgage lenders. These were also non traditional lenders who appear to have thought that they could avoid having to face problems if loans they made defaulted down the road since these mortgages were bundled, securitized, and sold—meaning that others who were downstream would have to worry about getting stuck with defaulting loans. Herein lies another Enron parallel: Some subprime lenders seem to have cared more about booking immediate income (and possibly booking income if adjustable rate mortgages were refinanced) than about the risky mortgages they had made.

In short, the lessons of history weren ’t adequately learned or remembered. Clearly some lenders will try to do what they can not to recognize a loss despite the severe regulatory repercussions of such malfeasance. Whether their behavior is viewed as irrational or amoral is not particularly important. Unscrupulous individuals will take chances and think that they will not get caught despite the increased punishment now in place for bank fraud and the associated increases under the Sentencing Guidelines.

During the S&L crisis, for some lenders the “solution ” to their mounting problems too often meant conspiring with others to exchange bad loans which let them book income on their new loans instead of having to set aside capital to cover nonperforming loans as required by applicable regulations. This meant making new loans for nonperforming loans in larger amounts to keep them from defaulting too soon. Although this violated federal laws, some lenders rationalized their conduct, arguing that their acts would not hurt anyone after the market moved in the right direction. But, as we know, the market only got worse for a period of years.

In short, this type of lending was, at its core, a Ponzi scheme that ultimately imploded. Even while the magnitude of the losses were staggering, the investing public wasn’t all that interested since they were not directly affected because their savings accounts were federally insured. Instead, the impact was indirect and hidden because our government defrayed the costs as longterm debt obligations for future generations to repay. Further, since the activities involved in these events were arcane and not immediately recognizable, the public was apathetic for too long a time. At the end, by tasking the Department of Justice to go after the “S&L crooks,” Congress and the White House deflected much of their blame for the mess by pointing to others as being the cause for the problems that could no longer be ignored.

Parallels Between Enron, the Recent Corporate Crisis, and the Subprime Mortgage Crisis
The Enron debacle—which occurred not very many years following the S&L crisis—once again revealed the perils of accounting alchemy (albeit from a different angle). While marktomarket accounting is a bit complex, basically it requires companies which regularly trade various commodities to mark their trading books daily to record their gains and losses for a net position. Unfortunately, this regimen also allows unscrupulous individuals to manipulate a company's reported earnings in various ways. And, a core problem found after Enron’s collapse was that too many of its trading activities lacked basic financial substance. By encouraging its employees to go after “big deals ” so that the company could immediately book profits on long term anticipated stream of income, Enron’s management moved away from what had been the company ’s core asset activities (pipelines and gas trading) to new and exotic markets in which the company had no experience. Unfortunately, once again, the problem was that few in its management had properly evaluated these deals using basic prudential considerations such as by asking if the deals made financial sense and would perform in the long term.

A major accounting slightofhand that Enron and other energy trading companies relied upon to accomplish their remarkable reported incomes involved using “Special Purpose Entities” or “SPEs” to separate a company’s liabilities from reported gains. While the use of SPEs makes sense for companies legitimately handling problems raised by mark tomarket accounting, these devices also present opportunities for corrupt individuals to misuse them.

Almost unbelievably, a parallel problem at the bottom of many subprime mortgage defaults involved the misuse of “Special Purposes Vehicles, ” which are basically the same thing as the SPEs that got Enron and other energy companies into so much trouble. Still another of the core problems at the heart of the Subprime Market Mortgage debacle was the lack of sufficient “moral hazard” or “skin inthegame ” by the borrowers in many of these loans.

Common sense and good loan underwriting principles inform lenders that borrowers will be far less willing to walk away from mortgages if the market moves against them if they have a substantial investment in the mortgage that they will lose by letting the loan default. Once again, however, good underwriting principles seem to have been ignored by lenders with many of these subprime mortgages that are now defaulting— and particularly in markets that for years had been hot. Lenders in hot markets, such as California, had been loaning 100% or more of the mortgage amount to borrowers, apparently thinking that if a borrower could not continue to pay the amount, they either could refinance the loan or sell the property to a buyer who could pay the amount.

Yet, as we will later discuss, housing markets, like stock markets, are affected by the laws of gravity—a lesson that seems to have forgotten by many when this market seemed to be so hot.

More to Come
Interested readers may find the following articles and reports helpful:

1. CRS Report, “Housing Issues in the 110th Congress ” (Feb. 8, 2008), available at

2. CRS Report, Subprime Mortgages: Primer on Current Lending and Foreclosure Issues, RL33930 (March 19, 2007)

3. Anthony PenningtonCross, Subprime Lending in the Primary and Secondary Markets, Journal of Housing Research, Vol. 13, Issue 1 (Fannie Mae Foundation 2002)

4. Howard Lax, et al., Subprime Lending: An Investigation of Economic Efficiency, Housing Policy Debate, Vol. 15, No. 3 (Fannie Mae Foundation 2004)

5. SEC, Staff Report, “Enhancing Disclosure in the MortgageBacked Securities Markets” (Jan. 2003), available at

6. Allen Ferrell, et al., Legal and Economic Issues in Subprime Litigation , Harvard Law & Econ., Discussion Paper No. 612 (March 2008), available at

7. Christopher L. Foote, et al., Fed. Reserve BankBoston, Public Policy Discussion Papers No. 082, Subprime Facts: What (We Think) We Know about the Subprime Crisis, and What We Don’t, available at

8. Benjamin Keys, et. al, Did Securitization Lead to Lax Screening: Evidence from Subprime Loans , working draft (April 2008 version), available at

Michael E. Clark, Hamel Bowers & Clark LLP. Information provided in this blog does not, nor is it intended to, create an attorney client relationship. Rather, it is offered solely for informational purposes and is not intended to constitute advertising. More information about me, my practice, background, and interests, is available from the firm website, , and the following sites (including links to some of my published papers and articles: clark121553.html and a051f497181f4399862bcd4a7ad5c1cf.html The treatise on pharmaceutical law for which I am Editor in Chief was published in December 2007 by BNA. See .

Michael Clark


Michael E. Clark, a former federal prosecutor, has extensive trial experience in business and professional matters. He serves as an Adjunct Professor of Law, as a faculty instructor for NITA, is widely published, and speaks regularly on issues of importance to businesses and professionals. Within the ABA, he serves on the Standing Committee on Publishing Oversight; is the outgoing chair of the Business Law Section's White Collar Crimes Committee (and an Editorial Board member of The Business Lawyer); serves on the Governing Council for the Health Law Section and is the outgoing chair of its Publications Committee; and serves on the Planning Committee for the National Institute on Securities Fraud. Mr. Clark is a Fellow of the American Bar Foundation and he developed and serves as the Editor-in-Chief of a treatise published in 2007 by BNA and the ABA Health Law Section about pharmaceutical law. Mr. Clark has been Board Certified in Criminal Law by the Texas Board of Legal Specialization and the National Board of Trial Advocacy since the late 1980's.