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Freddie Mac Settles Legacy Repurchase Claims -- What's Next?

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Freddie Mac recently settled legacy repurchase claims with Wells Fargo (NYSE: WFC  ) and Citigroup (NYSE: C  ) . The deals resolve repurchase liabilities in connection with loans sold to the government-sponsored housing lender leading into the housing market collapse.

Freddie Mac's legacy repurchase settlements
Wells Fargo and Freddie Mac agreed to a $869 million settlement connected to loans sold by the lender prior to January 1, 2009. The deal includes prior repurchases of about $89 million. So the largest U.S. home lender will pony up a one-time cash pay-off of about $780 million. The settlement has been in the pipeline for some time as Wells Fargo set aside money to cover the cost of the pact at the end of the second quarter for June 30, 2013. 

Further, Citigroup and Freddie reached a deal similar to the tune of $395 million last month. Under the agreement, the housing lender released Citigroup from existing and future repurchase obligations for about 3.7 million loans funded by Freddie Mac between 2000 and 2012.

This settlement differs from the bargain reached between Citigroup and Fannie Mae back in July. That case was a $968 million pay-day to cover pre-existing loans and any potential future claims on loans originated and sold to the housing agency between 2000 and 2012.

What do settlements mean for investors in the banking sector?
While the agreements between Freddie and the lenders are essentially closed, the payments will take a bite out the lenders' profits. Moreover, the accords come in the wake of a series of settlements between federal authorities and the Big Four. In short, the big home lenders have been resolving claims over bad mortgage paper sold to Fannie and Freddie in the years leading into the financial crisis. 

But get this: The recently announced settlements include loans sold between 2000 and 2012, which means the lenders potentially sold faulty mortgage loans after Freddie and Fannie were placed in a conservatorship by the Treasury Department in August of 2008. While federal authorities now have greater enforcement powers because of the Dodd-Frank law, one has to wonder what the Feds were doing since Fannie and Freddie were under the Treasury's watch before the law became effective. 

Further, given the legal precedent now in play by way of JPMorgan Chase's (NYSE: JPM  )  London Whale settlement, investors should factor the legal and regulatory risks into their fundamental equations.

This is so because the JPMorgan Chase deal required the big bank to own up to violating federal securities laws with respect to its failure to fully disclose details about $6 billion in synthetic credit default swap losses to investors. The bank is forking over $920 million to a number of agencies, including the SEC. Beyond the stiff financial penalty, the acknowledgment of securities violations is a precedent that could expose JPMorgan Chase and its competitors to future legal actions.

JPMorgan Chase is also reportedly negotiating a multibillion-dollar global settlement with state and federal agencies in a play to head off a wave of potential litigation at the pass. The talks are centered on the bank's sale of troubled mortgage securities to investors leading into the 2008 financial crisis. The ongoing talks involve the Justice Department, the Department of Housing and Urban Development, and the New York attorney general's office.

The bottom line
Investors need to factor set-asides for legal costs and settlements into their fundamental analysis. That analysis should also consider the decline in mortgage lending activity that was triggered by the 1% spike in mortgage interest rates over the summer.

The legal costs incurred and the dollar amount of of the settlements coupled with lower mortgage activity will be a drain on the bank's profits. At the end of the day, quantifying future legal costs from a risk management perspective is subject to uncertainty as the London Whale precedent opens the door to another round of legal cases.

Another uncertainty investors need to consider is the stain these cases will leave on the reputations of key executives, and whether top-level shake-ups will occur. Perhaps a better question for investors to consider is the extent to which these legal actions are politically motivated.

Meanwhile, the LIBOR rigging probe is still looming on the horizon. Ultimately, uncertainty is not a good thing for investors, who are well advised to keep their eyes open this Friday when the banks announce earnings.

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