A Denver insurance company is suing Prudential Insurance Company of America, alleging deceit in connection with part of a $552 million issue of mortgage securities.
The action is a jolt to the mortgage securities market, which has been rebuilding its reputation after difficulties a few years ago exemplified by the Orange County, Calif., fiasco. The market gives lenders a key source of liquidity by packaging their mortgages and selling them as securities.
The suit's aggressive tone-it charges Prudential with using a battery of fraudulent tactics to saddle investors with crumbling loans-is raising eyebrows.
"You don't hear about suits being brought because of nonrecovery of principal," said Ronald S. Borod, senior partner at Brown, Rudnick, Freed & Gesmer, a Boston law firm that specializes in securities litigation.
Usually, mortgage investments are challenged in court over prepayment speeds-when investors don't make the profits they had hoped for because of unexpectedly quick prepayments of loans backing the securities.
Industry experts said it's too soon to determine whether the suit will cast a pall over the market. "It depends on the legitimacy of the complaint," Mr. Borod said.
The complaint, filed on behalf of a group of investors in state Superior Court in Newark, N.J., where Prudential is based, alleged that the giant insurer perpetrated a "massive fraud" to unload millions of dollars of mortgage securities it knew were troubled. The securities are now said to be selling at 5 cents on the dollar.
The wrongdoing is attributed to Prudential Insurance and a number of residential mortgage units that Prudential sold last year to Norwest Corp.
Norwest does not believe it will be directly involved in the suit, which does not name it. That's because the securities were packaged before the purchase of the Prudential units, a Norwest spokesman said.
Still, in building a defense some of Prudential's fact-finding involves gathering information from what are now Norwest Mortgage offices, according to executives familiar with the matter.
Prudential, one of the largest packagers of mortgage loans, learned about the suit last week when its lawyers were contacted about preparing a response. Their reply is expected to be filed this month.
The company will "make a full analysis and determine if there is any basis for the allegations," said Prudential spokesman Rick Matthews. "Based on what we know, we believe we should defend this."
At issue is more than $55 million of "subordinated" classes that were part of $552 million of collateralized mortgage obligations, or CMOs, that Prudential put together in late 1992. Denver-based Capitol Life Insurance bought about $5 million of the subordinated securities, which offered a potentially higher return in exchange for greater risk.
But Prudential, instead of indicating that there could be a downside, "stressed only the positive aspects of the securities at offering presentations, as well as at expensive lunches it hosted around the country," the complaint stated.
The practice continued even after the securities were bought, the suit alleged. "Prudential fraudulently concealed the fact that not only would the securities fail to make projected interest payments, (but) the principal was disappearing and would eventually have to be written down."
Mr. Matthews suggested that Prudential was just as surprised about that turn of events. The company had held on to some of the securities that soured and lost "much more" than the deal's other investors, including Capitol Life, he said.