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Stock Selloff Adds to Pressure on Banks to Fix Foreclosure Mess

Shares of U.S. banks slid for a third day as lenders and government officials faced mounting pressure to answer claims that home lending and foreclosures have been marred by illegal shortcuts.

Bank of America Corp. and JPMorgan Chase & Co. each fell more than 4 percent. Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia, raised his estimate for the cost of litigation and delays tied to mortgages to $10 billion yesterday from $6 billion.

An investigation by attorneys general in all 50 states into banks’ foreclosure practices fueled speculation about even greater losses if mortgage-bond investors successfully challenge the underlying loans and force lenders to buy them back. Faulty foreclosures also may lead banks to write down principal and take losses, analysts said.

“The nation has been in denial about the scope of the problem, and it’s now just being revealed,” said Janet Tavakoli, founder of Chicago-based Tavakoli Structured Finance Inc., a financial consulting firm. “This is a huge crisis for our country.”

The 24-company KBW Bank Index slumped 2.4 percent, with Bank of America dropping 62 cents, or 4.9 percent, to $11.98 at 4:15 p.m. in New York Stock Exchange composite trading. Wells Fargo & Co. declined 4.6 percent and Citigroup Inc. slipped 2.7 percent. Charlotte, North Carolina-based Bank of America and New York-based JPMorgan, which fell 4.1 percent, were among the worst performers in the 30-company Dow Jones Industrial Average.

GMAC Loans

The scrutiny began last month when a memo showed Ally Financial Inc.’s GMAC Mortgage unit halted evictions in 23 states to review foreclosures. An employee said in sworn testimony that he and his team signed 10,000 affidavits and other documents each month without checking the accuracy of the files. Bank of America last week halted foreclosures in 50 states, and units of JPMorgan, Goldman Sachs Group Inc. and PNC Financial Services Group Inc. have said they’re reviewing some foreclosures.

President Barack Obama and the federal agencies that share responsibility for housing finance are opposing calls for a nationwide foreclosure freeze, fearing further damage to the home sales. Even as bank stocks tumbled yesterday on concern that the mishandled loans will increase costs for lenders, the White House and federal regulators avoided any grand gestures designed to reassure investors.

‘Incremental’ Expense

U.S. regulators say they are aggressively investigating whether employees of lenders falsified documents used in foreclosure proceedings.

“No one should misunderstand the magnitude of our response,” said Federal Housing Administration Commissioner David Stevens. “The administration has been very clear that there is no excuse for not fixing the problem.”

JPMorgan said Oct. 13 that it expanded its initial review from 23 states to 41, and to about 115,000 homes, according to a presentation that accompanied its third-quarter earnings release. Chief Executive Officer Jamie Dimon, 54, said the expense will be “incremental.”

“If you’re talking about three or four weeks, it will be a blip in the housing market,” Dimon told investors on a conference call Oct. 13. “If it went on for a long period of time, it will have a lot of consequences, most of which will be adverse on everybody.”

Dimon said he had hope, not knowledge, that the problems could be a blip.

Evictions Proceed

Wells Fargo and Citigroup have said they are proceeding with foreclosures. Wells Fargo said in a statement earlier this week it is “satisfied that our foreclosure affidavit process is sound.” Ally spokeswoman Gina Proia said the bank “hasn’t found any evidence” of mistakes.

Mark C. Rodgers, a Citigroup spokesman, said in an e-mailed statement that the bank has safeguards in place to prevent improper filings. “We have no indication that our employees are not following our current procedures, and we do not believe suspension is necessary,” he said.

Harvard Law School visiting professor Katherine Porter said lenders would be better off agreeing to modify loans to curb lawsuits.

“From the beginning, mass modifications would have been better and I still think they’d be cost-saving,” said Porter, whose 2007 research examined practices of mortgage lenders and servicers foreclosing on bankrupt borrowers. “Doing new paperwork and doing it right is still a better choice.”

Loans Challenged

As many as 9 million U.S. mortgages in the foreclosure pipeline or already through the process may face challenges, Morgan Stanley’s Oliver Chang, Vishwanath Tirupattur and James Egan wrote in a note Oct. 12.

In one case, an attorney for a Yonkers, New York, homeowner secured a loan modification from Citigroup in February after finding that the bank misrepresented the chain of title.

The modification for Barbara and Ron Frusciante’s three- bedroom home shaved $200,000 in principal and interest off the life of the loan, according to calculations performed by their lawyer, Linda Tirelli. The bank also paid Tirelli’s fees of $15,000, she said.

“I just wish that CitiMortgage had done this on their own,” Ron Frusciante, 62, said in a phone interview. “The end result is exactly what we wanted.” Rodgers, the Citigroup spokesman, declined to comment on Frusciante’s case.

Potential Cost

Wide-scale principal reductions may lead to “huge losses” for banks, said James Ellman, a former Merrill Lynch & Co. bank- stock portfolio manager who is now president of San Francisco- based hedge fund Seacliff Capital.

“You could potentially be talking about hundreds of billions of dollars in losses,” Ellman said. “Though it is a low probability, banks would have to go back to the capital markets for more capital.”

