BUSINESS
02/26/2013 09:24 am ET Updated Feb 26, 2013

Mortgage Crisis Lawsuits Could Bring Hundreds Of Billions In Losses For Big Banks

A verdict delivered earlier this month by a prominent federal judge heightens the prospect that the nation’s largest financial institutions will be forced to pay as much as $250 billion to compensate investors who bought bundles of fraudulently marketed mortgage-related securities, according to financial and legal experts.

The Feb. 5 decision in New York Southern District Court issued by Judge Jed. S. Rakoff involved only one relatively minor lender: Michigan-based Flagstar Bank. Rakoff found that Flagstar had failed to disclose the real risks of the mortgages it was selling, and he ordered the lender to pay $90 million to an aggrieved insurer, Assured Guaranty Municipal Corporation.

But experts zeroed in on Rakoff’s reasoning as a potentially damaging precedent for other lenders contending with scores of similar lawsuits, many involving fraudulent assurances claims from the investors who bought mortgage-backed securities during the U.S. housing boom.

"This will certainly have a ripple effect on all those cases,” said Isaac Gradman, a securities litigator at Perry, Johnson, Anderson, Miller & Moskowitz in Santa Rosa, Calif., "This decision did not get made in a vacuum. The potential damages are enormous.”

Gradman -- who is not party to the case at issue but said has been involved in similar legal actions -- suggested that potential payouts from active lawsuits, as well as those yet to be filed, could run between $200 billion and $250 billion.

Major mortgage lenders with pending lawsuits declined to comment. But in recent public statements, executives at such institutions have downplayed the risk of a substantial hit to their balance sheets.

“We're comfortable with our legal positions across the board,” said Brian Moynihan, chief executive officer at Bank of America during a mid-January conference call with bank stock analysts, when asked to characterize the risk of lawsuits involving its sales of mortgage-backed securities.

Bank of America confronts a lawsuit from the federal government seeking unspecified damages as compensation for alleged fraud involving some $24.9 billion in bonds. MBIA, a private bond insurer, has a similar suit pending against Bank of America, a case analysts say could cost the bank $2 billion to $3 billion.

Bank of America has already paid $14 billion in settlements related to similar cases, and has set aside $19 billion to pay for future cases, according to the bank's most recent quarterly report.

But other lenders have yet to make similar reserves, said experts, raising the risk that they could be hit by a wave of costly legal judgments that could freeze capital in the financial system. The consequences would be felt not only by the lenders but by a range of players who depend upon their lending -- from small businesses in need of loans to ordinary households in pursuit of mortgages.

Prospective homebuyers seeking mortgages, especially those with patchy credit, could find it harder to obtain them, said Tomasz Piskorski, an economist at Columbia University who has explored the loan misrepresentations. “Banks may have to cut other types of lending, like risky business loans,” he said. As a result, the economy would suffer from “less lending, and so potentially less construction and business investment and potentially less current consumption by households.”

In the wake of the worst financial crisis since the 1930s, investors who bought so-called residential mortgage-backed securities during the housing boom have sued banks that packaged and sold such bonds. The investors claim that the banks touted their bonds as virtually risk-free, even as they clearly knew these securities were jammed full of mortgages almost certain to default.

Nearly every prominent name in banking has faced such lawsuits, from American giants like Goldman Sachs, JPMorgan Chase and Bank of America to foreign players like Credit Suisse, UBS and HSBC.

The banks have generally defended themselves by conceding that they did mislead investors on the risks of their products, but at the same time challenging the buyers to prove that those false assurances directly caused their losses. In the Flagstar case, Judge Rakoff rejected that defense, saying plaintiffs had the right to be compensated for having absorbed more risk than they opted for -- regardless of whether they could prove the increased risk triggered losses.

“It is the fact that Assured faced a greater risk than was warranted that is at issue for the question of breach,” Rakoff wrote in the decision.

Legal experts cautioned that the misrepresentations in the Flagstar case were particularly blatant, suggesting that other cases are likely to be weaker. Still, the precedent established by Rakoff's decision could make it harder for banks to defend themselves -- even in cases in which fraud is less evident.

"This decision enables [plaintiffs] to go against Credit Suisse and UBS, where the cases are not as strong, but where it’s still an issue," said a California hedge fund manager who was an investor in Flagstar and who spoke on condition of anonymity. "If I were Credit Suisse or UBS, I’d be running to settle.”

If banks wind up paying out larger sums to settle claims that they falsely marketed mortgage-backed securities, the losses are likely to spill out broadly, according to research by Piskorski and Amit Seru, another Columbia University economist, who identified “sizeable asset misrepresentations, even among the most reputable underwriters.”

According to the findings in their report -- touted as the first comprehensive analysis of mortgage-backed securities issued during the housing boom -- the lenders who most aggressively hid the risk of the underlying mortgages in their investments include a trio of defunct institutions: Lehman Brothers, Washington Mutual and Countrywide Financial. Securities put together by HSBC, Merrill Lynch, Deutsche Bank, Nomura, UBS and Credit Suisse also contained misrepresentations, but at a lower rate, the economists found.

“This phenomenom seems to be pervasive across the very reputable institutions we have in our data,” said Seru. “It’s not a few bad apples. It seems to be across the board.”

Since their research was released this month, he added, “lots of lawyers, lots of banks have been calling us.”

Investors have filed lawsuits against Swiss banking giant UBS in connection with bonds worth $44 billion. In the few cases the bank has settled so far, it’s had to pay plaintiffs with checks totaling 62 percent of the bonds at issue.

In its most recent quarterly report, the bank spelled out its legal situation: “We cannot reliably estimate the level of future repurchase demands, and do not know whether our rebuttals of such demands will be a good predictor of future rates of rebuttal. We also cannot reliably estimate the timing of any such demands.”

In its own quarterly report, British bank Barclays noted possible litigation over $76 billion in bonds issued during the boom, but declined to estimate how much the damage would be in court, saying, “It is not practicable to provide an estimate of the financial impact of the potential exposure.”

Scores of other banks face a similar set of challenges.

Bill Frey, a principal at Connecticut-based Greenwich Financial Services, concurs that large lenders routinely misled investors -- his shop included -- during the boom in mortgage-backed securities. But he expects that the banks will ultimately absorb only “minimal losses” from the resulting lawsuits.

The largest investors, who have standing to pursue potentially crippling claims, are generally choosing to avoid litigation, he said. A few Middle Eastern sovereign wealth funds, European pension funds and American “bond king” funds like PIMCO, Blackrock and Prudential, which hold the vast majority of mortgage-backed bonds at stake, could have sued years ago, Frey said.

“The major investors, the ones that manage the U.S. pension funds, have known about this for several years and have chosen not to act in a serious or responsible manner,” Frey said. As for the European pension funds, he added, “I don’t believe they’re going to get organized enough before the statute of limitations runs out.”

While that might be good news for the banks, it's less positive for the country, Frey said. Allowing banks to essentially cheat and keep their winnings sets a terrible precedent in the market. Investors have exited mortgage markets since 2008, and Frey said validating the banks’ fraudulent profit-making could prompt them to forswear trading in those areas long-term.

“The legal structure of mortgage backed securities is obviously flawed,” he said. “Until basic issues are addressed, you don’t have the legal structure needed for a market.”

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