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Banking behemoths JPMorgan Chase & Co. (JPM - Analyst Report) and Credit Suisse Group (CS - Snapshot Report) have agreed to resolve the allegations leveled by the Securities and Exchange Commission (SEC) by paying a total compensation of nearly $416.9 million. The allegations are related to the sale of faulty residential mortgage-backed securities (RMBS) by these banks prior to 2008 financial crisis.

Mortgage products, including RMBS, are considered by many as the staring point of the last financial crisis. It was claimed that many banks sold these risky mortgages using misleading statements. Eventually with the collapse of the housing sector, these mortgages resulted in huge losses for the investors. Consequently, regulatory authorities sprang into action, charged the banks of wrongdoing and slapped million of dollars in penalty.

Charges & Settlements

As per SEC, JPMorgan displayed a very deceptive picture of the underlying loans that supported nearly $ 1.8 billion worth of RMBS. JPMorgan represented that just four loans were delinquent by 30 to 59 days, whereas there were more than 620, or about 7% of the total. As a result, during the collapse, investors suffered losses to the tune of $37 million.

Moreover, Bear Sterns (acquired by JPMorgan in 2008) was indicted at failing to divulge its practice of collecting cash settlements from mortgage originators for loans that went bad without passing on the proceeds to the investors to whom it had sold the related securities. The earnings from this bulk-settlement practice were at least $137.8 million.

Similarly, SEC charged Credit Suisse and its affiliations for misleading investors about its practice of negotiated bulk settlements with loan originators in exchange of buyback loans owned by the RMBS trusts. Moreover, the bank kept these proceeds with it and did not disclose this practice to the investors who provided the loans. The proceeds earned from such misrepresentations amounted to nearly $55 million.

The SEC also charged Credit Suisse for misrepresenting First Payment Default (FPD) provision in two of its RMBS offerings. The FPD provision required the mortgage loan originator to repurchase/substitute loans that missed payments shortly before or after these were securitized.

Credit Suisse deceived investors by incorrectly claiming that First Payment Default Risk was removed from its RMBS, and at the same time, it put a cap on the number of FPD loans that were passed back to the originator. All these resulted in to huge losses for the investors when the housing bubble burst.

Both JPMorgan and Credit Suisse have agreed to settle the claims by shelling out $296.9 million and $120 million, respectively. Out of these, $84 million and $39 million, respectively, represent the amount that SEC will pay to the investors to make up for their losses. The JPMorgan settlement is subject to an approval by a federal judge in Washington, D.C., whereas Credit Suisse's case was settled in an SEC administrative proceeding.

All these actions by regulatory authority reflect the government’s strong stance to probe the malpractices adopted by banks in connection with RMBS that contributed greatly to the financial crisis.

Various Other Settlements

Earlier in June 2011, JPMorgan agreed to pay $153.6 million to settle a separate SEC case over its sale of mortgage securities to investors. Moreover, The Goldman Sachs Group, Inc. (GS - Analyst Report) paid $550 million to SEC to settle similar charges in 2010. Similarly, last year, Wells Fargo & Company (WFC - Analyst Report) agreed to pay SEC $11 million to resolve claims that charged it for selling old risky collateralized debt obligations at unreasonable prices.

In addition to SEC, JPMorgan is under review of Federal Housing Finance Agency, which has sued nearly seventeen of the Wall Street biggies, including Bank of America Corporation (BAC - Analyst Report), JPMorgan, Citigroup, Inc. (C - Analyst Report) and Goldman Sachs. The lawsuit pertains to the sale of billions of dollars worth of risky mortgage-backed securities (MBS) to government-sponsored entities (GSEs) – Freddie Mac (FMCC) and Fannie Mae (FNMA) – via misleading statements.

Further, New York Attorney General Eric Schneiderman has prosecuted JPMorgan in October this year, claiming that Bear Stearns deceived mortgage-bond investors about defective underlying loans that supported the securities.

Conclusion

The legal troubles like this will likely result in mounted expenses and affect the top line of many of the financial institutions. However, the measures undertaken by the regulatory and legal authorities to come down hard on such unwarranted activities of these institutions will let the investors breathe a sigh of relief.

JPMorgan currently retains a Zacks #2 Rank, which translates into a short-term Buy rating whereas Credit Suisse currently retains a Zacks #1 Rank, which translates into short-term Strong Buy rating. We believe that the legal hassles faced by these banks have the potential to generate downward estimate revisions leading to deterioration in the Zacks Rank.

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