FHFA Lawsuit Could Cost UBS and other banks Billions over Fannie Mae and Freddie Mac

Although a number of years have passed since the collapse of the housing bubble, which led to widespread foreclosures that destroyed the value of mortgage-backed securities and nearly took down the entire financial system, the banking sector has still not been able to fully recover from the wounds it received during the crisis.

During the housing boom in the first half of the last decade, banks were making billions in profits from the bundling of mortgages, which they proceeded to sell to investors throughout the world. In order to maintain the pipeline for these mortgage-backed securities, banks began to reduce their lending requirements, which led to unqualified borrowers receiving loans with low teaser rates. On many occasions, banks and other mortgage companies actually lent money to borrowers without verifying their incomes.

This worked well as long as housing prices continued to increase, but once prices stopped their meteoric rise, the banking sector was stuck with a load of worthless mortgage-backed securities. Between 2007 and 2010, the International Monetary Fund estimated that the U.S. banking system wrote down $885 billion in loans and assets. 

In addition, the banking sector has been the focus of numerous lawsuits concerning their lending practices and their efforts to mislead investors of their mortgage-backed security products. Bank of America, thanks to its untimely acquisition of Countrywide Financial in January of 2008, has been the main target of many of these lawsuits, which has helped to drive its stock price down more than 80 percent over the past five years.

Although some analysts thought the worst of the crisis was finally over, a lawsuit filed by the Federal Housing Finance Agency in September could hit the banking sector with as much as $60 billion in additional losses. The FHFA is suing on behalf of Fannie Mae and Freddie Mac, government-sponsored enterprises that purchased nearly $200 billion in worthless mortgage-backed securities from major U.S. banks. The FHFA claims that the banks did not disclose all the risks associated with their mortgage-backed securities, but the banks counter that Fannie Mae and Freddie Mac were sophisticated investors who should have known what they were doing.

This action has created more uncertainty in the banking sector because no one is sure what the ultimate liability to the banks will be from all the lawsuits. One estimate from FBR Capital Markets indicates that the banking system will incur total losses of $121 billion from the repurchasing of mortgage-backed securities that they fraudulently sold to investors. 

With respect to this lawsuit, most of the pain will be felt by America's four largest banks: JPMorgan Chase, Bank of America, Citigroup and Wells Fargo; however, there are 13 other banks that would also suffer losses if this lawsuit is ultimately successful.

In all likelihood, the FHFA will settle for an amount considerably less than the $60 billion figure used as a possible maximum penalty. However, the suit was just filed a few months ago and will probably not be settled any time soon.

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