Wall Street Success With Germans Boomerangs: Mortgages

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Photographer: Scott Eells/Bloomberg

A U.S. flag is hung on the exterior of the New York Stock Exchange (NYSE).

The biggest Wall Street banks have spent more than $93 billion dealing with the fallout from the housing bust, settling disputes with the U.S. government and homeowners. Now they must face the Germans.

HSH Nordbank AG, DZ Bank AG and Sealink Funding Ltd. are among firms that filed more than 30 lawsuits against Wall Street lenders in New York state court last year claiming they were sold flawed mortgage products. The litigation may contribute to about $25 billion in further costs for banks to resolve claims on bonds not backed by the government, Compass Point Research and Trading LLC estimates.

“It is a constant reminder that there is a tremendous amount of legacy costs related to underwriting, servicing and the selling of mortgages,” said Kevin Barker, an analyst with Compass. “We could see several material settlements in the next year as this plays out.”

German investors’ appetite for higher-yielding debt helped fuel the bubble that triggered the global credit crisis, forcing German taxpayers to spend more than 300 billion euros ($406 billion) to shore up the country’s biggest banks, which are now in varying stages of repaying the funds. In “Boomerang,” Michael Lewis’s book about the European debt crisis, he writes that when Wall Street banks “sent their sales forces out to scour the world for some idiot” to invest in their securities, a “disproportionate number of those idiots were in Germany.”

S&P Fallout

The global marketing and sales of subprime mortgage bonds centered on Wall Street firms creating securities that were given top credit grades by rating firms. In the latest repercussion, U.S. Attorney General Eric Holder said this week the government is seeking as much as $5 billion in penalties from McGraw-Hill Cos. after its Standard & Poor’s unit knowingly understated the risks of financial instruments tied to residential mortgage debt. Shares of New York-based McGraw-Hill dropped 1.8 percent today in New York at 4:15 p.m. to $43.81, extending the drop this week to 25 percent.

“The crisis was global, because these securities were sold all over the world,” said Gerald Hanweck, a former Federal Reserve economist who’s now a finance professor at George Mason University in Fairfax, Virginia. “The banks in Germany ended up holding these securities, which is striking because they are supposed to be funding local business and housing.”

According to complaints from German lenders filed last year in New York State Supreme Court in Manhattan, Bank of America Corp., Goldman Sachs Group Inc. (GS) Morgan Stanley (MS) and other banks created bonds that were riskier than promised, leading to defaults and losses for investors.

Investors ‘Defrauded’

“Large investors have been defrauded, plain and simple,” said Joel Bernstein, a partner at Labaton Sucharow LLP in New York, whose clients include Hamburg-based HSH Nordbank. “They’re discovering the reason they lost money is they were defrauded and one way or another time will run out on their ability to bring claims.”

Spokesmen for the German banks and Wall Street firms facing the litigation declined to comment. Lenders have denied the allegations in most cases. Firms including Charlotte, North Carolina-based Bank of America have settled some cases without disclosing details.

Six of the German firms -- HSH Nordbank, Frankfurt-based DZ Bank, Bayerische Landesbank, IKB Deutsche Industriebank AG (IKB) and investment companies Loreley Financing and Sealink Funding -- sued over at least $10 billion in mortgage-related securities, according to filings from last year’s cases.

State Lenders

Some of the plaintiffs, including Munich-based BayernLB and HSH Nordbank, are Landesbanken, or state-owned lenders, that have yet to repay bailouts that prevented their demise. Sealink Funding, one of the biggest plaintiffs, is a Dublin-based investment firm that traces its roots to the failure of Leipzig-based Landesbank Sachsen AG.

The Landesbanken were eager to invest in U.S. asset-backed securities after their borrowing surged in the years prior to the crisis, according to Konrad Becker, a bank analyst with Merck Finck & Co. in Munich. Executives relied on the credit ratings and lacked the ability to assess the risk, Becker said.

German demand for U.S. mortgages extended beyond the Landesbanken to IKB, the lender that sought to profit from collateralized debt obligations, or CDOs, which are pools of assets such as mortgage bonds that are packaged into new securities. IKB’s willingness to buy risky products from Wall Street banks led the Economist magazine to call it a “credit crunch chump” in a 2010 article.

In “Boomerang,” Lewis wrote that German investors, and particularly the Landesbanken, tended to ask few questions.

