Big Banks Fear Mortgage Suits

More than a dozen big banks could be sued by the U.S. Federal Housing Finance Agency (FHFA) for infringing commitments on the quality of mortgage securities sold to Fannie Mae (FNMA - Snapshot Report) and Freddie Mac (FMCC - Analyst Report) during the housing bubble, the New York Times reported on Thursday. As the overseer of mortgage giants Fannie Mae and Freddie Mac, the FHFA is contriving to charge these banks billions of dollars as compensation.

This FHFA action would come as a big blow to many banking giants that are already stifled by a tight regulatory noose. Subsequently, it will compound the mortgage litigation problem, making it more difficult for these banks to gain ground.

What Went Wrong?

Prior to the housing market collapse, big banks assembled these mortgages and marketed them as securities to investors. Incidentally, a large number of these mortgage securities were made up of subprime loans requiring little or no documents supporting a borrower's repayment ability. As a result, the value of these securities deteriorated drastically during the housing market slump.

Though Fannie Mae and Freddie Mac were not allowed to purchase those loans directly; they accumulated some of those securities as they were seeking expansion through investments in safe securities. Despite being backed by subprime and other risky loans, some of the controversial securities attracted mortgage giants with their AAA ratings.

The two mortgage giants also fell into the same trap and purchased those securities with high hopes of greater returns. Generally, such financial instruments provide higher yields at their inception, but these securities defied their nature.  

Subsequently, because of a sharp drop in the value of risky mortgage securities, Fannie and Freddie lost more than $30 billion when the housing bubble burst in late 2008. The losses were ultimately covered by government bailoutworth $141 billion and the two firms managed to remain afloat.

Finally, these two companies were placed under the conservatorship of FHFA. But to make matters worse, Fannie and Freddie defaulted on loans purchased by them prior to the recession and ended up incurring deeper losses over the last two years.

Was FHFA Silent Until Now?

No, the FHFA was not sitting idle. The impending suits stem from subpoenas it had issued a year ago.The FHFA had issued 64 subpoenas to issuers and servicers of mortgage-backed securities following one of the largest securities fraud investigations since the height of mortgage crisis till date.

Now, rather than asking the big banks to repurchase the original loans, the FHFA is looking for reimbursement against losses on the securities held by the mortgage giants.

Expected Time of Lawsuit

With the third anniversary of the federal takeover of Fannie Mae and Freddie Mac on September 6, 2011, the deadline to file claims will expire. So the lawsuits are expected to be filed before that date.

Target Banks

Though the FHFA didn't disclose its target banks at the time of issuing subpoenas, the New York Times report has enlisted the likes of Bank of America Corp. (BAC - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report), Goldman Sachs Group Inc. (GS - Analyst Report) and Deutsche Bank AG (DB - Snapshot Report) as facing the impending lawsuit.

The source also says that the financial agency will charge these banks of lacking in diligence that the securities law demands while assembling and selling mortgage securities plus keeping no evidence of inflated or falsified incomes shown by borrowers.

Tough Times Ahead?

The lawsuits could be another major threat to the financial service sector. At such a crucial moment of seesawing world economy, if the FHFA forces the big banks to cough up billions, it’ll be a long time before they can hold their heads up once again. The already jeopardized economic recovery will then be out of the question as banks are the lifeblood of the economy.

The same predicament will follow the housing market. It was only recently that the banks started contributing to the housing recovery. Going forward, the extent of damage that the FHFA lawsuits would have on the housing resurgence is anybody’s guess.

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