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US and big banks play a game of chicken over mortgages

/ Source: contributor

When the U.S. filed suit against Swiss bank UBS in July for allegedly misrepresenting the soundness of mortgage-backed securities bought by mortgage giants Fannie Mae and Freddie Mac, analysts speculated it was just the opening act in what promised to be a drawn-out courtroom drama.

The next act in the drama happened Friday after the stock markets closed. The Federal Housing Finance Agency, which oversees Fannie and Freddie, filed a lawsuit against 17 major banks over losses on more than $41 billion in subprime mortgage bonds. The lawsuit came ahead of a deadline next week to file claims against banks in the matter.

The lawsuit filed Friday in federal courts in New York and Connecticut included most of the industry's heavyweights, including Bank of America, JP Morgan Chase and Goldman Sachs.

Banks have said the litigation would spell disaster for the housing market, dry up mortgage lending and further hurt the economy. Economists and analysts agree, to a point.

"Having it come to this point is clearly going to make the uncertainty worse, but how much worse is hard to judge," said Doug Elliott, fellow at the Brookings Institution.

Some of this uncertainty is already baked into banks' stock prices and reflected in their shift to conservative lending practices over the past few years. But a protracted legal battle could create additional pressure.

"We're dealing with very large sums of money, and when you put it into legal proceeding, there's a very wide range of possible results," Elliott said.

Celia Chen, senior director at Moody's Analytics, said if banks spend huge sums defending themselves or paying fines, they'll likely respond by further constricting credit, which would hurt the already-abysmal real estate market.

"I certainly think there is the risk that this suit could hamper mortgage availability, which is an issue right now in keeping the housing market from coming back," she said.

In addition, sales of foreclosed properties would grind to a near-halt. Until those properties are digested by the market, housing prices can't stabilize.

Chen said initial signs that a settlement could be hammered out back in the spring would have meant that the housing market would have unfrozen by fall. "Now i'm starting to think that might be overly optimistic," she said, which means it will take until the middle of next year for the real estate market to improve.

The government seems to be aware that these suits are going to knock the big banks off their game, perhaps seriously. The Wall Street Journal reported Friday the Federal Reserve asked Bank of America to do some disaster-planning and come up with steps the Charlotte-based bank could take if if its legal woes threaten its financial health. The bank's shares have been under pressure lately as investors fret about its ability to withstand more legal problems and another possible downturn in the economy.

The Fed and the FHFA know the prospect of another bank bailout is politically unpalatable. According to the results of a Rasmussen Reports telephone survey released in May, 61 percent of Americans think it was a bad idea for the government to bail out financial institutions.

The government may be using the suit it filed back in July against UBS both as a test case and a warning to other banks, analysts say. "In our opinion, the evidence provided in this lawsuit is the most detailed public information of origination violations to date," Chris Gamaitoni, an analyst at Compass Point Research & Trading LLC, wrote in a report published last month. "(We) expect additional suits to commence as quickly as possible."

The UBS suit seeks $900 million in losses from $4.5 billion in securities it holds and asks that further damages be awarded at the court's discretion.

The 102-page document charges UBS with misrepresentation and noncompliance with underwriting guidelines, and of three separate violations of the Securities Act of 1933. "Given the GSEs only purchased AAA rated tranches and the correct characteristics would not have warranted that rating, we believe the GSEs have a strong argument," Gamaitoni added. GSEs refers to Fannie and Freddie, which are government-sponsored enterprises.

It's a high-stakes game of chicken, with the banks predicting financial Armageddon and the FHFA using the UBS case to implicitly suggest it will adopt a similarly aggressive strategy with other institutions.

Both sides are probably hoping for a settlement. "We could have discovery produce emails that are damning, or we could have not much turn up," Elliott said.

The latter prospect is a risk the FHFA would prefer not to take. For the banks' part, even if they have to pay a significant amount of money, a settlement at least would eliminate the uncertainty factor that's agitating the markets and fraying the nerves of investors.

An alternate settlement being pursued by all 50 state attorney generals might provide the FHFA with a road map for negotiating with banks that could possibly help beleaguered homeowners.

Some states want to require banks to modify mortgages by writing down the principals. Previous modification programs have fallen flat; a 2010 revision of a 2009 paper published by the Federal Reserve Bank of New York found that the average re-default rate for homeowners who received modifications was a disappointing 56 percent.

However, the relative handful of modifications that included principal write-downs yielded much better results. The authors noted, "Principal write-down reduces re-default risk both directly — through reducing or eliminating the negative equity of the borrower — and, also indirectly by reducing the required monthly payment."