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 LAW AND ECONOMIC ISSUESIN SUBPRIME LITIGATIONJennifer E. BethelAllen FerrellGang HuDiscussion Paper No. 61203/2008Harvard Law SchoolCambridge, MA 02138This paper can be downloaded without charge from:The Harvard John M. Olin Discussion Paper Series:http://www.law.harvard.edu/programs/olin_center/
 
The Social Science Research Network Electronic Paper Collection:http://papers.ssrn.comThis paper is also a discussion paper of theJohn M. Olin Center’s Program on Corporate Governance.
 
 
LEGAL AND ECONOMIC ISSUES INSUBPRIME LITIGATION
Jennifer E. Bethel*Allen Ferrell**Gang Hu***
A
BSTRACT
 
This paper explores the economic and legal causes and consequences of recent difficulties in thesubprime mortgage market. We provide basic descriptive statistics and institutional details on themortgage origination process, mortgage-backed securities (MBS), and collateralized debtobligations (CDOs). We examine a number of aspects of these markets, including the identity of MBS and CDO sponsors, CDO trustees, CDO liquidations, MBS insured and registeredamounts, the evolution of MBS tranche structure over time, mortgage originations, underwritingquality of mortgage originations, and write-downs of investment banks. In light of thisdiscussion, the paper then addresses questions as to how these difficulties might have not beenforeseen, and some of the main legal issues that will play an important role in the extensivesubprime litigation (summarized in the paper) that is underway, including the Rule 10b-5 classactions that have already been filed against the investment banks, pending ERISA litigation, thecauses-of-action available to MBS and CDO purchasers, and litigation against the ratingagencies. In the course of this discussion, the paper highlights three distinctions that will likely prove central in the resolution of this litigation: The distinction between reasonable
ex ante
 expectations and the occurrence of 
ex post 
losses; the distinction between the transparency of thequality of the underlying assets being securitized and the transparency as to which market participants are exposed to subprime losses; and, finally, the distinction between what investorsand market participants knew versus what individual entities in the structured finance processknew, particularly as to macroeconomic issues such as the state of the national housing market.
* Babson College, (781) 239-5797, bethel@babson.edu ** Greenfield Professor of Securities Law, Harvard Law School, (617) 495-8961,fferrell@law.harvard.edu *** Babson College, (781) 239-4946,ghu@babson.edu. The authors have benefited from discussionswith Tamar Frankel, David Sugarman, and research assistance from Eric Chan, Wallace de Witt, andJohnson Elugbadebo. Professor Ferrell is grateful to the John M. Olin Center in Law, Economics, andBusiness at Harvard Law School for financial support.
 
 
 The residential subprime mortgage industry crisis is one of the foremost economic issuesfacing the United States today. With housing prices high and interest rates low through 2006,millions of households with weak credit histories purchased homes or refinanced existing homes,using adjustable rate mortgage loans designed for high-risk borrowers known as subprimeresidential mortgage loans. Investment banks securitized these loans into residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs), selling risk-differentiatedtranches to investors. With the rise of interest rates and the decline in housing prices in 2007, asmany as two million homeowners have faced or are facing interest-rate resets on loans that willincrease their mortgage payment by as much as 30 percent. Some cannot or will not be able to pay their higher mortgage obligations and will default. The effects of these defaults andforeclosures are being felt by investors in the RMBS and CDO markets, loan originators, creditappraisers, underwriters, bond rating agencies, bond insurers, and others. In this paper weexplore the mortgage securitization market, some of the causes and consequences of thesubprime lending crisis, and the impact of these difficulties on various market participants. Weinvestigate the risks that can arise from financial and technology innovations and losses that areuniquely related to correlated events in the setting of the subprime loan market.The subprime mortgage industry crisis is not solely an economic phenomenon but a legalone as well. It is widely believed that the substantial decrease in the value of asset-backedsecurities faced by investment banks and other purchasers that held previously rated investment-grade CDOs with subprime exposure, as well as junior or mezzanine tranches of RMBS, willgenerate substantial, perhaps unprecedented, levels of litigation. The facts so far have beensobering. The percentage of securities class action suit filings has increased by almost 50 percent year over year. The threat of private litigation and its settlement value have been
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