Many investors want desperately to believe in the safety of a stock investment. Though the concept of a truly risk-free equity investment is naïve, all investors in 2012 should understand that bank stocks are risky. Investors who cannot stomach the idea of speculation should not invest in financial companies like JPMorgan Chase (JPM), Bank of America (BAC) and Citigroup (NYSE:C).
Risk in Many Forms
You may think of risk as a byproduct of competition in a dynamic business environment. Banks are indeed risky in this sense. However, banks are also risky in that they are highly politicized. That means that they are, and will continue to be, subject to the scrutiny of courts, regulators, and legislators.
The Federal Housing Finance Agency sued lead underwriter JPMorgan Chase and 16 other banks regarding the loans underlying mortgage backed securities. According to the plaintiff, the underwriting was not done in accordance with the initial guidelines, and the banks were aware of existing defects and did not inform or protect the investors. Bank of America and Citigroup were among the lenders who were sued for misleading and false statements of material facts that caused Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) to lose billions in damages.
U.S. District judge Denise Cote overruled the defendant's claim of insufficient evidence on the plaintiff's part and therefore failed to dismiss the Federal Housing Finance Agency v. JPMorgan Chase case. Judge Cote's decision was partly influenced by witnesses who had clearly described the practices of banks to grant loans to almost anyone alive regardless of their ability to pay. Such practices put banks at risk of bankruptcy and endangered saver's assets. According to Cote, "Actually I think if you were dead they would still give you a loan."
Judge Cote rejected the dismissal bid as she felt the case was plausible and it will now be the task of the FHFA to make a compelling argument based on substantive evidence against the banks.
More Legal Threats
Remember the LIBOR-fixing scandal? It's big and it still has uncompensated claimants. Borrowers filed a class action lawsuit against 12 banks that allegedly profited from LIBOR fixing price collusion.
LIBOR is the London interbank offered rate which is commonly utilized as a contracted benchmark for variable rate lending rates such as variable rate mortgages. Substantial deviations from a market value could have increased interest payments due on over $300 trillion of LIBOR-based loans like adjustable rate mortgages.
Fortunately for lawyers, these plaintiffs are loaded. Plaintiffs include the following banks in Europe and North America: JPMorgan Chase, Bank of America, Citigroup, UBS (NYSE:UBS), Lloyds Banking Group (NYSE:LYG), Barclays Bank (NYSE:BCS), HSBC Holdings (HBC), Royal Bank of Scotland (NYSE:RBS), Credit Suisse , Rabobank, Deutsche Bank (NYSE:DB), and Royal Bank of Canada (NYSE:RY).
A case like this is a lawyer's dream: the defendants are lovable and down-on-their-luck American homeowners while the plaintiffs appear to laypeople as evil financial goliaths who exploit their customers. This case almost wins itself!
Even better for attorneys, the complexity of this case will result in legal maneuvering and years of appeals. Imagine the billable hours!
These Risks are Par Course
Bank shareholders should have learned by now that news like this will surface over and over again. The probability of more allegations and legal issues coming to light is roughly the same as it basically unchanged. As an investor who is not privy to inside information, there is no way to predict which financial stocks will get caught in a particular lawsuit.
If you don't believe me, you don't have to take my word for it. Investors once considered JPMorgan as a safe bank. Was this eons ago? No, it was early 2012. Today, we think about JPMorgan very differently. Since then the firm has been investigated for its massive $7 billion trading loss by a U.S. Senate panel led by Carl Levin. Mr. Levin's senate panel is exceptionally thorough in its investigations and has spent years issuing subpoenas, interviewing witnesses, and checking documents. After the 2008 financial crisis the same panel investigated Wall Street players for two years, resulting in a 600 page report that and put much of the blame for the crisis on large banks.
The inquiry is challenging JPMorgan's version of events that led to this huge loss, and JPMorgan has stated publicly that its own internal review has found that traders may have tried to hide the full amount of losses on their transactions. JPMorgan has stated that the three London employees who were responsible for the bad trades are not with the firm any longer.
The government-sponsored lending agencies Fannie Mae and Freddie Mac issued new rules that are hoped to revive mortgage lending. These rules are held as vital since it is mandatory for banks to repurchase troubled mortgages. The Federal Housing Finance Agency will kick off these changes for future loans beginning in 2013. Loans which exist today will be unaffected.
Edward J. DeMarco said that "Lenders want more certainty about their risk exposure, and the enterprises want to ensure the quality of the loans."
Fannie Mae and Freddie Mac have made the audit process more rigorous and it is also reviewing files of loans defaulted during housing bubble from 2005 to 2009 for bad underwriting. In the current financial year alone banks were forced to buy non performing mortgages worth $18.9 billion. These government sponsored entities are still working to resolve old claims prior to September 2008.
Fannie Mae was the subject of controversy when reports stated that it paid more than $500 million to Bank of America for the transfer servicing of 384,000 mortgages. Bank of America later denied this. Fannie Mae defended these transfers because they were made to reduce portfolio losses which were forecast at $10.9 billion. There was optimism for specialty servicer like Bank of America's abilities to help it reduce $1.7 billion to $2.7 billion of losses.
A bipartisan group of congressmen asked for the audit to ensure that the transactions were valid and tax payer money was not misused. The audit found that Fannie Mae paid premium prices to the servicers, presumably to expedite the transaction and avoid scrutiny over its non-performing loans. This strategy backfired by attracting more scrutiny over its loan book losses while adding questions about mismanagement of the bid process for servicers.
Banks are risky. Investors who believe in "safe" investments should not invest in bank stocks. These stocks are speculative black boxes which are at the mercy of governmental institutions and political whim. These factors are impossible to predict, making bank stocks extremely speculative.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.