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Big banks still a legal nightmare

October 11, 2012: 12:29 PM ET

Big banks remain targets for lawsuits by federal, state and local regulators. And that makes them risky investments, despite improving fundamentals.

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.

It's been a great year for bank stocks. The KBW Bank Index (BKX) has surged more than 30%, easily outperforming the broader market. And Bank of America (BAC) is up nearly 70%, making it by far the top performer in the Dow Jones Industrial Average (INDU).

At first blush, it makes sense that bank investors are excited. Although merger activity and the IPO market are still relatively sluggish, banks are likely to report solid profits for the third quarter. JPMorgan Chase (JPM) and Wells Fargo (WFC) are both on tap to report their third quarter results Friday morning. Analysts are predicting that each bank will report earnings per share growth of about 20% from a year ago.

The housing market finally seems to be improving. Consumer loan quality appears to be good. Credit card delinquencies are at an 11-year low. Plus, the Federal Reserve and European Central Bank may still be in monetary easing mode by the time Harry Potter's Daniel Radcliffe is old enough to take over for Daniel Craig as James Bond.

So why should investors still be nervous about the big banks? Legal risks remain a dark cloud hovering over the industry. And they are not going away anytime soon.

The Department of Justice's lawsuit against Wells Fargo, a favorite stock of Berkshire Hathaway's (BRKB) Warren Buffett that was long thought to be among the "better" banks out there, is the latest example of how regulators around the world are still looking for (and apparently finding) egregious sins committed by the big banks during the lead-up to and onset of the financial crisis. The DOJ alleges that Wells Fargo fraudulently approved thousands of Federal Housing Administration mortgages from 2002 through 2010. This suit follows similar ones made against Citigroup (C) and Deutsche Bank (DB) earlier this year. Both banks wound up settling charges.

State and local governments are aggressively searching for skeletons in the closet too. Last week, New York's attorney general sued JPMorgan Chase over mortgage-backed securities created by Bear Stearns, which is now owned by JPMorgan Chase. New York attorney general Eric Schneiderman hinted that more lawsuits are coming.

The New York State Department of Financial Services also made waves this summer when it sued British bank Standard Chartered, alleging that the bank laundered money for Iran despite the fact that there are economic sanctions against the nation. In Los Angeles, the city attorney has accused U.S. Bancorp (USB) -- another Buffett favorite that was well regarded among investors as not being like the big Wall Street firms -- of being a slumlord for how the bank has handled foreclosed homes.

Related: Jamie Dimon gets mad at Washington

Across the pond, the crackdown against Barclays (BCS) over the Libor (or is it Lie-bor?) rate-fixing scandal shows that the increased scrutiny of banking behemoths is not a uniquely American phenomenon.

Sure, none of the big banks seem to face the risk that any of these legal headaches will cripple their balance sheets. To their credit, nearly all of the world's major financial institutions are in much better capital shape now than they were four years ago. (Sorry to sound like a campaign ad there.)

But at the very least, the lawsuits are a distraction. The more time that the banks have to spend fighting regulators and considering settlements, the less they have to focus on their core business and operational issues.

More importantly, the fact that banks are still being exposed for their past transgressions increases the chances that there could be even more strict rules put into place by lawmakers around the world. And that could limit future profit growth.

It doesn't mater whether you think governments are going too far to regulate banks. That's a different debate. The fact is that banks still have a big fat target on their backs.

When the Republican candidate for President of the United States accuses his Democratic challenger of giving New York banks the "biggest kiss" he's ever seen, that's as clear a sign as any that large financial firms have to worry. Romney is trying to paint Obama as a friend of Wall Street, which is laughable when you consider how much the big banks have been complaining about the Dodd-Frank reform law.

The big banks are convenient political punching bags. There's little downside to attacking the BofAs, JPMorgans and Citis of the world. What's more, exposing bad behavior at big banks is often a way to generate good press for ambitious litigators with aspirations of higher office. Add all that up and I can envision an environment over the next few years where the big banks remain under constant legal attack. That won't be good news for their earnings or their stocks.

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