The City of Baltimore and Wells Fargo (WFC) are engaged in a legal fight over who's to blame for the city's foreclosure problem. The row highlights the broadening search for guilty parties in the collapse of the mortgage industry.

MortgageDaily.com reports Baltimore has filed a lawsuit alleging the San Francisco-based bank is responsible for "tens of millions of dollars" in lost tax revenues. During the past seven years, Wells Fargo accounted for 313 of the 33,000 foreclosures filed in Baltimore. The city claims Wells intentionally marketed predatory loans to minorities, many of which ended up in foreclosure.

As a result of the increased foreclosure activity, Baltimore lost tax revenues, incurred property maintenance costs and had to boost police and fire protection in the affected areas. Despite the relatively small share total foreclosures, the city claims Wells should shoulder part of the burden.

For its part, Wells Fargo dismissed the claim as unfounded. It also countered with the assertion that the city is responsible for its own troubles, largely stemming from its policy of assessing liens for unpaid utility bills. The city sold the tax liens to investors, who then forced borrowers to pay exorbitant fees to keep their homes. In its motion, the bank said homeowners were forced into foreclosure for unpaid water bills as low as $272.

States and municipalities are stepping up legal proceedings, looking to recoup cash and punish lenders that may have been involved in predatory lending. The State of Massachusetts just filed a similar lawsuit against Option One Mortgage Corporation, a subsidiary of H&R Block (HRB).

Many of the court cases focus on the effect of predatory lending on minority communities. Plaintiffs assert that lenders targeted minorities for loans with higher interest rates than comparable white borrowers. Such discrimination lawsuits have ensnared many of the country's biggest lenders, including Wells Fargo, Option One and Countrywide (CFC). The lenders vehemently deny any wrongdoing.

The lawsuit parade in the aftermath of reckless subprime lending has only just begun. In January of 2006, privately held Ameriquest Mortgage coughed up $325 million to resolve a predatory lending class action lawsuit. Despite the settlement, the company denied the allegations.

Although much of the focus on mortgage-related losses is centered on delinquencies stemming from adjustable rate resets and eroding economic conditions, the potential for massive class action lawsuits could further impede the industry's recovery efforts.

The storm brewing on the horizon is in the form of Option Adjustable Rate Mortgages, or Option ARMs. These loans allow borrowers to choose from a variety of interest payments, some of which result in negative amortization (see number five).

Complicated loan terms were in many cases not fully explained, and falling home values are exacerbating borrowers' already precarious position. Impending rate resets (see chart below, courtesy of Credit Suisse) will set off another wave of delinquencies. Borrowers -- and their attorneys -- will demand retribution.


Click to enlarge image

It's no coincidence that the biggest issuers of these loans, Countrywide, Bear Stearns (BSC) and Washington Mutual (WM), have suffered the most during the mortgage crisis. Wachovia (WB) is also in the hot seat, as its ill-timed and now well publicized purchase of Golden West saddled the Charlotte-based bank with over $100 billion in Option ARMs. 60% of that portfolio is located in California, where property values are falling precipitously.

Future litigation will shape the regulatory response to the mortgage crisis. State authorities are already clamping down on the previously unregulated mortgage brokers and other small originators. Tighter restrictions will thwart some of the predatory practices prevalent during the boom, but they will also increase borrowing costs.

Mortgage industry professionals counter that overly restrictive regulations will lock out borrowers with mediocre credit. Faced with a web of rules and potential legal liabilities, banks just won't lend to anyone on the fringe of traditional loan qualifications.

Lenders need to be held accountable for their transgressions, especially if it can be proven they unfairly discriminated on the basis of race. Regulators will overreact, as they're apt to do. Despite its best efforts to rationalize away the need for tighter lending requirements, the mortgage business will feel the pain from its excesses for longer than many would like to believe.
 

Want top traders to sit at your desk and share their insight and ideas?
Minyanville's Buzz and Banter- 14 day FREE trial