The massive lawsuits that the federal government brought last week against many of the largest U.S. and global banks underscore the deepening tension within the executive branch with regard to housing.
At issue is how to allocate the staggering, debt-fueled losses that stem from the bursting of the housing bubble starting in 2007. Families that borrowed to buy homes will obviously bear a large share of the losses. The rest of the tab will ultimately be divided between lenders, private investors and U.S. taxpayers. How much each group will pay is still to be determined.
The government, while seeking to protect taxpayers, can't seem to make up its mind who should foot the bill.
On the one hand, federal regulators have openly worried about the litigation risk facing banks as a result of mortgages they sold that have since gone bad. Some analysts have said those lawsuits could cost the banks billions of dollars and undermine the solvency of a few institutions and the economy at large.
On the other, the Federal Housing Finance Agency's (FHFA) suit last week against the largest banks appears to amplify such risks, potentially forcing a bigger payout across the board and heightening economic uncertainty.
Most observers blame the conflict on the Obama administration for failing to set clear guidelines. "The administration hasn't really had a coherent idea of how the losses should be allocated," said Alan White, a law professor at Valparaiso University. "Most of the decisions have been made ad hoc."
Some said one reason the government's policy is confused is the conservatorship of Fannie Mae and Freddie Mac, which are now effectively being run by the FHFA. Under the law, the FHFA is charged with protecting taxpayer dollars, and its lawsuits are an effort to shift some housing sector losses from taxpayers to lenders.
Karen Shaw Petrou of Federal Financial Analytics said that when the FHFA was established the belief in Congress was that if Fannie or Freddie ever had to be bailed out, the FHFA would be in control of the mortgage giants only briefly. It has been in charge for nearly three years. "The fact is that there is an inherent and profound conflict here, which is why the conservatorship was never meant to last this long," Petrou said.
The agency's suits say 17 financial institutions misrepresented the quality of the mortgages in nearly $200 billion worth of bonds they sold to Fannie and Freddie, mostly between 2005 and 2007. An analysis by Keefe, Bruyette & Woods said the suits could cost the defendants $60 billion.
This is what banks call litigation risk, and it is a cause for concern among regulators and banks. Testifying before the Senate Banking Committee in May, Sheila Bair, then chairman of the Federal Deposit Insurance Corp., noted that some banks were reserving for mortgage-related losses, but a significant amount of their exposure had yet to be quantified.
The FHFA has different concerns. In explaining its decision to sue it noted its mandate to minimize taxpayer losses. "Some have claimed that these suits will disrupt economic recovery, or endanger the targeted banks, or increase their cost of capital," it said. "While everyone is concerned with these important issues, the long-term stability and resilience of the nation's financial system depends on investors being able to trust that the securities sold in this country adhere to applicable laws."
Paul Miller at FBR Capital Markets wrote in a report this week that the lawsuits will drain capital from the banking system and lead banks to overly tighten their lending standards, preventing some families from borrowing to buy a home. In an interview, however, the analyst didn't blame the FHFA. He faulted the Obama administration for not establishing a more coherent policy that cuts across different agencies.
White said fears that the lawsuits will threaten bank solvency are overblown. It's "perfectly appropriate for some of the profits [at banks] to be disgorged back to the taxpayers," he said.
The lawsuits further a rift that has been playing out for months inside the government. With increasing urgency the administration has been searching for ways to slash housing debt to spur the economy. But the FHFA has rejected the idea of principal reductions.
Late last year President Obama's nomination of North Carolina Banking Commissioner Joseph Smith to head the FHFA was torpedoed by Senate Republicans. The vacancy has left Edward DeMarco, a career civil servant, to run the agency on an acting basis. Not everyone agrees with the way that the FHFA has interpreted its mission during DeMarco's tenure. If the agency took a broader view of its responsibility to taxpayers, it might conclude short-term losses would eventually be at least somewhat offset as a result of better economic growth. This is probably the position the White House would like to see the FHFA adopt. "The heart of the controversy is whether or not FHFA must read its duties there as short-term and shareholder-focused as it does," Petrou said