01/11/2012 04:14 pm ET Updated Mar 12, 2012

2012: For Banks, The Year Of Fear And Litigation, And A Chance For Peace

Last year was a banner year for litigation addressing a decade's worth of risky bank behavior. Financial institutions agreed to pay billions in penalties and fines to resolve allegations of securities fraud and lending discrimination during the lead up to and fallout from the financial crisis. But the payments made to date pale in comparison to what is looming in 2012. This year looks like it will be only worse for the banks, as dozens of lawsuits will work their way through the courts, threatening bank balance sheets and likely dragging down the value of financial sector stocks. That some may collapse completely under the weight of these legal challenges is not out of the question.

Virtually every large bank is besieged in some way from litigation and the threat of litigation over its practices. Whether it is over shoddy securitizations or perjury in the foreclosure process, many banks face investigations, protracted litigation, and the prospect of stiff fines and large judgments. Added together, these could all translate into big hits to their bottom lines.

While recent employment figures are encouraging, no true economic recovery can occur until the housing market improves; yet such a rebound is intertwined with the financial health of the banks and the strength of the housing market in profound ways. As long as banks face a host of legal challenges to their practices, their mortgage records are rife with fraudulent documents, and they continue to spend their time pursuing millions of foreclosures instead of writing new mortgages, there can be no recovery in housing. In order to restart the housing and mortgage finance sectors, and reduce the legal cloud hanging over the banks, a simple solution exists: the meaningful modification of underwater mortgages as a means of resolving the myriad legal challenges the banks face. The quicker the litigation around bank practices is resolved to bring about such modifications, the quicker a housing recovery can take hold.

In the wake of the financial crisis, bank lawyers are practically camping out in the nation's court houses. Last year, the Federal Housing Finance Agency (FHFA), the conservator for the government-sponsored entities, Fannie Mae and Freddie Mac, sued seventeen of the world's largest banks for improprieties in their bundling of mortgage-backed securities, seeking over $200 billion in damages. Attacking foreclosure abuses, the Massachusetts Attorney General, Martha Coakley, sued five large banks over such conduct, seeking millions in relief for homeowners in Massachusetts impacted by these practices. Wells Fargo is fighting off lawsuits in Maryland and Tennessee that raise claims of lending discrimination in the origination of subprime loans. A state court judge in New York held recently, in another lawsuit over faulty securitizations, that MBIA, an insurer of mortgage-backed securities, will face few hurdles in its effort to establish that Bank of America's subsidiary, Countrywide, engaged in fraudulent practices when it packaged securities for MBIA to insure. In a lawsuit similar to those already settled by several investment banks, Citigroup faces the prospect of litigating charges by the SEC that it manipulated mortgage-backed securities so that the investment bank could offer investors the chance to bet against the bank's own securities, while the bank promoted those same securities to other investors; in that case, a federal judge rejected as inadequate a settlement of the case that included fines of hundreds of millions of dollars. Finally, various state courts, and, most recently, a federal appeals court, have ruled that banks cannot foreclose on properties where their mortgage records are tainted by fraudulent documents, meaning that thousands of foreclosure cases could get bogged down in legal wrangling over faulty records.

These are just some of the legal challenges banks face; and should plaintiffs continue to score legal victories in them, it is likely that more, not fewer, such cases will be filed in the near future.

In addition to these lawsuits, the banks also face the prospect of sweeping charges arising out of fraudulent foreclosure practices. In the wake of the robo-sign scandal, where mortgage servicers filed fraudulent documents in tens of thousands of cases, many state attorneys general and the federal government are negotiating a possible resolution of that investigation. Such a resolution could have several components tied to increasing the number of mortgage modifications for borrowers impacted by the scandal. While the details of such a settlement are still being negotiated, and the question of whether all state attorneys general join the agreement is something that needs to be resolved, the prospect of a settlement that could lead to more mortgage modifications offers hope that at least in one area, banks will get out from under the threat of penalties and litigation by offering mortgage modifications as a solution to the mortgage mess.

This approach -- resolving legal challenges by engaging in mortgage modifications through principal reduction -- offers a way out of the legal morass, and offers the banks the chance to clear out the toxic, tainted loans from their balance sheets, speed the housing recovery, end the circular firing squad of mortgage foreclosures, and breathe new life into bank balance sheets and stock values. (For a more in-depth look at the value of dealing with tainted loans in this manner, read here.)

A recently released Federal Reserve white paper confirms that mortgage modifications represent a means of improving the prospects of recovery in the housing sector, as well as the broader economy. One of the biggest problems dragging down real estate and mortgage lending is the great number of underwater properties, where borrowers owe more on their mortgage than their homes are worth. Indeed, depending on who is counting, roughly 12 million mortgages, or, roughly 25% of all outstanding mortgages in the country, are in this situation. Mortgage modifications that reduce mortgage principal in particular would align home values with mortgage balances, and lower the risk that these mortgages will go into foreclosure. Reducing principal allows borrowers to take advantage of lower interest rates to refinance their mortgages, gives them greater mobility to pursue jobs in other parts of the country, and re-aligns incentives: a borrower with equity in his or her home is less likely to engage in strategic default by walking away from the home and the mortgage.

But meaningful mortgage modifications do not simply make things easier on borrowers. If banks agree to make such modifications to settle some of the legal charges against them, it could free banks from the threat of more investigations and the continuing burdens of litigation. For banks, clearing the decks of this legal baggage will only help their bottom lines and boost shareholder value. Indeed, even the mere rumor of a new and sweeping mortgage modification program was enough to send bank stocks higher last week.

The FHFA lawsuits alone could serve as leverage to encourage banks to reduce principal balances. While FHFA's (read: the taxpayers') balance sheet could also take a hit as a result, as any damages the agency seeks would have to be sacrificed in favor of principal reductions, the long-term benefits to the broader economy could be substantial, and could greatly exceed such short-terms losses.

The economy will not fully recover until the banks resolve their legal problems. Meaningful mortgage modifications can accomplish many things at once: right-size underwater mortgages, encourage mortgage business through refinancing, and reduce the cloud of litigation hanging over banks. The quicker banks realize this, the faster the housing market can restart, mortgage refinance activity can increase, bank assets can revive, bank stock values can rise, and a broader economic recovery can take hold.