Tuesday, September 13, 2011

U.S. Sues Big Banks Over $196 Billion in High-Risk Home Loans

Fannie Mae
Federal Housing Financial Agency
FT: Banks Sued Over Mortgage Deals
Freddie Mac
NYT: Federal Regulators Sue Big Banks Over Mortgages
WSJ: U.S. Sues Big Banks Over Home Mortgages

Last Friday, the U.S. Federal Housing Finance Agency (FHFA) filed lawsuits against 17 of the world’s largest banks, alleging that they failed to disclose the high-risk nature of some of the home loans contained in $196 billion worth of mortgage-backed securities (MBS) they sold to Fannie Mae and Freddie Mac. The U.S. Congress established Fannie Mae and Freddie Mac (known as government-sponsored entities, or GSEs) to provide liquidity and stability to the U.S. housing market. As the largest source of home financing in the U.S., Fannie Mae and Freddie Mac play an integral role in ensuring that the average American can secure a home loan.

Although Fannie and Freddie do not lend money directly to homeowners, they are the largest purchasers of home loans from banks and other financial institutions that create the mortgages. Thus, they are able to influence what loans the banks issue based on what loans they (Fannie and Freddie) will purchase. The GSEs “securitize” many of the loans they purchase by bundling several loans together and selling them as one financial instrument called a mortgage-backed security or MBS. They also purchased MBSs from banks.

The FHFA lawsuits accuse the banks of making “materially false statements” about how risky the home loans were that the banks securitized and sold to the GSEs to mislead the GSEs into buying these unsafe investments. After the collapse of the U.S. mortgage market in 2008, Fannie Mae and Freddie Mac were left holding billions of dollars of home loans and MBSs that became worthless as homeowners defaulted at an unprecedented pace. Since then, the U.S. Treasury has spent $141 billion taxpayer dollars keeping the GSEs afloat as part of an ongoing effort to stimulate the U.S. housing market. Since 2008, the FHFA has been responsible for overseeing the preservation and conservation of Fannie’s and Freddie’s assets on behalf of U.S. taxpayers. The FHFA filed the lawsuit in keeping with this role.

The controversial lawsuits are the most sweeping governmental action aimed at holding the banks accountable for their role in the financial crisis. In their defense, the banks point to Fannie Mae’s and Freddie Mac’s formidable roles as “major players” in the mortgage market as they purchased, packaged and sold billions of dollars worth of mortgage securities. In July of 2008, just prior to the U.S. government taking control of Fannie and Freddie, the portfolios each GSE held were worth $758 and $798 billion respectively. The banks claim that Fannie and Freddie were, therefore, shrewd and sophisticated market participants with detailed knowledge of the home loans and securities they purchased. Because Fannie and Freddie knew so much about the home mortgage business, the banks argue, the government should not blame the banks for the GSEs’ investing mistakes.

The banks claim that, even if they are at fault, the lawsuits will do more harm than good. After spending the past three years rebalancing their business to address the massive losses they suffered during the financial crisis, the banks fear that the lawsuit creates enormous potential liabilities and uncertainty that threaten their stability. Of the seventeen banks named in the lawsuit, Deutsche Bank, Credit Suisse Holdings USA, Goldman Sachs and Morgan Stanley sold $10 billion or more each in MBSs containing questionable home loans to Fannie and Freddie. J.P. Morgan Chase and Royal Bank of Scotland Group sold over $30 billion each, and the beleaguered Bank of America’s total exceeds $57 billion due to its acquisitions of Countrywide and Merrill Lynch/First Franklin Financial. Although the lawsuit does not specify how much the government hopes to recoup in damages, prior settlements of similar lawsuits indicate that the government could recoup twenty percent (nearly $40 billion) of the total securities sold to the GSEs.

Government critics point to high U.S. unemployment rates, the declining stock market, including the rapid devaluation of bank stocks since the lawsuits were filed, and broad consumer concerns as an indication that the timing and potential consequences of the lawsuit could be bad news for the economy. Bank critics claim that the U.S. government needs to hold the banks accountable for their past reckless practices to prevent future misdeeds. Irrespective of the merits of the lawsuits, the litigation may take years and cost the banks and taxpayers millions of dollars in legal expenses. Most of the banks were in settlement negotiations with the regulators prior to the filing of the lawsuits and observers expect those negotiations to continue.

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