Mortgage Fraud: Will Wall Street finally have to pay for its misdeeds?

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Wall Street may soon have to finally pay for its folly. Earlier this week, the US Attorneys office of the Department of Justice sued Deutsche Bank for allegedly tricking a government insurance program into backing mortgage loans that were much riskier than they were portrayed. Many of those loans have defaulted causing nearly $400 million in losses for the government program already, and potentially much more. The question is what other big banks were also abusing government home loan programs during the housing bubble and after.

Of course, we have known for a while that banks and mortgage lenders were busy during the housing bubble passing off bad loans as good. That was in part what the $500 million Goldman Sachs settlement with the Securities Exchange Commission last year was about. Even when there wasn’t direct fraud, investment banks were using complex mortgage derivatives to make their home loan deals look safer than they were. What’s different is that for the first time since the financial crisis, it looks like the government is going to try to make Wall Street and big banks pay up for their poor and deceptive lending practices. So which banks will the government go after next?

Deutsche Bank is being sued under the False Claims Act, which was set up to punish companies that lie to the government in order to get tax payer money. It is only the second mortgage related case that has been brought by the US Attorney’s office under the act, and the first against a major financial firm. The False Claims Act allows the government to collect damages of three times what the government had to lay out, which in this case could mean that Deutsche has to pay the government nearly $1.2 billion for the current losses it allegedly tricked the government into covering. As losses grow, the bill could get larger. The program that Deutsche’s mortgage lending unit MortgageIT abused is an insurance program run by the Federal Housing Administration. The FHA program was set up to make housing more affordable to middle income families by allowing them to qualify for a mortgage without having to put down a large downpayment. In order to encourage lenders to make the loans, FHA agrees to cover the losses if the loan goes bad. But unlike many private mortgage programs that just relied on credit scores, FHA requires lender to verify that borrowers have enough income to qualify for the loan. It appears MortgageIT, which was bought in 2006 by Deutsche, repeated failed to do that even after it was warned by FHA that it wasn’t following standards, and as late as 2009, well after the financial crisis hit. HUD officials, which run the FHA, claim that Deutsche was an outlier in terms of bad behavior when it came to the FHA program. But since so many FHA loans went bad, US District Attorney Preet Bharara said it wasn’t a big leap to expect the government to go after other lenders to recover tax payer money.

Andrew Sandler, Chairman and Executive Partner with law firm BuckleySandler LLP, says he thinks the government will pursue cases against other lenders. Says Sandler, “This is the opening salvo of what likely will be a concerted campaign by the DOJ Financial Fraud Task Force to seek recovery of government funds from mortgage industry players. These are tough cases to prove but the stakes will be staggering.”

So what other banks may have been passing bad or unverified loans to FHA? According to the FHA’s Neighborhood Watch loan tracking website, FHA had to cover the losses  on 486 mortgage originated by Wells Fargo during the period 4/01/08 to 03/31/10. That was much higher than some rivals. For instance, the government had to cover losses on just 54 mortgage originated by Bank of America in the same time. And just 10 from CitiMortgage, though Citi originated far fewer mortgage in that time period than the other two.

But Bank of America may not be in the clear either. In March 2010, the FHA banned mortgage lender First Franklin from the FHA loan program for a number of violations including failing “to adequately document the stability and/or source of income used to qualify for loans,” which sounds a lot like what Deutsche is being sued for. First Franklin was bought by Merrill Lynch in late 2006. And Bank of America bought Merrill Lynch in late 2008 at the height of the financial crisis. That means BofA could be on the hook for First Franklin’s abuses.

FHA suffered heavy losses on mortgage loans that went bad in the go-go years of the housing bubble. The suit against Deutsche bank reaches all the way back to 1999. The bill for Wall Street to clean up the financial crisis could soon get a lot bigger.