Foreclosure fallout: subprime lending crisis adds tobanks' insurance headaches.

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The good news is that the subprime crisis hasn't been a huge direct challenge to community banks on the lending side. The bad news is that when a depth charge like that goes off, the ripples flow far and wide, and those are affecting community banks and their insurance coverages

Future impact on D&O market

Consider shareholder suits. As the nearby box details, stockholders have sued a number of large financial players because of subprime missteps. Thus far, community banks haven't been dragged into that, according to Mike Read, regional territory manager for the ABA-sponsored insurance program, underwritten by Progressive. However, Read points out that community banks are not immune from shareholder suits, and the evolution of subprime-related cases is young, yet.

And even though these banks aren't being sued, they stand a good chance of feeling some of the pain, once removed.

"We're starting to hear some saber rattling," says Progressive's Read, "about a hardening of the directors and officers insurance market, and the subprime crisis is driving that."

Read thinks D&O rates may be going up in 2008, as carriers insuring larger banking companies see potential payments and future risks rising.

The rattling will grow louder. Koorosh Talieh, partner at Howrey LLP, Washington, D.C., specializes in insurance coverage litigation--essentially, he's the one called in when carriers won't pay off. He says the subprime issue is already shaping up as a significant second-tier battleground. Take the matter of SIVs--structured investment vehicles. SIVs are not what D&O carriers thought they would be exposed to, and he fully expects them to fight before covering companies and executives and board members who have been sued, especially given the size of the claims.

"Typically," says Talieh, "the insurance case ripens later," sometime after the main case that the coverage relates to. Some of the claims that will be made regarding misleading lenders will wind up sparking suits between insureds and their errors and omissions insurance carriers.

"It always works this way," says Talieh. "The moment there is a crisis, the supply of coverage shrinks because the insurance companies get nervous. They push up the rates. Companies then either lower their coverages, or they look offshore."

Local challenges

Where community banks will likely be having more immediate challenges is right in their backyards, perhaps literally. As foreclosures grow, both in the residential and residential construction sectors, more banks will likely find themselves holding other real estate owned, according to Ronald Summerville, president, RCS Consulting Group, Chevy Chase, Md.

While typically community banks have not been holding much OREO, Summerville says the industry has seen an uptick in certain states and markets, and he expects the trend to spread.

The result of that is that the bank becomes the temporary owner of the homes and properties they've foreclosed on. Summerville says this brings up a host of insurance-related issues.

From the start, unless the bank regularly does enough volume that it has arranged a master insurance policy, each property foreclosed on is going to require basic coverages, much as the homeowner would have had to maintain. These would be to protect the lender/owner from loss from fire, broken frozen pipes, and such. The bank may also have to make a claim for vandalism damage, if the home is unoccupied prior to sale. The bank also has to cover itself for general liability, such as "slip and fall" cases.

The policies involved resemble homeowners' coverage, Summerville says, but they are not written on the homeowner's policy form. In some locales, windstorm damage coverage may be appropriate, Summerville says.

Alternatively, if the bank rents the property while its disposition is being worked out, Summerville says that brings up more issues. Even before insurance is considered, the bank must make sure the house is up to code; renting a substandard property poses legal liability. And more liability insurance may be in order if tenants will be in the property.

This all assumes the property is completed. If the bank has seized an unfinished property, other issues must be addressed through insurance, such as the presence of work crews on site finishing up the building. And other steps must be taken to safeguard the bank, some as simple as fencing the property to avoid an "attractive nuisance" problem. If a bank has taken over a large enough development, in the case of those who finance residential builders or developers, it may have to hire onsite security to patrol or control community gateways.

"These are less desirable risks," Summerville warns, and the carriers that write this coverage watch a lender's foreclosure levels very carefully. If and when their loss levels rise too high, they may cut off an institution, possibly even canceling coverage on OREO they already agreed to insure.

Technological challenges

Bankers have additional insurance concerns, as well. Progressive's Read says that identity theft worries and the growing reliance on electronic banking methods are driving demand for related insurance services.

