Hedge Funds Sniff for Even Bigger Payouts From Banks

One of the biggest bets on Wall Street rests on a theory that also deeply unsettles Wall Street.

The provocative theory is that the big banks have not paid enough in recent legal settlements to make amends for their role in stoking the subprime housing boom and bust. Hedge funds, contending that the banks have so far underpaid, have bought subprime mortgage-backed bonds, which they hope will rise in value. That would happen if Wall Street banks ultimately pay out a lot more money to settle other, more stringent litigation tied to these bonds. And the hedge funds holding the bonds may often be behind these more demanding lawsuits.

The notion that the big banks are getting off lightly in these settlements might seem stretched. After all, in recent months, several large banks have agreed to deals with government authorities and alliances of private investors that carry substantial penalties. The $13 billion that the Justice Department extracted from JPMorgan Chase last year was a record.

Around the same time, JPMorgan entered into a $4.5 billion settlement with a range of prominent investment firms, BlackRock and Pimco among them, over allegations that it packaged mortgages into bonds before the financial crisis that didn’t meet certain agreed-upon standards.

But as large as those penalties appear, some hedge funds believe they may have been too small for the abuses that they say actually took place. After digging deep into the pools of loans that back the bonds, the hedge funds assert that, in the case of certain securities, the banks’ missteps were more widespread than publicized. They argue that the big-name investment firms could have gotten more out of their JPMorgan settlement. To the hedge funds, it is as if an oil producer had to pay compensation only for the most obvious destruction caused by an oil spill, allowing it to escape its liability for large-scale damage that was not immediately obvious.

Now, the hedge funds, sniffing profits, see themselves as the ones to go after the banks for bigger sums. In recent months, the hedge funds have been buying bonds that are the target of lawsuits that typically want bigger payouts than the broad-based private litigation brought on behalf of big companies like Pimco.

If the more exacting lawsuits succeed, and the banks have to plow money into the bonds, the hedge funds stand to make a windfall. And the bond prices could rise merely if investors anticipate legal success, well before any settlement is ever reached.

The overall size of the hedge funds’ bet could be substantial. Nomura estimates that as many as 200 bond deals face lawsuits that aren’t part of the private litigation being brought on behalf of prominent investors. At the time they were issued, those bonds could have had a value of $100 billion to $200 billion. “Those deals are trading very well,” said Paul Nikodem, who is head of residential mortgage-backed securities research at Nomura.

Now, one hedge fund has gone one step further â€" it is trying to coax other investors out of participating in the JPMorgan settlement with private investors, which was brokered by Gibbs & Bruns, a Houston law firm. Fir Tree Partners last week proposed to buy several JPMorgan bond deals from other investors at set prices, asserting that its offer would give the other holders a higher and quicker return than if their bonds were included in the Gibbs & Bruns deal.

For instance, Fir Tree says that its offer for one bond, which contains first mortgages, is equivalent to 7 percent of the losses incurred on the bond, far higher than the 0.75 percent that the hedge fund says is available under the Gibbs & Bruns deal. (The law firm didn’t comment when asked.)

On five of the deals, Fir Tree, either alone or with others, has directed the bonds’ trustees to start litigation against JPMorgan.

Over all, the hedge funds face several challenges, however. Litigation can be costly. It can be difficult to amass the required level of support from other bondholders â€" typically 25 percent of their voting rights â€" to direct the trustee to carry out lawsuits.

And a recent ruling by a New York State appellate court may have made it all but impossible for hedge funds to file new lawsuits on precrisis mortgage bonds. In addition, because of the ruling, some existing legal actions may be thrown out because they were filed too late. (A trustee bank, HSBC, last week filed a motion opposing the ruling.)

The hedge funds may also face an uncomfortable type of counterattack that could complicate their litigation. The banks’ lawyers may question whether a hedge fund trading in litigated mortgage bonds had been unduly influenced by potentially material nonpublic information that the fund gained through the discovery process in their litigation.

Still, the hedge funds say that the numbers are on their side. They contend that the sheer awfulness of the mortgage loans in the bonds gives them a solid chance of victory. Fir Tree, for instance, says that it has been involved in a review of over 40,000 loans. It claims to have found that, in certain bonds, as many as 98 percent of the mortgages had flaws that should have kept them out of the deals.

Because of the deep dives into the loan data, some mortgage bond analysts think the hedge funds’ lawsuits could fare well. “We definitely do think there will be positive resolutions,” Mr. Nikodem, the Nomura analyst, said. “The payouts will likely be higher than for Gibbs & Bruns.”