A U.S. regulator sued a number of major banks Friday over losses on more than $41 billion in subprime mortgage bonds, which may hamper a broader government mortgage settlement with banks.
The lawsuits by the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, came as a surprise to the market and weighed on bank shares. The lawsuits could add billions of dollars to the banks' potential costs at perhaps the worst possible time for the industry.
The FHFA accused major banks, including Bank of America, its Merrill Lynch unit, Barclays, Citigroup and Nomura Holdings of selling bonds backed by mortgages that should have never been packaged into securities.
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The biggest banks are already negotiating with the attorneys general of all 50 states to address mortgage abuses. They are looking for a comprehensive settlement that will protect them from future litigation and limit their potential mortgage litigation losses.
"This new litigation could disrupt the AG settlement," said Anthony Sanders, finance professor at George Mason University and a former mortgage bond strategist.
Banks may be more reluctant to agree to a settlement if they know litigation from other government players could still wallop their capital, he said.
Before the FHFA lawsuits had even hit a court docket, financial experts offered blunt expectations for the outcome.
"The lawsuits will be settled. The end result will be a further outflow of cash from the banks, and more importantly an additional black eye," said Sean Egan, managing director of Egan-Jones Ratings.
FHFA director Edward DeMarco is looking to minimize future losses for Fannie Mae and Freddie Mac, which are owned by the government after failing in 2008. The firms are pillars of U.S. mortgage finance.
The KBW Bank Index closed down 4.5 percent, nearly doubling the losses of the broader market. Bank of America led the index lower, dropping 8.3 percent.
Bank shares also came under pressure from signs that the Federal Reserve could start selling shorter-term debt on its books and buying long-dated bonds to push longer-term yields lower as a stimulus measure.
Such a move, known as "operation twist," would hurt banks whose profit margin is tied to the short-term rates at which they fund and the longer-term rates at which they invest.
Major banks already face potential payouts of tens of billions of dollars to settle regulatory charges of abusive mortgage lending and foreclosure practices, and other investor lawsuits over mortgage debt losses.
Such payouts would reduce earnings and weaken capital levels, perhaps harming the ability of banks to lend money and provide much-needed life to a stalled housing market and weakened economy.
Representatives of the sued banks declined to comment or were not immediately available to comment.
Banks have been walloped by mortgage losses, but so have Fannie Mae and Freddie Mac, which failed after trying to finance too many bad mortgages with too little equity. The two entities guarantee bonds backed by mortgages.
The question of whether to take action for problems related to the mortgage bonds has been under discussion since Fannie Mae and Freddie Mac were placed in conservatorship in 2008, a person familiar with the matter said.
While the ultimate amount FHFA will seek is still unclear, that person said it could top the $20 billion being discussed by the banks and the state attorneys general.
"Defendants falsely represented that the underlying mortgage loans complied with certain underwriting standards and guidelines, including representations that significantly overstated the ability of the borrowers to repay their mortgage loans. These representations were material to the GSEs, as reasonable investors, and their falsity violates (the law) and constitutes negligent misrepresentation, common law fraud, and aiding and abetting fraud," the FHFA said in the suit against Merrill Lynch.
The blizzard of litigation against banks is hurting share prices in the sector because investors feel unable to estimate the ultimate scope of a given bank's legal liabilities.
Bank of America, for example, had intended its proposed $8.5 billion settlement in June with investors in Countrywide mortgage securities to resolve most litigation tied to its disastrous 2008 takeover of that home loan provider.
But many parties are objecting to that settlement, and the deal didn't stop the insurer American International Group from suing Bank of America for $10 billion over its own alleged mortgage securities losses.
Nor did it stop Nevada's attorney general from threatening to withdraw from an $8.4 billion nationwide settlement with the bank. The AG now wants to sue the bank, accusing it of reneging on promises to modify mortgages.
Other banks also face mortgage lawsuits. In May, for example, the U.S. Justice Department sued Deutsche Bank, accusing it of misleading a U.S. housing agency into believing loans it made qualified for federal insurance.
The FHFA's lawsuits follow an initial lawsuit in July against UBS seeking to recover $900 million of losses incurred on $4.5 billion of debt.
One legislator praised the expected FHFA lawsuits. Brad Miller, a Democratic congressman from North Carolina, said, "Not pursuing those claims would be an indirect subsidy for an industry that has gotten too many subsidies already."
FHFA and various investors have alleged that banks, while packaging residential home loans into securities sold to investors, failed to conduct adequate due diligence, and hid or misstated the quality of the underlying loans and underwriting as well as borrowers' ability to make payments.
As more borrowers fell behind or went into foreclosure, the value of securities backed by their loans fell, causing losses for investors.
Losses stemming from the precipitous deterioration in subprime and other mortgages pushed the government to take over Fannie Mae and Freddie Mac on Sept. 7, 2008. Since then, taxpayers have spent more than $140 billion to keep the firms afloat.
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