Wells Fargo, JPMorgan Won't Drown in Mortgage Muck: Street Whispers

NEW YORK ( TheStreet) -- A recent string of housing bust lawsuits aimed at Wells Fargo ( WFC) and JPMorgan Chase ( JPM) seems to pull both lenders back into a tangled legal mess on the underwriting of mortgages and real estate-backed securities prior to the financial crisis.

However, as has been the case on Wall Street for the past year, expect that Wells Fargo and JPMorgan will continue to be buffeted from the biggest legal risks of the mortgage mess as competitors like Bank of America ( BAC) remain in the stock doghouse on exposure to pending litigation such as tens of billions in liability tied to mortgages sold to government agencies Fannie Mae and Freddie Mac.

While settlements on mortgage and shareholder lawsuits, in addition to conventional asset writedowns can wipe out a quarter of profit for struggling lenders like Bank of America and Citigroup ( C), the recovering earnings of Wells Fargo and JPMorgan are likely to outweigh the risks posed by recent lawsuits.

Since the start of October, lawsuits from the U.S. attorney's office and the New York state attorney general have ensnarled Wells Fargo and JPMorgan respectively, pulling both banks back into the mortgage muck and forcing them to defend loans and securities underwritten during the housing boom.

In its lawsuit against Wells Fargo, the U.S. attorney's office and the Federal Housing Authority are asking for a return of hundreds of millions in FHA insurance that the bank allegedly claimed on shoddily underwritten loans. In the case of JPMorgan, New York State attorney general Eric Schneiderman, in concert with President Obama's Residential Mortgage-Backed Securities Working Group, is suing the bank for $22.5 billion in losses suffered by investors on securities underwritten by Bear Stearns, the investment bank it rescued in March 2008.

In both instances, investors seem generally unconcerned by the legal risks of the suits even if headlines and allegations provide a hit to the reputation of both banks. Wells Fargo shares are off marginally since the U.S. attorney unveiled its claims of civil mortgage fraud against the lender late on Tuesday. Meanwhile, JPMorgan shares have gained since the Schneiderman and the mortgage task force opened its suit on losses tied to Bear Stearns backed mortgage securities.

For Bank of America and Citigroup, legal risks and writedowns appear to pose a bigger risk. In late September, a $243 million settlement on a shareholder lawsuit filed against Bank of America for its acquisition of Merrill Lynch in September of 2008 is expected wipe out a quarter of profit and months more of capital repair for the nation's second largest lender. Citigroup's settlement with Morgan Stanley ( MS) on the value of its stake in a brokerage joint venture is also expected to create a third quarter writedown that will wipe out the bank's overall profitability and dent its capital position.

Because Wells Fargo is on track for strong profitability through year-end, even a worst case scenario on litigation tied to its FHA-insured underwriting standards won't provide a meaningful hit to overall profitability. KBW bank analyst Fred Cannon calculates a settlement would shave just 5 cents from Wells Fargo's 89 cents in forecast fourth quarter earnings per share.

In a worst case scenario, Cannon of KBW projects a settlement as high as $770 million. Using a previous Deutsche Bank settlement on FHA insurance, Cannon estimates a range of damages between $104.5 million and $423.5 million, with the mid-point expected at $264 million.

"This is certainly a negative for Wells Fargo but we believe that the lawsuit will be settled and the exposure is manageable," writes Cannon, in a Wednesday note to clients. The analyst adds its still unclear is whether Wells Fargo is reserved against FHA claims and highlights the bank's strong worded response as a positive.

"Wells Fargo denies the allegations and believes it acted in good faith and in compliance with Federal Housing Administration (FHA) and Department of Housing and Urban Development (HUD) rules," said Wells Fargo, in a statement reeased to TheStreet on Wednesday, which also highlighted the banks FHA delinquency rates have been as low as half the industry average. "The Bank will present facts to vigorously defend itself against this action," the bank added.

For its part, JPMorgan has already proven it can overcome giant one-time charges, while remaining profitable. In the second quarter, the bank booked a $5.8 billion loss tied to a misguided holding of illiquid credit products - now known as the London Whale trade - but the bank remained solidly profitable posting $5 billion in net income. After a near 20% stock dive on revelations on the trading position and an expected loss that may now reach as much as $7.8 billion, JPMorgan shares rallied in the third quarter, gaining back most of its stock drop.

Although investors in Wells Fargo and JPMorgan may be taken aback by the claims made in the respective October suits filed against both banks, bruised reputations aside, the issues don't appear to pose a big earnings risk. In contrast the weaker earnings and balance sheet uncertainties of Bank of America and Citigroup give investors good cause to remain vigilant about the impact of legal settlements and one-time accounting charges.

For more on the legal challenges of America's largest banks, see why Bank of America investors should expect the unexpected and why Wall Street is still skeptical Citigroup CEO Vikram Pandit's strategy can resolve the bank's lingering problems.

-- Written by Antoine Gara in New York