Call it the subprime headache that won't go away.
Regions Financial (RF) in Birmingham, Ala., has enjoyed a 33% surge in its stock price in the past year. That improvement largely reflects improved asset quality at Regions, which was hit hard by real estate loans that soured during the financial crisis.
Despite the progress, a dark cloud still hangs over the $119 billion-asset company. Regions remains on the hook for litigation tied to Morgan Keegan, a brokerage and investment bank it sold last year to Raymond James Financial (RJF).
Regions agreed to indemnify Raymond James for all legal costs associated to the business. One analyst Christopher Marinac at FIG Partners estimates that those expenses could eventually shave 14 cents a share off Regions' earnings.
It is a cautionary tale that banks of all sizes must be mindful of the lingering financial exposure that can exist after they sell or shut down a troubled business.
The problem for Regions is that no one really knows if, or when, those costs will ultimately come out of the company's bottom line. "These things are uncertain by their nature," Marinac says.
Issues tied to Morgan Keegan continue to surface six years after the housing market imploded. Plaintiffs continue to pursue civil cases against the business based on claims it mismanaged funds that were pummeled by losses on subprime mortgages. State and federal investigators are also looking into claims that Morgan Keegan violated securities laws during the sale of municipal bonds.
Regions brought in capital by selling Morgan Keegan, and management has touted the sale as an important step in the company's comeback.
The sale will "enhance liquidity and improve key capital ratios," Grayson Hall, Regions' chairman, president and chief executive, said during a conference call in January 2012 discussing the sale.
The sale "lowers the overall risk profile of the company," Hall added. "We have fair valued" any exposure from the legal indemnification.
To be sure, the indemnification obligation carries its own level of risk, says Doron Lipshitz, a lawyer at O'Melveny & Myers who is not involved with any Morgan Keegan cases.
Regions would be wise to maintain reserves for a long period of time to cover costs associated with Morgan Keegan. "The bottom line is, they are going to have this headache for many years to come," Lipshitz says.
Regions is more optimistic about the time line for maintaining reserves for Morgan Keegan litigation. The company said in a regulatory filing last month that it "expects the majority of ongoing legal matters to be resolved within" two to three years." A Regions spokeswoman declined to make comment further.
Regions has also estimated that its total legal exposure, which include Morgan Keegan cases, could be as high as $60 million. Regions has not provided a specific breakout of what portion of those costs are tied to its Morgan Keegan exposure.
"Indemnifiable losses include legal and other expenses, such as costs for defense, judgments, settlements and awards associated with the resolution of litigation related to pre-closing activities," Regions said in an annual report filed earlier this year.
Regions completed the sale of the former unit in April 2012.
The problem is that pending litigation always has a level of unanticipated risk, Marinac says. Still, he says that Regions should be able to weather any hits it takes from its former brokerage business.
Financially, Regions is required to book the cost of the indemnification obligation as a liability on its balance sheet. The obligation's value varies based on "future cash flows that a market participant would expect to receive from holding the indemnification liability as an asset," Regions said in its August filing.
The amount of the carrying cost has fallen to $257 million at June 30, compared to a peak of $385 million when the sale closed. But there is no guarantee that the amount will continue to decline and it could rise based on the status of ongoing cases, Lipshitz says. More than half of the carrying cost is recognized by Regions as a reduction to its gain on the former unit's sale.
Lawsuits surfaced in 2007, in federal and state courts, alleging mismanagement of the Regions Morgan Keegan Select Funds group of investment funds. Those lawsuits were later consolidated into class-action and shareholder derivative cases.
In a separate case, a Canadian insurance company, Fairfax Financial, argued that Morgan Keegan violated the federal Racketeer Influenced and Corrupt Organizations Act, by trying to depress the company's stock price and benefit from shorting its stock. A federal judge dismissed that last September, but Fairfax has appealed the decision, Regions disclosed in its most recent quarterly filing.
In another matter, the Securities and Exchange Commission and officials from Missouri and Texas are investigating potential securities law violations tied to the brokerage's underwriting and sale of municipal bonds.
A number of other civil lawsuits are also pending, based on the municipal bond allegations. Those lawsuits involve institutional investors and private, retail investors. Those investigations are in the "early stages," Regions said in its quarterly filing.