With more experts putting numbers to the possible insurance liability impact of the subprime mortgage crisis last month, the figures are starting to mount, with estimates ranging from $3 billion to 10-times that amount. The first figure--which relates only to potential directors and officers liability claims--could be dwarfed by $16 billion-plus in professional liability insurance losses, also known as errors and omissions insurance, some experts say.

While the latest expert analyses are based on data collected so far, some forecasters also note that information available to date represents just the tip of what seemed like a slow moving iceberg back in April, when National Underwriter first reported on the subject. (See NU, April 2, page 14.)

Then experts were speculating that the subprime crisis would not have the D&O impact of financial meltdowns like Enron or WorldCom, or even the lesser impact of options backdating cases.

Now, "the numbers are staggering," according to Frederick Zauderer, technical director of Travelers Bond & Financial Products in New York.

In particular, Mr. Zauderer--speaking at a session of the Professional Liability Underwriting Society International conference in November--was referring to precipitous drops in share values of publicly traded subprime mortgage lenders, homebuilders and guaranty insurers that have prompted securities fraud class-action filings that may be covered under D&O insurance policies.

Citing figures from a Sept. 6 research report by Bear Stearns analyst David Small on 55 such companies--including a 94.2 percent stock drop for lender Novastar Financial, a 77.4 percent dip for builder Beazer Homes, and a 56.8 percent slide for guaranty insurer ACA Capital--Mr. Zauderer said that "more than half the value of the marketplace vanished, and we are not yet at the peak."

Explaining why more fallout is expected, Mr. Zauderer first reviewed the multiple factors driving such results--loose standards for writing mortgages that fed a securitization market for packaging mortgages and other debt obligations, followed by a housing slump and a jump in interest rates, prompting defaults and foreclosures.

Depending on the region, home prices have fallen anywhere from 5-to-10 percent since 2006, and it's expected that they won't stop dropping until next year, he said.

In addition, he said that interest rates on adjustable-rate subprime loans originated in 2006 are yet to adjust, adding that more than 29 percent of all home loans in 2006 were subprime (citing a figure from a Wall Street Journal article, "The United States of Subprime," Oct. 4, 2007, page 1).

"That's why...we're not yet even close to the peak of this problem--because those are going to begin adjusting next year," Mr. Zauderer said.

In dollars, roughly $600 billion worth of 2006 originations were subprime, he reported, noting that while the figure was down from a $625 billion high in 2005, it had grown from just $120 billion in 2001.

Scott Schechter, a partner with Kaufman Borgeest & Ryan LLP in New York--who spoke about the domino effects of the subprime crisis on a variety of financial institutions that could ultimately be felt by their D&O and E&O insurers--suggested one unusual twist related to the collapse of investment banks that participated in the mortgage securitization market.

"Everyone associates the subprime problem with people who have very poor credit, [but along] with some of [those] investment bank collapses, there are going to be some pretty high-net-worth people affected by this whole situation," Mr. Schechter said. "Some well-to-do people overextended themselves, buying extremely expensive homes with long-term mortgage products," he explained.

"There are going to be people at Citibank who were expecting huge bonuses," he said, adding that when they don't get them, they'll be stuck with tremendous monthly housing bills on which they can't make their payments, "in a housing market where some [areas] will be glutted with homes over $1 million and $2 million.

Mr. Zauderer noted that high-end borrowers included many young professionals who got good-paying jobs upon graduation. These people were given adjustable rate mortgages and so-called "piggyback loans," he said--explaining that a piggyback, offered to a home buyer with good income but no assets, is the loan of a down payment. "You could close with little or no money out of your own pocket."

"Banks lent 100 percent of the value of the home...and [now] they can't get the prices that they lent" as home prices plummet, he said.

"They're going to own homes that are way under water," Mr. Schechter agreed.

