Banks are still haunted by bad underwriting of mortgage loans from the last housing boom, and the nightmare could endure for months to come.
M&T Bank's disclosure Thursday that it is in settlement talks with the Justice Department for not complying with underwriting guidelines on Federal Housing Administration loans has renewed fears that more lenders will be the targets of probes and possible litigation.
The $97 billion-asset bank M&T, in Buffalo, N.Y., joins a growing list of large and regional banks currently in litigation or settlement discussions with the government for allegations of shoddy underwriting.
What is unique about M&T's case is that it is not a top-20 mortgage lender. Most of the top banks including Bank of America, JPMorgan Chase, Citigroup and U.S. Bancorp have already reached settlements so there is a sense that the government is moving further down the list of lenders.
Some lawyers expect the Justice Department will wrap up most of the probes in the next year before the 2016 election. In the meantime, a handful of regional and midsize banks, particularly those with high default rates or poor quality control, could still be targets, lawyers say. But it is still unclear if community banks will end up in the crosshairs.
"We could see some others that haven't faced this issue yet," said Frank Schiraldi, a managing director at Sandler O'Neill. "I think if you do see more regional banks announce disclosures [of probes], you're going to most likely see more settlements as opposed to the banks fighting the government on this."
Most banks have already set aside reserves to cover the liability. M&T did not increase its reserve for "reasonably possible" litigation charges, which is as much as $40 million, Schiraldi said. The probe is not expected to have an impact on its acquisition of the $36 billion-asset Hudson City Bancorp, in Paramus, N.J., he said.
M&T said in an SEC filing that it did not agree with the sampling methodology and loan analysis employed by the government, based on its own review of a sample of loans.
Brian Chappelle, a partner at the consulting firm Potomac Partners, in Washington D.C., said many lenders object to the government's methodology. Typically investigators will look at a small sample of defaulted loans and determine the percentage of those with material underwriting defects. Then that number is extrapolated to the lender's entire book of business.
"These are really hyper-technical fouls," Chappelle said. "Unfortunately I think there are quite a few coming since they started with the most serious allegations and the largest lenders."
Lenders have been particularly galled by the Justice Department's use of the False Claims Act, a Civil War-era law that allows the government to collect triple damages for fraud. Lenders have argued that underwriting is subjective. Moreover, FHA has encouraged lenders to make affordable loans to low- and moderate-income borrowers, many with low credit scores who by their very nature have higher defaults.
Most of the investigations into FHA lending began in 2012 or 2013, though the FHA loans in question could have been originated as far back as 2001 and up to 2010.
Theoretically lenders are required to indemnify FHA for loans that have mistakes or are defective, essentially self-insuring the loan so taxpayers are not on the hook for potential losses. In many of the cases, the Department of Housing and Urban Development paid insurance claims on defaulted loans that it later found had significant material violations of its underwriting guidelines.
Some lawyers predict more probes are coming.
"HUD's aggressive enforcement actions against FHA lenders over the past few years are likely to continue," Kyle Tayman, an associate at the law firm Goodwin Procter, wrote in a blog post in December. "Lenders should remain vigilant of new FHA enforcement actions and be aware of the common underwriting and origination practices and FHA program requirements targeted by HUD in prior investigations."
Both Wells Fargo and Quicken Loans are fighting the government's allegations. Wells is currently in the discovery phase of litigation after settlement talks broke down last year. The $1.7 billion-asset San Francisco bank, the largest U.S. mortgage lender, raised its "reasonably possible" loss disclosure for litigation to $1.4 billion in the second quarter, up from $1.2 billion in the first, said Brian Foran, an analyst at Autonomous Research.
Bill Emerson, the CEO of Detroit-based Quicken, has been an outspoken critic of the Justice Department. The company sued the government in April claiming it was forcing its hand to settle.
"They wanted us to admit to things that were blatantly false," Emerson said at a housing forum in April held by the National Association of Realtors. "They just want us to write a check."
Some lenders initially pulled back from FHA lending after getting hit with large settlements.
Jamie Dimon echoed many of the large bankers' anger when he said a year ago on an earnings conference call: "The real question for me is should we be in the FHA business at all."
JPMorgan Chase settled a probe for $614 million in February 2014.
In May, the FHA released guidelines that were designed to clarify the rules and penalties for mistakes lenders might make on FHA-insured loans. The intent is to free up banks and mortgage lenders from the fear of being sued for being held liable for small errors that likely have no impact on a default.
With the housing market in recovery, though, the FHA's performance has strengthened. The agency is on track to insure an estimated $190 billion in loans this year, which would be a 42% increase from last year, Chappelle said. The agency also has whittled down its seriously delinquent loans to $60 billion at the end of May, down from $105 billion in 2013, he said.
"It's one thing for the [Justice Department] to go after banks because the FHA has a cloud over it and losses are costing taxpayer money," Chappelle said. "But now the FHA is making money so there should be less interest in holding the industry accountable for loans from the past."