JPMorgan Settlement Implies Billions for Others: BGOV Insight, Banking Report (BNA)...

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Prepared for: Karen Donovan

JPMorgan Settlement Implies Billions for Others: BGOV Insight, Banking Report (BNA)

BNA's Banking Report

November 12, 2013

Securities

JPMorgan Settlement Implies Billions for Others: BGOV Insight

Analysis by Nela Richardson Key Action: The Federal Housing Finance Agency (FHFA), the chief regulator for Fannie Mae and Freddie Mac, on Oct. 25 reached a $5.1 billion settlement with JPMorgan Chase & Co. The settlement stemmed from a September 2011 lawsuit against the bank claiming that JPMorgan misrepresented the quality of mortgage securities it sold to Fannie and Freddie. The case has implications for other companies involved in FHFA lawsuits: Bloomberg Government's examination of data in the JPMorgan settlement suggests that some big banks could be liable for as much as $8 billion. JPMorgan was also reportedly about to settle with the Justice Department in a related action, but that settlement has been held up by a dispute over JPMorgan's claim that the Federal Deposit Insurance Corp. should bear some or all of the losses on certain securities.

Misrepresented Quality During the height of the subprime mortgage boom from 2005 to 2007, JPMorgan and two companies it would later acquire, Washington Mutual Inc. and Bear Stearns Cos., sold $33 billion in misreported mortgage

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securities to Fannie and Freddie. FHFA claimed that JPMorgan fraudulently misrepresented the credit quality of the mortgage loans underlying the securities, making them look less risky to investors. The alleged fraudulent reporting centered on two important mortgage characteristics: occupancy status and the loan-to-value (LTV) ratio. Owner-occupants are less likely to default on their mortgages than second-home buyers and investors. Also, the lower the LTV ratio, the less likely it is that the borrower will default. Bloomberg Government's evaluation of data in the FHFA filings reveals that for the 103 securities that Fannie bought between 2005 and 2008, JPMorgan claimed that an average of 16 percent of the underlying mortgages were for investor or second homes. In reality, 25 percent of the securities were backed by loans that were not related to a primary residence. JPMorgan also stated that, on average, just 38 percent of the mortgages had loan-to-value ratios exceeding 80 percent, and that there were no mortgages in its pool that had a LTV ratio of 100 percent or more. Regulators estimated that the true LTV average for mortgages sold to Fannie and Freddie was closer to 60 percent, and found that 18 percent of the securities JPMorgan sold to Fannie and Freddie had zero or negative equity.

Implications of the Settlement The first chart shows that JPMorgan was not alone in misrepresenting the quality of its securities. Bloomberg Government calculated the average underwriting characteristics of disputed mortgage securities for the 10 largest banks that are still operating independently since the financial crisis. The analysis reveals that these banks also appear to have consistently inflated the percentage of owner-occupied mortgage loans and lowballed the percentage of mortgages with high LTVs. The Royal Bank of Scotland Group Plc, for example, sold Fannie and Freddie almost the same amount of disputed mortgages as JPMorgan, around $30 billion. Deutsche Bank AG, Credit Suisse Group AG and Goldman Sachs Group Inc. also sold a large amount of securities to Fannie and Freddie that FHFA says omitted key details about or mischaracterized the underlying mortgages. Bloomberg Government used JPMorgan's settlement with FHFA to estimate the liabilities that other large banks face in similar suits. JPMorgan's $5.1 billion settlement, for example, represents 15 percent of the $33 billion in disputed mortgage securities cited in the FHFA's lawsuit. Because the other large banks displayed reporting patterns similar to those in the JPMorgan case, it's likely that their settlements will be similar. Using the JPMorgan settlement ratio of 15 percent as a benchmark to estimate the ultimate liabilities in these cases, the combined settlement estimate for the other nine banks comes to $23 billion. Bank of America Corp. has the highest exposure of the banks analyzed because it's also liable for suits filed by FHFA against Countrywide Financial Corp. and Merrill Lynch & Co., bringing its total litigation exposure to $57 billion. According to BGOV estimates, Bank of America faces $8.8 billion in settlements. What's Ahead

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Since 2010 JPMorgan has increased its litigation reserves by $28 billion, which covered the cost of the recent settlement and some others. The second chart shows estimated settlement amounts by which the other large banks are likely to increase their litigation reserves, if they have not done so already. Other investors, such as pension funds and insurance companies, may also seek compensation for losses, making these estimates a lower bound on likely reserve increases. For More Information ABOUT THE ANALYST: Nela Richardson is a Senior Economist, Finance with Bloomberg Government. She was a research economist at the Commodity Futures Trading Commission. She was also a senior economist at Freddie Mac, a researcher at Harvard's Joint Center for Housing Studies, and an adjunct professor of finance at John Hopkins. Richardson has a Ph.D. in economics from the University of Maryland, an M.A. from the University of Pennsylvania, and a B.A. from Indiana University. Follow Nela on Twitter: @NelaRichardson The settlement can be viewed at http://www.fhfa.gov/webfiles/25649/FHFAJPMorganSettlementAgreement.pdf 2013 Bloomberg L.P. All rights reserved. Used with permission.

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