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Uncle Sam's new crusade against banks

November 8, 2011: 5:00 AM ET

The Feds are suing 18 banks over the billions Fannie and Freddie lost on toxic mortgages. How solid is their case?

By Roger Parloff, senior editor

FORTUNE -- As if the banks didn't have enough problems. Uncle Sam is now suing 18 of the country's largest banks for selling $200 billion in toxic mortgage-backed securities to Fannie Mae and Freddie Mac. Columbia Law School professor Jack Coffee termed the action "the most aggressive attempt by federal authorities to litigate financial claims since the S&L crisis of the 1980s." Some greeted the news joyously, for it meant that the marquee villains of the financial crisis-- including BofA (BAC), J.P. Morgan Chase (JPM), and Goldman Sachs (GS) -- have finally been placed in the federal dock, even if only in civil suits.

At the same time, the industry -- all defendants either deny wrongdoing or decline to comment -- protested that the suits would endanger the viability of the targeted banks. In response, the Federal Housing Finance Agency (FHFA), which seized the insolvent mortgage giants in September 2008 and is bringing the cases, stressed that it was not seeking, as the media have widely reported, $200 billion in the suits (the total amount of mortgage securities Fannie and Freddie bought from the banks), but only the securities' actual loss in value -- which might approach $40 billion. Still, the FHFA cases add to the banking industry's formidable pile of legal woes, which include an inquiry by 50 state attorneys general seeking $20 billion to redress alleged foreclosure-related abuses.

Losing those cases would be a big blow to the banks, but some legal experts think they see a major weakness in the feds' case. They point to a legal concept known as "loss causation" or, as some have called it, the "Are you kidding me?" defense. The FHFA claims the banks overstated the value of the mortgaged homes and the number that were owner-occupied. But those alleged misstatements, insist the legal experts, had nothing to do with Fannie and Freddie's actual losses. The reason their holdings plummeted was a change in market conditions. "The bottom dropped out of the housing industry," says one expert. The precedent: a 1990 appellate case stemming from a sudden drop in oil prices, in which Judge Richard Posner of Chicago opined: "No social purpose would be served by encouraging everyone who suffers an investment loss because of an unanticipated change in market conditions to pick through offering memoranda with a fine-tooth comb in hope of uncovering a misrepresentation."

So the banks can win by successfully arguing the agencies' losses were caused not by misrepresentations but by the bursting of the housing bubble. Fannie and Freddie have themselves invoked this defense in suits brought against them by their own shareholders, notes a lawyer partial to the banks' position. To call the suit ironic, he claims, is an "understatement."

This article is from the November 7, 2011 issue of Fortune.

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