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The FHFA made the most recent move in this grand game by suing seventeen banks for misrepresenting mortgages. This can’t go well for anyone but the lawyers involved. The question every investor should be asking is; what will be the next move? While some banks may be able to swallow the losses, others are severely jeopardized. I’m going to peer into my crystal ball to see what possible outcome could come of this.
I see… Bank of America…
Bank of America (NYSE:BAC) must be wide eyed in disbelief at FHFA's move against it. BAC has $57.4 billion in exposure and not many ways to pay it. That’s a substantial sum in itself, but that is only half the story. In late August, BAC reached a settlement with homeowners to the tune of $8.5 billion. However, other homeowners have moved to block that settlement, seeking even more. I would be surprised if the new target figure was any less than $20 billion, putting their total exposure up to a whopping 77.4 billion dollars. Will BAC pay that much? Probably not, the sum is just too astronomical. BAC will surely fight this case for as long as possible. The better question to ask is can BAC pay that sum? How about half? Considering the deal BAC made with Warren Buffett, BAC likely has a huge capital shortfall. What happens if these lawsuits are successful? I’m not sure BAC could survive.
Which brings me to my next point, would the government willingly and purposefully cause the very same banks they bailed out to go bankrupt? Even for the government this seems counterproductive. If BAC were to go bankrupt, that would trigger credit default swaps (CDS) across the board. If you add in Europe’s current financial predicament, CDS payouts could then cause these banks to collapse and bring down the entire system. I find this whole scenario very unlikely. I have to wonder then, what does the government have up its sleeve?
I see… political maneuvering…
Litigation for litigation's sake also seems unrealistic. Banks have done as they please for decades with no more than a slap on the wrist. The government using litigation to make their point would have no impact for them. If they don’t want BAC to fail (which they probably don’t) then what could they want? I don’t think they’re after the bank's money, after all, we paid them billions only a couple years ago and we don’t seem to have a problem running more debt. Therefore, I think they have an ulterior motive. After the last crisis, everyone is aware of the impact of collapsing financial institutions. The government is aware of the troubles that banks face, so they are trying to make changes to them before we get another Lehman. They plan to do this by dismembering some of the TBTF banks.
I don’t see a future with a couple of giants turned into a couple of hundred small banks, instead I see this as a way to get these banks to forcefully dump off the toxic assets that have yet to be written down, and then letting these smaller pieces fail. This will have a massive negative effect on their near term bottom line, but under these conditions the parent banks should survive, as well as the financial system as a whole. I think big government has given up hope that TBTF banks will make a move on their own, so they are making their moves for them. It’s almost like a casual game of chess with a friend where you are a few moves from checkmate and your friend just sits there, making no move because whatever he does will almost surely end up in disaster.
I see… a possible future?
This will put in an immediate bottom for real estate prices. Home prices will fall like they’ve never fallen before. Fortunately, since most of the underwater homeowners who were going to be crushed already have been, the effects from this should not be too impactful. In order to further soften the blow, the FOMC will announce some clever backwards working system that will have the same effect as homeowner assistance, or debt forgiveness. Combine this with the promised low interest rates through 2013, and this will allow a home purchasing spree the likes of which have not been seen since... a few years ago (but hopefully on more solid grounds). This will put homes into the hands of people who can pay for them, and essentially wipe the plate clean of this never ending housing mess.
Banks and REITs will be hit the hardest and fastest. The flip side to this is, as housing prices are at levels we have not seen in decades, REITs (and banks to some degree) should also be able to produce brand new portfolios of clean, cheap properties and mortgages. After banks and REITs hit bottom, they should rebound in spectacular ways.
With easing targeted at the greater population, this should free up cash flows for households and small businesses, increasing spending across the board. Without the toxic assets on banks balance sheets, loans should be easier to make. In less than 3 years, this down economy will look like a thing of the far forgotten past, and all business should be performing much better.
Conclusion: Big government has a big plan for the big banks, and suing them is just a means to the murky end of separating the TBTF banks from their toxic assets.
This is just one outcome of many possibilities, but it does appear that the TBTF banks have peeved off the wrong someone in big government.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Using A Crystal Ball On The Goals Of The FHFA