Payback May Backfire as U.S. Presses BofA on Bad Mortgages

Efforts by U.S. regulators and government-controlled firms to recoup billions of dollars from Bank of America Corp. for faulty mortgages may backfire, hurting the same taxpayers they’re meant to protect.

After committing more than $30 billion for claims and writedowns, the bank faces a $10 billion lawsuit from American International Group Inc. (AIG) alleging “massive fraud.” Fannie Mae and Freddie Mac stepped up efforts to extract refunds beyond the $5.1 billion already expected. The lender is also the biggest target of a 50-state foreclosure probe seeking $20 billion from the five largest home lenders and an $8.5 billion mortgage-bond accord that includes the Federal Reserve Bank of New York.

Regulators behind these companies and agencies are walking a thin line between success and renewed crisis, according to Neil Barofsky, former special inspector general for the Troubled Asset Relief Program. While each is pushing for its own interests, their collective demands could leave the nation’s biggest lender needing another taxpayer rescue, Barofsky said.

“There is an inherent conflict,” said Barofsky, who’s now a senior fellow at New York University School of Law. “As a policy matter, is it really a good idea to permit a government- controlled entity to potentially provoke a global meltdown by laying claims against Bank of America?”

Stock specialists work at the Bank of America/Merrill Lynch post on the floor of the New York Stock Exchange Aug. 10. Concern about Bank of America's health swelled as its stock price plunged earlier this month. Photo: Stan Honda/AFP/Getty Images Close

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Stock specialists work at the Bank of America/Merrill Lynch post on the floor of the New York Stock Exchange Aug. 10. Concern about Bank of America's health swelled as its stock price plunged earlier this month. Photo: Stan Honda/AFP/Getty Images

Capital Debate

New York-based AIG, Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac are each almost 80 percent owned by U.S. taxpayers after 2008 rescues conducted at the depths of the financial crisis. Created by Congress to boost U.S. homeownership by buying loans, the two mortgage firms have already received more than $170 billion in taxpayer funds, while AIG at its height received $182 billion.

Concern about the Charlotte, North Carolina-based bank swelled as its stock plunged earlier this month to a two-year low. It traded at $7.53 as of 9:44 a.m. today in New York Stock Exchange composite trading. Bank of America lost as much as half its value this year amid speculation it will sell new shares to raise capital, a move Chief Executive Officer Brian T. Moynihan has said won’t be necessary.

Moynihan told investors Aug. 10 that if there’s no recession, the bank is “very comfortable” it can meet international capital goals through earnings and asset sales, buoyed by conditions that are better than when the credit crisis broke out in 2007. The lender’s July earnings statement said the company is “creating a fortress balance sheet.”

John E. McDonald, the Sanford C. Bernstein & Co. analyst with an “outperform” rating on the shares, estimated this week the bank will face only $15 billion of new buyback losses. Even if losses are four times that number, the bank will still exceed minimum capital thresholds, McDonald wrote.

More Claims

By contrast, Bank of America may face another $62 billion in losses from repurchasing bad mortgages under a worst-case scenario dated Aug. 10 by Chris Gamaitoni, a former Fannie Mae (FNMA) senior financial analyst who now works for Compass Point Research and Trading LLC. That’s including $17.8 billion Bank of America had set aside to cover such costs at the end of June.

Claims totaling $11.6 billion were outstanding at midyear, including the $5.1 billion by Fannie Mae and Freddie Mac, the company said in its second-quarter presentation. While some reserves have been set aside, the bank said it expects more demands from private investors that may total $5 billion or more over existing accruals.

As for the $8.5 billion settlement with a group that includes the New York Fed, BlackRock Inc. (BLK) and Pacific Investment Management Co., that’s being challenged by a group of Federal Home Loan Banks who say the sum is too small. The U.S.-backed cooperatives claim a reasonable settlement could exceed $27.5 billion.

Capital Ratios

“BofA is getting hit from all fronts,” said Mark Williams, a former Federal Reserve bank examiner who is now an executive-in-residence at Boston University’s School of Management. “Its too-big-to-fail size and wobbly financial condition has put it in the middle of a potential regulatory tug-of-war.”

Bank of America traded for as little as 50 percent of its tangible book value, the lowest among the 10 largest U.S. lenders, reflecting doubt about the true worth of its assets. The company listed $222 billion in shareholders’ equity as of June 30.

By the end of 2012, the bank has said it expects to have a capital ratio of between 6.75 percent and 7 percent as measured by the Basel III accords, which were designed to head off another financial crisis by requiring banks to hold more capital. Starting in 2013, Basel III rules require a ratio of 3.5 percent, expanding for firms like Bank of America to 9.5 percent by 2019, finance chief Bruce R. Thompson said.

AIG’s Suit

The conflict came into focus this month as AIG sued to recover more than $10 billion in losses suffered on $28 billion of mortgage securities, saying it was duped by Bank of America. The lender rejected the allegations, saying AIG’s own “excesses and errors” led to the losses.

