Raining Fines on Wall Street

Edited by Vani Rao

DOJ Hits Wall Street Darlings for Record Fines Home Run; will this lead 28to CHANGE….

Source: http://cpa-connecticut.com/blog
Source: http://cpa-connecticut.com/blog

Large Wall Street banks and their faulty mortgage practices have been in the news lately. JPMorgan Chase (JPM)reached a settlement of $5.1 billion with Federal Housing Finance Agency (FHFA) over charges of misleading Freddie Mac and Fannie Mae, both government sponsored enterprises (GSEs) on Friday 25 October.

However, it is not clear whether this is part of the $13-billion tentative settlement deal between JPM and the Department of Justice (DOJ) for its mortgage-backed securities (MBS) frauds. Bank of America (BoFA) was also found guilty of committing fraud by selling defective mortgages through its Countrywide unit.

Looking back, the genesis of the issue lies in the financial crisis of 2008, when large investment banks created financial products known as mortgage-backed securities. As part of their offerings, banks pooled home loans originated by retail banks and private mortgage brokers, bunched these loans, and sold them to investors. These mortgages were bought by GSEs like Fannie Mae and Freddie Mac. Banks also offered privately issued ‘residential MBS’ to investors across the globe.

Banks also sold a large amount of bad and risky loans packaged in these securities. A large amount of theseloans belonged to the ‘sub-prime category’, which has the highest risk on defaults on payments. Also included were loans of ‘Alt-A’ category, which carried lesser risk then subprime, but significantly higher than prime category loans. Although the investing companies knew the risks associated with these securities, they might not have anticipated the enormity of the situation. Since lending standards had downgraded, banks considered quantity over quality in churning out loans to unqualified borrowers and were destined to fail sooner or later.

Sub-prime MortgageInvestors who purchased the MBS ended up losing money as borrowers were unable to make the required mortgage payments. Securities with ‘AAA’ rating contained faulty underlying mortgages that turned out to be junk assets as borrowers were unable to make payments, following which investors realized that the securities they owned were worth a fraction of the official book value. Banks and private investors incurred huge losses, causing a crisis of confidence in the global banking and financial system. The US banking system required a bailout of a whopping $700 billion. Furthermore, the bailout of Fannie Mae and Freddie Mac cost the US taxpayers another $188 billion.

In the aftermath of the crisis, the FHFA filed a lawsuit against leading financial institutions including JPM and BoFA in September2011 for faulty mortgage practices and intentionally hiding vital details from investors. The agency is trying to reclaim the losses incurred by Fannie Mae and Freddie Mac that were ultimately paid by taxpayers during the financial crisis. Although the charges have been pending for two years, severalfinancial institutions have reached or are in the process of settlement with the DoJ.

For common people, it means that the fines would be paid by the banks and financial institutions and this would be reflected in their balance sheet. However, there is a little known aspect of corporate law that the companies exploit to write any portion of the settlement amount as deductible corporate expenses, if not paid directly tothe government treasury.

The large amount of fines and disgorgements to settle the charges are bandied in the media to show the effectiveness and hard work of the government agencies working overtime to bring justice to investors and public. However,one does wonder whether the money really goes to the victims and hapless homeowners who were thrown out of their homes or gullible investors and the government agencies who blindly accepted (or ignored) the deals. There is also a lack of clarity as to whether the funds are remitted to the US Treasury, which was used to bail out banks and GSEs or, is used to launch more investigations.

Some analysts argue that the money received through fines should not be provided to the homeowners as the parties harmed are not directly the consumers. Rather, it should be given to investors such as pension funds and union memberswho have invested in these faulty securities. Also, the relief fund set aside for homeowners can potentially hurt the mortgage-bond investors if this results in a write down of the underlying loans. The move to provide relief to homeowners rather than the actual investors seems to be a populist measure that can help in restoring the image of US Government.

Taking the example of the Independent Foreclosure Review case, 10 mortgage servicers including Bank of America, Citigroup and JPMorgan Chase were found guilty and were directed to provide relief of $3.3 billion in direct assistance to the homeowners. The relief would range from hundredsof dollars to $125,000, depending on the type of possible servicer error. Even if $125,000 were made available to each homeowner who was subjected to foreclosure although they were on time with their mortgage payments, it is a matter of debate whether the amount will be able to cover the cost of being wrongfully thrown out of their house, losing equity, respect, as well as facing humiliation and other dire consequences.

Post the financial crisis, the US government signed alaw aimed at curbinginstitutional bad behavior and preventing re-occurrence of the conditions that led to the crisis. Included later in the proposal was the “Volcker Rule” was designed to stop banks from becoming ‘big’ (prohibits banks from using the M&A approach to become larger in value then 10% of the total liabilities off all US financial institutions) or interconnected, where the failure of one bank or financial institution could bring about the collapse of other institutions. Banks were also prohibited from trading with their own money; however, they were allowed to invest up to 3% of the capital in hedge funds (third-party) or in the form of private equity.

The legislation abolished the protection provided to rating agencies from lawsuits where ratings are included in deal prospectus by the underwriter. Moreover, financial firms were also required to put in place detailed protocols for the orderly liquidation process, instead of going in for bankruptcy and/or government support. The Consumer Financial Protection Bureau, housed under the Federal Reserve, was also created. The bureau was given the authority to write and enforce lending regulations for banks with assets more than $10billion in mortgage-related businesses and other non-banking financial companies.

The fines and settlement of charges would continue; however, it remains to be seen whether the exercise would ever be enough to recover the money paid by taxpayers ($888 billion). In addition, would this help homeowners to revert to the situation they were prior to the crisis? Would this repay the amount that investors lost because of the faults of the financial institutions?

The narrative played in public is that the government is coming under populist pressure to hang the banks and all those guilty. Thescene depicts the banks as greedy financiers who exploited the unsuspecting public and gullible investors. The missing link in the theory is that everyone, from Wall Street to Washington, thought that housing prices would never fall. Homeowners were under the impression that home equity can be squeezed to the end in the form of second and third mortgages and can be utilized from paying credit card bills to other luxuries of life which they might not have been able to afford otherwise and equally to blame are the banks, which were just interested in filling their coffers and generating revenue and profits, hoping that the rising prices would offset the risk of default on home mortgages.

The remedy of bubbles and panics, if there areany, lies in systematic reforms, an objective the case against BoFA,JPM, and other Wall Street banks hardly advance.

Till then watch the GAME.

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