Repeatedly, Mr. Schechter and Mr. Zauderer presented figures on stock drops and lawsuit filings offering apologies because they were outdated just days after they were compiled. Indeed, during the three-day PLUS conference and in the days immediately preceding it:

o Citigroup announced an anticipated $8-to-$11 billion write-down related to subprime exposures, and that its chairman, Charles Prince, would be leaving.

o Merrill Lynch said its CEO, Stan O'Neal, was departing in the wake of a $7.9 billion write-down (which dwarfed a $4.5 billion disclosure in an earnings warning released weeks earlier).

o Morgan Stanley and American International Group announced subprime-related losses of roughly $3 billion and $1 billion, respectively.

Mr. Zauderer started his presentation with numbers in the trillions, noting that $1.9 trillion of $2.5 trillion in mortgages originated in 2006 were securitized, and that roughly 25 percent of mortgage-backed securities were backed by subprime loans--amounting to nearly $500 billion of securitized subprime debt overall.

Later, turning to a list of publicly announced losses for 10 major financial institutions that added up to $26.1 billion, Mr. Zauderer said experts are expecting the three institutions with the largest write-offs to date--Morgan Stanley, Citigroup and Merrill Lynch--to write off another $27 billion in the fourth quarter.

Citing an Oct. 28 New York Times commentary suggesting that auditors will force these large firms to adopt more realistic values of their mortgage portfolios, Mr. Zauderer noted that one key problem is mortgages aren't readily traded in a market like stocks. "Mortgages, once they're securitized and sold to investors, sit there until they mature," leaving holders to decide what they're worth, he explained.

"They apparently made some errors," he said, referring to the write-downs.

The fallout doesn't end there, he said, noting that companies like Federal Express and Lowes cut earnings estimates, Whirlpool announced weaker sales, and Home Depot and furniture makers Ethan Allen and Herman Miller traded at 52-week lows at the time of the PLUS conference.

"People aren't buying houses, they're not fixing houses, [and] they're not buying appliances," he said. "The impact of this is just going to keep growing exponentially."

While all of these stock drops aren't likely to produce securities lawsuits (which need allegations of fraud or misrepresentation to survive dismissal motions), reinsurance broker Guy Carpenter, in a recent report, highlighted one serious situation in which a financial institution not involved in subprime lending is already facing lawsuits against its directors.

Northern Rock, a U.K. mortgage lender that was not involved in subprime lending, relied heavily on short-term debt to fund its mortgage lending activities, Guy Carpenter said, reporting that the general tightening of credit following the collapse forced Northern Rock to seek emergency funding from the Bank of England.

This, in turn, led to the first run on a U.K. bank in more than a century, and Northern Rock lost 90 percent of its market value, prompting the shareholder suits, the Guy Carpenter report said.

"D&O was the first thing to pop out of the woodwork" in terms of experts pegging potential places for insurance losses, said Mr. Schechter, as he showed a list of 18 subprime-related securities class-actions. (See text box, "How Bad Is It?" for updated information.)

"It's easy to get your arms around" the idea that there will be D&O claims when lenders like Countrywide report losses in one quarter of $1.2 billion, or others, such as New Century and American Home Mortgage, have filed for bankruptcy, he said.

More recently, securities class actions against investment firms like Citigroup and Merrill Lynch have been filed.

Already Bear Stearns and Guy Carpenter have come up with D&O loss estimates in the $1 billion-to-$3 billion range, based on the market losses of mortgage lenders, builders, financial institutions and others suffering stock drops. "What is even more frightening" is the potential magnitude of E&O losses, Mr. Schechter said, noting that picture is not developed enough to get a real understanding of how bad they might be.

Referring to one analysis presented in Guy Carpenter's November report, "Credit Market Aftershock Threatens Professional Liability Profits," he said there is $16 billion in E&O insurance coverage just for mortgage brokers. Deriving the figure, the report noted that there are 53,000 licensed mortgage brokers, and in accordance with regulation, they have to carry limits of $300,000 in E&O insurance.

"We're not suggesting that all of the mortgage companies are going to have subprime problems, but even if only a small percentage [do] and $300,000 policies are a baseline, then you can do the math....The defense costs on E&O claims involving just the mortgage sector are going to be extensive," Mr. Schechter said.

