On September 2, the Federal Housing and Finance Authority (FHFA) sued 17 companies over sales of toxic mortgage-backed securities to Fannie Mae and Freddie Mac. Among those named in the suit were many of the country’s largest banks, including Bank of America, JP Morgan Chase, CitiGroup, and Morgan Stanley.

The suit does not currently request a specific amount of money in damages, but according to the Associated Press, Fannie and Freddie bought $196 billion worth of toxic securities during the housing boom. Here’s a closer look at the suit and what might happen.

FHFA: Financial Firms Broke State & Federal Laws

One of the suit’s allegations is that the financial firms violated federal and state laws by selling the securities to Fannie Mae and Freddie Mac, two government-sponsored companies that help make mortgages more affordable to Americans. Specifically, the lawsuit claims that the banks and other lenders:

• Sold mortgage-backed securities that had “materially false or misleading” statements and omissions of critical information;
• Falsely indicated that the mortgages met legal underwriting guidelines and were all thoroughly reviewed; and
• Substantially overstated borrowers’ ability to make mortgage payments on their loans.

At its core, the lawsuit claims that the 17 sellers lied to Fannie Mae and Freddie Mac to get them to buy loans that they knew were toxic, yet sold them as low-risk to the government agencies.

Housing Market Bubble, Burst & Fallout

The housing boom allowed millions of Americans to get mortgage loans. Many of those loans were sub-prime, had adjustable rates or were ultimately unaffordable to the borrowers. When interest rates reset a few years after the loans were originated, many borrowers were unable to make payments and defaulted.

While those borrowers faced the problem of foreclosure and perhaps filed for bankruptcy to help ease their debt burden, they were not the only ones affected by their inability to pay.

Investors that bought their mortgages (often after the loans were pooled and sold off in sections in a process called “securitization”) stopped earning money on their investments. Because Fannie and Freddie were big investors, they stood to lose a lot of cash – which put into question their ability to continue supporting the U.S. housing market by buying mortgage debt.

The FHFA (which oversees Fannie and Freddie) is taking legal action in part because of the devastating financial consequences the two companies faced. In July 2008, the federal government had to take action to make sure the two enterprises didn’t fail because, at the time, they guaranteed or owned about half of the residential mortgages in the U.S. (worth about $6 trillion).

Theoretically, the lawsuit could help recover losses that Fannie and Freddie suffered from the collapse of the housing bubble. It might also serve as a warning and/or deterrent to other financial institutions and could prompt legislative change to regulate how residential mortgages are originated, securitized and sold.

The lawsuit was filed in New York and Connecticut.