Mortgage Backed Securities and Collateralized Debt Obligation Losses Mount as Lawyers Weigh Investors’ Options

The other shoe is dropping on mortgage securities holders who have already suffered devaluations on what many were told were low risk investments. Monthly interest payments are now falling and in some cases have ended on securities backed by risky home loans.

Large numbers of collateralized debt obligations (CDO’s) and mortgage back securities (CMO’s) made up of bonds backed by sub-prime home loans are starting to shut-off cash payments to investors. Such cash flow cutoffs are expected to accelerate, as observers speculate whether this will cause a new round of panic in the battered mortgage securities market.

Owners of collateralized obligations, including investment banks, hedge funds, insurance companies and public pension funds continue to write down mortgage investments beyond the billions they have already written off. Some of the securities may, for example, fall from 70 percent of face value to almost worthless overnight, bankers and analysts say.

The extent of the chain reaction this could cause is hard to predict. Such adjustments will adversely affect individuals sold such securities and could further disrupt their lives as the availability of credit to homebuyers and consumers could dry up and stock prices (and thus pension funds) fall in value. A resulting recession would cause many to lose jobs, which would result in new mortgage delinquencies which would fuel a repeat of this cycle.

“At this point, it’s fair to say that everybody expects this shoe will drop,” said Mark Adelson, an independent mortgage securities consultant and analyst. “It’s a foregone conclusion. But when it happens, there will be a market reaction to it.”

Standard & Poor’s recently lowered the ratings on $22 billion in bonds backed by mortgages made to people with weak credit in 2006, citing the continued deterioration in the housing market. Another credit rater, Moody’s Investors Service, lowered a similarly large group of bonds earlier in the month. Congress is investigating why so many securities were rated so highly in the first place.

Meanwhile, lawyers are evaluating cases for investors based on lack of, poor and even fraudulent information given to them at the time of purchase. Credit rating agencies will likely fall in the legal category established by the so-called “Good Housekeeping Seal” line of cases, which held that opinions are usually not actionable.

The question is, rather, why those selling the securities relied upon the inflated ratings in the first place. The ultimate issue is whether a credit rating alone is a “reasonable basis for a recommendation” and/or whether proper “due diligence” was performed concerning these investments prior to the sales.

Even after early warning signs and discussions of sub-prime mortgages emerged, in 2006 and 2007, investment banks issued and sold an additional half-trillion dollars in new debt obligations linked to mortgages. Sellers of these securities apparently chose to ignore the risks in order to peddle their wares. In any event, whether it be a case of commission or omission, sellers can be held liable under the law for their failures to properly appropriately disclose risks.

Comparing this situation to the “tech bubble burst” in early 2000, the few who advised clients early to reduce holdings avoided disaster. Most instead refused to admit their mistakes and told their clients to hold on as the majority of their clients’ losses occurred in 2001 and 2002.

Most mortgage securities have not yet experienced significant internal losses, recorded when homes are foreclosed and sold. Up to two years can pass between a borrower’s falling behind on payments and an auction. Such securities usually have a reservoir of excess cash to draw upon to pay bondholders when borrowers do not make monthly payments.

“It’s only once the property is effectively sold that a loss is recorded,” said Nicholas Weill, chief credit officer at Moody’s. “The process of foreclosure is a long process. It doesn’t just happen overnight.” John Schiavetta, a group managing director at Derivative Fitch, which rates the debt obligations says “[The mortgage securities market] is still the early stages of a very significant stress.”

Investment brokers and advisors who sell their clients securities which then fall in value typically tell their clients to hold on, rather than heed warnings and act responsibly to advise clients to get out. If these brokers listened to credit agencies when saying the securities were safe, how can they now ignore those same credit agencies which are lowering ratings and warning of worse to come?

Shepherd Smith and Edwards represents institutional and individual investors nationwide in claims against securities firms. We have represented investors in more than 1,000 securities cases, including many involving mortgage securities. To learn whether we may be able to assist you with a claim contact us to arrange a free consultation with one of our attorneys.