Small Law Firm’s Big Role in Bundling Mortgages

Originally Published: February 1, 2008

In recent years, as subprime lending proliferated, a small law firm played a big role on Wall Street.

Back of the Envelope The young firm, McKee Nelson, helped investment banks and mortgage lenders bundle home loans into securities — lots of them. Since 2000, McKee has been involved in almost 3,300 deals totaling $2.7 trillion, according to Asset Backed Alert, an industry newsletter.

The Wall Street banks and lenders hired McKee Nelson, which is based in Washington and New York, to write or review prospectuses for the securities. It was a lucrative arrangement, helping to generate $202.5 million for the firm in 2006, the latest year for which figures are available.

Now, with losses on bad mortgage investments exceeding $135 billion, questions are growing about whether prospectuses like these adequately disclosed the risks to investors.

Mark H. Adelson, a co-founder of Adelson & Jacob Consulting, a securitization and real estate consulting firm, said offering documents in general lacked clear warnings about the deteriorating quality of home loans. “That’s what was missing,” Mr. Adelson said. Most of these documents, however, did detail the mechanics of the investments and the kinds of loans backing the securities, he said.

Reed D. Auerbach, a structured finance partner at McKee Nelson, stands by the firm’s work.

“We get paid to write good disclosure,” Mr. Auerbach said. “We think that the offering documents we’ve written disclosed all the risks to investors.”

New York state prosecutors are investigating whether Wall Street banks withheld crucial information from investors about the risks posed by subprime loans. McKee Nelson has not been subpoenaed in the investigation or accused of any wrongdoing.

But as investors’ losses mount, companies across the financial services industry are coming under scrutiny. Bankers, auditors and lawyers are bracing for a wave of lawsuits. One law firm, Cadwalader Wickersham & Taft, is already fighting a $70 million malpractice suit over its mortgage securities work.

“Anybody who touched the security in the process of creating or selling it is going to be subject to litigation,” said Joseph A. Grundfest, a business and law professor at Stanford and a former commissioner of the Securities and Exchange Commission.

The Internal Revenue Service, meantime, recently opened an inquiry into the special trusts that are typically used to issue mortgage securities. A McKee Nelson spokeswoman declined to comment.

McKee Nelson burst onto the scene in 1999 and quickly grabbed lucrative Wall Street work from long-established rivals. William F. Nelson, one of its co-founders, said the firm, which is known for its sophisticated tax work, did not employ any special legal maneuvers to outflank its competitors. “There’s no secret, magic elixir that we sprinkled,” Mr. Nelson said.

In any case, the mortgage turmoil is now hitting the highly regarded McKee Nelson hard. The firm recently pared its structured finance department to 80 lawyers from about 115 through buyouts, sabbaticals and transfers to other departments. More cuts are unlikely, a spokeswoman said.

Across Wall Street, the structured finance industry is hurting. Just this week Merrill Lynch, which has lost billions of dollars on mortgage investments, said it would pull back from the business.

But after profiting from the mortgage boom, McKee Nelson is now positioning itself to profit from the bust by riding the coming wave of lawsuits. In January, the firm flew its partners and their spouses to Charleston, S.C., aboard four Delta commuter jets, to map out its strategy.

“We’re heavily committed to doing more litigation,” Mr. Nelson said. The firm hopes to represent investment banks, hedge funds and other financial companies, as well as their executives, in a variety of litigation, he said.