A recent string of lawsuits against Wells Fargo
) and JPMorgan Chase
) related to the underwriting of mortgages and real estate-backed securities seems to have pulled both lenders back into the tangled legal mess arising out of the financial crisis.
Meanwhile, competitors like Bank of America
) remain in the stock doghouse over exposure to litigation tied to mortgages sold to government agencies Fannie Mae and Freddie Mac.
However, while settlements of lawsuits and asset writedowns can wipe out a quarter of profit for struggling lenders like Bank of America and Citigroup
), the recovering earnings of Wells Fargo and JPMorgan are likely to outweigh the risks posed by the recent lawsuits.
In a lawsuit against Wells Fargo, the U.S. Attorney's Office and the Federal Housing Authority are asking for the return of hundreds of millions
in FHA insurance that the bank allegedly claimed on shoddily underwritten loans. Meanwhile, New York State Attorney General Eric Schneiderman, in concert with President Obama's Residential Mortgage-Backed Securities Working Group, is suing JPMorgan for $22.5 billion in losses suffered by investors on securities underwritten by Bear Stearns, the investment bank it rescued in March 2008.
In both instances, investors seem generally unconcerned by the legal risks of the suits even if headlines and allegations damage the banks' reputations. Wells Fargo shares are off marginally since the U.S. Attorney unveiled claims of civil mortgage fraud against the lender late on Tuesday. Meanwhile, JPMorgan shares have gained since the Schneiderman suit was filed.
For Bank of America and Citigroup, legal risks and writedowns appear to pose a bigger risk. A $243 million settlement
of a shareholder lawsuit against Bank of America over its acquisition of Merrill Lynch in 2008 is expected to wipe out a quarter of profit and months more of capital repair for the nation's second largest lender. Citigroup's settlement with Morgan Stanley
) on the value of its stake in a brokerage joint venture is also expected to create a third-quarter writedown that will wipe out the bank's overall profitability and dent its capital position.
Because Wells Fargo is on track for strong profitability through year-end, even a worst-case scenario for the FHA litigation won't provide a meaningful hit to overall profitability. KBW bank analyst Fred Cannon calculates a settlement would shave just 5 cents from forecast fourth-quarter earnings per share of 89 cents.
In the worst-case scenario, Cannon projects a settlement as high as $770 million. Using a previous Deutsche Bank settlement for guidance, he estimates a range of damages between $104.5 million and $423.5 million, with a mid-point of $264 million.
"This is certainly a negative for Wells Fargo but we believe that the lawsuit will be settled and the exposure is manageable," Cannon said in a note to clients. While it is unclear whether Wells Fargo is reserved against the FHA claims, he regarded the bank's strongly worded response as a positive.
"Wells Fargo denies the allegations and believes it acted in good faith and in compliance with Federal Housing Administration (FHA) and Department of Housing and Urban Development (HUD) rules," said Wells Fargo, in a statement released to TheStreet on Wednesday. Noting that its FHA delinquency rates have been as low as half the industry average, it said: "The Bank will present facts to vigorously defend itself against this action."
For its part, JPMorgan has already proven it can overcome giant one-time charges while remaining profitable. In the second quarter, it booked a $5.8 billion loss tied to a misguided holding of illiquid credit products -- now known as the London Whale trade -- but still posted $5 billion in net income. After falling nearly 20% on revelations of the trading position and expectations that the loss could reach as much as $7.8 billion, JPMorgan shares rallied in the third quarter, regaining most of the lost ground.
Although investors in Wells Fargo and JPMorgan may be taken aback by the claims made in the latest suits, they don't appear to pose a big earnings risk. In contrast the weaker earnings and balance sheet uncertainties of Bank of America and Citigroup give investors good cause to remain vigilant about the impact of legal settlements and one-time accounting charges.
For more on the legal challenges facing America's largest banks, see why Bank of America investors should expect the unexpected
, and why Wall Street is still skeptical whether CEO Vikram Pandit can resolve Citigroup's lingering problems