The banks are choosing to settle lawsuits for their roles in shoddy mortgage practices before the financial crisis of 2008, paying out multibillion-dollar sums to make amends. The size of JPMorgan’s settlement with the Justice Department, struck late last year, shocked many in the industry. Now, other large banks — in particular, Bank of America, with its enormous exposure to sour precrisis mortgages — are expected to announce painful deals with the government in the coming months.
As these legal threats loom, the nagging question is whether the banks have properly girded themselves for the payouts. The banks are supposed to build up a financial cushion in advance to absorb the estimated cost of the payouts.
Knowing the size of this cushion, called the litigation reserve, is extremely important to outsiders trying to weigh the financial strength of banks. For instance, if a bank’s litigation reserve turns out to be much too small for the agreed-to settlements, it could call into question the strength and management of the bank.
Yet most banks are not disclosing the overall size of their litigation reserves. That has left investors and analysts groping in the dark. “I definitely feel that the disclosures around this aren’t great,” said Richard Ramsden, a bank analyst with Goldman Sachs.
Banking experts say they don’t think the large banks are surreptitiously sitting on litigation reserves that are catastrophically low. The analysts have been able to piece together roughly how much banks have paid into litigation reserves, but it is hard to know what the banks have paid out from the reserves to settle cases.
In some instances, the payments into the reserve appear large. Bank of America, for example, has paid roughly $50 billion into its reserve to cover mortgage-related legal costs since the crisis, according to Bernstein Research.
Still, even if the banks aren’t facing huge shortfalls, the failure to reveal the size of the litigation reserve sits at odds with longstanding industry practices. Banks, for example, regularly reveal the size of another critical financial cushion: the reserve for bad loans.
Investors might also have expected regulators to push the banks to reveal the size of their litigation reserves. In the turbulent years since the crisis, the authorities have pressed the banks to reveal more details about troubled areas of their businesses, so that shareholders and others can be better informed.
The Securities and Exchange Commission sent out a public memo in 2012 to the banking industry, telling lenders to bolster disclosures on their holdings of European government bonds, which were perceived to be particularly risky at the time. The banks complied, and the public now gets comparable, and comprehensive, numbers on banks’ European holdings every quarter.
But the commission has not sent out a similarly broad communiqué on litigation reserves, even though the banks’ mortgage-related payouts are almost certainly causing more financial pain than Europe is right now.
As mortgage lawsuits became a material threat, the commission’s staff corresponded frequently with the banks, asking them to improve disclosures on their exposure to the litigation, according to public filings. Notably though, the correspondence did not appear to prompt the industry to disclose the size of its litigation reserves.
American accounting rules appear to give the banks some leeway to keep the size of their litigation reserves under wraps. That, in theory, might have made it harder for the commission to command the industry to release that number.
Bankers certainly are not fans of disclosing the size of their litigation reserves. Doing so, they contend, would seriously undermine their ability to negotiate fair settlements. If investors or government authorities suing the banks know how much banks have set aside, bank executives assert, they will be emboldened to increase their demands. And since bank shareholders effectively are liable for legal payouts, they should support management’s desire to keep the size of the litigation reserve secret, the bankers argue.
Still, it is not clear that revealing the size of the litigation reserve would weaken a bank’s legal fight.
For instance, Credit Suisse, which is battling its fair share of mortgage lawsuits, has been regularly disclosing the size of its litigation reserve for some time (and it presents its financials under American accounting rules). Deutsche Bank also recently provided the size of its litigation reserve.
What is more, JPMorgan chose to reveal the size of its litigation reserve in October, before it closed its deal with the Justice Department. When revealing the litigation reserve, which was $23 billion at the end of the third quarter of 2013, JPMorgan’s chief financial officer, Marianne Lake, said the bank was not going to get in the habit of giving out the number. It didn’t do so when it released its fourth quarter results this week.
Even so, some banking specialists were hopeful that JPMorgan’s move might prompt other institutions to follow suit. But so far, its rivals have stayed silent on this figure. “I thought JPMorgan disclosing it was going to put pressure on more banks to start doing it,” said Mr. Ramsden, the analyst.