Real Estate Agents, Mortgage Brokers Could Leave Subprime Crisis Unscathed

The distressed mortgage investments that have triggered the current subprime crisis have estimated losses approaching tens of billions of dollars.

These losses will clearly eclipse those caused by the implosion of Long Term Capital Management, a hedge fund that collapsed in the late 1990s, and the entire liquidated loss of the Resolution Trust Corporation in connection with the Savings and Loan crisis in the 1980s.

But unlike subprime's predecessor crises, figuring out who's to blame is not so easy.

Aggrieved investors will try to recoup their losses by looking to third parties with deep pockets. Professional liability claims may be brought against the entire gambit of subprime mortgage players–auditors who gave mortgage lenders clean opinions shortly before imploding, directors and officers, attorneys, investment advisors, hedge fund and pension fund managers, and many others who plaintiffs will claim have played some role.

Therefore, as with any professional risk, insurers must understand their client's business, and where it fits into the scheme of losses. Keen underwriters should take a basic approach: understand what functions are performed by whom and how close causally and legally they are to the injured parties.

It's no different than assigning blame in a product liability case over a car crash. Every component maker might have liability, but the airbag supplier's and upholstery maker's faults are similar in kind only.

o The bottom-line: companies that are directly connected with marketing, purchasing, pricing or insuring mortgage-backed securities are at the greatest risk.

o Secondary players with only indirect connection to residential mortgages–like derivatives and credit insurance writers– fill the next layer.

o Front-line professionals like real estate agents and mortgage brokers, while still apt to become involved in the spat, are far enough removed from investor exposure to escape relatively unscathed.

Some of the casualties of the subprime crisis are already obvious. Public companies, such as Bear Stearns, Citigroup and others, succumbed to massive write-downs of their mortgage securities portfolios. Their market capitalizations fell by billions.

Investors (stockholders) have already filed scores of securities cases asserting management failed to report the value of the subprime assets held by the company in a timely manner. But the converse is true as well–many financial institutions may treat the current year as a “kitchen sink” year and be quick to write down assets. After all, how do you mark to market an illiquid asset?

Loan originators like NovaStar and New Century incurred massive losses as investors demanded repurchase of underperforming loan portfolios and the investors and banks upon which they rely made margin calls. This double whammy capital drain forced many out of business quickly.

These firms may face direct exposure to investors and from other companies who either relied on their advice, wrote credit swaps, or with whom they had other financial dealings. They, in turn, often relied on rating and underwriting agencies, accountants, and lawyers, and are also exposed to investor and company professional liability claims.

What's more, fund managers have direct relationships with fund investors. Low global interest rates and yields caused investors to seek out returns, and many funds found them in the form of mortgage-backed investments. Fund managers who bought risky mortgage instruments may face direct liability for their role in selecting the investments.

Lastly, real estate appraisers are a high-impact target although, to date, they have been under the radar screen. This group has direct relationships with mortgage lenders to the extent they offered independent valuations of real property that lenders used to justify mortgage programs. Lenders will point to accidental or intentional inflation of home values as a causative factor when they underwrote underperforming loans.

Finance companies and investment banks that are not directly exposed to residential mortgages could face exposures to shareholders and others.

Specialty finance companies still suffer badly if their business model relies on short-term debt to fund their operations. The systematic margin calls caused a global unwinding of interconnected leverage and has left these businesses scrambling for cash. While these firms have no direct connection to souring mortgage investments, they and their stockholders are no doubt feeling the pinch.

Counterparties and insurers of mortgage lenders, while not directly exposed to angry investors, suffer when the big company suffers. Excessive pressure in the credit derivative markets is already bearing this out.

Not every firm connected with residential real estate and poor credit borrowers faces catastrophic exposure to subprime mortgage losses. Front-line professionals far removed from the aggrieved investors are in much better shape.

For example, mortgage brokers and real estate agents face relatively little exposure to the subprime crisis because their direct relationships are with buyers and sellers.

By contrast with lenders and mortgage banks, mortgage brokers are arrangers of credit. They do not render investment advice nor underwrite buyer credit quality. These front-line professionals facilitate or arrange deals between willing buyers and sellers of real property.

Real estate and mortgage brokers do not face direct liability from the largest aggrieved class: the investors who own mortgage-backed securities. These front-line professionals are much safer bets to survive the subprime crisis for at least three reasons:

(1) The legal nuance that all real property is unique.

Essentially, there is no material fact to misrepresent because home value is established by the convergence of a willing buyer and willing seller. Real estate agents face borrower claims that they overpaid for their house, or did not understand the financing, but arrangers are not responsible for truth-in-lending disclosures.

(2) Difficulty in establishing damages.

An aggrieved investor will face a number of hurdles tracing liability back to a front-line professional. For example, many states have remedy and anti-deficiency laws that require the owners of most loans secured by real property to make a difficult choice should they not be getting paid.

The choice is to forego the security (the house) and sue the borrower on the note, or obtain the proceeds via exercise of a power of sale. In short, lenders can either get a money judgment or the house, but not both.

The economy and security of foreclosure is far preferable to abandoning the security and obtaining an uncollectible judgment. What is usually left is a lender that bids the full value of their note at public sale. Successful or not, this “full credit bid” is an admission the property was worth at least the loan amount. Voil?–no damages.

(3) General unwillingness of mortgage lenders to bring direct actions against real estate and mortgage brokers.

Most mortgages are still originated through independent channels. Lenders are heavily dependent on the retail and wholesale distribution channels and are therefore reluctant to alienate these key partners.

There is more bathwater than baby, but underwriters are wise to choose risks carefully and favor risks further removed from the pricing, purchase, and security of mortgage-backed securities.

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