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Wall Street Whispers: Bank Stocks' Real Risk

NEW YORK (TheStreet) -- In assessing the risks of mortgage-related litigation -- and translating it into buy, hold or sell -- bank investors may want to consider the fact that very few parties have been successful in forcing banks to pay enormous amounts of money via the court system.

In fact, considering the outcome of such cases so far, one could argue that the most significant concern pertains to "headline risk" -- widely broadcast reports of big financial exposure that don't turn out to be accurate.

In actual court cases, plaintiffs have had pretty miserable results so far. Homeowners haven't been able to stop banks from seizing their property or return their foreclosed-upon homes. (Nor have state attorneys general, cities or municipalities.) Mortgage-bond insurers haven't been able to force banks to buy back bad debt or cover related losses, though they've been trying for more than two years. (Nor have investors.)

Bank of America (BAC) disclosed in a Nov. 5 securities filing that investors holding $375 billion worth of mortgage debt had filed suit. Within hours, that number had dwindled to $54 billion because a court found in the bank's favor regarding a single case.

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Still, as news percolated about BofA's buyback exposure last month, its stock lost $15 billion worth of market value in less than two weeks' time. Shares bottomed out at $11.03, but still hovered below $12 until the court ruling came in on Nov. 4.

"Any time there's any kind of a whiff of bad news, negativity, scandal, whatever you want to call it, the first reaction on the part of institutional investors is to sell the stock, then see what happens," says Michael Driscoll, a former Bear Stearns executive who now teaches business at Adelphi University. "They have no problem going back into it -- even at a higher price if things do recover -- but the initial reaction is always to sell these days."

Driscoll calls this the "Enron syndrome" -- a reference to the lesson learned by investors who rode that stock down to zero. Now, the fear isn't so much about bankruptcy and accounting scandals. Instead, it's about anything pertaining to litigation, particularly mortgage-related litigation and, even more particularly, mortgage-related litigation that's tied to the government.

For instance, Goldman Sachs (GS) shares sailed up above $186 on April 16, but lost 17% on the very same day. Why? The Securities and Exchange Commission launched fraud allegations against the company, related to a mortgage deal Goldman crafted back in 2007. The SEC's action led to speculation about piggyback lawsuits and whether Goldman's clients would stay with the firm, given the allegations and reputational risk.

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