Days before, the bank’s quarterly filing said Fannie Mae and Freddie Mac, which own or guarantee about half of the almost $11 trillion U.S. mortgage market, had become “more rigid” in resolving their demands for refunds. Fannie Mae’s most recent quarterly report said its increasing number of claims raises the risk that banks “will not be willing or able” to meet their obligations.

Bank of America took $45 billion in U.S. aid plus asset guarantees under former CEO Kenneth D. Lewis, and has since repaid the sum. When Moynihan, 51, was named his successor in late 2009, he said his goals included making sure the bank would never again need government help, calling that task a “solemn duty” in a 2010 essay.

Most of the claims stem from mortgages made by the lender and Countrywide Financial Corp., which Lewis purchased in 2008, using underwriting standards that were later criticized by lawmakers and regulators as too lax.

Packaged Loans

The loans were packaged into securities and sold to Fannie Mae and Freddie Mac with a promise to buy them back if they contained defects such as false information about borrowers or properties. When defaults began to pile up, so did demands from the two mortgage firms for refunds, totaling $27.7 billion on loans originated by Bank of America and Countrywide from 2004 through 2008. The company had resolved $22 billion of those claims through year-end.

Lawmakers are pressing Fannie Mae, which hasn’t posted an annual profit since 2006, and Freddie Mac to shift more of the burden back to banks that created defective loans. In an August 2010 letter to President Barack Obama, Representative Barney Frank, the Massachusetts Democrat who led the House Financial Services Committee at the time, said the battle to get refunds “should be fought with every tool.”

Pressing for Settlement

The danger is that added claims and losses may destabilize the bank, said Williams, the former Fed examiner. Bank of America posted a record second-quarter loss of $8.8 billion, its sixth deficit in the past 11 quarters. It’s the largest U.S. mortgage servicer, which involves billing, collections and foreclosures, and handles about one-fourth of Fannie Mae’s single-family loans.

Moynihan met Treasury Secretary Timothy F. Geithner and Fed governor Daniel Tarullo last week to press for a settlement of the state mortgage foreclosure probes, said two people with direct knowledge of the event. An agreement among banks, state attorneys general and the Department of Justice would enable lenders to resolve delinquent loans and allow the U.S. housing market to recover, Moynihan told the officials.

Barofsky and James Cox, a Duke University law professor in Durham, North Carolina, said they supported efforts by AIG, Fannie Mae and Freddie Mac to pursue large penalties. “There are no political gains and only gigantic potential losses by further appearing to involve the government in private industry,” Cox said.

Duty Roster

The Obama administration won’t take part in management decisions of the companies it owns, according to Treasury Department spokesman Mark Paustenbach. Barofsky said he “never got a single bit of pushback” from Treasury when he was the inspector general to go easy on the largest U.S. banks, a sentiment echoed by Corinne Russell, a spokeswoman for the Federal Housing Finance Agency.

The FHFA, which oversees Fannie Mae and Freddie Mac, is obliged by law to protect the assets and property of the two enterprises, and that duty requires “first and foremost, minimizing credit losses from delinquent mortgages,” Russell said in an e-mailed statement. The refund demands are “an important part of minimizing credit losses by holding originators accountable.”

Lawrence Grayson, a Bank of America spokesman, Mark Herr at AIG, and Jack Gutt at the New York Fed declined to comment for this article.

State Cases

At the state level, the duty of the attorneys general in civil actions is to advocate for their clients -- in this case, their taxpayers -- and let the defendants and their guarantors deal with the consequences, said William K. Black, a former bank regulator and now an economics and law professor at the University of Missouri Kansas City. New York may be among states omitted from an accord between Bank of America and the states because Attorney General Eric Schneiderman doesn’t want a deal that would impede his probe into mortgage securitization, said two people with direct knowledge of the talks.

The results may not be good policy, according to Tim Rood, a partner and managing director at The Collingwood Group, a Washington-based firm that specializes in housing issues.

“I don’t think the AGs should be overly ambitious on how big the settlement should be, at the risk of damaging already fragile institutions,” Rood said. “We risk the unintended consequences of having to, in one form or fashion, bail them out of the financial hole that we are now digging for them.”

Geoff Greenwood, spokesman for Iowa Attorney General Tom Miller, who’s leading the 50-state probe, said officials are aware of the need to balance competing interests.

“We’ve been criticized by some as not being hard enough on the banks and by others for being too tough on them,” Greenwood said in a phone interview. “Welcome to our world.”

To contact the reporters on this story: Dakin Campbell in San Francisco at dcampbell27@bloomberg.net; Lorraine Woellert in Washington at lwoellert@bloomberg.net.

To contact the editors responsible for this story: David Scheer in New York at dscheer@bloomberg.net; Rick Green in New York at rgreen18@bloomberg.net.

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