Government Regulator Sues Wall Street Banks For Fraud In Subprime Mortgage Deals

The federal government late Friday filed lawsuits against 17 financial institutions , including some of the nations largest banks, alleging a pattern of fraud in their packaging and selling of roughly $200 billion worth of mortgage-linked securities. The suits amount to one of the most significant legal actions to emerge from the rubble of the financial crisis nearly three years ago.

The allegations by the Federal Housing Finance Agency, which is seeking unspecified compensation, penetrate the heart of Wall Streets role in helping lead the economy to ruin. The FHFA claims these institutions knowingly peddled shoddy deals without informing investors. When the housing market crashed, and those deals went south, the damage rippled through economies around the globe, plunging nations into recession.

The legal action, which comes in addition to separate allegations of dubious mortgage and foreclosure practices at some of these banks, may roil financial markets next week, and is likely to have dramatic political consequences for the Obama administration. The banks, some of which have lately been subjected to punishing speculation about the adequacy of their capital reserves, could face massive losses. A spokeswoman for the FHFA said it was premature to judge what the actual penalties from Fridays lawsuits might be.

The FHFA alleges that banks repeatedly made false claims to the mortgage giants Fannie Mae and Freddie Mac about the very nature of the loans banks were selling. In many cases, the FHFA claims, banks sold the shoddy loans even after a third-party analysis company informed the banks that billions of dollars worth of mortgages did not meet the specifications that the banks made in legal filings and in statements to Fannie and Freddie, which are still owned by U.S. taxpayers.

Make no mistake: fraud is a business model, said Janet Tavakoli, president of the Chicago-based consulting firm Tavakoli Structured Finance.

Unfortunately, Fannie Mae and Freddie Mac were often tagged with a lot of these loans, she continued. Whether they were willing victims in some cases is almost irrelevant at this point, because now it is a matter of public interest, since taxpayers had to bail out Fannie and Freddie. The whole ballgame has changed."

Representatives for the banks were either unavailable to comment, or declined to comment, on Friday evening. The institutions being sued include Ally Bank, Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, First Horizon, General Electric, Goldman Sachs, HSBC, Societe Generale, JPMorgan Chase, Morgan Stanley, Nomura and Royal Bank of Scotland.

Bank of America and Deutsche Bank each released statements Friday saying that Fannie and Freddie are sophisticated investors, with the ability to assess complicated securities. The banks claimed that Fannie and Freddie have said the losses were caused by broader economic forces.

Fannie Mae and Freddie Mac were among the most sophisticated, powerful and heavily regulated financial institutions in the U.S. mortgage finance system, Bank of America said in a statement. They claimed to understand the risks inherent in investing in subprime securities and, in fact, continued to invest heavily in those securities even after their regulator told them they did not have the risk management capabilities to do so.

But the mortgage giants were deceived, the FHFA claims. Banks concealed crucial information about the investments they were selling, so that even the most sophisticated investor would be left in the dark, lawsuits allege.

Fannie Mae and Freddie Mac did not know, and in the exercise of reasonable diligence could not have known, of the untruths and omissions, the lawsuit against Goldman Sachs says. If Fannie and Freddie had known, the suit continues, they would not have bought the securities.

Near the center of the allegations is the relationship between the banks and an independent firm known as Clayton Holdings, which analyzed mortgages for these bank clients. Clayton, which found problems with many of these loans, got national attention last fall when a former executive gave explosive testimony to a government panel.

Wall Street banks bought pools of subprime home loans to turn into securities, and submitted a percentage of those loans to Clayton for review. Clayton found that as many as 28 percent of these loans failed to meet basic standards, the company revealed in September of last year .

But nearly half the time, banks went ahead and purchased the bad loans anyway, using this information to go back and buy the loans on the cheap, according to Clayton data and testimony from the former executive.

Worse, the banks didnt tell investors about Claytons concerns, the FHFA alleged Friday.

Goldman Sachs, an FHFA lawsuit claims, also bet against the securities it was selling, and reaped profits from doing so. Such bets were the subject of a lawsuit brought by the Securities and Exchange Commission, which resulted in a $550 million settlement last year, and has contributed to an ongoing public relations nightmare for the Wall Street titan.

Goldman was like a car dealership that realized it had a whole lot full of cars with faulty brakes, wrote journalist Matt Taibbi, in an article that the FHFA quotes in its lawsuit. Instead of announcing a recall, it surged ahead with a two-fold plan to make a fortune: first, by dumping the dangerous products on other people, and second, by taking out life insurance against the fools who bought the deadly cars.

The lawsuits put intense pressure on the Obama administration, which has long insisted that U.S. banks are healthy, while pushing for a cheap and speedy settlement over separate allegations that banks committed widespread fraud in the foreclosure process.

The suits also underscore tensions over housing policy between President Barack Obama and Edward DeMarco, acting FHFA director. DeMarco, a holdover from the Bush administration, has rebuffed a push from Obama insiders to spur mortgage refinancing for underwater borrowers.

The government took over Fannie and Freddie in the summer of 2008 as the mortgage giants suffered massive losses, and DeMarco is bound by that takeover deal to limit losses for taxpayers. Some housing experts have criticized the Obama team's push for refinancing, saying it has failed to eliminate excess bubble-era housing debt for underwater homeowners.

Nevertheless, the FHFA's move prompted applause from Rep. Brad Miller (D-N.C.), one of the top mortgage experts in Congress, and a persistent critic of big bank abuses both during and after the housing bubble.

"I dont agree with Mr. DeMarco on every issue, but I have consistently supported FHFAs efforts to pursue legitimate claims for fraud and breach of contract to limit taxpayer losses," Miller said. "Not pursuing those claims would be an indirect subsidy for an industry that has gotten too many subsidies already. The American people should expect their government not to give the biggest banks a backdoor bailout."

The administration has long sought to maintain the stability of major financial firms in the aftermath of the politically unpopular bank bailouts of 2008 and 2009. Although the bailouts were initiated under President George W. Bush, Obama continued the policies, and has repeatedly touted Wall Street's health as evidence that the programs were successful. Further losses absorbed by banks could weaken the economy and stymie job creation.

The suits include at least one explicitly political problem for Obama. The FHFA's targets include General Electric, an international beacon of American business whose CEO, Jeffrey Immelt, currently serves as a top economic adviser to Obama .

Stock market investors have hammered financial institutions in recent weeks, as worries that the economy could be entering a new recession combined with fears that these companies could be on the hook for many billions in legal liabilities -- and could face losses from exposure to troubled European banks.

The value of Bank of America shares at closing on Friday had sunk to a third of its so-called book value, according to its recent financial statement. The closing price of $7.25 a share was just cents higher than its price before the widely-admired investor Warren Buffett injected several billions into the company last week.