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Why Bank of America Is Getting Sued and What it Means for Today’s Housing Market

Nov. 8, 2012
Investing
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The Department of Justice just last week announced a lawsuit against Bank of America. At issue: The District Attorney asserts that Countrywide deliberately sold thousands of bad mortgages upstream to Fannie Mae and Freddie Mac with negligent underwriting.

Specifically, the government objected to the so-called “high-speed swim lane” or “hustle” program where loans with slovenly or non-existent underwriting, no-documentation or obvious misrepresentation were rubber stamped by Countrywide officials and executives before being sold to Fannie and Freddie. According to the Justice Department lawsuit, Bank of America kept the program going for some time after purchasing Countrywide.

How did this come to happen, and what does it mean for the housing market?

The Story of the Mortgage Crisis in a Nutshell

Allow us to set the scene:

It was 2007, and the mortgage industry was just beginning to unravel. As a die-hard value investor and a disciple of Ben Graham and Warrant Buffet, I was on the lookout for ways to buy troubled stocks on the cheap.  So I looked at Countrywide. I even went so far as to send away for their annual report.

Here’s what I wrote about Countrywide at the time:

“It’s tempting. It trades at 5x official earnings.  I mentally adjust that to more like 8 to 9 times “real world” earnings, and trades at 20 to 30 percent off book value. It is less than 10% into subprimes….

It’s very tempting – with a nice dividend in the meantime to pay me for waiting for a recovery.

But I look at their CEO, and he is selling shares as fast as his options vest. He doesn’t seem to be retaining any of them personally, and therefore I distrust him as an owner-manager.”

And as it turned out, my instincts were right about the CEO, Angelo Mozilo. He got his company to initiate a huge share repurchase program – even as he was dumping shares from his personal account like it was going out of style.

How The Government First Got Involved

The SEC got wind of it a couple of years later and finally went after him, personally. Mozilo set up four separate executive stock sales plans for himself in 2006, even as he was loading the company up with debt to buy back millions of shares.  Alas, Mozilo’s generous sweetheart deals made to prominent politicians paid off. He essentially defrauded his fellow investors of $140 million or so, but the SEC ultimately didn’t pursue criminal charges. They let him off with a then-record $67 million settlement. A big fine, sure, but nowhere near what he stole, and only about 10 or 15 percent of his net worth. Bonus points: Mozilo got the company whose shareholders he defrauded into paying $20 million of it.

The SEC didn’t pursue the fraud charges until 2009. But the insider sales and the stock buybacks were public record in 2007. I passed on the stock, smelling a dog with fleas, as Gordon Gekko would say. Bank of America looked at the same fact pattern that I did – and bought the whole company for $4 billion.

Bad move.

It took until now for the DOJ to step in.

What Did Bank of America Do Wrong?

Typically, banks are expected to buy back loans with faulty underwriting that fail to perform, and keep them on their books. But Bank of America is saying there’s a limit to what they can be expected to do. They’re willing to buy back loans with bad underwriting. But some of these loans didn’t go bad until the economic downturn happened, and that had nothing to do with the Hustle.

BofA spokesperson Lawrence Grayson said,

“Bank of America has stepped up and acted responsibly to resolve legacy mortgage matters; the claim that we have failed to repurchase loans from Fannie Mae is simply false.” He went on to say, “At some point, Bank of America can’t be expected to compensate every entity that claims losses that actually were caused by the economic downturn.”

Indeed, Bank of America has already repurchased a bunch of those loans. $2.5 billion worth of them in a deal they reached with Fannie and Freddie in January 2011. Since, it has paid dearly to regulators and plaintiffs in fines and judgments over the last several years.

What’s the Moral of the Story?

A fish rots from the head down.  When it comes to corporate governance, it’s not just the head that contributes to the rot. A corrupt, faithless executive will attract a corrupt, faithless set of vice presidents. At best, they are naïve and easily manipulated. That’s why they got hired. Most are willing to look the other way or tolerate operations like The Hustle, and obvious breaches of fiduciary duty like Mozilo directing Countrywide to borrow millions of dollars to buy back inflated shares, even as he dumped them himself. And in the worst cases, they actually participated in the fraud on the market.

The CEO sets the ethical tone of a company. He will ultimately surround himself with people like him.  Bank of America is no Countrywide. But they forgot that rule, and looked only at a fat dividend and an attractive P/E ratio. But the dividend and P/E were little more than a façade.

Outlook: How Will Bank of America Do In Court?

It’s too early to tell what the prospects of the government’s lawsuit are – both sides have some strong arguments to make. The government will point to the very real losses that occurred because of Countrywide’s negligent practices, if not outright fraud in misrepresenting the quality of their underwriting to Fannie and Freddie and the insurance companies that insure mortgage pools relying on the good faith of bankers and mortgage companies generating the loans.

Bank of America can point to the fact that there have been a lot of alternate causes of default between the time the loans were originated and the time they actually defaulted. Even well-underwritten loans occasionally go bust, after all.

Bank of America can also argue that the False Claims Act doesn’t apply, because Fannie and Freddie didn’t qualify as government officials for the purpose of that particular law. Perhaps they do now, but they didn’t before the government took over the two entities. In fact, in 1996 a federal judge created precisely this precedent, ruling that Freddie Mac was not a government entity because a large majority of its directors were not government-appointed, and the government did not maintain substantial control over Freddie Mac’s operations.  But it’s going to be tough to find a jury that’s going to be very sympathetic to Bank of America and Countrywide in the current environment.

What Investors Should Learn From This Tale

Bank of America paid $4 billion – for the privilege of taking on $40 billion in liabilities.

When you buy a share of stock, you not only own a claim on future earnings. You also take on a share of the company’s future liabilities as well. The ball may already have been set in motion years before you buy. But any judgments will apply to current shareholders, not to shareholders at the time of the screw-up. Never, ever forget this. Incidentally, this is why people who buy closely held businesses usually are better to buy assets, rather than stock. Assets don’t come with hidden liabilities, unless there’s a lien on them, which is public information.