Analysis: Banks Prepared for Cost of U.S. Mortgage Pact

(Reuters) -- As the five largest U.S. mortgage lenders edge close to a $25 billion settlement over foreclosure abuses, it's becoming clear that the deal will have little or no impact on their future bottom lines.

After more than a year of negotiations, the banks already have set aside money to cover legal costs and have built up their reserves to cover losses from reducing how much borrowers owe. Accounting for these costs in past earnings means future earnings won't be affected much.

"If they're not fully reserved, I've got to believe the industry is pretty close," said Nancy Bush, a longtime banking analyst and contributing editor at SNL Financial.

State attorneys general and federal officials have been working on a settlement since allegations that banks improperly handled foreclosure paperwork emerged in the fall of 2010. More than 40 states have signed onto the agreement as of a Monday deadline, but key states, including California and New York, are still holding out.

The core banks involved in the talks are the largest mortgage servicers -- Bank of America Corp, JPMorgan Chase & Co, Wells Fargo & Co, Citigroup Inc and Ally Financial Inc. The U.S. Justice Department has also started to reach out to smaller regional banks about their inclusion in the agreement.

Under the proposed pact, the banks would provide $17 billion in loan modifications for delinquent borrowers; $3 billion in refinancing for homeowners who are current but unable to refinance because they owe more than their homes are worth; and around $1.5 billion in direct payments of up to $2,000 each to borrowers who lost their homes to foreclosure, according to a letter supporting the agreement sent Monday by Delaware banking commissioner Robert Glen.

In addition, participating states will receive a total of $2.5 billion for housing programs. The agreement also requires banks to reform their mortgage servicing practices under supervision of an outside monitor.

The lion's share of the settlement costs to banks would not be cash payments, but accounting entries to reflect the lower values of loans to be modified for borrowers. Many of those markdowns in value likely have been counted already as expenses when the banks added to loan-loss reserves, said Paul Miller, analyst at FBR Capital Markets.

"I don't see it as that big of a hit," Miller said.

BANKS TOOK CHARGES IN FOURTH QUARTER

A number of banks involved in the talks increased their legal reserves in the fourth quarter. These charges likely would cover the cost of payments to homeowners and for state foreclosure prevention programs.

Bank of America last month set aside $1.5 billion for litigation, partly for a possible settlement, while Ally Financial last week took a $270 million charge for penalties that it expects to pay.

JPMorgan's consumer segment booked $1.7 billion in costs in 2011 for mortgage litigation and foreclosure matters, partly for a settlement, the company reported on January 13.

"We should pay for the mistakes we made," JPMorgan Chief Executive Officer Jamie Dimon said in an investor conference call on January 13.

Citigroup said fourth-quarter expenses increased by 4 percent from the third quarter, or $476 million, due to higher legal and related costs driven partly by the mortgage business. Executives didn't comment specifically on the foreclosure settlement. Wells Fargo hasn't said how much it has booked for a possible agreement.

Among smaller banks, PNC Financial Services Group Inc and US Bancorp, reported a total of $370 million in mortgage-related expenses, and SunTrust Banks Inc said it may take a charge.

In addition to upping litigation reserves, banks also have been amassing reserves for losses on residential mortgages, even as they reduce reserves for other types of loans, such as credit cards. As of December, Bank of America, for example, had accrued $5.9 billion to cover residential mortgage losses, equal to 17.6 percent of its mortgage loans, up from $5.1 billion, or 12.1 percent, a year earlier. Setting the money aside hurt past earnings. But it will protect future earnings from bearing the cost of the proposed $25 billion settlement.

Under the settlement, banks will be required to reduce principal owed on some loans owned by the banks themselves. In certain cases they may also modify loans owned by other investors. Loans owned by government-controlled mortgage entities Fannie Mae and Freddie Mac are not covered by the pact.

The reserves set aside for the settlement are likely sequestered in multiple areas within the banks, said SNL's Bush. For example, banks will need to account for lost revenue from reduced interest and principal payments, she said.

"It's not very straight-forward," she said.

ACCOUNTING STANDARDS

Accounting professors Ed Ketz, of Penn State University, and Anthony Catanach, of Villanova University, said that stock analysts are probably right to expect that the banks have already taken out many of the costs when reporting quarterly profits and losses.

While the accounting rules leave a lot of room for judgment in recording expenses for contingencies, in this situation it is unlikely that the banks have dramatically understated the costs, the professors said. The likelihood that the banks would have to pay billions of dollars has been rising for a year in the sight of the public and regulators watching the financial press, the professors said.

"This one is too open to the public -- and there are enough other areas that the public is not aware of -- for them to try to play games with it," said Ketz. "They should at least have booked whatever minimum losses that they expect."

Accounting rules, the professors said, call for companies to apply two tests when deciding whether to go ahead and subtract costs for contingencies from earnings -- whether the expense is probable and, then, whether the amount can be reasonably estimated.

The banks may face criticism that they are getting off lightly in the settlement because they won't be announcing big new hits to profits, said Guy Cecala, publisher of industry publication Inside Mortgage Finance. The settlement also does only so much to compensate borrowers who have already lost their homes, he said.

"Clearly, the regulators caught them doing something wrong," he said, "and now they're trying to get some money out of them to do some proactive good and prevent foreclosures."

Of course, most of the money the banks would use to pay is accounted for already.

(Reporting By Rick Rothacker in Charlotte N.C.; Additional reporting by Aruna Viswanatha in Washington, D.C. Editing by Alwyn Scott and Gerald E. McCormick)