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Three Lawsuit Investments

By Alexander MacLennan - August 16, 2013 | Tickers: BAC, FNMA, FMCC | 0 Comments

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Lawsuits are part of doing business, and for some companies they are the business. Whether your company’s business model is built on filing lawsuits, your company is the target of lawsuits, or game-changing lawsuits are being filed by third parties, legal action is a key part of many businesses. Here we will look at three financially-based companies with pending lawsuits that could drastically alter shareholder returns.

A mortgage mess is profitable again

In the midst of the housing meltdown, government sponsored entities (GSE's) Fannie Mae (NASDAQOTCBB: FNMA) and Freddie Mac (NASDAQOTCBB: FMCC) were bailed out by the federal government in the interest of preventing a complete collapse of the housing system. Over the next few years the GSEs existed as zombie stocks, with both trading over the counter for around $0.30 per share. The preferred stock given to the Treasury continued to take massive dividends from the companies as their losses brought them deeper and deeper into debt.

But then the story got interesting. Fannie and Freddie began making a little money again. Then a good amount of money. And then a ton of money amounting to billions of dollars per quarter. Shares shot higher, touching the $5 range at both companies before cooling back into the $1 range. But there was a problem for shareholders--all the profits were going to the government.

In late 2012, an amendment was made to Fannie and Freddie’s agreements whereby all profits made by the two would be swept into the Treasury. As a result, neither junior preferred stockholders nor common stockholders were to receive any profits.

But not all investors are content to wait for the government to give up its cash cow. Perry Capital, a holder of preferred shares, launched a lawsuit to challenge the dividend sweep amendment on the grounds it violated the purpose of the conservatorship. If successful, Fannie and Freddie’s profits could begin to be used to repurchase the Treasury’s senior preferred stake and eventually free the GSE's from government ownership. Under this situation, some analysts have pegged Fannie and Freddie’s values at north of $20 per share. However, lawsuits can take years to resolve and politicians are already putting forth plans to wind down the GSEs. Whether anything will happen politically is uncertain since the role of the government in the housing market cuts along party lines and even within each party. As a result, the fate of Fannie and Freddie shareholders depends on a combination of delay in Congress and a lawsuit victory. In this case, the former may be more likely than the latter.

An $8.5 billion penalty is a good outcome

When it comes to mortgage crisis lawsuits, Bank of America (NYSE: BAC) has become a wonderful target thanks to its acquisition of Countrywide Financial’s assets and legal troubles. BofA’s earnings have been regularly impacted by legal settlements, and more lawsuits are expected in the future.

The biggest issue at hand for BofA is a $8.5 billion settlement currently being evaluated. In this case, BofA would be happy to pay a mere $8.5 billion, since analysts have given a worst case scenario of damages totaling $60 billion. But this settlement is far from settled. The issue in the courts now is whether the settlement will stand. If it does, BofA can put a rough patch of history behind itself. If it doesn’t, look for even more lawsuits against BofA in the future.

But legal troubles for BofA extend beyond the $8.5 billion settlement at hand. BofA encounters legal problems in other ways, whether it be in large amounts such as federal action and fines, or civil action alleging foreclosures on the wrong houses. It will be several years before BofA can bid farewell to all mortgage crisis-related lawsuits. But in the meantime, shareholders can hope the current lawsuits won’t be too damaging.

Legal action means share price action

Fannie Mae, Freddie Mac, and Bank of America all have lawsuits relating to shareholder value pertaining to the mortgage crisis. The GSE lawsuit could finally bring value back to common and preferred shares of the companies, but a final ruling is at least a couple years down the road. At this point, Fannie and Freddie shares are a highly speculative investment bordering on gambling, and investors should only investment money in them that they can easily afford to lose. Unlike Fannie and Freddie shareholders, the lawsuits against Bank of America tend to target the bank as plaintiffs try to extract money for the banks past wrongs. While BofA, and Countrywide for which BofA is now legally responsible, have committed past wrongs, the bank also risks becoming an even bigger lawsuit target as more parties realize BofA is paying out. Like any big bank, BofA has a powerful legal team, and they will need it as much of the future will be fought in the courts. These companies are just three examples of lawsuit-based investments. All carry risks beyond standard financial operations, and shareholders will need to watch legal results carefully to assess their investment’s value.