Bank of America’s legal loss could spell doom for other banks

October 25, 2013, 1:00 PM UTC

FORTUNE — Bank of America’s great mortgage “Hustle” opens a legal can of worms, which could have dangerous consequences for the rest of Wall Street.

A jury late Tuesday found Bank of America’s Countrywide mortgage lending unit liable for fraud in selling the government bad mortgages under a scheme known internally as “The Hustle.” This marks the first time the courts have found a bank liable for wrongdoing in connection with a deal done in the lead-up to the financial crisis.

But the significant development here is not the fact that the government won, but how it won. Government attorneys successfully used a controversial interpretation of an obscure law to gain a victory against Bank of America (BAC). Armed with this new piece of legal weaponry, there is concern on the Street that the government could lay waste to basically any financial institution that had anything to do with trading mortgage securities going back as far as a decade.

The government has launched dozens of lawsuits against Wall Street in the last two years due to shenanigans involving residential mortgage backed securities (RMBS), but few have actually made it to court. They were either dismissed on some legal technicality, or the banks settled before trial. Citigroup (C) and Deutsche Bank (DB) were amongst those accused of wrongdoing that decided to settle right away, costing them $158 million and $202 million, respectively.

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Bank of America, though, stood its ground when the government accused its Countrywide mortgage lending unit of gross misconduct in the lead-up to the financial crisis. In a nutshell, the government alleged that Countrywide, through an internal program nicknamed “The Hustle,” made “disastrously” bad mortgages, which it then sold to Freddie Mac and Fannie Mae. The government, which took over Freddie and Fannie at the height of the financial crisis, claimed it suffered a gross loss of $850 million, while Countrywide earned $165 million.

The interesting thing here is that the government chose to sue BofA under The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). The act allows the Justice Department to bring civil proceedings against individuals or institutions who committed banking crimes against the government or a federally insured entity (a bank).

Being a civil proceeding, the burden of proof the government had to meet to win the case was much easier to achieve, as it only needed to prove guilt by a “preponderance of the evidence” as opposed to “beyond a reasonable doubt,” which is used in criminal proceedings. That means that only 50% of the evidence needs to point to fraud to gain a conviction. The act also gives the government more time to bring an action by doubling the statute of limitations needed to file a case from five to 10 years. That’s important because many of the actions that led to the mortgage meltdown occurred more than five years ago, from 2003 to 2007.

In winning its case, the government successfully argued under FIRREA that Countrywide’s “Hustle” program harmed both the government (Freddie and Fannie) as well as Bank of America (a federally insured entity) and thus was liable for civil fraud. No, that wasn’t a typo. The government argued effectively in court that one of the victims of the fraud was also the perpetrator of the fraud.

This interpretation therefore means that the government can use FIRREA to sue a bank for fraud even if the only victim is itself. That sounds very odd, but in a large organization, such as a multinational bank with dozens of businesses spread throughout the globe, it is entirely possible.

A spokesman for Bank of America said that the bank was evaluating its options to file an appeal. For now, the bank is waiting to hear what, if any, damages it might have to pay in connection with the fraud.

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Armed with FIRREA, the government could now potentially go after any financial institution that was involved in the RMBS market going back as far as 2003. That stretch of time covers the entire mortgage debacle and puts basically all of Wall Street within the government’s sights. It isn’t just the banks that should be worried; the government has even threatened to use FIRREA against Standard & Poor’s (MHFI), the ratings agency. In that case, the government alleges that S&P, which doesn’t trade but rates RMBS, knowingly issued triple-A ratings to securities it knew were garbage. The government is looking for $5 billion in restitution, a fantastically large sum. If S&P falls to FIRREA, then its rivals Moody’s (MCO) and Fitch should also expect to find themselves in front of a government firing squad.

So what is the endgame here for the government? If the goal is to achieve some sort of justice for the losses incurred by Fannie and Freddie during the crisis, then Wall Street is in deep trouble. From the third quarter of 2008, the Federal Housing Finance Agency (FHFA) has requested over $187 billion to fill the holes in Freddie and Fannie’s tattered balance sheets. If the government tries to regain even half that amount, then one can expect multiple lawsuits to be filed against banks and other financial institutions for years to come.

Now that prosecutors have won their first case under FIRREA, financial institutions may be more inclined to settle with the government than go to trial. That may explain why J.P. Morgan (JPM) reportedly settled with the government last Friday for the whopping figure of $13 billion. The bank may have settled claims going back as far as a decade on concern that the government would come after it later using FIRREA. Meanwhile, those banks that are determined to go to trial, like Wells Fargo (WFC), may rethink that position and choose to settle than deal with a potential FIRREA onslaught.

But by settling, banks would have to claim fault, which would open themselves up to an equally lethal barrage of civil suits from investors. Large asset managers could team up and go after the banks themselves. This could wipe out a bank’s litigation reserve and threaten its capital base. J.P. Morgan is reportedly trying to head off that fate by settling with institutional investors in advance for around $6 billion. If it is successful, the deal may become a useful template other banks could use to make things right with their clients. That means that even if a bank has already settled its RMBS issues with the government, like Citi and Deutsche, it may now have to open its wallet again to pay off institutional investors as well.