Investors In These Large Banks Should Be Wary Of Coming Lawsuits And Settlements

Includes: BAC, BCS, C, JPM, WFC
by: Zvi Bar

Last Wednesday, federal prosecutors sued Bank of America (NYSE:BAC), alleging that the bank defrauded government-sponsored mortgage agencies Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) of at least $1 billion. The lawsuit also comes just a few weeks after the same office filed a lawsuit against Wells Fargo (NYSE:WFC) that claimed reckless lending standards on Federal Housing Administration-insured loans.

The claim actually involves the actions of subprime lender Countrywide Financial, which Bank of America acquired in 2008, and claims fraudulent home loans were processed without quality checks or proper oversight, and through a program that it called The Hustle. The feds claim the hustling started in 2007 and continued into 2009, or after Bank of America's acquisition.

Bank of America has lost billions in write-downs, legal settlements and asset sales related to Countrywide's mortgages and the bank's 2009 acquisition of Merrill Lynch, and its billions in mortgage-backed security exposure. Bank of America's last report indicated that repurchase demands now total about $25.5 billion.

More similar lawsuits are likely, as are settlement announcements for already existing claims. Beyond the massive potential liability most U.S. mega banks now have relating to mortgage lending practices, several also have potential exposure to alleged LIBOR (the London inter-bank offered rate) rigging. LIBOR sets payments on many financial instruments, including most standard commercial mortgages and interest rate-based derivatives, and the banks that set LIBOR may have massive liabilities worth hundreds of millions of dollars and possibly totaling tens of billions, if not more, due to rigging the benchmark. Bank of America, Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM) are the three U.S. banks that are involved in setting LIBOR.

LIBOR is set by taking estimates from a panel made of 18 banks on what they believe they would have to pay to borrow. The banks submit their cost of borrowing unsecured funds for 15 periods of time in 10 currencies. Submissions by all participating banks are published. After discarding the higher and lower estimates, the average of the remaining estimates becomes the LIBOR rate. A key issue with how LIBOR is set is that it is based upon estimates when the actual prices banks lent or borrowed from one another could be used, and are apparently not being used.

A settlement (pdf) between one of the LIBOR setting banks, Barclays (NYSE:BCS), and regulators in both Britain and the United States has shown that, for several years, employees of BCS and several other unnamed banks conspired to routinely rig LIBOR. A multitude of corporations and their lawyers have been considering whether the caught banks may be sued by the various parties that were victimized by a slightly worse LIBOR, from their perspective.

If the banks do have exposure to liabilities beyond penalties to regulating agencies, the limits of such liability are still unknown. It is still not clear who can sue which banks, or how damages should and/or will be calculated. Nonetheless, the total cost to the banking industry could total tens of billions of dollars, if not more. Costs would likely include institutional and corporate litigation, government claims, changes to business practices, changes in management and a further erosion to both the margins and public opinion of the lending system and each bank's brand.

The precise damage to any single party is difficult to delineate or quantify without specific data that many parties will prefer to keep private. LIBOR manipulation may have affected rates by one or two basis points per day. Damages claims are generally founded on showing some actual, calculable measure of injury and that it was caused by another, and with LIBOR-based instruments it should be difficult for many to calculate an injury. It would appear likely that many parties to LIBOR-based instruments unknowingly benefited from the conspiracy, and also that many may have knowingly benefited, and the difference may be difficult to discern.

In total, Barclays spent over $600 million in charges related to settling the LIBOR scandal. Such charges do not include the potential damage to the centuries old Barclays brand name. More settlements appear likely in the coming months. It is possible that Barclays received a reduced fine for settling early. A deal for the first to flip is often the case, though it is also possible that the evidence against Barclays was simply more damning. The DOJ indicated Barclays was let off easy. Nonetheless, if Barclays' expenses are any indicator of approximate charges to its peers, Barclays paid about $450 million to settle U.S. and British government agency liability, plus $150 million to its attorneys.

Moreover, these expenses only consider obligations to U.S. and British agencies, while other nations should also require settlements. Canadian, Japanese and European Union regulatory authorities are also investigating matters. Further, if allowed, private claims could substantially overshadow any expected public agreements.

Any announcements of settlements are likely to weigh on settling banks shares, as well as the peers that remain unsettled. Investors should be aware that at least some such announcements are likely forthcoming within Q4 or early 2013, and that they have the potential to depress the equity of these banks, most of which have appreciated substantially during the second half of 2012.

Disclosure: I am long BAC, C. 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.