The 2008 Credit Freeze And Its Repercussions – 'Barclay v. Devonshire', Misrepresentation And Bad Faith

The meltdown of the world economy from early 2007 through the end of 2011 and which is still ongoing is unparalleled. Globalization, along with electronic communication and the computerization of banking and business, has added a new dimension to the current economic troubles. The dramatic demise of the economy and plummeting value of very significant and sophisticated investments have given rise to complex and interesting litigation.

1. INTRODUCTION

   This article focuses on Barclays v. Devonshire,1 a case heard in the Ontario Superior Court arising as a consequence of the economic crisis in 2008, when the Canadian market for Asset Backed Commercial Paper ("ABCP") collapsed.

   Barclays is a U.K.-based bank, self-described on its website as:

   With over 300 years of history and expertise in banking, Barclays operates in over 50 countries and employs over 145,000 people. Barclays moves, lends, invests, and protects money for customers and clients worldwide.2

   Devonshire was a special-purpose conduit created for the transactions under scrutiny in the litigation described below.

2. RISK AND REWARD — 2004-2007

   The background of the economic problems western economies now face includes the disassociation of risk from reward. Traditional investment models demand that a risk analysis be performed to determine if the reward justifies the risk. For typical investments such as government bonds, corporate bonds, stocks, and real estate investments, risk analysis methods are well known.

   In bubble economies (e.g., the United States real estate market in 2007), investors, buyers, and lenders, for a variety of reasons, underestimated risk. When there is too much liquidity in the system and excessive competition for investments, investors are prone to reducing their risk criteria. When this happens, it becomes easier to sell investments that are difficult to evaluate or have "good credit ratings", even though the actual risks may have increased.

   Syndicators, including Wall Street investment banks, took advantage of this situation. They created and issued products that had limited market liquidity, good credit ratings, and were extremely difficult to value, both in terms of intrinsic value and risk. The credit ratings were delivered by rating agencies who were paid by the issuers.

3. ECONOMIC CRISIS - 2007-2011

   The markets unravelled in late 2006, although the underlying causes emerged decades earlier. Blame has been attributed to many factors, including Wall Street financial institutions,3 large mortgage lenders, lack of or inadequate government regulation, and economic models based on free markets and the assumption that people act rationally when making economic decisions, which is now in some doubt.4 As previously mentioned, globalization, along with the ease with which money was moved around the world and investments packaged to obscure their true underlying value, were also contributing factors.5

   (a) Deregulation and the Savings and Loan Crisis — Early 1980s

   The trend towards deregulation in the banking industry in the U.S. in the early 1980s, commonly known as Reaganomics,6 led to the Savings and Loan Crisis7 in the late 1980s. Previously, U.S. Savings and Loan associations ("S&L") were regulated by U.S. federal law and restricted to offering homeowner loans at a low fixed percentage rate. The S&Ls were generally locally run and very conservative, offering a needed financial service to homeowners not available elsewhere. Deposits in S&Ls were federally guaranteed to a specified limit, giving depositors a secure investment with a modest return.

   S&Ls were deregulated under the Reagan Administration. This presented an opportunity for many unscrupulous businessmen to gain control over S&Ls and use depositors' money to loan on virtually any security with little regard to risk.

   It is estimated that 747 S&Ls failed shortly following deregulation; the U.S. federal government had to intervene to rescue depositors at a cost of over $87 billion. The result created a general slowdown of the economy in the U.S. along with budget deficits for many years, into the 1990s.

   The term "moral hazard" is sometimes used to describe the hazard of permitting a financial institution to lend while the risks are borne by a third party. In the case of the S&Ls, the third party was the government. S&L depositors were federally insured (at least to a certain limit), but the federal government did not oversee the lending practices of the S&Ls.8 The moral hazard concept can arise in the management of banks that are "too big to fail".

   Some of the more corrupt S&L executives were prosecuted and jailed.

   (b) Junk Bonds — 1980s

   The subject of junk bonds is discussed in the section entitled "The Sub-Prime Crisis".

