Capital One asked to pay for the sins of Chevy Chase Bank

Capital One disclosed this week that it is being sued by bond insurer Ambac Assurance Corp. over alleged breach of contract on mortgage securities originated by Chevy Chase Bank, the ailing Bethesda-based institution it acquired in 2008.

The case is the latest example of a big bank paying for the sins of a company that it bought during the height of the financial crisis. JPMorgan Chase is contending with mortgage lawsuits against Bear Stearns, much like Bank of America is with Merrill Lynch and Countrywide Financial.

While all companies face litigation liability in acquisitions, analysts say cases stemming from crisis deals, coupled with looming lending rules, could have a chilling effect on the mortgage market.

“There is a very real concern that the regulation and litigation threat will lead the mortgage originators in the direction of being very cautious in their lending,” banking analyst Bert Ely said. “A lot of people who have slightly dinged credit records aren’t going to be able to get a mortgage.”

McLean-based Capital One has suffered few legal setbacks tied to its $520 million acquisition of Chevy Chase Bank. The regional bank was crippled by its portfolio of risky home loans made during the housing bubble — the basis for the lawsuits that Capital One faces. The Federal Home Loan Bank of Boston, for instance, filed a lawsuit in April 2011 alleging that Chevy Chase sold shoddy mortgage-backed securities. That case is pending.

In the latest lawsuit, filed Oct. 24 in federal court in Manhattan, Ambac alleges that Chevy Chase Bank violated warranties in contracts for six mortgage-backed securities Ambac insured in 2006 and 2007. The transactions involved 12,675 loans with an original principal balance of roughly $5.2 billion, according to the complaint.

Ambac claims that many of those loans were “plagued by rampant fraud and a wholesale abandonment of proper and prudent origination and underwriting practices,” according to court documents. As a result, the trusts have experienced severe delinquencies or defaults.

Ambac is seeking unspecified damages and an order compelling Capital One to indemnify the company for all damages stemming from the alleged breach.

Capital One, which declined to comment for this article, said in a financial filing that it established a reserve to cover the costs of warranty problems. At the end of September, the bank estimated future losses from warranties could exceed its reserve by about $1.7 billion.

But in its latest filing Thursday, Capital One did not increase its reserves, which banking analyst Sanjay Sakhrani of Keefe, Bruyette & Woods considers a sign that the lawsuit will have limited impact.

“Clearly, these headlines and the potential impacts are not ideal,” he said in a research note, “however, we don’t think these are thesis-changing.”

Bond insurers have aggressively taken action against banks over mortgage securities that allegedly held poorly underwritten loans, but they have had limited success in recouping losses, Ely said.

“This is not your classic widow and orphan kind of investor,” he said. “These guys are sophisticated and are supposed to look at the risks. The question is what is their liability in these kinds of deals? What kind of due diligence did they do?”

The mortgage-backed securities business has been a prime target for federal regulators and prosecutors seeking retribution for investors who suffered staggering losses in the fallout of the housing crisis.

The Securities and Exchange Commission, for example, has launched probes into the mortgage securitization operations at JPMorgan, Goldman Sachs and Wells Fargo. Goldman Sachs paid $550 million in 2010 to resolve claims that it misled investors on related investments in 2007. And on Thursday, JPMorgan disclosed in a filing that it reached an agreement with the regulator to wrap up two similar investigations.

In a recent interview with The Washington Post, David Stevens, president of the Mortgage Bankers Association, expressed concern that the tense lending environment created by all of these lawsuits could get worse once regulators implement rules requiring banks to hold a piece of risky mortgages on their books next year.

Ely agreed, adding that higher capital requirements that regulators are considering will further exacerbate the problem.

Danielle Douglas covers the banking industry for The Washington Post.
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