On Thursday, the Department of Justice (DoJ) announced that Wells Fargo & Company ( WFC - Analyst Report ) has agreed to pay nearly $175 million to settle civil charges against it. The settlement agreement was filed with the U.S. District Court in Washington, D.C. and awaits approval.

The lawsuit alleged Wells Fargo of discriminatory lending practices against qualified African-American and Hispanic borrowers on home loans. Moreover, some of these borrowers were dragged into subprime mortgages.

Reasons Behind the Claims

After reviewing loans, including loan terms and creditworthiness of the borrowers, the DoJ revealed that Wells Fargo overcharged (higher fees and interest rates) about 34,000 minority borrowers in 36 states and District of Columbia compared with white borrowers who had similar credit profiles. Moreover, among these, 4,000 borrowers were duped with subprime mortgages. Majority of these victims were not even aware of this bias and the trap they were falling into.

The DoJ reviewed loans between the period from 2004 to 2009 and revealed that the anti-discrimination laws were indeed violated by the company. The settlement amount paid by Wells Fargo would be distributed amongst the aggrieved borrowers. Moreover, Deputy Attorney General James Cole commented that with the settlement, the government will also certainly help the borrowers, affected by the housing crisis, to have a chance to access homeownership.

The DoJ’s civil rights division, created in 2010, mainly focuses on banks and financial institutions that are suspected of discriminating against minority borrowers. At present, the department is pursuing nearly 20 lawsuits with charges related to biased practices against minorities who are buying homes.

The investigation of Wells Fargo’s lending practices was initiated in 2009 by the DoJ. Moreover, in 2010, the department received a referral from the Office of the Comptroller of the Currency (OCC), confirming the involment of Wells Fargo in discriminatory lending practices.

Such measures will aid the housing market to recover going forward and stop fraudulent practices in the industry to some extent.

The settlement also resolute the pending litigation filed by the state of Illinois in 2009 in support of the borrowers belonging to this region. It also settled the complaint filed by the Pennsylvania Human Relations Commission in 2010.

Price to be Paid

Precisely, Wells Fargo will have to pay $125 million to wholesale borrowers who were trapped in subprime mortgages or discriminating lending rates. Further, additional $50 million will be paid as direct down payment aid to the borrowers in seven metro areas in the country, where huge number of victims of racism, who are affected by housing crisis, were recognized by the DoJ.

Additionally, Wells Fargo will internally assess the working procedures of its retail lending division in providing subprime loans to Hispanic and African-American borrowers between 2004 and 2008. If any compensation arises, after the review process, to be paid to sufferers of discrimination, it will be in addition to $125 million reserve for wholesale borrowers.

Steps Taken by the Company

While going through the details of its mortgage lending procedures, Wells Fargo illustrated that most of the claims under this settlement are related to its wholesale mortgage program. These mortgages were priced and sold to customers by sovereign mortgage brokers. Therefore, with no control over such issues, Wells Fargo voluntarily discontinued its mortgage wholesale program.

After July 13, no new applications for loans, provided by independent mortgage brokers through Wells Fargo’s wholesale program, will be accepted. Moreover, existing applications will be processed and bunged. At current level, mortgages sold by independent brokers through mortgage wholesale program stands at 5% of the company's mortgage loan volume.

Wells Fargo has, however, denied such charges but agreed to the settlement to put an end to the legal battle. In May 2012, Wells Fargo had agreed to settle a similar lawsuit by assuring over $432 million in lending as well as other investments in Memphis, Tennessee. The lawsuit accused the company of racially discriminatory practices in lending.

The lawsuit filed by Memphis and Shelby County in 2010 accused Wells Fargo of victimizing African-American neighborhoods over rapacious loans. This conduct of Wells Fargo since 2000 has led to a huge number of foreclosures in these neighborhoods. Notably, the company is battling charges from the DoJ under laws, which forbid bias against minority homebuyers.

Similar Practices by Peers

Wells Fargo is not the only bank entrapped in such lawsuits. Bank of America Corporation ( BAC - Analyst Report ) settled similar civil charges amounting $335 million against its Countrywide Financial unit in December 2011. Likewise, the mortgage-lending unit of SunTrust Banks Inc. ( STI - Analyst Report ) has agreed to pay nearly $21 million to settle such charges in May 2012.

Conclusion

We believe that this step would put the mortgage borrowers at ease to some extent. Such settlements also provide some relief to the companies and their shareholders as these reduces the litigation overhang. However, the company’s dented financials and goodwill due to such lawsuits cannot be ignored.

Shares of Wells Fargo currently retain a Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain a long-term ‘Neutral’ recommendation on the stock.