Loan blame game now in court

The sub-prime debacle is spurring a big-money litigation free-for-all.

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By Walter Hamilton

NEW YORK -- Insurance lawyer David Grais has been poring over equations in finance books to get up to speed on his new specialty: lawsuits stemming from the sub-prime mortgage debacle.

With his traditional insurance practice slowing down, the 55-year-old partner at a small New York firm began segueing into sub-prime in June, after a friend predicted at lunch that it would become the next legal blockbuster.

"This whole area is a new dawn" for lawyers, Grais said.

First came the sub-prime mortgage boom. Next was the bust. Now, as surely as day follows night, come the lawsuits.

All large-scale financial scandals spawn mountains of litigation, but the sub-prime fiasco stands out because of the complexity of the system that funneled more than $1 trillion from investors around the world through Wall Street and mortgage lenders to borrowers with dicey credit.

As losses mount on those loans, the scene of the blame game is shifting to the courts.

Sub-prime borrowers are suing loan brokers and lenders, accusing them of deceptive practices. Wall Street firms that bought now-delinquent sub-prime loans are trying to force lenders to buy them back.

Investment-bank shareholders are going after those firms' managers, saying they took excessive risks by loading up on bonds backed by sub-prime mortgages. And investors are suing money managers whose sub-prime-laden funds have suffered hefty losses.

"Somebody described it to me as, 'Everybody's standing in a circle shooting at each other,' " said Kevin LaCroix, a lawyer who writes a blog on sub-prime litigation.

In all, the 278 civil sub-prime-related cases filed in federal courts last year already amounted to half of the 559 actions brought during the entire savings-and-loan crisis from 1989 to 1995, according to research firm Navigant Consulting Inc.

"The pace of filings has just accelerated dramatically," said Navigant Managing Director Jeff Nielsen.

The data don't include the unknown number of suits filed in state courts -- or the probes by federal and state regulators and prosecutors, who are bearing down on many of the key players in the mortgage industry, looking for evidence of wrongdoing.

The sub-prime meltdown is likely to overtake the S&L crisis as the civil litigation record-holder this year, Nielsen said.

"We're at the stage now of throwing a lot against the wall and seeing what sticks," said Therese Pritchard, a securities law partner at Bryan Cave in Washington.

In one novel case that began in January, the city of Cleveland sued 21 major banks under Ohio's public nuisance law, accusing them of reckless lending that is burdening the city with a mass of foreclosures.

Grais, of Grais & Ellsworth, said the legal intricacies of the sub-prime disaster are what appealed to him. He has been taking classes to understand how Wall Street pieces together exotic mortgage-backed securities.

"This is the most interesting stuff I've studied in 30 years as a lawyer," he said.

Of course, as with most legal free-for-alls tied to financial blowups, most of those suing in the sub-prime mess aren't hoping to go to trial. The goal is compensation in an out-of-court agreement.

"The plan for plaintiffs is to get a settlement out of the case," said Michael Perino, a securities-law professor at St. John's University in Queens who studies class-action litigation. "That's the exit strategy."

Plaintiffs' attorneys contend that their investor clients suffered enormous losses because lenders made loans to unqualified borrowers, and investment banks, hungry for fees, packaged the toxic debt into bonds.

"The wrongdoing is absolutely awful," said Sal Graziano, a partner at Bernstein Litowitz Berger & Grossmann in New York. "Some of our clients have lost easily tens of millions of dollars."

Graziano's firm has sued money manager State Street Corp. on grounds that its supposedly conservative bond funds were irresponsible in buying sub-prime securities.

Some companies are bracing for possibly being on the hook for sizable settlements. State Street said recently that it would record a $618-million pre-tax loss to cover potential legal liability stemming from sub-prime losses in some of its investment funds.

Many homeowners who believe they were defrauded by sub-prime lenders, as well as small investors with related losses, are likely to end up in class-action lawsuits with hundreds or thousands of others.

Although participating in class actions saves the time and cost of pursuing cases individually, plaintiffs typically recover only pennies for each dollar of losses they allegedly incurred, legal experts note.

A wild card in the litigation frenzy is whether the numerous investigations by state and federal prosecutors turn up proof of wrongdoing that could bolster suits by investors, homeowners and others.

The Securities and Exchange Commission, the Justice Department, the FBI and many state attorneys general all are conducting sub-prime-related probes. Partly because companies feel compelled to cooperate with regulators, the government may have the best chance of uncovering incriminating evidence, experts said.

"The government is apt to get to the truth of what companies knew faster and more effectively than a civil litigant," said Maria T. Galeno, a white-collar defense lawyer at Pillsbury Winthrop Shaw Pittman in New York.

A key issue in many cases is sure to be whether the lenders and securities underwriters fully disclosed the risks to borrowers who took out sub-prime loans or to investors who bought securities backed by them.

"It's, 'What did you know when you sold me this stuff, and what did you tell me about it?' " said Bill Sullivan, chairman of the securities-litigation practice at Paul Hastings in Los Angeles. "Marrying up what was disclosed versus what was known will be an important inquiry in each case."

The banks are likely to argue that sub-prime bonds were bought by sophisticated investors who understood the dangers and that it was impossible to foresee the turmoil that upended the housing market.

But if government regulators show that banks didn't adequately disclose the risks, it "would put this litigation into an entirely different and far more serious category," said Jonathan Macey, a securities-law professor at Yale University.

"That would take these from 'kind of improbable to win' to 'How many zeros are we talking about on the check?' "