Are They Still 'Too Big to Fail?'

09/02/2011 5:20 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Big US banks are leading the US stock market down today.

The driver here isn’t simply the prospect of slower economic growth represented by the lack of any job growth in August data released today—although that certainly doesn’t help.

Bank stocks are reeling because the big US mortgage lenders and mortgage packagers are reportedly facing a suit be filed next week by the Federal Housing Finance Agency, the agency that represents Fannie Mae and Freddie Mac, seeking to force these financial companies to repurchase bad mortgages. [This has actually happened earlier than expected, after the close today—Editor.]

The amounts at stake—and it’s extremely hard to put a dollar figure on this suit—could dwarf the $20 billion sought in a suit brought by the states' attorneys general.

Fannie Mae and Freddie Mac own about $227 billion of the so-called "private label" mortgages that are the subject of this suit. (Bank of America (BAC) probably faces the biggest exposure, since it sold the most of these private label mortgages to Fannie Mae and Freddie Mac.)

No surprise then that Bank of America was down 8.7% as of 3:30 p.m. New York time, JPMorgan Chase (JPM) 4.7%, Goldman Sachs Group (GS) 5%, Citigroup (C) 5.1%, and Wells Fargo (WFC) 4.5%.

The suit would be the result of 64 subpoenas issued last year to originators and servicers of mortgage-backed securities. The statute of limitations is due to expire next week, so the Federal Home Finance Administration has to file or forever hold its peace.

The subpoenas and the likely suit focus on private label mortgage-backed securities originated by mortgage lenders, packaged by Wall Street investment companies, and then sold to investors. Fannie Mae and Freddie Mac were permitted to buy slices of these securities, which carried AAA ratings.

As of the end of July, the two companies—now owned by taxpayers—held $78 billion and $149 billion in such securities, respectively.

Private label mortgage-backed securities have been among the worst performing mortgage-backed assets, showing the kind of losses nobody expects from AAA-rated securities. The likely suit would allege that the banks in question misrepresented the content of the mortgage pools when they packaged them and sold them to Fannie Mae and Freddie Mac.

Testimony in front of the Financial Crisis Inquiry Commission showed that a large percentages of mortgages included in mortgage-backed securities deals had received inadequate due diligence, and that the big Wall Street investment companies ignored those problems and packaged them in the mortgage pools anyway.

A suit from the Federal Housing Finance Agency would be a nightmare for the big mortgage banks, not just because of the sums involved, but because it would also pretty much blow up all other efforts to put together settlements that would cap bank liabilities.

Forget about the proposed settlement with state attorneys—a settlement already in danger. And it would almost certainly bring other investors into court demanding that banks buy back their mortgage paper too.

But the effects don’t stop there.

First, a suit from the Federal Housing Finance Agency—headed by Ed DeMarco, a Bush administration holdover—would kill the already slim chances of any comprehensive foreclosure fraud settlement. Part of that settlement would have granted banks immunity against mortgage-foreclosure lawsuits in exchanges for a program of mortgage relief to stressed mortgage holders. Forget immunity now.

And without immunity, banks aren’t going to do more to prevent mortgages on the verge of default from going into foreclosure.

Second, the potential hits to the big banks are large enough to raise fears about the need for these banks to raise new equity capital. With financial markets in their current state, raising new capital wouldn’t be easy for these banks.

And that, of course, raises worries that the Federal Reserve would have to lead another rescue effort for some of the too-big-to-fail banks.

The Wall Street Journal has reported, for example, that the Federal Reserve has asked Bank of America to explain its contingency plans if its financial condition deteriorates. One option the bank listed would involve floating a class of shares backed by its Merrill Lynch unit.

The mortgage crisis just keeps on giving.

Full disclosure: I don’t own shares of any stock mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.

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