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Harvard Pub on Legal & Economic Issues in Litigation

Harvard Pub on Legal & Economic Issues in Litigation

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Published by 83jjmack
Legal & economic issues arising from the credit crisis.
Legal & economic issues arising from the credit crisis.

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Published by: 83jjmack on Jun 02, 2010
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07/24/2010

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Electronic copy available at: http://ssrn.com/abstract=1096582
HARVARD
 J
OHN
M.
 
O
LIN
C
ENTER FOR
L
AW
,
 
E
CONOMICS
,
AND
B
USINESS
 
LEGAL
 
AND
 
ECONOMIC
 
ISSUES
 
IN
 
LITIGATION
 
ARISING
 
FROM
 
THE
 
2007-2008
 
CREDIT
 
CRISIS
Jennifer E. BethelAllen FerrellGang HuNovember 17, 2008Discussion Paper02/2008Revised10/2008Harvard 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.com/ This paper is also a discussion paper of theJohn M. Olin Center’s Program on Corporate Governance.
 
Electronic copy available at: http://ssrn.com/abstract=1096582
 
LEGAL
 
AND
 
ECONOMIC
 
ISSUES
 
IN
 
LITIGATION
 
ARISING
 
FROM
 
THE
 
2007-2008
 
CREDIT
 
CRISIS
Jennifer E. Bethel*Allen Ferrell**Gang Hu***
A
BSTRACT
 
This paper explores the economic and legal causes and consequences of the 2007-2008 creditcrisis. We provide basic descriptive statistics and institutional details on the mortgage originationprocess, mortgage-backed securities (MBS), and collateralized debt obligations (CDOs). Weexamine a number of aspects of these markets, including the identity of MBS and CDO sponsors,CDO trustees, CDO liquidations, MBS insured and registered amounts, the evolution of MBStranche structure over time, mortgage originations, underwriting quality of mortgageoriginations, and writedowns of the commercial and investment banks. We discuss the financialdifficulties faced by investment and commercial banks. In light of this discussion, the paper thenaddresses questions as to whether these difficulties might have been foreseen, and some of themain legal issues that will play an important role in the extensive litigation (summarized in thepaper) that is underway, including the Rule 10b-5 class-action lawsuits that have already beenfiled against the banks, pending ERISA litigation, the causes-of-action available to MBS andCDO purchasers, and litigation against the rating agencies. In the course of this discussion, thepaper discusses three principles that will likely prove central in the resolution of the securitiesclass-action litigation: (1) “no fraud by hindsight”; (2) “truth on the market”; and (3) “losscausation.”
* 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 Ralph Ferrara, Paul Ferrillo, Tamar Frankel, Hal Scott, Steve Shavell, Erik Sirri, Laura Stiglin,David Sugarman, and the participants at many seminars and presentations of the paper, including theHarvard Law School Law & Economics Workshop and the Brookings – Tokyo Club – WhartonConference on Prudent Lending Restored: Securitization after the 2007 Mortgage Securities Meltdown.We appreciate research assistance from AK, Eric Chan, Wallace de Witt, and Johnson Elugbadebo.Professor Ferrell is grateful to the John M. Olin Center in Law, Economics, and Business at Harvard LawSchool for financial support.
 
 
Electronic copy available at: http://ssrn.com/abstract=1096582
The credit crisis is the foremost economic issue facing the United States today. Withhousing prices high and interest rates low through 2006, millions of households with weak credithistories purchased new homes or refinanced existing ones, using subprime residential mortgageloans, many with adjustable interest rates. Investment banks securitized these loans intoresidential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs),selling risk-differentiated tranches to investors. With the rise of interest rates and the decline inhousing prices beginning in 2007, as many as two million homeowners have faced or are facinginterest-rate resets that will increase mortgage payments by as much as 30 percent. Manyhomeowners have negative equity. Some have already defaulted, whereas others will default inthe future. These defaults and foreclosures have driven down the value of many RMBS andCDOs. Losses on these securities and their derivative effects are being felt by banks, investors,loan originators, credit appraisers, underwriters, bond rating agencies, bond insurers, and others.Having written down and continuing to write down assets, banks are now facing liquidity,solvency, and funding issues. Counter-party risk is high and lending markets, including themarkets for leveraged loans, auction-rate securities, commercial mortgages, student loans, andothers, have seized up. In this paper we explore some of the causes and consequences of the2007-2008 credit crisis, and its impact on various market participants. We investigate the risksthat can arise from financial and technology innovations and losses that are uniquely related tocorrelated events in the setting of loan markets.The credit crisis is not solely an economic phenomenon, but a legal one as well. It iswidely believed that the substantial decrease in the value of asset-backed securities held by thecommercial and investment banks and other purchasers will generate substantial, perhaps evenunprecedented levels of litigation. The facts so far are sobering. The percentage of securities

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