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The Department of Justice's Investor-Unfriendly Mortgage Settlements

In reaching mortgage-related settlements with the big banks, the Department of Justice forgot about investors.

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In late January, the U.S. Senate held confirmation hearings for President Obama’s nominee for attorney general, Loretta Lynch. One question that senators should have asked Lynch: Are you an advocate for investors in a way that the current attorney general, Eric Holder, was not?

In the aftermath of the global financial crisis, the Justice Department might be fairly criticized for many things, including--according to some commentators--failing to hold individual bank executives accountable for alleged criminal activity. (See Matt Taibbi’s recent Rolling Stone article for one such account.) You may or may not believe that bank executives should have gone to jail. But it is undeniable that the Justice Department’s mortgage-related settlements with the major banks failed to reflect investor interests.

True, on the surface many of these mortgage settlements, including the Justice Department’s $13 billion deal with  JPMorgan Chase & Co (JPM), seem unobjectionable. That settlement, joined by a number of states and federal agencies, obligated JPMorgan Chase to pay penalties to a number of government entities, including the Department of Justice, the Federal Deposit Insurance Corporation, and the Federal Housing Finance Agency, which oversees Fannie Mae (FNMA) and Freddie Mac. The settlement also included $4 billion of consumer mortgage relief, including $2 billion of principal write-downs for borrowers. The government entered into similar settlements with other large banks, including  Bank of America (BAC) and  Citigroup (C).

The problem with the mortgage relief is this: More often than not, the banks no longer owned the mortgages. Instead, years ago the banks packaged together many of the mortgages and sold them to investors, including mutual funds, individuals, and pension funds.

In J.P. Morgan’s settlement, the bank acknowledged that it made misrepresentations about the quality of the loans that it had sold to investors. To punish JPMorgan Chase for these misrepresentations, the Justice Department required write-downs of mortgages.

So, as part of the banks’ penance after misrepresenting the quality of loans sold to investors--causing investors to suffer significant losses--banks were required to take actions that ... reduced the value of loans held by investors.

You might wonder what sort of investor would agree to such a bum deal. In short, none did, because investors were not parties to the JPMorgan Chase settlement. In the mortgage market, the servicers--often owned by the banks--are charged with taking actions on behalf of the investors and institutions that purchased the securitized mortgages. So, a bank’s mortgage-servicing unit can be responsible for representing the interests of investors who purchased faulty mortgages from that same bank. One need not be a cynic about human nature to see why a bank potentially might prefer to pay billions of investors’ dollars, in the form of mortgage relief, to paying billions of dollars of its own money, in the form of an even larger fine than it already faced. As  BlackRock (BLK) put it simply, the settlements, “which are related to misdeeds that caused harm to investors, are likely to cause additional harm to investors.”

Now, to be sure, there are some investors who have earned huge profits in the nonagency mortgage arena. For example,  TCW Total Return Bond (TGLMX) has posted outsize gains in recent years, in part because it purchased already-beaten-down nonagency securities in 2009 and 2010 and then rode their subsequent rebound. Similarly,  DoubleLine Total Return Bond (DBLTX) and  Metropolitan West Total Return Bond (MWTIX) have enjoyed strong returns due to the rebound in nonagency mortgage securities.

But these managers have arguably succeeded despite--not because of--the Justice Department’s mortgage settlements. In short, no matter how large the gains earned by a TCW or DoubleLine, the profits may have been greater without the mortgage settlements. Moreover, the settlements provided nothing for the investors who initially bought the tainted mortgages and suffered huge losses in 2007 and 2008. Finally, for investors the mortgage settlements could set a bad precedent: Will the federal government ignore their interests the next time the mortgage market faces significant stress? Will the Justice Department impose costs on investors as a remedy for the alleged misdeeds of others?

The best way to ensure that these questions do not arise in the future is to ask them now. What say you, future Attorney General Lynch?

Scott Cooley does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.