In The Black Swan: The Impact of the Highly Improbable (2007), former derivatives trader Nassim Nicholas Taleb uses the 17th-century discovery of Australian black swans-considered impossible by Europeans-as a metaphor to describe rare events with high impact that, in retrospect, seem utterly predictable. Though Taleb's book predates the subprime mortgage melt-down, black swans are a perfect fit for the recurring crises of 21st-century speculative finance.
Certainly the subprime crisis has had high impact. Mortgage originators have gone belly up, and investment banks still aren't finished firing executives and writing off billions of dollars in bad bets associated with their special investment vehicles (SIVs). Treasury Secretary Henry Paulson proposed a "super SIV" bailout-ultimately rejected by the big banks-while Rep. Barney Frank (D-Mass.) cosponsored a reform bill (HR 3915) to assist mortgage consumers.
In retrospect, the unwinding of the speculative subprime market seems utterly predictable. For awhile everyone got a piece, and then everyone got greedy. Risk assessments went undone, or undisclosed, or unread, or unheeded. Crisis followed bad bets, which yielded reluctant devaluations. Lots of investors lost lots of money. Financial markets thrive on crises. But someone has to be blamed. That's why we have lawsuits.
By now plaintiffs attorneys have filed scores of securities class actions and derivative suits against loan originators, underwriters, credit-rating agencies, and SIV sponsors seeking billions of dollars in compensatory damages. Some shareholder complaints allege that banks aided and abetted fraud committed by hedge funds. Others, filed by the purchasers of commercial paper issued by the SIVs, allege the banks that sponsored the SIVs failed to disclose their risks. And finally, complaints filed by current and former bank employees allege breach of fiduciary duties that resulted in huge losses to company pension funds.
With this much alleged wrongdoing, you'd expect defense attorneys to be worried. Apparently, they're not. "The cases filed to date are mostly traditional securities-fraud claims that tend to be brought whenever a public company has a significant write-down," says Richard A. Spehr, a litigation partner in the New York office of Mayer Brown who represents several investment banks and AIG in pending subprime litigation. "What's new here is the variety of defenses, all recently affirmed by the U.S. Supreme Court, that are available to financial institutions." Chief among them, Spehr says, are the heightened pleading requirements incorporated in the Court's decisions in Dura Pharmaceuticals, Inc. v. Broudo (544 U.S. 336 (2005)), Bell Atlantic Corp. v. Twombly (127 S. Ct. 1955 (2007)), and Tellabs, Inc. v. Makor Issues & Rights Ltd. (127 S. Ct. 2499 (2007)).
Establishing loss causation could be a huge hurdle. David M. Furbush, national coleader of the securities litigation group at the Silicon Valley office of Pillsbury Winthrop Shaw Pittman, says that plaintiffs suing based on losses on mortgage-backed securities "may have a hard time tracing the loss to any particular misstatement or omission in the offering documents, since these types of instruments are losing value across the board."
So far the most interesting twist is litigation filed against the credit-rating agencies that graded mortgage-backed securities. At least two putative class actions against credit-rating agencies allege securities fraud and breach of fiduciary duty based on misrepresentations in company financial disclosures. (Teamsters Local 282 Pension Trust Fund v. Moody's Corp., S.D.N.Y., No. 07-CV-8375, filed 9/26/07.); (Reese v. Bahash, D.D.C, No. 1:07-CV-01530, filed 8/27/07.)
"The credit-rating agencies are well-paid cheerleaders that helped design and structure these deals," claims Darren J. Robbins, a partner in the San Diego office of Coughlin Stoia Geller Rudman & Robbins and co-counsel in the Reese case, which alleges McGraw-Hill subsidiary Standard & Poor's assigned excessively high ratings to bonds backed by risky subprime mortgages. "Human greed and lucrative business practices are not a good mix," says Robbins. A McGraw-Hill spokesperson simply stated, "We believe the complaint is without any factual or legal merit."
Certainly the credit agencies had an incentive to grade high, because the SIVs that sold commercial paper based on securitized mortgages could do so only if they were rated investment grade. Last fall Congress held hearings on the potential for conflicts of interest when credit agencies provide both credit-risk ratings to investors and regulatory licenses to the issuers of securitized debt. The SEC has begun its own review, and the offices of several state attorneys general have also opened investigations.
At bottom, the factual questions are about risk assessment, conflicts of interest, and disclosure. In a draft study published last year, finance professor Joseph R. Mason of Drexel University and Joshua Rosner of Graham Fisher & Co. noted that the essential role played by the rating agencies gives reason to question whether their asserted and legally upheld "freedom of the press" protection would be valid were it challenged in relation to a structured-finance transaction. ("Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," Hudson Institute (2007).)
The authors speculated that, "if a rating agency's role in an issuance were determined to move beyond the traditional role of publishing opinions and extended to being determined an 'underwriter,' their liability could become tied to any liabilities of any other 'underwriter' of the transaction."
Plaintiffs lawyers, including Gerald H. Silk, a partner in the New York office of Bernstein Litowitz Berger & Grossmann, find that argument intriguing. "These cases are in the early stages," says Silk, whose firm represents institutional investors in shareholder litigation. "We believe the earlier rulings [regarding the First Amendment rights of rating agencies] occurred in different contexts, and are distinguishable."
But once again, defense attorneys don't appear concerned. Furbush at Pillsbury Winthrop says, "The credit-rating agencies claim their predictions are based on mortgage-default rates-and nothing so far shows that those predictions aren't accurate."
Still, someone needs to be blamed for the high impact of this black swan. Officials must investigate, reports must be written, lawsuits must be filed. "My bones tell me that much of the litigation will be in the Second Circuit-that's where the investment banks are," says Ernest T. Patrikis, a partner in the New York office of Pillsbury Winthrop. "We are now up to our knees in it."