Why Wells Fargo Blinked in Its FHA Fight with the Government

The long arm of the government is tough to elude, even if you are the nation's largest home lender.

Wells Fargo stunned the mortgage industry Wednesday by tentatively agreeing to pay $1.2 billion to resolve civil claims by the Justice Department and other federal agencies that it originated shoddy loans insured by the Federal Housing Administration.

The proposed settlement could prove a bellwether for other banks that have outstanding investigations of FHA loans including PNC Financial Services Group, Regions Financial and BB&T.

Wells had been the lone big bank holdout willing to go to trial as a potential test of the government's pursuit of banks for violations of the False Claims Act. That Civil War-era law allows the government to collect triple damages for fraud against the government. The law also has been a lightning rod for banks, causing some to pull out of FHA lending entirely.

Some observers said they were surprised at the size of the deal. Wells had put up a fight, claiming it has always been a prudent and responsible FHA lender. But some observers said the risk to its reputation and the cost of continuing the litigation was just too great.

"Nobody's put [the government] to the test like Wells," said Allen Jones, an independent mortgage consultant who managed Bank of America's FHA business from 2005 to 2009. "They definitely made a run like no one else has. But there comes a point in time where you add it up and have to quantify the downside risk."

The $1.8 trillion-asset bank reached an "agreement in principle" on Monday to resolve the FHA claims but could not provide any additional details until the deal is finalized, said Catherine Pulley, a Wells spokeswoman.

The agreement is forcing Wells to shave $134 million, or three cents a share, off its previously reported net income for 2015, the bank said in a Securities and Exchange Commission filing. Wells said its revised profit for 2015 is $22.9 billion, or $4.12 a share.

The San Francisco bank had to provide for an additional legal accrual because of the settlement, which increased its operating losses within noninterest expense by $200 million, the filing said.

The deal appears to provide Wells some future protections. It would resolve "other potential civil claims relating to the company's FHA lending activities for other periods," the filing said.

Prosecutors had alleged that Wells "engaged in a regular practice of reckless origination and underwriting of its retail FHA loans" from 2001 to 2010.

Theoretically lenders are required to indemnify FHA for loans that contain mistakes or are defective, essentially self-insuring the loan so taxpayers are not on the hook for potential losses. In this case, Wells not only failed to report material violations to the Department of Housing and Urban Development, but HUD also paid insurance claims on thousands of defaulted loans that it later found had significant violations, the lawsuit alleged.

Last year the government added a Wells executive in charge of quality control, Kurt Lofrano, as a defendant to the lawsuit, which was originally filed in 2012. Lofrano was responsible for reporting loans with material defects to HUD, which oversees the FHA.

Prosecutors were preparing to use Wells' own internal quality control reports to prove that executives knew some loans were of poor quality but did nothing about it. Wells failed to report the errors or change its practices because of pressure to fund more loans, the government claimed.

Patricia McCoy, a professor at Boston College Law School who specializes in banking law, said that because details of the settlement have not yet been released, there is no way to gauge the severity of Wells' lending errors.

"Part of the problem is, there is a continuum of different types of conduct that would have led to a False Claims Act claim, and depending on the lender it could have been really bad, or a mixture with innocuous errors that slipped through," McCoy said. "We don't know where Wells Fargo fell along that continuum. At worst, it was a mix, some bad and probably a lot of innocuous errors."

A bigger problem, McCoy said, is that the Justice Department has used the False Claims Act and its potential for treble damages for each violation as a tool to get banks to settle FHA violations. That threat has caused many to flee the program, she said.

"It's a very heavy sledgehammer, and that's not a constructive approach because in the course of underwriting innocent mistakes can happen and often they can be cured or fixed," she said. "If the FHA is saying as a condition of a lender doing FHA loans, they have to be 100% perfect or else they are automatically going to face this threat of treble damages — that's not a viable lending program."

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