Credit Suisse analysts Moshe Orenbuch, Jill Glaser Shea, Nick Karzon, Christian Bolu, and Craig Siegenthaler take a close look at Morgan Stanley’s FHFA settlement over deals with Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) both in terms of its effect on Morgan Stanley and in terms of the effects on the banking community at large.

Fannie Mae

Fannie Mae and Freddie Mac Settlements

Out of the 18 financial institutions that were sued by FHFA in 2011, 7 banks have settled so far, including most recently Morgan Stanley. Of the banks that have settled already, the settlement amounts equate to roughly 12% of original principal balance of securities sold to the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). Separately, we estimate the settlements at roughly 49% of the cumulative loss on the underlying securities. Refer to

We estimate that roughly $70Bn of the ~$200Bn securities cited in the FHFA lawsuit have been settled, leaving roughly $130Bn remaining. Bank of America Corp (NYSE:BAC) has the largest securities exposure cited in the lawsuit at $57.5Bn (including legacy Bank of America, Countrywide and Merrill Lynch). Specific to Bank of America Corp (NYSE:BAC), there could be some securities cited in the FHFA lawsuit that may be covered by the Bank of New York Mellon settlement of $8.5Bn. That said, assuming a settlement with the FHFA at 12% of principal balance (similar to settlements announced so far), this would equate to roughly $7 billion.

Banks have established significant litigation reserves although it remains unclear the level of reserves set aside for the FHFA lawsuit. Following JPM’s settlement in late 2013, some banks may have provided additional legal reserves in 4Q’13. With MS’s $1.25Bn settlement, it will add $150mm to its legal reserves following additions to litigation reserves last quarter. While large banks may have trued-up reserves to some degree, we estimate that there could be incremental earnings hits for the remaining banks related to FHFA settlements.

Overview

In September 2011, the FHFA released the details of its lawsuits against 17 financial institutions. With the lawsuit, it was FHFA cited that the industry sold the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) just over $200 billion of securities that caused losses to the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) for which there should be compensation. The basic claims was that “the statistical data provided in the prospectus supplements concerning owner occupancy and LTV Ratios was materially false” and “government investigations have confirmed issuers systematically disregarded its underwriting guidelines.” Refer to Exhibit 2 for a list of financial institutions and total value of securities cited in the lawsuit.

US Financial institutions named in FHFA lawsuit Fannie Mae

Source: The Federal Housing Finance Agency (FHFA). Fled lawsuits against 17 financial institutions, certain of their officers and various unaffiliated lead underwriters. The suits allege violations of federal securities laws and common law in the sale of residential private-label mortgage-backed securities (PLS) to the Enterprises. Complaints have been filed against the following lead defendants, in alphabetical order. Note 1-UBS AG not a part of the lawsuit against 17 financial institutions; however, sued by FHFA in July 2011 to recover losses to Fannie Mae and Freddie Mac. Note 2-Wells Fargo & Co. not a part of the lawsuit against 17 financial institutions; however, settlement with FHFA on nonlitigation PLS (private label securities).

Settlements so Far …

Out of the 18 financial institutions that were sued by FHFA, 7 banks have settled, including most recently Morgan Stanley (NYSE:MS). Yesterday, MS settled for $1.25 billion or 12% of original principal balance cited in the lawsuit. UBS AG (NYSE:UBS) settled with FHFA for $885 million related to $4.5 billion in RMBS that UBS sponsored and $1.8Bn of third-party RMBS sold to Fannie Mae and Freddie Mac. Citigroup Inc (NYSE:C) settled for $250 million, while General Electric Company (NYSE:GE) settled for $6.25 million. JPMorgan Chase & Co. (NYSE:JPM) settled for $4 billion or about 12% of the principal balance cited in the lawsuit ($33 billion). Similarly, Deutsche settled for about 14% of the principal balance cited in the lawsuit or $1.9 billion on $14.2 billion of balance. Refer to Exhibit 2. Of the banks that have settled already, the settlement amounts equate to roughly 12% of original principal balance of securities sold to the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). Separately, we estimate the settlements at roughly 49% of the cumulative loss on the underlying securities. Refer to Exhibit 3- Exhibit 4. Assuming similar ranges on the remaining securities left to be settled, we expect $15 billion or so in additional settlements from the remaining banks to come.

Fannie Mae and Freddie Mac

Implications for Large Cap Banks (M. Orenbuch)

Banks have established significant litigation reserves although it remains unclear the level of reserves set aside for the FHFA lawsuit. Following JPM’s settlement in late 2013, some banks may have provided additional legal reserves in 4Q’13. With MS’s announced settlement, they noted that they will add $150 million to its legal reserves following additions to litigation reserves last quarter. While large banks may have trued-up reserves to some degree, we estimate that there could be incremental earnings hits for the remaining banks related to FHFA settlements.

Notably, Bank of America accounts for about 29% of the industry’s sales to the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) cited in the lawsuit. Bank of America received separate complaints filed for Bank of America ($6 billion), Merrill Lynch and First Franklin ($24.9 billion) and Countrywide ($26.6 billion). Specific to Bank of America Corp (NYSE:BAC), there could be some securities cited in the FHFA lawsuit that may be covered by the Bank of New York Mellon $8.5 billion settlement. While we estimate that Bank of America Corp (NYSE:BAC) has recognized $18 billion of litigation expense since the beginning of 2010, we do not necessarily think that there are reserves established to completely cover a potential settlement with the FHFA (roughly $7 billion assuming a ~12% settlement on principal balance which would be similar to settlements announced so far).

Implications for Regional Banks (N. Karzon)

We view the recent FHFA settlements as a positive for First Horizon (FHN, OP) as we believe FHN’s losses will be well below Street expectations (and fears) and potentially even our “bullish” base case estimate. The two drivers of this expectation are: 1) settlements have come at just 50% of cumulative losses on average relative to our base case of 100% and 2) FHN’s securitizations have superior performance relative to peers with a 7% cumulative loss rate vs. 21% among the institutions listed in the lawsuit. Additionally, settling outstanding private label litigation would put FHN one step closer to re-starting share buybacks (leaving the FHA Investigation the last major legacy mortgage liability).

FHN is currently the only regional bank named in the FHFA lawsuit ($874 million in FHFA balances plus $9 million of cost over par with an additional $576 million of UPB held by private investors named in other lawsuits / indemnifications). We currently estimate FHN has reserved ~$30 million for private label lawsuits with the ultimate settlement likely to result in a further charge. However, FHN also has 1.1 million Visa Class B shares currently held at $0 on the balance sheet, which they may sell to offset the accrual for PLS settlements (est. ~$0.28 after-tax offset). See below for our “base case estimate” for total PLS losses.

Implications for Investment Banks (C. Bolu)

We see Morgan Stanley’s FHFA settlement as another important step in resolving precrisis litigation issues and removes one of the most significant legal cases facing the company. The $1.25 billion settlement represents 12% of the original principal balance 45% of unpaid principal balance as at September 2013–-roughly in line with other banks that have settled so far. Looking forward, while there remain other legal proceedings outstanding we take comfort in the elevated litigation accruals over recent quarter’s. For Goldman Sachs Group Inc (NYSE:GS), while we await resolution and are aware that every case is different, we note that a similar settlement to Morgan Stanley (12% of the original principal balance) would imply ~ $1.3 billion in settlement cost. That said, we note that provisions for litigation and regulatory proceedings have been elevated over recent periods ($962 million in 2013) and best class capital ratios should help mitigate any potential adverse impact.

GSES Fannie Mae