   (c) Long-Term Capital Management — Late 1990s

   In the late 1990s, several former Salomon bond traders and two future Nobel Prize winners in economics created and ran a hedge fund called the Long-Term Asset Management Fund ("LTCM") and made a huge bet on the Russian ruble. The Russian economy crashed in August 1998; Russia defaulted on its debt and the ruble was devalued.9

   Per Wikipedia:

   [LTCM] did business with nearly everyone important on Wall Street. As LTCM teetered, Wall Street feared that LTCM's failure could cause a chain reaction in numerous markets, causing catastrophic losses throughout the financial system. After LTCM failed to raise more money on its own, it became clear it was running out of options. On September 23, 1998, Goldman Sachs, AIG, and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $3.75 billion and to operate LTCM within Goldman's own trading division. The offer was stunningly low to LTCM's partners because at the start of the year their firm had been worth $4.7 billion. Buffett gave Meriwether [head of LTCM] less than one hour to accept the deal; the time period lapsed before a deal could be worked out.

   Seeing no options left the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.10

   LTCM was considered "too big to fail" and therefore had to be bailed out by the government. While the amount of money involved seems modest by today's standards, this action made the bailout concept legitimized.

   (d) The Dot-com Bubble — 2000-2001

   The economic situation, at least superficially, seemed vibrant during the Clinton years, spanning 1992 to 2000. The economy was very strong and there was a transformation in industry due to the emergence of the Internet, resulting in the Dot-com Bubble.11

   During the Dot-com Bubble there was widespread belief that normal commerce would be transformed into e-commerce. The shares of companies without business plans, histories, or operations, were offered to the public in IPOs at non-supportable prices. There was no relationship between the price of new offerings and the performance of the companies. Promoters of the IPOs made a lot of money, and the retail investor ultimately paid the price.

   The Bubble burst in 2001, resulting in corporate failures and catastrophic losses in the stock market. Many of the stocks crashed from their IPO prices and became virtually worthless. There was limited effort by the Bush Administration to take action against the most egregious participants, such as the principals of Enron. The worldwide accounting firm of Arthur Anderson went into bankruptcy.12

   (e) The Subprime Crisis — 2005-2012

   President Clinton's closest financial advisors were Larry Summers and Robert Rubin. Alan Greenspan was the head of the Federal Reserve. They were all advocates of deregulation. Although they departed government when the Bush Administration was elected, the newly-appointed advisors held the same, if not more conservative, views.

   The subprime mortgage market that gave rise to Collateralized Debt Obligations ("CDO") and Credit Default Swaps ("CDS") began to emerge in 2004.13 The world was awash with capital. Liquidity was produced by lax lending policies, the speculative housing bubble, and the extension of credit by China to the U.S., among other things.

   Wall Street financial institutions have a long history of creating various syndicated loans and other securities instruments for purchase by banks, institutions, pension plans, and municipalities, among other bodies. Syndicators were aware that money was available from these sources and that they could create and control an incredibly lucrative market. By 2005, this market became known as the subprime and CDO market. The ability to control the market assured the syndicators, as intermediaries, substantial profit with little risk. The traditional role of the private banks or near banks expanded from offering mezzanine financing and investment advice to wealthy individuals and institutions to include these sophisticated offerings to their "clients".

   Michael Lewis writes about the origins of the subprime disaster in his book The Big Short.14 At p. 61 he observes that the stock market "was not only transparent but heavily policed. It had been legislated and regulated to at least seem fair." But:

   The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. In the bond market it was still possible to make huge sums of money from the fear, and the ignorance of customers.15

   Manipulation of the bond market is nothing new. In the 1980s, Michael Milken made almost a billion dollars while controlling "junk bonds". The junk bonds that Milken traded were mainly bonds issued by companies that were at a higher risk of default. Milken made the market; he brokered the deals rather than holding the bonds, or, if he held bonds, he was able to sell them before taking losses.16

   Milken was indicted on 98 counts of racketeering and securities fraud in 1989 as the result of...