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The U.S. Department of Justice filed a lawsuit Tuesday accusing Deutsche Bank AG (NYSE: DB) of "reckless lending practices" when recommending loans to be insured by the Federal Housing Administration (FHA).
The suit seeks damages of more than $1 billion.
Deutsche Bank and its subsidiary, MortgageIT, broke U.S. Department of Housing and Urban Development (HUD) rules for establishing that borrowers had the income and credit histories that would ensure repayment of the loans, according to the Justice Department's complaint.
"As alleged, MortgageIT and Deutsche Bank ignored every type of red flag and breached every duty of due diligence before underwriting thousands of federally insured mortgages," U.S. Attorney Preet Bharara told United Press International. "Ultimately, prudence was trumped by profit, and good faith took a back seat to good fees. This is exactly the kind of misconduct that our Civil Frauds Unit was created to combat."
Deutsche Bank naturally objected to the allegations.
"We believe the claims against MortgageIT and Deutsche Bank are unreasonable and unfair"Renee Calabro, a spokeswoman for the Frankfurt-based company, told Bloomberg News. "Close to 90% of the activity covered by the DOJ allegations happened prior to Deutsche Bank's acquisition of MortgageIT."
HUD general counsel Helen Kanovsky told The New York Times that MortgageIT had ignored FHA warnings for years, telling the government all along it was dealing with the problems, "all of which turned out to be not true."
In fact, MortgageIT actually hired a consultant in 2004 to examine its loan procedures. According to the government's complaint, every audit report the consultant sent ended up "unopened and unread" in a closet.
MortgageIT, which Deutsche Bank bought in 2007, approved FHA insurance for more than 39,000 loans worth more than $5 billion between 1999 and 2009.
Almost a third of the loans have defaulted, forcing HUD to pay out $386 million. Claims not yet paid amount to $880 million.
Worse, the Deutsche Bank loans are just a fraction of the soured mortgages for which the FHA is responsible. The portion of loans insured by the FHA has risen from 5% in 2005 to about one-third. With approximately 25% of the loans made in 2007 and 2008 expected to go bad, payouts could soar.
And that could pressure the FHA's reserves, which fell from $21 billion in 2007 to $4.7 billion as of September of last year. If it exhausts those reserves, the FHA would need to tap into taxpayer money for the first time in its history.
The lawsuit against Deutsche Bank is the most noteworthy case to be brought by Bharara's unit thus far. The action immediately sparked speculation that other big banks responsible for passing bad loans to the FHA during the housing bubble could be in the Justice Department's crosshairs – a notion HUD officials did not dispel.
"We go where the evidence takes us, and if it takes us to the larger players onWall Street, so be it," HUD's Kanovsky told Bloomberg.
Although neither Kanovsky nor Bharara named any institutions, a list of likely candidates is easy to compile. Bank of America Corporation (NYSE: BAC) bought Countrywide Financial Corp. in 2008; Countrywide was the largest originator of FHA-insured loans in 2008 with $10.8 billion. Bank of America itself was fourth with $3.2 billion in FHA loans.
The second largest originator of FHA loans, Wells Fargo & Company (NYSE: WFC), had $9.8 billion in endorsed mortgages. National City Corp., with $3.6 billion, was third. PNC Financial Services Group Inc. (NYSE: PNC) bought National City in 2009.
If nothing else, suing Deutsche Bank sends a message to other financial institutions.
"This is a warning shot across the bow of mortgage lenders past, present and future," Ed Pinto, a resident scholar at the American Enterprise Institute in Washington and a longtime student of the FHA, told Fortune. "It's encouraging they're doing this, to remind the lenders someone is watching."
The Justice Department is using an 1863 law called the False Claims Act, which gives the government the ability to go after companies that attempt to defraud it. Last year the government recovered $3 billion under the law.
The act calls for triple damages plus penalties, putting the potential cost to Deutsche Bank in a range of $1 billion to $2 billion.
Of course, the suit's success is far from guaranteed. That the Justice Department filed it as a civil suit, rather than a criminal suit with its higher standard of proof, indicates that the government realizes just how tough it will be to win.
"You have two options in False Claims Act cases," David Feuerstein, a litigation partner at Herrick Feinstein in New York, told Fortune. "The fact that they took the civil option rather than the criminal one may allow you to make some assumptions about the strength of their case."
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