Federal regulators allege the banks misled Fannie Mae and Freddie Mac over the safety of the bonds. But analysts say the two mortgage giants should have known that the loans behind the bonds were toxic.
The government’s latest attempt to hold large banks accountable for helping trigger the Great Recession could fall as flat as earlier efforts to punish Wall Street villains and compensate taxpayers for bailing out the financial industry.
Federal regulators, in landmark lawsuits this month, alleged that 17 large banks misled Fannie Mae and Freddie Mac on the safety and soundness of $200 billion worth of mortgage-backed securities sold to the two housing finance giants, sending them to the brink of bankruptcy and forcing the government to seize them.
Targets of other federal lawsuits and investigations have deflected such claims by arguing, for example, that the collapse of the housing market and job losses from the recession caused the loss in the value of mortgage-backed securities.
The big banks, though, might have a more powerful defense: Fannie Mae and Freddie Mac were no novices at investment decisions.
The two companies were major players in the subprime housing boom through the mortgage-backed securities market they helped create, and they should have known better than anyone that many of the loans behind those securities were toxic, some analysts and legal experts said.
“I can’t think of two more sophisticated clients who were in a better position to do the due diligence on these investments,” said Andrew Stoltmann, a Chicago investors’ lawyer specializing in securities lawsuits. “For them to claim they were misled in some form or fashion, I think, is an extremely difficult legal argument to make.”
But the Federal Housing Finance Agency, which has been running Fannie Mae and Freddie Mac since the government seized them in 2008, argued that banks can’t misrepresent the quality of their products no matter how savvy the investor.
“Under the securities laws at issue here, it does not matter how ‘big’ or ‘sophisticated’ a security purchaser is. The seller has a legal responsibility to accurately represent the characteristics of the loans backing the securities being sold,” the FHFA said.
The sophistication of Fannie and Freddie is expected to be the centerpiece of the banks’ aggressive defense. Analysts still expect the suits to be settled to avoid lengthy court battles, but they said the weakness of the case meant that financial firms would have to pay far less money than Fannie and Freddie lost on the securities.
Stoltmann predicted that a settlement would bring in only several hundred million dollars on total losses estimated so far at about $30 billion.
In the 17 suits, the FHFA alleged that it was given misleading data.
For example, in the suit against General Electric Co. over two securities sold in 2005 by its former mortgage banking subsidiary, the FHFA said Freddie Mac was told that at least 90% of the loans in those securities were for owner-occupied homes.
The real figure was slightly less than 80%, which significantly increased the likelihood of losses on the combined $549 million in securities, the suit said.
GE said it “plans to vigorously contest these claims.” The company said it had made all its scheduled payments to date and had paid down the principal to about $66 million.
The federal agency also has taken on some of the titans of the financial industry, including Goldman Sachs & Co., Bank of America Corp. and JPMorgan Chase & Co., to try to recoup some of the losses on the securities. That would help offset the $145 billion that taxpayers now are owed in the Fannie and Freddie bailouts.
The suits represent one of the most forceful government legal actions against the banking industry nearly four years after the start of a severe recession and financial crisis brought on in part by the crash of the housing market.
The FHFA had been negotiating separately with the banks to recover losses from mortgage-backed securities purchased by Fannie and Freddie, but decided to get more aggressive.
“Over the last couple of years, they’ve been doing sort of hand-to-hand combat with each of the banks,” said Michael Bar, a University of Michigan law professor who was assistant Treasury secretary for financial institutions in 2009-10. “The suits are an attempt to consolidate those fights over individual loans.”
Bar thinks the government has a legitimate case.
“The banks will say, ‘You got what you paid for,'” he said. “And the investors will say, ‘No we didn’t. We thought we were getting bad loans and we got horrible loans.'”
Edward Mills, a financial policy analyst with FBR Capital Markets, said the FHFA has a fiduciary responsibility to try to limit the losses by Fannie and Freddie. But the independent regulatory agency also probably felt political pressure to ensure that banks be held accountable for their actions leading up to the financial crisis, he said.
“There’s still a feeling out there that most of these entities got away without a real penalty, so there’s still a desire from the American people to show that someone had to pay,” Mills said.
Although the suits cover $200 billion in mortgage-backed securities, the actual losses that Fannie and Freddie incurred are much less. For example, the FHFA sued UBS Americas Inc. separately in July seeking to recover at least $900 million in losses on $4.5 billion in securities.
The faulty mortgage-backed securities contributed to combined losses of about $30 billion by Fannie and Freddie, but a final figure is likely to change as the real estate market struggles to work its way through a growing number of foreclosures.
Some experts worry that the uncertainty created by the lawsuits makes it more difficult for the housing market to recover, which adds to the pressure on the FHFA and the banks to settle.
The government case also could be weakened by an ongoing Securities and Exchange Commission investigation into whether Fannie and Freddie did to their own investors what they’re accusing the banks of doing — not properly disclosing the risks of their investments.
Banks are expected to make that point as well. But both sides have strong motives to settle the cases and move on, said Peter Wallison, a housing finance expert at the American Enterprise Institute for Public Policy Research.
“Within any institution there are people who send emails and say crazy things, and the more these things are litigated, the more they get exposed,” Wallison said.
Because of flaws in its case and political pressures, the FHFA also will be motivated to settle, Wallison said.
“There will be a settlement because the settlement addresses the political issue … that the government is going to get its pound of flesh from the banks,” he said.