Will Legacy Issues Haunt These Stocks Forever?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Many financial institutions face legacy issues from precarious loans and mortgages. In particular, reinsurance companies and mortgage banks seem to be endlessly battling over who will take losses. Since valuing these companies is somewhere between challenging and impossible, prudent investors may wish to avoid these companies all together. Speculators who want to bottom fish should be very picky about which stocks they select.

MBIA complaints about CS mortgages

MBIA Insurance (NYSE: MBI) sued Credit Suisse Group (NYSE: CS) for selling faulty securities to investors and in turn exposing them to risk of losses. Credit Suisse is said to have packaged flawed mortgage contracts into bonds and the deal involves more than $1 billion. The underlying loan contracts were meant to be repurchased by the mortgage companies in question due to underwriting errors or early defaults but Credit Suisse knowingly sold them to investors around the time when the Great Recession hit the U.S. market. Six years later, guarantors and investors are still handling court cases in attempt to have banks compensate them for the losses made. Credit Suisse spokesperson Drew Benson defended the company while expressing hope that the court would rule out MBIA’s claims. According to Benson, “MBIA’s amended complaint is built on discredited testimony and fragments from a handful of e-mails that emerged after a review of millions of messages - they are intentionally taken out of context.”

Credit Suisse further indicated that some of the email evidence presented in court related to deals that it did not accept and which had nothing to do with the mortgage bonds. New York’s Attorney General Eric Schneiderman also took Credit Suisse to court over mortgage bond losses of about $11 billion and he believes the company should he held liable for the misappropriations. According to Schneiderman, “You talk about people selling tens of billions of dollars of securities over a period of years in which their due diligence process was essentially a sham.”

Credit Suisse has had to pay the Securities Exchange Commission about $120 million in settlement for allegations of keeping reimbursements from lenders though it did not admit or refute the findings. Credit Suisse is also facing lawsuits from investors like Deutsche Industriebank and bond insurers like Assured Guaranty and Ambac Assurance but it continues to be on the defensive. MBIA, on the other hand, has had to pay over $386 million in claims related to Credit Suisse and continues to collect evidence for its lawsuit. MBIA also alleges that Credit Suisse was careless in its dealings by continually securitizing loans from lenders who had been blacklisted, amongst other misappropriations. It is not clear how the case will be judged, but both sides continue to gather evidence.

Sunesis Capital founder Manal Mehta analyzed the effect of the suits and all the private information that is usually publicized under the guise of evidence. According to Mehta, “Damaging e-mails and other documents uncovered by lawsuits such as this will only intensify the public’s disdain for a system that is viewed as being riddled with fraud and self-dealing.”

Bank of America sells servicing rights from Countrywide loans

Bank of America (NYSE: BAC) recently closed a deal that settles unresolved demands made by private investors and pays about $11.7 billion to resolve a dispute with Fannie Mae. The figure paid to Fannie Mae will include a cash payment of about $3.6 billion for compensation for overdue claims and money to repurchase residential loans. The lender is also expected to improve its relations with regulators and sell rights to service about $300 billion worth of mortgages in a bid to get the home lending business back on track. Scotia Capital analyst Kevin Choquette spoke on the importance of dealing with pending legal issues. According to Choquette, “Resolving legacy issues allows the bank to shift attention from non-revenue-generating activities to focusing on growing business.”

Bank of America was greatly affected by the 2008 financial crisis and the current Chief Executive Officer Brian Moynihan will have to do a lot to clean up the mess. The bank took over Countrywide at a point when the U.S. housing market was on the decline and it will now have to sell rights to service loans from Countrywide too. The acquisition of Countrywide also saw the bank drop in rank from first to fourth and it consequently lost business to competitors like JPMorgan Chase and Wells Fargo. The clean-up measures being implemented by the CEO will see Bank of America spending nearly $50 billion for litigation costs and for refunds for faulty mortgages.

