INSIGHT: Next Economic Downturn Will See Increase in Structured Finance Litigation

If the economy heads toward a downturn, refinancings, defaults, and foreclosures will not be far behind. That would also mean an increase of litigation in the credit markets, including structured products.

With the benefit of over a decade of litigation arising out of the 2008 financial crisis, investors in asset-backed securities (ABS) will be better prepared and more willing to protect their interests this time around.

Asset-backed securities are debt instruments collateralized by mortgage loans, student loans, auto loans, or other debt obligations. They are typically issued through securitization structures: the collateral assets are sold into trusts; the trusts issue securities, commonly called certificates; and the certificates are sold to investors.

At the outset, entities that structure the securitizations, typically called sponsors, make representations and warranties concerning the quality and characteristics of the collateral, and agree to buy back any collateral assets that do not comply with those representations. During their lifetimes, the securitization trusts are administered by corporate trustees, and the collateral is managed—monitored, bought, and sold—by entities typically called collateral managers.

In good market conditions, ABS collateral generally performs well. Borrowers make their interest and principal payments on time, and refinancings and modifications are relatively rare and usually problem-free. But as market conditions worsen, collateral delinquencies and defaults increase in frequency and severity as borrowers struggle to meet their obligations, and ABS investors, in turn, suffer losses.

ABS Investors Have Overcome Fear of Litigation

Historically, ABS losses from poor collateral performance were a cost of doing business. ABS investors rarely relied on litigation to recover their losses. But that changed in the wake of the 2008 financial crisis, which spurred an unprecedented level of litigation activity.

ABS investors overcame whatever apprehension they might have had about litigation—fear of suing banks or being labeled as litigious—and commenced lawsuits against ABS sponsors, collateral managers, and corporate trustees on a massive scale, the likes of which had never before been seen in the financial industry.

Those lawsuits spanned alleged violations of representations and warranties made by sponsors of residential mortgage-backed securities (RMBS), as well as disputes over distributions and asset dispositions in commercial mortgage-backed securities and collateralized debt and loan obligations. While many of these lawsuits have been resolved or settled, a number of similar cases are still ongoing (including cases in which our firm is counsel for investors).

Having participated, or observed their competitors participate, in the post-crisis litigation wave, ABS investors have evolved in how they view and use litigation with respect to their investments. Litigation is no longer perceived as a last resort, but has instead become a valuable tool in investors’ arsenal. In fact, existing or potential litigation claims are a common consideration in valuing ABS investments.

As a result, investors are more prepared—and more willing—to litigate the fallout from the next downturn. Below are two potential areas that may see an increase in this activity.

Collateralized Loan Obligations

One example is collateralized loan obligations (CLOs) backed by leveraged loans. Much has been written about the risks of leveraged loans, which are loans issued to companies or individuals with significant pre-existing debt obligations. The CLO market has grown to over $600 billion, and it is estimated that over half of all leveraged loans are held in CLOs.

Because leveraged loans are issued to riskier borrowers, the loans bear a higher risk of default or a downgrade than other debt obligations. Either scenario can be harmful for CLO investors. Defaults translate into collateral losses, while downgrades not only impair the value of the CLO securities but make matters worse by triggering covenants that limit the amount of junk-rated loans held in the CLO.

If another recession arrives, investors may be quicker to blame CLO sponsors, collateral managers, and trustees for insufficient diligence, inadequate disclosures, and failure to abide by collateral quality covenants and investment criteria, among other things.

Investors may also invoke event of default provisions that require immediate liquidation of CLOs. Inevitably, these events may—and likely will—end up in court.

Auto Loans ABS

ABS backed by auto loans are another area that may see a spike in lawsuits following a downturn. These suits are likely to mirror the post-crisis RMBS litigation where investors pursued claims against sponsors and trustees for the poor quality of the securitized mortgages.

Both RMBS and auto loan ABS agreements contain representations and warranties concerning the quality of the underlying loans and require the sponsors to buy back non-conforming loans. And, like pre-2008 crisis RMBS, there are signs that underwriting standards for auto loans have loosened in the past few years and that borrowers appear to be taking on substantially more debt than the value of their vehicles. These developments are a recipe for litigation.

To illustrate, as Bloomberg recently reported, one auto loan originator has already come under heavy regulatory scrutiny and been subjected to increased loan buy backs. Santander Consumer USA Holdings has settled with several states and has been required to buy back over $40 million in subprime auto loans from a single transaction. Private lawsuits seeking similar relief may soon follow if auto loans come under downward economic pressure.

There are other ABS that may see an increase in litigation activity in the event of a downturn. They include ABS backed by student loans and commercial mortgage loans, which have also recently come under significant stress and rising defaults.

In sum, while the timing and impact of the next downturn is hard to predict, one thing is certain: If the downturn hits the ABS sector, investors are more likely to use the courts to seek relief against ABS deal parties sooner and with more sophistication than in the wake of the 2008 crisis.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Uri A. Itkin, a partner at Kasowitz Benson Torres LLP, represents hedge funds and private equity firms in litigation and potential disputes relating to their investments, including in asset-backed securities, structured products, and real estate.

Andrew W. Breland, an associate at Kasowitz Benson Torres LLP, represents clients in structured finance and complex financial products litigation.