Feds Play Hardball With the Big Banks

Federal regulators have stepped up the pressure on big banks in a number of evolving legal cases. The Securities Exchange Commission has teamed up with the Justice Department in ongoing investigations.

JPMorgan Chase under the microscope
As has widely been reported, JPMorgan Chase (NYSE: JPM  ) has been negotiating a settlement with the SEC in connection with the $6 billion synthetic credit default swap loss. The botched trades by the affectionately named London Whale may result in a new legal precedent as the agency is pushing for an admission of wrongdoing from the big bank. 

Until now, it has been usual and customary in these civil actions for targeted players to pony up while not admitting or denying wrong doing. This protects the banks from other private legal actions that could arise, and it also protects the traders involved -- as well as executives -- from the possibility of criminal actions. And the money center banks' problems don't stop there.

The agency in tandem with the U.S. Attorney in Manhattan is also bringing criminal charges against two traders in the London office involved with the whale-sized blunder. 

Whether they have a case beyond a reasonable doubt remains to be seen. But U.S. Attorney head honcho Preet Bharara spearheaded the criminal probe in the hedge fund insider trading cases that led to 70 or so guilty verdicts and plea deals.

More hot water for Bank of America
Bank of America (NYSE: BAC  ) continues to face the music regarding offerings of residential mortgage-backed securities that tanked in the years leading up to the financial crisis. The SEC announced yet another case against the bank for defrauding investors by failing to disclose the real situation regarding the "BOAMS 2008-A" series of wholesale loans.

The securities watchdog claims the loans were "riddled with ineligible appraisals, unsupported statements of income," and other misrepresentations associated with these subprime loans, also known as liar loans. The agency also contends debt-to-income and loan-to-value ratios provided to the investing public were "routinely miscalculated."

Of course, this leads to the question, did these institutional investors do their due diligence? Institutional investors are held to different standards than retail investors like you and I.

To win the fraud case, the SEC must prove the bank intended to defraud the other investors. And that is a high bar to cross. Meanwhile, the Justice Department is also on the case and is pursuing a parallel civil action. In short, the hits keep coming for Bank of America.

Banks fall short on Federal Reserve stress tests
Finally, combined news sources reported on the Federal Reserve's report this week citing its concerns over the banks' shortcomings regarding new stringent stress tests.

The central bank said banks were applying the tests too generally while failing to fully account for the possibility of falling house prices in determining the value of mortgage-related assets. Earlier this year, the central bank objected to the proposed capital plans of BB&T (NYSE: BBT  ) in a squabble over the methods used by the regional bank in valuing its assets.

In relatively simple terms, banks are required to assume a number of possibilities that can adversely affect the value of their assets and calculate the worst-case losses. The banks must then factor those losses into regulatory capital requirements.

While the big banks have raced to meet the new capital requirements, the Fed's announcement noted significant shortcomings were found in the banks' responses to the stress tests. In other words, this could be the Federal Reserve's "shot across the bow" that capital requirements could be made even tighter as the definition of "qualifying assets" is revisited.

The bottom line for ordinary investors
So, what's an ordinary investor to do? Good question.

All of this news might be more worrisome if the banks were on shaky ground regarding their fundamental strength. However, banks have been performing well in 2013 despite these numerous legal speed bumps.

A continuing series of settlements will take small bites from the banks' profits. But the troubles posed by these incessant legal and regulatory dust-ups are mainly intangibles that may adversely impact the banks' reputation, as opposed to their financial strength. The black eyes on the images of these players could ultimately move directors to shuffle the executive deck.

But if the SEC prevails in getting JPMorgan to admit wrongdoing, this could be a watershed moment in how federal regulators pursue civil actions, and it could open the door to criminal charges being brought for these repeated violations of securities law with greater frequency. And this is something all investors should consider.

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