The bank has been able to increase its mortgage originations by about 37 percent. Mortgage rates may fall if Bank of America’s home lending business increases volume. Fourth quarter results had to cover legal expenses yet they were still considered modestly profitable. The cost of protecting debt using credit swaps has reduced though shares are yet to indicate a stable increase or decrease.

It is clear that Bank of America is trying to avoid another downfall. Quality checks are carried out on mortgages three times to ensure that there are no loopholes that would lead to future disputes. Though the checks are a move in the right direction for the home lending business, CEO Brian Moynihan indicates that it will affect the frequency with which the bank originates mortgages. According to Moynihan, “It’s frustrating to me because we can’t get our loans closed fast enough for our customers.”

Bank of America will also have to pay about $2.9 billion in a different settlement that involves 10 of the largest mortgage servicers and U.S. regulators. The lender still has a long way to go after settling Fannie Mae since it will also have to deal with MBIA and other counterparties who are demanding refunds. The pressure to make refunds is mounting, so Bank of America may take as long as two more years to settle all the disputes.

Valuation

Many reinsurance stocks and banks embroiled in lending issues are trading at discounts to their book values:

<table> <tbody> <tr> <td> <p><strong><span>Ticker</span></strong></p> </td> <td> <p><strong><span>Company</span></strong></p> </td> <td> <p><strong><span>P/E</span></strong></p> </td> <td> <p><strong><span>P/S</span></strong></p> </td> <td> <p><strong><span>P/B</span></strong></p> </td> <td> <p><strong><span>D/E</span></strong></p> </td> </tr> <tr> <td> <p><span>CS</span></p> </td> <td> <p><span>Credit Suisse</span></p> </td> <td> <p><span>27.37</span></p> </td> <td> <p><span>1.49</span></p> </td> <td> <p><span>0.9</span></p> </td> <td> <p><span>8.41</span></p> </td> </tr> <tr> <td> <p><span>BAC</span></p> </td> <td> <p><span>Bank of America</span></p> </td> <td> <p><span>44.12</span></p> </td> <td> <p><span>2.07</span></p> </td> <td> <p><span>0.5</span></p> </td> <td> <p><span>2.53</span></p> </td> </tr> <tr> <td> <p><span>GNW</span></p> </td> <td> <p><span>Genworth Financial</span></p> </td> <td> <p><span>12.82</span></p> </td> <td> <p><span>0.41</span></p> </td> <td> <p><span>0.25</span></p> </td> <td> <p><span>0.43</span></p> </td> </tr> <tr> <td> <p><span>AGO</span></p> </td> <td> <p><span>Assured Guaranty</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>4.24</span></p> </td> <td> <p><span>0.7</span></p> </td> <td> <p><span>0.6</span></p> </td> </tr> <tr> <td> <p><span>MBI</span></p> </td> <td> <p><span>MBIA</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>3.56</span></p> </td> <td> <p><span>0.74</span></p> </td> <td> <p><span>5.48</span></p> </td> </tr> <tr> <td> <p><span>MTG</span></p> </td> <td> <p><span>MGIC Investment</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>0.36</span></p> </td> <td> <p><span>0.8</span></p> </td> <td> <p><span>1.22</span></p> </td> </tr> <tr> <td> <p><span>RDN</span></p> </td> <td> <p><span>Radian Group</span></p> </td> <td> <p><span>NA</span></p> </td> <td> <p><span>1.32</span></p> </td> <td> <p><span>1.48</span></p> </td> <td> <p><span>1.05</span></p> </td> </tr> </tbody> </table>

I am not excited about this. Normally, value investors find P/B ratios that are less than one to be exciting based on the premise that the accounting value of equity is a conservative estimate. With financial companies, this cannot be assumed.

Conclusion

Reinsurance companies and lenders are cheap for a reason. Losses in this sector are still working their way through the legal system. Investors determined to speculate on cheap companies on this list should consider Assured Guaranty and Bank of America before their competitors since they trade at the steepest discounts to their book values. However, investors will have to research the accounting basis for this seemingly attractive ratio.


BillEdson11 has no position in any stocks mentioned. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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