A good case in point is merchant remote deposit capture service. Banks are concerned about depositor frauds that could be accomplished in an RDC context.

"I think at this point it is still a theoretical loss," says Read. "I'm not aware of any actual loss that we've had." But the risk is considered genuine, so Progressive covers such risks under the financial institution bond program that it offers under ABA sponsorship.

This comes along with the increasing attention banks are paying to covering the risks of electronic banking and other IT practices. Fraud has become a pervasive risk on many fronts that bankers must safeguard their institutions against.

RELATED ARTICLE: Subprime crisis breeds class-action suits.

"Never stoops the soaring vulture, On his quarry in the desert,... But another vulture, watching,... Sees the downward plunge, and follows; And a third pursues the second,... Till the air is dark with pinions."

From "The Ghosts," in The Song of Hiawatha, by Henry Wadsworth Longfellow

While financial services companies, mortgage investors, corporate stockholders, and homeowners either facing the effects of subprime and exotic loan resets or the aftermath of foreclosure live through their share of the current credit crisis, one profession has zeroed in on the mess as a fresh source of successful business: class-action lawsuit attorneys.

Indeed, since the first cracks began appearing in the subprime and exotic mortgage field, about two dozen class-action suits have been filed against companies that made or purchased these mortgages, according to Charles B. Casper, chairman of the Class Action Defense Practice at Montgomery, McCracken, Walker & Rhoads, LLP. He has been tracking these cases.

Casper, based in Philadelphia, who has served as Microsoft's class-action counsel since 1993, says the first types of filings to appear were traditional shareholder suits against boards and managements of lenders and other financial players. Filed under federal securities laws, these concerned claims against decisionmakers who oversaw the companies' subprime lending efforts. While some suits involve companies that have had trouble but that continue to operate, others are against those that went out of business or filed for bankruptcy.

Another type of case that's starting to be seen are those filed under state unfair and deceptive practices statutes, alleging that borrowers were misled. And, most recently, classes of employees of subprime lenders have filed suit against companies when their retirement savings, invested in company stock, has evaporated. These suits are being filed under the federal Employee Retirement Income Security Act against parties seen as fiduciaries. These can include not only the members of plan committees, but also employer directors and officers.

Banking companies are among the financial services firms that have been caught up in the class actions, according to Casper's research. (He is not currently representing any defendants to any of these actions.) Washington Mutual, for instance, faces a securities holder suit, filed in September, as well as an employee pension plan suit filed in November. Other companies in the class-action bar's crosshairs already include Countrywide Financial, E-Trade Financial, Merrill Lynch, Citigroup, and World Savings Bank (now part of Wachovia). Casper notes that in 2007 Wells Fargo & Co. settled a class-action suit filed in 2003 by ACORN, the Association of Community Organizations for Reform Now, on behalf of subprime borrowers.

Unfair and deceptive practices cases. Casper says these types of cases will hinge on plaintiffs' attorneys being able to demonstrate that Lenders and brokers failed to comply with appropriate disclosure requirements or outright misrepresented loans.

Firms facing such exposure could benefit from the private-sector program that the Bush Administration worked out with members of the Hope NOW alliance. Borrowers who accept some measure of assistance under the program will have less basis for action, Casper explains.

Securities class action suits. Among the suits filed are actions against defunct companies. One is a securities Law class action filed in October 2007 against NetBank, which was dosed by the Office of Thrift Supervision in September 2007. Senior officers were also included. While most such suits have been filed against living companies, Casper says suits against dosed firms seek recovery from the bankruptcy estate, as unsecured creditors.

Employee pension class-action suits. One case Casper pointed to, in this category, was filed in September by a law firm attempting to represent participants in Countrywide Financial's 401k plan. This suit, against the company and the fiduciaries, alleges that they negligently managed and administered the plan, in part by failing to disclose information about the risks Countrywide faced from under-reserving for loan losses as conditions deteriorated in the subprime sector.

By Steve Cocheo, executive editor