The US government takes action over mortgage-backed securities.
Banking used to be a nice steady business. For many years the banks followed a business model called "3-6-3"; borrow at 3%, lend at 6% and their staff could clock off at 3pm to go and play golf. The conservative bank manager, personified by Captain Mainwaring in the classic BBC comedy Dad's Army, was a respected pillar of the community who prided prudence above everything else.
Nowadays many people see the banks as nothing more than a bunch of spivs and thieves whilst the word "banker" has become a term of abuse. This is because during the last few decades most of the American and British banking industry was turned into a glorified casino, which all but wiped out their shareholders when things went horribly wrong.
The taxpayer was stuck with the bill whilst the banks' senior staff continued to gorge themselves on fat bonuses at their expense. But some of the banks are in for a shock as the American government has finally decided to set its lawyers upon them. About time too, I say.
See you in court
World stock markets took yet another tumble last Friday when a story broke in the New York Times that an agency of the United States Federal government is planning to sue seventeen banks on behalf of the government-backed mortgage lenders Fannie Mae and Freddie Mac.
These banks are accused of misrepresenting the quality of mortgage-backed securities; the infamous collateralised debt obligations which were at the heart of the 2008 global financial crisis. They deliberately made a lot of very bad loans which, with the assistance of the ratings agencies, they sold on to investors like Fannie Mae and Freddie Mac as if they were triple-A rated securities. It was the equivalent of passing off a thirty-year old van as a Bugatti Veyron supercar.
One of the key principles of contract law is caveat emptor, otherwise known as "buyer beware", and it is often used by defendants to avoid liability. But if someone enters into a contract because they relied upon a statement which turned out to be complete a pack of lies, they have a strong claim for damages against whoever made that statement.
The agency is relying upon this and expects to be paid billions of dollars as a result.
British banks are in the net
Three British-based banks are on the Feds' hit list: Barclays (LSE: BARC), HSBC (LSE: HSBC) and Royal Bank of Scotland (LSE: RBS). RBS has said that it will vigorously defend itself but to paraphrase Mandy Rice-Davies, they would say that wouldn't they!
I'd imagine that these cases will be settled out of court. It's going to be very difficult for the banks to argue that they did not misrepresent these loans as triple-A rated securities, given that in many instances their agents openly solicited "liar loans" where they encouraged people to lie about their income which just happens to be a criminal offence.
You can't repay the loan? Don't worry about that.
Would you lend money to someone who had no chance of paying you back? For much of the last decade this had increasingly become standard practice for many banks provided that it was for a home loan. They rushed to lend money to increasingly worse credit risks and this culminated in the NINJA loan (No Income, No Job, no Assets) where the borrower was guaranteed to default.
In America for much of the 2000s anyone with a pulse who wanted to buy residential property could get a loan.
Naturally the banks didn't want to get saddled with these high risk loans, so they packaged up thousands of them into "pools" which were sold to investors who were eager for triple-A rated investments. The credit ratings agencies, another group who should be in the dock, gave these pools the all-important triple-A credit rating in return for some nice fat fees from the same banks.
Um, we own the mortgage. Honest
Some American banks are already in trouble for "foreclosure fraud", which results from their having mishandled the paper trail for many mortgages to such an extent that they have destroyed the mortgage guarantees and turned secured loans into far riskier unsecured loans.
There have been cases where the bank could not legally foreclose upon a loan but they nonetheless did so by forging people's signatures on legal documents. This seems to have been going on since the early 1990s and in a few instances the banks' records are so bad that people have had their homes taken away from them even though they never took out a mortgage with the foreclosing bank!
They call it "robo-signing" but it's better known as "fraud" and people should go to jail for it.
Doing the perp walk
I wouldn't in be the least bit surprised to see criminal charges being eventually brought against some of the directors and former directors of American banks, as well as mortgage agents and possibly even the ratings agencies. If this happens then the authorities will make them do the "Perp Walk" in front of the world's cameras after they are arrested.
America has a particularly effective weapon to deploy in these cases; the Racketeer Influenced and Corrupt Organizations Act, aka "RICO", which is designed to be used against organised crime but works just as well in these sorts of case. RICO is particularly nasty because under it anyone who succeeds with a claim can be awarded up to three times their losses as compensation.
Taking a punt
At the height of the dotcom boom Warren Buffett said that if he was setting an investment exam he would ask one question; how do you value an internet company which has no sales or profits? Anyone who answered the question would be failed.
That's how I feel about some of Britain's banks, particularly RBS. Loss-making companies are hard enough to value at the best of times and in the worst cases there are probably some of Donald Rumsfeld's known unknowns and unknown unknowns which are still to be found.
But shareholders in the banks which weren't cited by the US government, such as Lloyds Banking Group (LSE: LLOY) and Standard Chartered (LSE: STAN), can breathe a bit easier as this means that they didn't engage in the dodgiest activities.
I currently own shares in one bank, mostly as a bet that things can't get much worse. But I view it as a very speculative investment, on par with options and tiny oil explorers.
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> Tony owns shares in Lloyds Banking Group. The Motley Fool owns shares in Standard Chartered.
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