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How "Headline Risk" Could Force Bank of America, Wall Street to Their Knees

Individually, the mounting legal threats facing Bank of America (BAC) and other big banks over their mishandling of mortgage documents may not amount to much. Together, however, they amount to a potentially explosive -- and largely political -- problem for these companies.

Powerhouse private investors including PIMCO and BlackRock, the world's largest bond fund and money manager, respectively, are joining forces with the Federal Reserve Bank of New York and Freddie Mac (FMCC) to demand that B of A repurchase a portion of the $47 billion in bonds they bought from the bank's Countrywide mortgage lending unit.

For now, the investors are merely rattling their sabers by stating their demands in a letter -- and for good reason. As Yves Smith explains, a full-blown lawsuit against BofA to force it to repurchase shoddy mortgages would be complicated, expensive and highly uncertain:

While the letter that the investors sent to Countrywide is laying the groundwork for litigation, any litigation is going to be more of an uphill battle and less lucrative than the breathless reports would lead you to believe.... [T]he presence of famous names, particularly that of the New York Fed, has led this case-in-the-making to be treated as more damaging than it is likely to be.
That may be true. To prove that Countrywide sold them bad loans, plaintiffs in a suit would need access to its mortgage documentation. That paperwork may simply not exist, while if it does BofA could choose not to provide it. And even if investors did get the files, as Smith notes, they would have to show that each and every contested loan violated Countrywide's mortgage servicing contract. That's a huge undertaking.

Yet if PIMCO and its allies against BofA face daunting legal hurdles, the environment is ripe for such pressure tactics as banks are forced to defend themselves on multiple fronts.

State legal officials have launched what amounts to a nationwide probe into banks' foreclosure practices, with a focus on the propriety of mortgage documents. Meanwhile, bond insurers MBIA (MBI) and Ambac (ABK) also have already sued BofA on grounds that Countrywide mortgages the firms insured were fraudulent. Dozens of major mortgage investors, including Fannie Mae (FNMA), are also pooling resources to pursue litigation against banks, demanding "putbacks" and that banks replace loan servicers.

Growing pressure by the Government-Sponsored Enterprises (i.e., Fannie and Freddie) to recoup mortgage-related losses is no idle threat. As one mortgage lender told American Banker:

"If you're a mortgage banker, and you sell a loan to a GSE-sponsored company-- the number one thing you have to be worried about is that at some point, that loan is going to have to be repurchased due to a fraud claim by the GSE," said Scott Stern, the chief executive of Lenders One, a cooperative of mortgage banks based in St. Louis.
In looking into cases of improper foreclosure, federal officials are also raising the heat by exploring whether financial institutions broke the law in filing fraudulent paperwork. Such inquiries are usually left to the states, which usually have jurisdiction in real estate disputes. Since government housing agencies buy and guarantee bank mortgages, however, a criminal investigation could have teeth. And unlike private investors, obviously, the government has enormous power to compel banks to provide evidence of faulty documentation involved in originating and securitizing loans:
"In more than 25 years dealing with major financial crisis issues, I have never seen this many agencies focused on a single issue," said Andrew Sandler, a lawyer who works on government investigations. "We are beginning to see signs of extensive governmental investigation that may also have criminal law implications."
As a result, banks are girding for a surge in costs related to mortgage securitization. Both JPMorgan Chase (JPM) and Citigroup (C) disclosed this week they are setting aside more money to buy back loans. Analyst Paul Miller of FBR Capital Markets estimates banks may have to spend upwards of $91 billion to repurchase flawed mortgages.

Beyond these costs, the drumbeat of bad new is hurting financial firms in other ways. First, it's punishing financial stocks, as investors struggle to calculate the likely hit to bank earnings stemming from faulty mortgage loans (Notably, the share price of some investors pursuing legal claims against loan servicers, such as MBIA, is rising.)

Second, a tide of litigation against mortgage lenders threatens to hamstring not only foreclosures, but the broader housing market. Applications for new mortgages and to refinance existing loans have fallen since news of the "robo-signing" scandal surfaced. Worse, the hubbub could make it much harder for banks to sell the millions of homes they have repossessed over the last few years. Confusion over the ownership of mortgages is sure to dampen such sales, further gouging bank earnings.

Third, and perhaps more important, the intensifying "headline risk" for banks resulting from the mortgage mess will make it harder for the White House and for Congress to take a soft line with the industry. The Obama administration is expected within weeks to announce its findings of a four-month government investigation into bank performance in servicing home loans. The early signs suggest the probe revealed serious flaws. Said U.S. Secretary of Housing and Urban Development chief Shaun Donovan to the WSJ:

"The issues that we've seen around the affidavit process are potentially symptomatic of problems in other parts of the process as well, and we want to make sure that we are reviewing more broadly" how the industry operates.
Obama is, understandably, hesitant to do anything that delays a housing recovery, such as urging banks to freeze foreclosures. Yet if litigation threatens to drag the mortgage fight out over years, and with reelection to consider in 2012, he may ultimately seek a quicker resolution. One possibility: forcing Wall Street into a multi-billion dollar settlement with investors and homeowners.

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