New Mortgage Suits: U.S. Financial Problems Are Far from Fixed

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Lawsuits against Bank of America and others are making investors nervous about the health of the banking sector (Emmanuel Dunand / AFP / Getty Images)

UPDATE: 9/2/11, 10:15 PM

Remember the financial crisis. It’s back, sort of. This time the worry about the banks is being created not directly from bad loans, but from lawsuits that are now coming out of those now sour deals. And it appears a new round, and perhaps the biggest so far, could be coming came at the banks as soon as next week. on Friday. (See UPDATE at bottom.)

The regulator that oversees Fannie Mae and Freddie Mac – remember the government basically took over the two mortgage guarantors just as the financial crisis was getting started – is reportedly planning to sued dozens of banks for their role in creating the many mortgage bonds that have gone bust in the past few years. Freddie and Fannie bought hundreds of billions of these bonds, and it has cost the two mortgage giants dearly. Fannie and Freddie have been one of Uncle Sam’s biggest tabs from the financial crisis. The cost of the two bailouts totaling $153 billion so far. Now the Federal Housing and Finance Authority is trying to get some of that money back.

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While it’s not clear how much more the banks will have to pay, what is clear is that nearly three years after the financial crisis hit the banking industry’s problems are far from fixed. It’s another sign that the government has not done enough, and may have to do more, to clean up the nation’s lingering issues with bad debt.

Earlier this year, I predicted that the legal assault against Wall Street would shift from trying to put bankers behind bars to trying to get Wall Street to pony up for the losses. And that’s exactly what’s happened. The Department of Justice sued Deutsche Bank, claiming the German bank duped government mortgage guarantor Federal Housing Administration into backing mortgages that were much riskier than a Deutsche unit let on. AIG recently sued Bank of America for $10 billion for its role in creating mortgage bonds that the giant insurer lost money on. And there are dozens of suits by private mortgage investors trying to get money back from the banks.

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Investors are worried about how much money banks will eventually be forced to pay. And bank stocks have taken a significant hit this year. To be sure, banks are not nearly in as bad a shape as they were a few years ago. Capital ratios are up, and the total number of bad loans they have on their books is down. The risk of a bank going under, or having to be saved by Uncle Sam is minimal. Most estimates before the soon to be filed Fannie and Freddie lawsuits put the cost of the banks’ legal bills at about $45 billion. That bill will go up from this suit, which will focus on the subprime bonds that banks underwrote and sold to the government mortgage guarantors. Fannie and Freddie hold about $225 billion in subprime bonds. Earlier this year, the FHFA sued UBS for $900 million to recover losses Fannie and Freddie incurred on $4.5 billion in soured mortgages it bought from the Swiss bank. Based on that math, the current suits, spread among the banks, could be for nearly $45 billion.

But how much the banks will eventually have to pay is not clear. Adam Sorensen over at our sister blog Swampland points out the FHFA lawsuit will likely jam up the government’s efforts to force the banks to come to a settlement on their foreclosure practices. State AGs have been pushing for banks to write down the mortgages of people who are at risk of foreclosure to ease their monthly payments. These latest suits could just become another bargaining chip in those negotiations.

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So far, Bank of America, because it is one of the largest mortgage servicers and because it bought both Merrill Lynch and Countrywide – two large players in the subprime mortgage market – is the firm investors seem most worried about. The Federal Reserve has quietly asked Bank of America to draw up plans to raise more capital should it need it. But Dick Bove of Rochdale Securities, one of the analysts who was early to sound the warning signal that there was trouble in the banking system before the financial crisis hit, says not to worry. He says Bank of America has more than enough capital to pay its legal tab.

Even so, the suits are highlighting how weak the U.S. banking sector is. According to Paul Miller at FBR Capital Markets, lending at nearly all of the nation’s biggest banks has fallen inĀ  every quarter since the beginning of 2010. Bove says the suits will only cause the banks to retreat more. At the time of the financial crisis, we were worried about zombie banks. Well, here they are – constantly shrinking institutions that stay alive by slowly sucking the blood out of the economy. More money is what we need in the economy. Instead what we are getting is less. This is costing the country jobs. It’s just another sign that the bailout, TARP and all, was not nearly enough to fix the problems in the banking sector. And another reason this recovery looks to be about to go bust.

UPDATE: The FHFA lawsuits are out. The government is suing 17 banks in all (including Countrywide and Merrill Lynch, which are now both divisions of Bank Of America). There are also some 200 bankers who are named individually in the suits. The suits cover $196 billion in mortgage bonds that were bought by Fannie Mae and Freddie Mac. But the suits don’t name damages. So it’s not clear how off I am on my earlier guess that the suits might cost the banks $45 billion. Most of the bonds are not worthless. Still, many of the suits seek punitive damages as well as to recover Fannie and Freddie’s losses, so the banks could be on the hook for more than I thought. Anyway, it is by far the governments largest effort to recover losses from the banks from the financial crisis, and it’s a significant one. Nice to see the government take a stand. Wrong doing should not go unpunished no matter how widespread it was. Felix Salmon has put together a nice rundown of the lawsuits.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.