Investment Implications Of FHFA's Suing UBS

| About: UBS Group (UBS)
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The Federal Housing Finance Authority (FHFA) is suing UBS for violating securities laws in the sale of private label MBS to Fannie Mae and Freddie Mac. From the press release:

The lawsuit alleges that UBS Americas made numerous material misstatements and omissions about the mortgage loans underlying the private-label MBS, including the creditworthiness of the borrowers and the quality of the origination and underwriting practices used to evaluate and approve such loans. The defendants also failed to conduct adequate due diligence. This lawsuit seeks to recoup the losses suffered by the Enterprises related to their $4.5 billion investment in securities sold by UBS.

“FHFA is taking this action consistent with our responsibilities as conservator of each Enterprise,” said FHFA Acting Director Edward J. DeMarco. “From the issuance of 64 subpoenas last year to the filing of this lawsuit and further actions to come, we continue to seek redress for the losses suffered by the Enterprises.”

It's worth noting that a year has elapsed since the issuance of the 64 subpoenas. On July 10, 2010 FHFA, as conservator of Fannie Mae and Freddie Mac (the enterprises), issued 64 subpoenas to various entities, seeking documents related to private-label mortgage-backed securities (PLS) in which the two enterprises invested. From the press release:

Before and during conservatorship, the Enterprises sought to assess and enforce their rights as investors in PLS, in an effort to recoup losses suffered in connection with their portfolios. Specifically, the Enterprises have attempted to determine whether misrepresentations, breaches of warranties or other acts or omissions by PLS counterparties would require repurchase of loans underlying the PLS by the counterparties and whether other remedies might be appropriate. However, difficulty in obtaining the loan documents has presented a challenge to the Enterprises’ efforts. FHFA has therefore issued these subpoenas for various loan files and transaction documents pertaining to loans securing the PLS to trustees and servicers controlling or holding that documentation.

Was it cause and effect? In a touching display of unity, Senators Chris Dodd and Richard Shelby on July 28, 2010 issued a joint letter to President Obama, calling for the nomination of a new director for FHFA, a permanent replacement for acting director Edward J. DeMarco. One can imagine the subpoenas showing up in the corner offices of the big banks, followed in short order by the phone calls, the e-mails, the text messages, all directed to one purpose: Removal of the offending regulator.

Issuing subpoenas doesn't always work well. Chris Cox, at the height of the meltdown, issued subpoenas in an effort to investigate the short and distort phenomenon, the coordinated attacks by CDS and naked short-selling that dropped major financials like dominoes. Nothing came of it. The SEC had exceeded its authority, we are told; it had no right to expect that hedge funds or anyone involved with CDS would even keep records. Cox faded into invisibility, a non-entity during his lame duck tenure. So much for regulators who inconvenience the wrong parties with unpleasant and unnecessary legal harassment.

After the midterm elections, President Obama announced the nomination of North Carolina banking commissioner Joseph A. Smith to replace DeMarco. There was speculation that Smith would not be as aggressive in the putback arena as his predecessor. In addition to serving as North Carolina banking commissioner from 2002 to the present, Smith served as 2009-10 chairman of CSBS, the Conference of State Bank Supervisors. He is respected by his peers and represented their viewpoints capably in testimony before Congress.

Smith's testimony in his capacity as a spokesman for CSBS reveals a plain-spoken regulator with no excessive fondness for the big banks, a resolute defender of the states' role in financial regulation, and a consumer advocate. Smith's nomination was not confirmed, for political reasons, and he withdrew from consideration. His credentials were excellent: There was no reason not to confirm him other than politics.

After a one year hiatus, DeMarco is now continuing his efforts to redress the wrongs done to the GSEs. It's worth doing: Taxpayers are on the hook for billions of dollars, and the big banks don't want to pay up.

The announcement of the suit against UBS mentions "further actions to come." It is imperative, in the wake of the financial crisis, that the economic losses be borne by those who caused them. The whole chain of mortgage origination and securitization was rife with fraud, as has become progressively more evident by the flood of litigation that has been unleashed. In the interest of justice, and to reduce the chances of a recurrence, each and every transaction should be reviewed and forced back down the chain until it rests with the person or institution that perpetrated the fraud.

Financials and especially big banks have been under-performing, with good reason. Despite their political connections and vigorous efforts to avoid responsibility, the effort to make them bear the losses caused by their fraudulent conduct in creating and securitizing morgages continues. While JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC), Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), Wells Fargo (NYSE:WFC), CitiGroup (NYSE:C) and others are very attractively valued on many metrics, questions remain about the losses from putbacks and litigation that they may not have properly reflected in their financial statements. Going long is not an attractive option.

It should be noted that the process of law and the intervention of regulators is very uncertain in the current legal and political climate of the United States. For that reason, it's not a very good idea to short the big banks either.

The most prudent thing to do, from an investment point of view, is to avoid the area altogether. If I felt compelled to invest, I would go long JPM or WFC. Jamie Dimon is politically adroit and seems to have avoided a lot of bad press, while quietly booking the necessary losses for put-backs and litigation. WFC is a favorite of Warren Buffett, who is politically adroit and has not attracted a great deal of negative attention to date.

MBIA (NYSE:MBI) and Assured Guaranty (NYSE:AGO) insured a large amount of MBS, some of which was sold to the GSEs. They have been suing the banks in order to enforce the legal rights afforded to them by representations and warranites they banks made in order to sell and securitize mortgages. They have encountered difficulties in getting evidence of bank malfeasance, since they have no right to subpoena the banks in order to get access to the files. Instead, they must go through a painstaking and uncertain legal process of discovery.

For certain, the bond insurers will be reading any complaints the FHFA may file against the banks very attentively. They may find evidence of fraud or concealment of information that will help their causes, and greatly assist them in the process of discovery.

FHFA's actions are bullish for insurance companies generally, and specifically for MBI and AGO.

From a long term view, the US will benefit from efforts to lance and disinfect the abscess of greed, fraud, lawlessness and dishonesty that afflicts our financial system. The current suit against UBS, despite the passage of time between the subpoena and the litigation, is another small step in the right direction.

Disclosure: I am long MBI, AGO.