(DB) Deutsche Bank AG Confronts FHFA Ire

Deutsche Bank AG (DB) is facing the wrath of the Federal Housing Finance Agency (FHFA). Its unit, named DB Structured Products Inc., has been sued by FHFA over mortgage backed securities, according to a Bloomberg report.

In a court filing, FHFA alleged that Deutsche Bank’s unit violated its pledge regarding the loans that were clubbed together and securitized and also failed to buyback them as needed. The investment amount in consideration was, however, not disclosed in the court filing.

However, according to the report, Deutsche Bank argued that it has always responded well to lawful buyback demands. It said that this particular case is based on factual conjecture and not supported by lawful theories. The firm plans to strongly defend this suit.

Notably, FHFA, which supervises Fannie Mae and Freddie Mac, sued Deutsche Bank and several other financial institutions in 2011 over mortgage backed securities alleging that the underlying loans were more risky than it had assured.

The Back Story

In the aftermath of the real estate market collapse in 2008 and the financial crisis, mortgage and mortgage-backed securities occupied a significant share of the total financial system. In several situations, the legitimacy of the mortgages as well as the documents was ambiguous. The mortgage originators did not exercise due diligence in several cases and also deliberately defrauded.

Now, when banks sell mortgage-backed securities to investors and GSEs, there is a clause that can force a bank to buy back the securities in the event of fraudulent or faulty underwriting or origination of the underlying mortgage. Therefore, in cases of fraudulent and faulty origination documents, the holder of the mortgage-backed securities can demand buybacks by the seller of the security.

Moreover, it has been found that in many cases the buyers of the mortgage backed securities were misinformed about the quality of the underlying loans of the securities and they were found to be more risky than claimed.

Others in the Same Pool

As a matter fact, another big Wall Street firm, Wells Fargo & Co. (WFC), is also experiencing increasing demand for mortgage repurchases from government sponsored entities (GSEs) Fannie Mae and Freddie Mac, related to loans made from 2006 to 2008.

Not only is Wells Fargo suffering from this mortgage mess and experiencing higher repurchases requests, other companies such as First Horizon National Corp. (FHN) and PNC Financial Services Group Inc. (PNC), are witnessing similar increases in buyback demands. These companies have substantially beefed up their reserves for the rising demands and consequently their second quarter 2012 results bore the brunt.

Our Take

We believe that increasing demands for mortgage buybacks would remain a headwind in the quarters ahead for Deutsche Bank. Moreover, such suits would result in piling of litigation risks for Deutsche Bank, which poses a menace to both the company’s image as well as it financials.

Deutsche Bank currently retains a Zacks #4 Rank, which translates into a short-term Sell rating.

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