Government Hounds Bank of America Over Mortgage Lending

Bank of America

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Bank of America (NYSE:BAC) squared off against the government on Tuesday morning for the first day of a trial that is expected to last as long as four weeks. Prosecutors, led by U.S. Attorney General for the Southern District of New York Preet Bharara, have accused the bank of “massive fraud” by selling bad mortgages to Freddie Mac and Freddie Mae during the build up to the financial crisis.

It’s important to clarify that while prosecutors have their cross hairs on Bank of America, this particular case has more to do with Countrywide Financial, once the country’s largest mortgage lender. Countrywide was purchased by Bank of America in 2008 as the housing market was collapsing, and the lender along with it.

In a complaint initially filed in October of 2012, the plaintiffs explained their case. “In 2007, as loan default rates rose across the country and the GSEs reevaluated their loan purchase requirements, Countrywide rolled out a new “streamlined” loan origination model it called the ‘Hustle.’” The ‘Hustle’ program — or, High Speed Swim Lane, “HSSL” — is at the heart of the case against the mortgage lender.

The plaintiffs continue that, “In order to increase the speed at which it originated and sold loans to the GSEs, Countrywide eliminated every significant checkpoint on loan quality and compensated its employees solely based on the volume of loans originated, leading to rampant instances of fraud and other serious loan defects, all while Countrywide was informing the GSEs that it had tightened its underwriting guidelines. When the loans predictably defaulted, the GSEs incurred more than a billion dollars in unreimbursed losses.”

It’s interesting to point out that some of the framework for the government’s case against Bank of America has been built on an interpretation of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. For a period, it was unclear exactly how plaintiffs would seek civil penalties against the bank, but U.S. District Judge Jed Rakoff, who has worked his way into infamy as one of the top judges involving cases against major Wall Street firms, recently announced that a “straightforward application of the plain words” of FIRREA allowed Bharara and the Justice Department to bring a case against Bank of America and others related to toxic mortgages sold during the financial crisis, according to Reuters.

The government’s case against Bank of America argues that a process to streamline the sale of loans to often unqualified people pretty much amounts to criminal neglect. FIRREA states that the government can prosecute firms that commit fraud against federally insured deposit institutions. The interesting part of the interpretation of the act is that the government may prosecute Bank of America for hurting itself as an FDIC-insured firm. This means that the government can seek civil penalties against Bank of America because it committed fraud against itself by selling toxic mortgages to Fannie Mae and Freddie Mac, an act that it paid billions of dollars to resolve.

For some background, FIRREA was passed in response to a crisis in the 1980s and 1990s, when nearly one in four savings and loans associations in the United States failed. These institutions perform the familiar function of turning long-term savings deposits into economically and socially valuable loans like mortgages and carry out other banking and financial services, and their aggregate failure was the backbone of the savings and loan crisis.

At a glance, these associations experienced mass failure in the ’80s and ’90s because high interest rates forced them into insolvency. The benchmark Federal Funds Rate was nearly doubled by then-Chairman of the U.S. Federal Reserve Paul Volcker between 1979 and 1991 from 11.2 percent to 20 percent in an attempt to curb inflation, which averaged about 10.8 percent between 1979 and 1982. The prime rate — the rate at which banks lent to “favored” customers — climbed as high as 21.5 percent, dramatically reducing demand for new loans, and unemployment continued to creep higher, from 5.9 percent at the beginning of 1979 to a peak of 10.8 percent in November and December 1982.

The economy was in a bind. People drained their savings accounts at the same time when savings and loans associations could not sell any new loans. The associations were pincered, and at the end of the day, 747 thrifts with assets worth about $400 billion were either closed or otherwise resolved. The thrifts were resolved or closed by the Resolution Trust Corporation, a special-purpose, government-owned asset management company created by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 for the sole purpose of liquidating the assets of savings and loans (S&L) that had been declared insolvent by the Office of Thrift Supervision — a department of the U.S. Treasury also created by FIRREA.

All told, the number of federally insured S&L associations declined by about 50 percent — from 3,234 to 1,645 — between the beginning and end of the crisis. Taxpayer losses have been estimated at $123.8 billion, which at that time was considered by the Federal Deposit Insurance Corporation to be the greatest collapse of financial institutions since the Great Depression.

But then the late-2000s financial crisis tore through the global economy and left a path of ruin in its wake. The S&L crisis quickly became the second-greatest collapse of financial institutions since the Great Depression. The financial institutions of the 21st century proved to have a much greater capacity to cause economic damage because of their immense size and interconnectedness. Just like FIRREA was passed in an attempt to “fix” the financial landscape to prevent another crisis of the same breed from occurring again, legislation like the Dodd-Frank Act has been passed in recent years to attempt the same thing.

Organizations created by the Dodd-Frank Act and established regulatory institutions granted new powers are in the midst of a crackdown on the financial industry, which is the wave that has is sweeping up financial institutions like Bank of America and JPMorgan Chase (NYSE:JPM). JPMorgan is currently facing an enormous mountain of litigation that could cost the firm as much as $6.8 billion, a sum roughly equivalent to what it lost in the London Whale trade. Most recently, the National Credit Union Association filed suit against JPMorgan alleging that it was involved in the manipulation of the London Interbank Exchange Rate as well as the fraudulent sale of securities to credit unions.

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