It was really just a matter of time. As a percentage of assets, large, money center bank loans outstanding are usually well under 50%. For instance, at year's end 2011, just 31% of JP Morgan Chase's (JPM) assets were its loan portfolio. The loan percentage was 42% at Bank of America (BAC), and at Citigroup (C), 36%. And for these larger banks, within their loan portfolios we have many commercial and industrial scale loans, and a relative trickle of home loans. Many of these home loans are purchased by the money center banks from the originating bank. Regional ranks typically have 60% or more of their assets tied up in their loan portfolios. So, I have long believed it was just a matter of time before some of the same mortgage fraud allegations that have been brought against the likes of Citibank and Bank of America were brought to bear against regional banks as well. That day has arrived.
Last month, the Department of Justice and 49 state authorities announced a $25 billion omnibus settlement with the country's five largest mortgage servicing companies, the three money center banks listed above, Ally Financial, and Wells Fargo (WFC) on claims of mortgage foreclosure abuse such as the infamous "robosigning" and lost paperwork. Of that $25 billion, nearly $800 million was in the form of fines on behalf of the Federal Reserve.
This week, The Wall Street Journal reports that the Federal Reserve plans to fine eight regional banks, including such top tier names as US Bancorp (USB), Suntrust Banks (STI), and PNC Financial Services Group (PNC), for loose paperwork in their mortgage foreclosure practices.
About a year ago, the Fed ordered each of the country's 14 largest mortgage servicing companies to hire independent consultants in order to "tidy up" their paperwork flows in foreclosure matters. The consultant would also ultimately arbitrate claims made by homeowners being foreclosed against.
This announcement of a fine was probably not a surprise to any of the affected institutions. Suntrust took a $120 million charge against pretax earnings in February, 2012. PNC could not have been surprised either, as it filed a lengthy action plan in January 2012 about reforming its mortgage servicing focus. As for US Bancorp, it specifically stated that the proposed fine would not have a material effect on its results.
What this Federal Reserve action does is continue its pattern of clamping down on the finance industry. Jamie Dimon, Chief Executive at JP Morgan, has complained that congressional legislation and Fed policy seem intent on reducing his bank's and its peers' profits. Yet, the Fed is not in business to protect banks. It is in business, at least in part, to protect the integrity of the banking industry, and by calling out banks for such abusive processes as robosigning of foreclosure documents, protecting the integrity of the industry is exactly what these fines are doing.
Going forward, these banks are caught in a bit of a dilemma. Yes, it will be more expensive now to properly document mortgage documents of all kinds. Yet, banks of all sizes are in the midst of pressure from all sides to reduce expenses. Some of these expense reduction initiatives, even have titles like Bank of America's "New BAC" and PNC's "Continuous Improvement." At the same time, in our current era of a flattening yield curve, the preferred way to grow earnings is to grow the loan portfolio. Many large banks, including Bank of America and Citigroup, have shrunk their loans outstanding in recent years. For instance, Bank of America's total loans outstanding at year end 2008 were $908 billion, and by year end 2011 has fallen to $892 billion. PNC's loan portfolio peaked at $171 billion in 2008, before falling to as low as $145 billion in mid-2011. Banks have no choice other to continue to write and acquire mortgage loans.
Money center banks have suffered due to repeated rounds of litigation, regulation, and fines at both the state and federal levels. My fear with regional banks, which I have long preferred over money center banks as investment options, is that this may be the beginning of the same pattern. Perhaps US Bancorp is right and the future fines the Fed imposes on these regional banks is not material to their earnings or balance sheets. Or, perhaps cautious investors should focus on banks with less than $50 billion dollars in assets, the level above which tighter Fed scrutiny comes into play. Smaller regional banks such as Bank of Hawaii (BOH) and Susquehanna Bancshares (SUSQ) offer compelling long term appreciation potential from today's prices, and are small enough to "fly under the radar' of Federal Reserve scrutiny.
The best advice I can really offer though, is to pay attention. Are these new fines the start of a new legal and regulatory push, or an isolated, one-time event? I cannot say right now, but as a shareholder of one of the impacted banks, I am a tad nervous.
Disclosure: I own Suntrust stock.