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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But, as it happens, the worst-case scenario never materialized. Goldman lost few clients as a result of the case and the negative attention. It ultimately settled with the SEC for $500 million without admitting to the charges. The Wall Street giant saw its stock bottom out around $130 on July 1 and move on a fairly steady trajectory upward since then. Goldman's shares closed above $170 last week for the first time in more than half a year.

The fallout from mortgage litigation is different in its details and its scope, but not that much different in nature.

"In 2008, you were staring at what could have been the end of the system, so anytime you get a whiff of mortgage issues again, you get the 'sell first ask questions later' attitude," says Driscoll. "With Bank of America, you had the stock go down to $3, so even at $12, people are still nervous."

UNCERTAIN EXPOSURE

What touched off the bearishness in Bank of America shares was a report by a hedge fund outlining $74 billion in potential buyback exposure. The analysis by Branch Hill Capital was performed months earlier, but began gaining traction in the market the week of Oct. 11. The headline number was pooh-poohed by analysts and effectively disregarded by the company a week later.

In a presentation to investors on Oct. 19, executives outlined the elements of its buyback exposure - at least those that it felt comfortable predicting.

CFO Charles Noski cited nearly $13 billion in buyback requests, $4.4 billion of which management considered a liability. Most of the company's exposure came from requests by government-sponsored entities (GSEs) Fannie Mae ( FNMA.OB) and Freddie Mac ( FMCC.OB). Management found it more difficult to estimate exposure to claims from private investors and monoline bond insurers, mainly because it had limited, inconsistent experience with them.

"Until we have a meaningful repurchase experience with these counter parties, we believe it is not possible to reasonably estimate this exposure," said Noski.

Officials at other large mortgage servicers have characterized exposure similarly. Wells Fargo ( WFC) executives outlined even less buyback exposure than BofA in an earnings report the following day, but then said in a quarterly filing that it "cannot estimate the possible loss or range of loss" from litigation. Similarly, JPMorgan Chase ( JPM) outlined higher buyback reserves and increased activity related to the GSEs. But commenting on other repurchase requests, CEO Jamie Dimon noted that "a lot of the private label stuff didn't have the same rules, requirements, disclosures, all that, so they're all different."

Indeed, just hours after its earnings call, news hit that BlackRock ( BLK) and Pimco had teamed with the Federal Reserve to formally request that Bank of America ( BAC) buy back $47 billion worth of mortgage-backed securities (MBS). Executives alluded to the letter sent by those investors during the call, but related exposure wasn't included in the quarterly numbers, which went through Sept. 30.

The letter caught management - and the market - off guard, sending BofA shares down sharply. The stock moved accordingly as exposure bounced around like a ping-pong ball from $74 billion to $13 billion to $375 billion to $31 billion in matter of three weeks.

But now, the market seems to have gotten its arms around the problem. A Bernstein report on Friday put exposure to private-label buybacks at $23 billion - for the entire banking industry. Analyst John McDonald pegged exposure to GSE putbacks a little higher, in a range of $28 billion to $34 billion.

He called the costs "manageable," and maintained "outperform" ratings on large mortgage servicers caught in the crosshairs, including BofA, Wells Fargo ( WFC), JPMorgan Chase ( JPM), PNC Financial Services ( PN) and Capital One ( COF). However, McDonald expects litigation costs to be elevated and headline risk to persist: "Banks will face a significant amount of mortgage repurchase-related litigation and expense over the next few years," he concluded.

Similarly, Morgan Stanley ( MS) analyst Betsy Graseck reiterated an "outperform" rating on Bank of America last week, declaring that the market "misunderstands" its buyback risk.

"Market is missing that the litigation around $352 billion of these claims were dismissed on November 4 as the plaintiffs don't have proper standing," said Graseck.

LEGAL OUTCOMES

The problem with most mortgage-related lawsuits against banks is that purported victims often doubled as bad actors. "It's kind of like a dance that they're all doing" in trying to assess each party's cost of the mortgage reckoning, says Adams.

In gauging the litigation risks for big banks, it helps to stop and consider the merits and motivations of various claims.

There are homeowners who signed up for mortgages they couldn't afford, then stopped paying the loan for months or years on end. Some are fighting banks in court, with the help of pro-bono attorneys or government officials, because they'd like to stay in their homes. At issue are sloppy and irresponsible practices by banks in which employees signed affidavits without having verified the information properly. But, by and large, the basis for foreclosure was accurate, even if the signatures on paperwork were not.

As Driscoll puts it: "Maybe I'm oversimplifying it but if someone borrows money, they owe the money back. That's pretty cut and dry."

Then there are mortgage-bond insurers whose business model relied on the viability of private-label RMBS. They are obligated to cover investors' losses on bonds that go bad.

