Law and Economics Issues in Subprime Litigation

This paper explores the economic and legal causes and consequences of recent difficulties in the subprime mortgage market. We provide basic descriptive statistics and institutional details on the mortgage origination process, mortgage-backed securities (MBS), and collateralized debt obligations (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 registered amounts, the evolution of MBS tranche structure over time, mortgage originations, underwriting quality of mortgage originations, and write-downs of investment banks. In light of this discussion, the paper then addresses questions as to how these difficulties might have not been foreseen, and some of the main legal issues that will play an important role in the extensive subprime litigation (summarized in the paper) that is underway, including the Rule 10b-5 class actions that have already been filed against the investment banks, pending ERISA litigation, the causes-of-action available to MBS and CDO purchasers, and litigation against the rating agencies. 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 the quality 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 investors and market participants knew versus what individual entities in the structured finance process knew, 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 discussions with Tamar Frankel, David Sugerman, and research assistance from 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 Law School for financial support.