FHFA vs. Mortgage Powerhouses: What Does It Mean for the Market?

It's official. The ""Federal Housing Finance Agency"":http://www.fhfa.gov (FHFA) has unleashed a ""barrage of lawsuits"":http://www.fhfa.gov/Default.aspx?Page=110 against Wall Street investment banks and major mortgage lenders.
[IMAGE] The GSEs' conservator is suing 17 financial institutions, as well as officers of the companies and unaffiliated underwriters, alleging violations of federal securities laws related to private-label mortgage bonds sold to ""Fannie Mae"":http://www.fanniemae.com and ""Freddie Mac"":http://www.freddiemac.com.

Complaints have been filed against the following lead defendants:
# Ally Financial Inc. f/k/a GMAC, LLC
# Bank of America Corporation
# Barclays Bank PLC
# Citigroup, Inc.
# Countrywide Financial Corporation
# Credit Suisse Holdings (USA), Inc.
# Deutsche Bank AG
# First Horizon National Corporation
# General Electric Company
# Goldman Sachs & Co.
# HSBC North America Holdings, Inc.
# JPMorgan Chase & Co.
# Merrill Lynch & Co. / First Franklin Financial Corp.
# Morgan Stanley
# Nomura Holding America Inc.
# The Royal Bank of Scotland Group PLC
# Société Générale

When news of the impending lawsuits broke, the industry was all abuzz, but those we've spoken with say it shouldn't have come as a surprise.

The complaints seek damages and civil penalties. Based on initial reports, FHFA is looking to recoup between $30 billion and $45 billion hemorrhaged from the GSEs’ pockets after they bought securities issued between 2005 and 2007, which were made up of loans that later went into default.

FHFA alleges that the loans underlying the mortgage bonds carried a higher risk than what was disclosed to Fannie and Freddie at the time of purchase.

Ron D’Vari, CEO and co-founder of the capital markets advisory firm ""NewOak Capital"":http://www.newoakcapital.com, says because Congress passed a measure in September 2008 placing a three-year statute of limitations on such lawsuits to be filed by FHFA, the agency was running up against a deadline.

“The last thing a regulatory body wants to be accused of is, ‘you should have taken some action and you didn’t.’” D’Vari says.

The complaints, filed Friday after the markets closed, stem from an investigation launched last year by FHFA, in

[COLUMN_BREAK]

which the agency issued 64 subpoenas to obtain information about deals with the two GSEs.

The first lawsuit to result from that investigation was ""filed in late July"":http://dsnews.comarticles/fhfa-sues-ubs-to-recover-fannie-and-freddie-losses-2011-08-02 against UBS Americas, Inc. Edward DeMarco, FHFA’s acting director, warned at that time there would be “further actions to come.”

Jack Konyk is executive director of government affairs with the law firm ""Weiner Brodsky Sidman Kider PC"":http://www.wbsk.com. He says there are two sides to this coin and both have legs to stand on, which means a court may be the best place for the scene that’s about to play out.

With Fannie and Freddie bleeding green for some time now, Konyk says FHFA is in a political position where they have to do something. As conservator, the agency’s primary responsibility is to protect the GSEs’ assets and promote financial soundness.

On the other hand, Konyk points out that “it’s awfully easy to apply hindsight” when you have the benefit of knowing the bond issuers were off the mark in their assessments years earlier.

The problem in this circumstance, he says, is there are other mitigating factors that likely played a role in loan deterioration, including a historic economic downturn, rampant unemployment, and regressive conditions in the housing market.

Konyk asks, to what degree can the federal agency expect, and then lay legal liability on, the ability of these financial firms to gauge the economic future correctly?

Gene Kirsch, senior financial analyst at ""Weiss Ratings"":http://www.weissratings.com/ says he finds it “ironic” that after bailing out these institutions, the government would then turn around and sue the very companies they rescued.

He says we’re back to the same uneasy feeling of 2008 and 2009, where the overhang of bad mortgages is threatening the viability of these same institutions.

For the most part, though, Kirsch says the banks have some sort of contingency strategy for this situation, having set aside reserves for loan losses and possible litigation.

According to Kirsch, this will likely go the way most litigation does and end in a settlement, probably “significantly south” of the $45 billion figure at the upper end of initial estimates.

A more long-lasting impact may come in the form of higher mortgage costs for consumers, Konyk says.

Such a strong-arm action by the regulator of the nation’s two largest mortgage financiers could potentially change behavior in terms of underwriting, rating, and selling mortgage-backed securities, according to Konyk, especially if financial institutions feel they have to be able to judge future performance based on unforeseen conditions.

The extra risk that comes with such assessments and the liability for getting it wrong, Konyk explained, will be priced in and people will have to start paying more for mortgages.

The legal complaints filed by FHFA against each of the 17 firms ""can be accessed online"":http://www.fhfa.gov/Default.aspx?Page=110.