More Legal Woes Imperil Bank Profits

By Kyle Colona - April 3, 2013 | Tickers: BAC , C , UCBI , VLY | 1 Comment

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A continuous wave of mortgage-related legal cases may pose a threat to the banking industry’s profits in 2013.

Several sources have recently reported that since the 2008 economic crisis erupted, banks have been slammed with lawsuits filed by private investors and federal and state authorities. The lawsuits center on the banks’ selling billions of dollars of subprime mortgages that tanked and drove the economy off the hook.

FHFA Legal Actions Against Money Center Banks

Now, the nation’s largest banks are facing a series of rulings in a legal action being pursued by the Federal Housing Finance Agency. The FHFA oversees Fannie Mae (NASDAQOTCBB: FNMA.OB) and Freddie Mac (NASDAQOTCBB: FMCC.OB).

The case was originally brought in 2011 against a number of money center banks like Bank of America (NYSE: BAC ) , and Citigroup (NYSE: C ) .

In this action, the agency claims the banks duped the housing behemoths into buying $200 billion of mortgage securities that tanked during the financial crisis. The banks are pushing back against a strict discovery progress.

In short, the ruling allowed the agency to take far more depositions than the banks. These lenders claim that by doing so, the presiding judge has tilted the balance of the case in the FHFA’s favor. This ultimately means that the banks could end up on the losing side, which could cost them hundreds of millions in settlement fees and additional legal costs.

In fact, Citigroup already agreed to pony up $730 million to settle FHFA allegations that the too-big-to-fail bank deceived investors in securities backed by bad mortgage loans. While Citigroup did not admit wrongdoing (as is always the case in these settlements), the bank’s profit took a $1.3 billion hit to cover the total settlement and legal bill.

While it’s unclear whether the big banks will prevail, Fannie and Freddie's coffers will gain billions if the Agency wins this case. As I recently reported, preferred shares of Fannie and Freddie have risen dramatically, and their common stock is dirt cheap, and also worth considering. A win in this case will enable both companies to add to their cash reserves and enhance their balance sheets.

FHFA Recent Settlement with Bank of America

This legal proceeding is a separate case than the recently announced settlement between Fannie and Freddie with Bank of America. That deal calls for the big bank to buy back bad mortgage paper sold to FNMA and FMCC between January 2001 and December 2008.

BAC will cough up $11.6 billion, and the deal will end the parties' dispute over so-called “put-backs.” These are mortgage loans that Fannie requires lenders to buy back as a result of poor underwriting and other missteps.

What Do Mortgage Cases Mean for Investors ?

In the final analysis, the legal costs of the FHFA case, others in the pipeline, and any other settlements will continue to hit the banks’ profits, even if they have deep pockets.

While some analysts will argue that bank profits are improving, and base their calls solely on fundamentals, these continued legal actions five years after the economic crisis rolled in are a troublesome sign for the sector. And with other ongoing mortgage and fraud litigations waiting in the wings, legal settlements and costs will continue to be a drag on the banks’ profits if not a black eye.

But investors who still seek profits in financials could also consider regional and community banks.

In particular, United Community Banks (NASDAQ: UCBI ) and Valley National Bank (NYSE: VLY ) do not face the same legal challenges and may provide safe harbors from the endless waves of mortgage litigation.

United Community Banks, Inc. is the bank holding company for United Community Bank. UCB provides retail and corporate banking services to individuals as well as small to mid-size businesses. Shares are up more than 25% this year. The company has a number of strengths, including a solid record of earnings per share growth, growing net income, and expanding profit margins.

Finally, Valley National Bancorp is the holding company for the Valley National Bank. Valley provides various commercial, retail, trust, and investment services. Its deposit products include savings accounts, money market accounts and certificates of deposit. Shares are up about 5% in 2013.

At the end of the day, investors need to ask: Why invest in big banks when the economic tempest stirred by the massive mortgage fraud continues to linger? And while the business of business is business, to paraphrase the late Milton Friedman, perhaps investors should also factor the ethical responsibilities of business into their calculus.