Suing Banks Is Next Best to Letting Them Fail: Jonathan Weil

Illustration by Keith Shore Close

Illustration by Keith Shore

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Illustration by Keith Shore

The Vietnam War gave us the expression, “We had to destroy the village in order to save it.” The same kind of thinking might help explain the U.S. bank rescues of 2008: We had to save the banks in order to sue them.

Last week, the conservator for Fannie Mae and Freddie Mac filed lawsuits against 17 financial institutions to recover losses on faulty mortgage bonds sold to the two government- backed housing financiers. One of the defendants was Ally Financial Inc., the lender formerly known as GMAC that once was the finance arm of General Motors Co.

If the Federal Housing Finance Agency recovers damages from Ally for Freddie Mac, it will be a win for taxpayers. Yet it also will be a loss. That’s because Ally is still majority-owned by the U.S. Treasury.

It’s a ridiculous situation, for sure. Then again the FHFA is doing what it’s supposed to do: preserve and conserve the assets of Fannie and Freddie. It’s not the agency’s fault that Congress passed the Troubled Asset Relief Program and gave the Treasury Department new powers to keep Ally and its ilk alive.

Congress could have let those companies die, as they deserved to. It didn’t, though. So now the inevitable claims are working their way through the courts. The government’s roles as both a referee and a player in the financial markets remain as conflated as ever.

Great Worries

American International Group Inc. (AIG), still majority-owned by the Treasury Department, last month accused Bank of America Corp. (BAC) of fraud in a suit over losses on mortgage bonds, many of them packaged by Countrywide Financial Corp. One of the markets’ great worries is that Bank of America might not have enough capital to cover all the mortgage-repurchase liabilities it assumed when it bought Countrywide in 2008. The lawsuit by AIG, which is seeking $10 billion, piles on to those concerns.

That AIG filed a lawsuit isn’t the problem. What’s perverse is that the Treasury continues to hold a stake in AIG -- three years after it joined with the Fed to save the giant insurer from bankruptcy -- while AIG sues a company the Treasury Department oversees. Bank of America wouldn’t even be around for AIG to sue had it not been for the Treasury’s rescue money.

The same kinds of weird conflicts are evident in the $8.5 billion settlement that Bank of America struck in June with the Federal Reserve Bank of New York and other holders of defective Countrywide mortgage bonds. Among the parties that have filed objections to the deal are the Federal Deposit Insurance Corp. and AIG, giving new meaning to the term divided government.

Time to Wonder

It’s only natural to wonder from those anecdotes if U.S. regulators want to help the banking industry or push it back to the brink. This week, Paul Miller, a bank analyst at FBR Capital Markets, said the FHFA, Fannie and Freddie “need to stop punishing banks for their lending practices from several years ago” on the grounds that they are impeding an economic recovery, “even though they may have a legal right to do so.”

What’s the FHFA supposed to do, though, if not exercise its legal rights? Had the agency chosen to forgo what it sees as legitimate claims against Ally, Bank of America and JPMorgan Chase & Co. (JPM), to name a few of the defendants it’s suing, this would mark another surreptitious subsidy for the companies’ shareholders. While the government may have saved the banks, it didn’t extinguish their liabilities from lawsuits.

Lawsuit Too Far

In contrast to the latest suits, the FHFA went even further last year when it allowed Freddie to sue the Internal Revenue Service over a $3 billion tax claim. A trial date in that suit is set for December in U.S. Tax Court. In essence, one arm of the Treasury is directly suing another arm. However the case turns out, it will be a wash for the Treasury, which has injected about $65 billion into Freddie to keep it afloat.

That boneheaded lawsuit is distinguishable from the cases filed last week, where the FHFA says Freddie and Fannie got ripped off by private-sector actors that committed securities- law violations. The agency accused several firms of fraud, including Morgan Stanley, JPMorgan, and Goldman Sachs Group Inc.

So why haven’t other federal agencies such as the Securities and Exchange Commission filed complaints against the same banks for allegedly defrauding Fannie and Freddie? And where’s the justice for the Fannie and Freddie executives who, with their regulator’s approval, kept saying their companies were healthy even while they were dying?

The government has so many conflicting agendas, we may never get satisfactory answers to those questions. All of this is part of the legacy of the unprecedented federal interventions in 2008, as well as a reminder of what a colossal mistake it was in the first place to create Fannie and Freddie with all their privatized profits and socialized losses.

The proper role of government in a free-enterprise system is to police market participants at arm’s length, not join their ranks and choose winners and losers. That’s a line we crossed a long time ago, though. The great outrage isn’t that a federal agency is suing some of these too-big-to-fail banks for damages. It’s that we ever bailed them out at all.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the writer of this article: Jonathan Weil in New York at jweil6@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net

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