‘Stupid Germans’

“When Goldman Sachs helped the New York hedge-fund manager John Paulson design a bond to bet against -- a bond that Paulson hoped would fail -- the buyer on the other side was a German bank called IKB,” Lewis wrote in the book. “IKB, along with another famous fool at the Wall Street poker table called WestLB, is based in Dusseldorf -- which is why, when you asked a smart Wall Street bond trader who was buying all this crap during the boom, he might well say, simply, ‘Stupid Germans in Düsseldorf.’”

It was “incompetence, greed and whatever you want,” Becker said in a phone interview. “CDOs, CDSs, all these very new words coming from the U.S. -- nobody knew them but they saw triple-A, and higher returns, so why not? It was the emperor’s new clothes.”

Sealink Funding, which was created to manage the riskiest assets of SachsenLB, sued at least seven Wall Street firms last year over almost $4 billion in mortgage-backed securities. Defendants include Citigroup Inc. (C), Goldman Sachs and Deutsche Bank AG.

Avoid Collapse

SachsenLB, a bank once owned by the state of Saxony, needed a bailout to avoid collapse and was later sold. Neuberger Berman Group LLC, the money manager that was part of Lehman Brothers Holdings Inc., now manages Sealink Funding’s assets. Alex Samuelson, a spokesman for the New York-based firm, declined to comment on the litigation.

BayernLB, Germany’s second-biggest state-owned lender, last year sued Goldman Sachs, Bank of America, Deutsche Bank and Barclays Plc (BARC) over almost $2 billion in mortgage-backed securities, according to court filings. HSH Nordbank, the world’s biggest shipping bank, filed lawsuits against four lenders including Morgan Stanley over almost $1 billion of the products.

IKB, now owned by Texas private equity firm Lone Star Funds LP, sued at least three Wall Street firms last year over more than $400 million in mortgage-backed securities. An entity tied to IKB called Loreley Financing, meantime, sued Citigroup and UBS AG (UBSN) over about $1.3 billion of securities.

Private Investors

Cases from private investors show that costs from mortgages will persist for the biggest U.S. banks, even after they dealt with some of their biggest headaches in 2012.

U.S. lenders settled two nationwide probes into allegations that they improperly seized homes, including a $25 billion deal last year with state attorneys general and an $8.5 billion accord with federal regulators last month.

Bank of America last month agreed to an $11.7 billion settlement with Fannie Mae (FNMA), the government-sponsored enterprise that buys mortgages from lenders. The Washington-based company has said it’s about three-quarters of the way through its effort to force banks to buy back failed loans.

The deal could lead to more settlements this year between Fannie Mae and other lenders, according to Tim Rood, a partner in consulting firm Collingwood LLC. The GSE had about $4.7 billion of outstanding repurchase requests with other lenders, including Citigroup and JPMorgan Chase & Co. (JPM), according to a quarterly filing.

“The word of the day in Washington is ‘settlement,’ said Rood in a phone interview. ‘‘The genie is out of the bottle.’’

Mortgage Costs

Lenders including Bank of America and New York-based JPMorgan added at least $17.4 billion in mortgage-related costs last year, including reserves to cover repurchases and litigation expenses, according to a Bloomberg analysis of regulatory filings, company statements and financial presentations.

Last year’s expenses pushed the biggest U.S. banks’ total mortgage-related costs since 2007 to more than $93 billion, according to Bloomberg’s tally. Costs from private claims, such as the German lawsuits, could push the total over $100 billion, according to Compass’s research.

In Germany, costs also persist. Taxpayers shored up eight of the country’s biggest banks with more than 300 billion euros in capital and guarantees during the turmoil sparked by the U.S. housing market meltdown. The banks are in varying stages of repaying the funds. Decker, the analyst in Munich, said that any courtroom victory in the U.S. for the country’s banks will be a pyrrhic one.

‘‘The amount they will get back is only a fraction of the money the taxpayer in Germany has paid to save Landesbanken and other banks,” Decker said. “So if they win, ok, it’s nice. If they lose, it’s no big difference.”

To contact the reporters on this story: Donal Griffin in New York at dgriffin10@bloomberg.net; David McLaughlin in New York at dmclaughlin9@bloomberg.net

To contact the editors responsible for this story: David Scheer at dscheer@bloomberg.net; John Pickering at jpickering@bloomberg.net; Rob Urban at robprag@bloomberg.net

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