How Much Will Foreclosures Weigh Down Big Banks?

Bank-owned real estate in mortgage foreclosure
Bank-owned real estate in mortgage foreclosure

The country is in the grip of a home mortgage scandal, with big banks facing investigations, fines and penalties for playing fast and loose during the foreclosure process. There's no question that the banks will suffer, but will their stocks get hurt as a result?

One indication came on Oct. 18, when Citigroup (C) reported a third-quarter profit of $2.15 billion, easily beating analysts' expectations and sending the company's shares higher by 5%. That lifted all banks shares, which had lost $50 billion in valuation at the end of the previous week because of concerns about foreclosure losses.

But Citi indicated that it had managed to sidestep the problems facing banking rivals JPMorgan Chase (JPM), Bank of America (BAC) and Wells Fargo (WFC), which have announced moratoriums on foreclosures while they study whether they acted improperly in the process of documenting foreclosures prior to sales. "We believe that our overall process is sound, and our reviews indicate that nothing is amiss," says John Gerspach, Citi's chief financial officer.

The current mortgage crisis could hurt bank earnings in several possible ways, not all of them directly related to the foreclosure problem.

Investors to Banks: Take It Back

The first is what the banks have termed "putbacks," but are really repurchases of mortgages. Most banks don't keep mortgages on their books any more. Instead, they pool home loans together and sell slices of those bundled securities to investors, who assume the credit and interest rate risk on the underlying loans.

When they sell the loans, the banks make "representations and warrants" to the investors that the borrowers meet certain loan criteria, such as the level of their FICO credit scores or their income. If it turns out later that this information is wrong, the investor can force the bank to repurchase the mortgage from the trust that holds them.

JPMorgan analysts said in a report released Oct. 18 that the putback risk to the industry as a whole might be as high as $55 billion to $120 billion. They said those losses would probably be realized over a period of about five years, so the annual total might run at $10 billion to $25 billion.

Squeezing Every Penny

The JPMorgan estimate was different for loans securitized by government-controlled agencies like Fannie Mae and Freddie Mac. With Congress in an uproar about Fannie's and Freddie's losses, now estimated at $140 billion, the government will likely try to squeeze every penny out of the banks that it can, given that they're now making large profits after being bailed out by taxpayers.

The JPMorgan analysts said the agencies are likely to try to force the banks to take back about 25% of defaulted loans, with about 40% of those demands being successful.

With private sector securitization of mortgages, banks have less recourse to complain about fraud and other misstatements, so repurchases of mortgages would have only a 20% success rate, leading to an estimated 5% loss on defaulted loans.

JPMorgan itself acknowledged this last week when it released its own third-quarter earnings and disclosed that it had put aside an additional $622 million in reserves to cover losses from forced repurchases of mortgages. That didn't seem to have hurt JPMorgan's stock: It was up 2.5% on Oct. 18.

Potential Fines and Penalties

Al Savastano, banking analyst at Macquarie Securities in New York, says the repurchase problem is likely to fester for years and that it's hard to know how much each bank faces in losses. "We think it's going to be an earnings issue, not a capital issue," Savastano says. 'We are a lot more comfortable trying to estimate credit losses than this."

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The other potential cost to banks comes from losses the banks suffer because of their actions in the foreclosure crisis. Treasury Secretary Timothy Geithner said last week that the Obama administration opposes any national moratorium on foreclosures, so losses caused by not being able to sell foreclosed homes are likely to be limited in the short term.

"We believe that the big banks have the capacity to withstand potential setbacks from the foreclosure moratoriums and related issues as they currently stand, and we believe these issues should ultimately prove manageable in the context of large bank franchises," say CreditSights research analysts.

Based on a potential fine of $25,000 for each false affidavit filed -- the banks have to attest that they reviewed each loan file, but in many cases, they didn't -- CreditSIghts estimates JPMorgan could face $2 billion to $3 billion in fines, which could possibly be settled for $500 million to $1 billion. The CreditSights analysts say BofA and Wells Fargo also might face a similar amount.