Those insurers relied on ratings agencies' stamps of approval and processes in place - such as loan sampling -to ensure that deals were worth standing behind. But, as losses escalated, bond insurers have filed fraud charges against big banks whose deals they stood behind, claiming that the bonds were marketed dishonestly. They have also scrutinized loan documents to find flaws in representations and warranties. When those terms are proven to be breached, banks are required to buy back debt.

"They have plenty of responsibility to do due diligence," says Thomas Adams, a lawyer and former executive at two major monolines. "The bond insurers frequently did do due diligence prior to insuring the loans. They did their own file samples of 200 or 300 loans, prior to insuring the deal. So, it makes their case pretty hard."

Investors who have burned through the insurance protection to lose money on RMBS deals are suing the banks as well. Their claims have largely the same premise: We invested in stuff that was marketed as good, but turned out to be really bad. But the hedge funds and big institutional investors suing big banks are sophisticated market players with their own due diligence processes in place. They only started legal proceedings after losing tons of money on deals gone awry.

Randy Robertson, who headed mortgage divisions at Wachovia through 2008, notes that people simply got lazy about due diligence processes during the boom years.

"As originators' product saw heightened demand, people buying the pools did less and less sampling," Robertson, who's now a managing director at BlackRock, said in a recent interview with TheStreet. "So, you started at 25%, then it went to 15, then to 10 and in the end some people were doing 5% sampling due diligence on the loans when they securitized them."

As it stands, the litigation over buybacks, foreclosures and alleged mortgage fraud haven't gone much further than the negative headlines.

A few "robosigning" cases against Bank of America and Wells Fargo garnered a lot of attention but were also dismissed by courts. The coalition of regulators and attorneys general investigating banks' practices haven't yet announced any kind of monetary damages - despite Ohio Attorney General Richard Cordray's aim to get $25,000 for each court document that GMAC is found to have handled improperly.

With the private RMBS market still largely frozen, bond insurers have been paying out claims and hanging onto litigation, without writing any new business. A judge has allowed a lawsuit by MBIA ( MBI), begun in the fall of 2008, to move forward, but it hasn't moved past the discovery stage. The trial isn't expected to begin until July.

THE REAL RISK

It's unsurprising that, as the party with the deepest pockets, big banks are taking the brunt of legal claims from the mortgage mess.

But in assessing the real litigation risk, it's worth putting one's self in the shoes of judges who will ultimately decide which parties are left bearing the cost of souring mortgage debt. Would you find in favor of homeowners who are broke and delinquent? What about monoline insurers whose business model is clearly busted? Or investors who bought lousy product in a frenzy and are now performing more comprehensive due diligence, years after the deals were done?

Ultimately, the government seems to be the only party involved in the mortgage reckoning that poses a significant risk. As taxpayer-funded institutions working to repair the housing market, the GSEs are sympathetic. And since their buyback processes are well-established, they had effectively been "settling" before anything had to go to court, with banks repurchasing tens of billions of dollars' worth of souring debt.

While overall reserves are dropping across the industry, repurchase reserves have been the only area where banks added billions in capital last quarter. Still, Adams says the GSE buyback demands haven't been excessive so far.

"Fannie and Freddie don't really want the banks to be blown up by these mortgage putbacks," he says. "They want to do it in a way that allocates some risk back but keeps them in business and keeps them sending loans their way."

Things have started to become a little less amicable, though.

Shortly after the GSEs' regulator, the Federal Housing Finance Agency, began talking tough about banks' refusal to repurchase certain loans, the Federal Home Loan Bank of Chicago, which is also a GSE, filed suit against Citigroup ( C). Additionally, the Federal Deposit Insurance Corp. is examining the practices of banks who entered "loss-share" agreements to acquire failed bank assets. If those banks are found to have engaged in "robosigning" or any other unsavory practice related to acquired mortgages, those incentives will be shelved or clawed back.

And while Bank of America has called claims by Pimco, Blackrock and the Federal Reserve Bank of New York "utterly baseless," the Fed's mere appearance on a formal buyback request letter was troubling.

"I know from your standpoint the fact that they signed a letter was a surprise to you," Bank of America CEO Brian Moynihan said at a conference on Nov. 4. "It surprised me and I think it surprised a lot of people, quite frankly."

Still, Moynihan didn't seem overly concerned. He characterized the issue as a process that comes with the territory of running a large, diverse financial institution. He noted that BofA has sued companies over mortgage issues as well. He has also spoken with Larry Fink, the head of BlackRock, in which Bank of America was a major investor at the time the letter was sent.

"I called Larry," said Moynihan, saying his counterpart responded, "'Yes, we'll work through it.'"

-- Written by Lauren Tara LaCapra in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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