Banks may also settle for more short sales, when lenders agree to let homeowners sell properties for less than they owe on the mortgage, Morgan Stanley’s Chang said.

Bank of America CEO Brian T. Moynihan, 51, speaking at a conference in Boston yesterday, said he didn’t think the drop in the company’s stock was justified, and today Barbara Desoer, head of home lending, said estimates of added costs from foreclosures have been “grossly distorted.” The bank stands by the accuracy of its foreclosure process, she said in an interview.

Signs of Progress

Florida’s attorney general, Bill McCollum, said he met with JPMorgan yesterday and had telephone conference with Bank of America this week to discuss the foreclosure crisis. They seem to be “well on their way” to correcting problems in their foreclosure procedures, he said.

McCollum, who sits on the executive committee of the 50- state task force of attorneys general that is investigating foreclosures, has asked to meet with Goldman Sachs’s Litton, PNC and GMAC, he said in an interview. McCollum said while he didn’t know the ultimate outcome, companies might have to pay “some kind of penalty.”

Matt McCormick, a banking-industry analyst and portfolio manager at Cincinnati-based Bahl & Gaynor Inc., said his firm is avoiding most U.S. bank stocks. He said he doesn’t think bank executives have answers yet.

‘More Unknowns’

“I don’t think they truly know the depth of the exposure,” McCormick, whose firm manages $2.9 billion, said yesterday. “There are more unknowns than knowns, and investors today are not going to tolerate that.”

Mortgage brokers and Wall Street investment banks sought to ramp up mortgage lending to feed the creation of bonds backed by those same loans, Tavakoli said. Banks produced so many home loans that they couldn’t keep up with the paperwork, she said.

“If they were less than interested in the financial health of these people when they were giving loans out, do you really think they dotted all the i’s and crossed all the t’s in terms of verifying the paperwork? I don’t think so,” said McCormick of Bahl & Gaynor. “The housing market is going to take longer to heal and it just prolongs the agony.”

“The vast majority of the losses we have paid or expect to pay on mortgage-related securitizations are related to fraud and violations of representations and warranties,” said Kevin Brown, a spokesman for Armonk, New York-based MBIA Inc., owner of the largest bond insurer.

Lawsuits

Foreclosure improprieties, including defective loan- transfer documentation, will make it easier to sue banks that packaged mortgages, he said.

“We expect these repurchase obligations to be honored, and therefore we anticipate substantial recoveries on these transactions,” Brown said.

While investors’ sales of mortgage securities not backed by the government increased to more than $1 billion a day this week from about $300 million to $500 million a few weeks ago, values are little changed, with bond buyers willing to “wait to see what the fallout is,” according to Jesse Litvak, a mortgage- bond trader at Jefferies & Co. in New York.

“For the better part of the last three days, there’s been a ton of selling, but so far prices are not budging,” Litvak said in a telephone interview.

A Markit ABX index of credit-default swaps tied to 20 subprime-mortgage bonds rated AAA when created in the second half of 2006, for instance, yesterday closed at 58.81, near a two-year high and up from 58.73 on Oct. 1, according to London- based Markit Group Ltd. The index’s level, which rises as bond prices do, fell as low as 28.5 in April 2009 from 100 in early 2007.

Reserves

JPMorgan, the second-biggest U.S. bank by assets, said it was adding $1 billion to reserves for repurchasing mortgages.

While Morgan Stanley bank analyst Betsy Graseck stopped short of estimating litigation expenses in an Oct. 12 note, she said that “banks need to either fess up and announce a reserve build or state they are clean.”

FBR’s Miller said delays tied to the probes may cost U.S. lenders $2 billion for every month of delay. Extending foreclosures by one month costs about $1,000 for each property in the pipeline, according to Miller, a former bank examiner. He raised his estimate yesterday because he now foresees litigation costs ranging from $3 billion to $4 billion, he said in a note.

Federal banking regulators have been examining the document procedures of individual banks to pinpoint problems. The results of those exams will determine the next step, said Kevin Mukri, spokesman for the Office of the Comptroller of the Currency. The agency has directed seven of the nation’s largest servicers to review their foreclosure processes, including JPMorgan Chase, Bank of America, Citigroup, HSBC Finance Corp., PNC, and Wells Fargo.

Moratorium Opposed

The FDIC has started an independent review of banks with which it shares loan losses and won’t make payments if it finds foreclosures were conducted unlawfully, the agency said.

Treasury Secretary Timothy F. Geithner said in an interview on “Charlie Rose” that a nationwide moratorium on foreclosures would be “very damaging.”

“Making excuses and whining about moratoria is not going to solve the problem,” Alan White, a law professor at Valparaiso University in Indiana, said in a phone interview. “This is an occasion to call out the banks on their performance and they aren’t doing it. If anything the administration seems to be aligning themselves with the banks. I find that deeply disappointing.”

To contact the reporters on this story: Dakin Campbell in San Francisco at dcampbell27@bloomberg.net; Christine Harper in New York at charper@bloomberg.net.

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net

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