Mega-banks get hit with mega $250 billion lawsuit. Is the party over?

It’s one thing when angry homeowners attempt to stare-down $1000/hr corporate lawyers over fraud-related losses during the housing bust.  The analogy of bringing a squirt-gun to a gun-fight comes to mind.

But it’s quite another when a group of heavy-hitters led by BlackRock and PIMCO fire off a massive $250 Billion lawsuit in the New York State Supreme Court aimed directly at Deutche Bank, US Bancorp, Wells Fargo, Citigroup, HSBC and Bank of New York Mellon.   In military parlance, that’s called showing up in”full battle rattle“.  This lawsuit is a very big deal.

The lawsuits by BlackRock and Pimco funds claim the banks breached their duty to the bondholders by failing to force lenders and bond issuers to repurchase loans that fell short of the quality standards described to buyers when the securities were sold.

A focus on the trustees represents a new tack for the investors who have spent recent years demanding that firms that made the loans and sold bonds repurchase them. Large U.S. banks have paid out tens of billions of dollars in legal and regulatory settlements and repurchase claims since the financial crisis, addressing claims that poor underwriting was at the heart of the housing meltdown.

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This time it’s the trustees

The case is different from previous cases because as noted above, it focuses on the trustees.  The trustees in turn, deny that they have the obligation towards oversight which the lawsuit implies.   The courts will have to decide whether the trustees were aware that the mortgage-backed bonds in question were knowingly composed of worthless loans.

In some cases, the trustees were directly informed by bondholders and bond insurers of violations by lenders and issuers, the lawsuits say. The investors say that trustees were conflicted because the issuers that appointed them often had stakes in the firms that serviced the loans.

The case against the banks is extremely compelling but here’s the rub:   If found liable, the banks would be on the hook for an amount of cash which is likely beyond their capacity to pay.   Furthermore Dodd Frank prohibits the government from once again bailing out said banks in the event that their obligations exceed their assets.   So what’s the last remaining option:  Bail ins (ie:  Depositor haircuts).  

Who pays?

Technically speaking, retail depositors are protected by the FDIC for a total of $250,000 per account.   Except the FDIC is capitalized to just under $50 billion, or only 1/3rd the size of the massive lawsuit.

What’s amazing about this battle of titans is that the prosecution’s case looks extremely compelling.  And yet there simply isn’t remotely enough money in the system to reward the damages-owed without collapsing the entire financial system.

We can’t help noticing the ironic timing of Elizabeth Warren grilling Janet Yellen yesterday regarding  too big to fail.

Might be time to re-read that bit in Dodd Frank about resolution authority, Mrs. Yellen.  This promises to get extremely interesting.