"The list goes on," he added, noting that mortgage lenders aren't the only class of professionals with E&O insurance likely to be caught in the subprime fallout. In particular, he believes another big driver of E&O claims will be suits brought against investment advisers by clients.

After years of healthy returns, these clients are suddenly getting statements showing their investments "are down exponentially for the year."

"Some people are claiming...that when they were purchasing these mutual fund products, they had no idea they were bundled with mortgage-backed securities." Suits will allege that advisers had these clients involved in products they had no business being in when the clients were seeking safe returns, Mr. Schechter said.

Mr. Zauderer noted that one case along these lines already filed is Prudential vs. State Street & Trust Corp. and State Street Global Advisors--a suit in which Prudential, which acted as an adviser for pension funds, is actually suing a subadviser, State Street, which Prudential alleges did not follow certain investment guidelines. Prudential, which stepped in and made its pension clients whole, is now seeking to recover those losses from State Street, he explained.

Beyond this case, Mr. Schechter cited 14 others already filed and potentially covered by E&O or D&O insurance, including four in which large banks are suing mortgage companies for breach of contract for failing to buy back the mortgages in default. Some of these mortgage companies, headed for bankruptcy, simply can't buy back the mortgages, he added.

He also reviewed a list of regulatory investigations and suits that have been brought by several attorneys general--noting, for example, that the Massachusetts AG has sued Fremont Investment & Loan, accusing it of predatory lending practices.

Mr. Schechter went on to predict that an ambitious plaintiffs' bar will ultimately file a nationwide class action along the same lines, and Mr. Zauderer predicted a reverse redlining suit. "The overwhelming majority of the true subprimes were among minority communities," he said. "Somebody's going to bring that action. I guarantee it."

Other state regulatory and SEC probes cited by the pair include attorneys general accusing lenders of pressuring appraisers to inflate home values, the SEC looking into valuations of mortgage securities by financial institutions and related disclosures, as well as probes of rating agencies.

Guy Carpenter in its report lists rating agencies and mortgage brokers as the most worrisome "high exposure" E&O classes, while assessing regional banks, home appraisers, real estate agents, bond insurers, hedge and private equity funds in the "medium exposure" category.

But there are reasons to believe the subprime E&O insurance bill will fall short of "crisis proportions," according to some experts, including Joseph Monteleone, a partner in the New York office of Tressler, Soderstrom, Maloney & Priess.

In a newsletter to his firm's clients, he noted that "there has been little focus to date on liability and causation issues," adding that affixing blame for damages on potential defendants may prove difficult.

Rating agencies, for example, successfully weathered similar claims in the past for alleged failures to downgrade financial institutions in a timely manner--although they incurred large defense costs in the process, he wrote. Now, he suggested, high defense costs may be paid out initially, but cases may then ultimately peter out as plaintiffs' initial efforts for recoveries prove to be unsuccessful.

Guy Carpenter, in its report putting forth the $16 billion figure for E&O dollars at stake, also went on to suggest a lesser impact could play out--noting, in particular, that claims brought by individuals would represent high frequency but lower losses than class actions, which would likely be limited to the largest defendants.

On the D&O side, Guy Carpenter believes insured losses will be at the top end of analysts' estimates--$3 billion--reasoning that most analysts "have understated D&O limits at risk and assume there will not be many claims beyond what has already filed." (See text box, "Understanding the Estimates.")

"Insurance losses could account for 30-to-35 percent of D&O industry premium," the Guy Carpenter report said, deriving D&O loss figures from $1-to-$2.5 billion.

In addition, Guy Carpenter said that traditionally profitable Side-A D&O coverage "could mushroom the insured loss" total. Large investment banks, for example, could see "failure to supervise" exposures arising for trading losses or debt-structuring, leading to shareholder derivative lawsuits.

(Side-A policies provide D&O coverage in situations where companies cannot indemnify directors and officers, including derivative suits brought by shareholders on behalf of the company.)

Special Reports /

Will Professional Liability Insurers Take $19B Hit From Subprime Crisis?

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