Why Bank of America Must Be Thrilled to Pay a $3 Billion Penalty

Some people who aren't familiar with the mortgage market might have gasped as they read the news that Bank of America would pay $3 billion to government-sponsored mortgage companies Fannie Mae and Freddie Mac. After all, $3 billion sounds like a lot of money. "Maybe BOA is finally getting what it deserves," some naive bank-haters might have exclaimed. In fact, paying this sum is an incredible win for the bank. The penalty is so small that it's effectively insignificant.

A Drop in the Bucket

For starters, it's important to remember that Bank of America also means Countrywide. After purchasing the ailing mortgage company in 2008, Countrywide's problems became BoA's problems. And according to the press release, this $3 billion loss provision the bank is taking should cover all Countrywide/BoA mortgages sold or guaranteed by Fannie and Freddie during the housing bubble.

How much is that? According to a Washington Post article on the story, it covers a BoA-Countrywide portfolio of about $530 billion held by Fannie and Freddie. That puts the loss rate on these loans that BoA will be responsible for at less than 1%. You don't need to be a mortgage analyst to know that a 1% loss doesn't begin to characterize housing's deterioration.

No Wonder the Market Celebrated

After this revelation struck, financial stocks were broadly up yesterday. This should come as no surprise. BoA-Countrywide together were originating more than to one-quarter of the mortgages created when the housing market was humming along in the middle of the last decade. If the losses imposed by Fannie and Freddie's put-backs are in the couple billion dollar range for BoA-Countrywide, then you only need to multiply by three to figure out what the rest of the market probably owes.

If this settlement is any indication, then the other banks and probably won't be responsible for much more than $9 billion of put-backs from the government entities. That's a loss they would be happy to endure, considering that the downside could have been well into the tens of billions of dollars. No wonder they're celebrating.

A Backdoor Bailout?

This settlement has a few implications. The most significant is that Fannie and Freddie are essentially admitting that the vast majority of their losses are their fault. The cost of the bailout alone to taxpayers is expected to easily exceed $150 billion. If it obtains a measly $12 billion or so from banks, that puts its responsibility at roughly 92%.

This means one of two things. The first possibility is that Fannie and Freddie really were so screwed up that banks rarely broke any rules or tricked these companies into buying and guaranteeing their garbage mortgages. This is actually somewhat plausible, considering that there was a relatively standardized system in place for selling mortgage risk to Fannie and Freddie. Any bad behavior by banks should be relatively easily identifiable through inaccurate or missing documents.

But the second possibility is that banks were, in fact, shady and Fannie and Freddie could legally push more of its mortgage losses to the banks, but has chosen not to do so. Why take such a strategy? The companies' willingness to let banks off easy could be politically-driven. It could be a sort of backdoor bailout.

How Fannie and Freddie Complicate the Role of Government

This latter possibility demonstrates the unfortunate situation the government has gotten itself into through its decision to stand behind Fannie and Freddie. On one hand, it doesn't want to see financial stability or the housing market thrown back into chaos. So it doesn't want to be too hard on the financial industry. On the other hand, it's duty is to act to minimize the loss to taxpayers from Fannie and Freddie.

If this settlement is a backdoor bailout, then the government has prioritized stability over taxpayers, again. Under these circumstances, the two are in conflict. Either Fannie and Freddie didn't have enough evidence to bring the banks to court to demand a higher settlement, or the bureaucrats who now run these entities chose not to, for the sake of the stability of the financial system and housing market.