In 2011, President Obama's Federal Housing Finance Agency (FHFA) made financial history when it filed civil suits against Bank of America (NYSE:BAC) and other mortgage lenders. The FHFA argued that the lenders in question grossly misrepresented the quality of their mortgage-backed securities. Packaged deceptively and sold to semi-public institutions like Fannie Mae and Freddie Mac, these toxic securities would threaten the foundations of the global economy. Three years after the worst days of the Great Recession, the FHFA finally took action against the architects of worldwide economic instability.
A lot has happened since the FHFA filed its lawsuit against Bank of America (BoA). Since the very beginning of this ordeal, BofA executives have tried to prepare for the worst. However, it is hard to imagine that anyone could have predicted a possible $8 billion dollar fine. Though massive, this possible sum is quite realistic in light of a recent fine levied against J.P Morgan (NYSE:JPM).
The FHFA recently made a tentative agreement to settle its JPM lawsuit for $4 billion. In that case, the federal agency cited $33 billion in mismanaged JPM securities. BofA may be on the hook for $57 billion in toxic securities foisted on unsuspected buyers. We believe that the FHFA could use the JPM deal as a precedent for extracting $8 billion from BofA.
The size of various settlements with the major banks seems to reflect the more aggressive stance taken by the Obama Administration in resolving litigation against banks involving precrisis bad behavior if the particular bank is willing to write a big check and not go to court. Most bank CEOs do not like to see the inside of courtrooms therefore the huge checks are written and the cases seem to be getting "settled".
More conservative analysts estimate that Bank of America will ultimately pay the government anywhere from $5 to $8 billion. Whatever the final details of BofA's settlement, the bank is facing enormous loss of face in the global investment community. BofA is so large and well-established that it probably won't go out of business any time soon but BAC investors should not expect a higher dividend than the one cent they currently receive for the foreseeable future. However, the bank's FHFA problem explicitly demonstrate a stark new reality on Wall Street. After years of harsh political consequences, the government is no longer willing to coddle firms that engage in questionable behavior.
Some critics argue that the FHFA lawsuits are anti-business and will create a chilling effect on the business community. This opinion is a shortsighted viewpoint promulgated by those with financial interests in maintaining the status quo. While securities and derivative investment play important roles in the modern economy, securities dealers must act responsibly. When dealers deliberately allow market bubbles to form by misleading investors, this erodes faith and trust in the financial system. By misrepresenting the risks of buying mortgage-backed securities, firms like BoA did more to chill business activity than any government regulator or politician.
Bank of America isn't the only lender scrambling to deal with the consequences of J.P Morgan's massive fine. Throughout the mortgage industry, lenders will likely have to boost their litigation reserves. These cases are providing full employment for many of America's best and most expensive law firms. Fortunately, the expenses associated with settlements are not expected at this time to uniformly affect lenders credit ratings.
Although this is a day of reckoning for Bank of America and the broader mortgage industry, the latest round of fines could ultimately improve the health of the economy. Bubbles in exotic assets are not simple accidents or mistakes. Instead, the growth of bubbles benefits certain powerful players at the expense of the ordinary investors. By discouraging Wall Street from allowing bubbles to form, government fines can encourage greater public investment.
As Bank of America pays for its sins, BofA boosters will try to convince people that what is bad for the bank is bad for the economy. Don't let these short-sighted individuals obscure the reality of BofA's past indiscretions, decisions and questionable activities.
It is all too common for investors to follow popular trends and pin their hopes on the largest, most prominent bank stocks. To truly safeguard their future, investors should diversify into smaller and mid size financial banks and companies with levelheaded business practices for their financial sector exposure. As companies like Bank of America, JPM, and Goldman Sachs (NYSE:GS) face massive fines, companies with more conservative practices will reap many benefits and may increase their dividends at a faster pace.
Until the air clears over the next few years, it may be prudent to take some profits in BAC, JPM and GS and reinvest the proceeds in stocks like Berkshire Hathaway (NYSE:BRK.B), Charles Schwab (NYSE:SCHW) and Discover Financial (NYSE:DFS) that don't have the ongoing legacy issues that plague the mega banks.
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.