Livinglies's Weblog

I’m surprised it has taken this long for Mr. Market to wake up and smell the coffee.

Major bank suspending foreclosures in a whole passel of states, overwhelming evidence of fraud on courts (commemorated in sworn testimony), and increasing evidence that these developments are mere symptoms of much deeper problems had been spun by the banks and its Team Obama enablers as mere “technical” or “paperwork” problems.

It’s taken analysts a bit of time to start taking a stab at what this might mean for banks. The Wall Street Journal, New York Times, and Financial Times all have prominent, alarmed articles tonight on the decline in bank stocks and residential mortgage bonds.

The funny bit is that the analysts whose reports stirred so much alarm really don’t have a good grip yet on the nature of the liability (as in you need to understand what units with the bank are vulnerable due to their involvement with this mess and what their exposure might be). A Washington Post piece gives a more candid comment on the lack of a decent understanding of the wider ramifications:

It is not yet clear what the consequences would be if large quantities of mortgage-backed securities turn out to be defective – or how the trouble could be solved.

“If the basic principles of property law have been violated here . . . it may be extremely difficult to fix,” said a source involved in government oversight of financial institutions, who spoke on condition of anonymity because of the uncertainties involved. “There is a chain of questions that no one seems to know the answer to.”

We’ve been poking at this story since early in the year, more intensively since May, and even with persistent effort and good contacts to people in a position to give good readings on the legal and procedural issues, there are still a lot of unknowns, simply because the real estate market is fragmented and practices varied. But what has been striking the deeper we have dug into this morass is that on almost every matter of fact (as in how exactly did the banks handle the notes, which is the borrower IOU), the answers are coming in consistent with worse case scenarios. I continue to be gobsmacked at the flagrant disregard by large numbers of securitization industry participants for adherence to their own contracts and legal procedures necessary to protect their clients and ultimately, their organizations.

Ah, but I forget, a banker’s primary loyalty is to his own paycheck.

With that as background, the analyst reports that caused a bit of frisson on Thursday are actually pretty tame, in that they are putting more realistic numbers on known issues but have not yet made a serious reading of the implications of the escalating foreclosure mess and the much bigger issues it raises of the failures to convey residential mortgage loans properly to the securitization trusts.

The sighting that caused the big alarm focused on a longer-standing but not widely recognized process, namely, that Freddie and Fannie have been putting back mortgage backed securities to due to purported problems with the loans as originated. The report by Manal Mehta Branch Hill which was released in August but got heightened attention today, includes some pretty dubious analysis. For instance, it seems remarkably unaware of the fact that the suits filed by some monolines are called “rep and warranty” suits, in that they allege that the defendant made inaccurate representations and that those in turn led to investor losses. Gee, the banks sold subprime crap, it blew up, surely the monolines have a case, right?

Um, not so easy. The banks did say these were not such great loans. So the legal question is two part: to what extent were the loans worse than specified, and to what extent did those shortcomings produce losses.

So guess what? The second part gets argued on a loan by loan basis. No joke. The plaintiff has to establish that loans failed because they were crappier than promised, as opposed to, say, bad luck (the economy went to hell and a lot of people lost their jobs). Proving why a borrower defaulted is not trivial. Therefore these cases do not generate large settlements.

And amusingly, the presentation lists Assured Guaranty as a potential beneficiary of litigation related to putbacks (see page 4). Guess what? Assured hasn’t even filed a lawsuit. Kinda hard to win the lottery if you haven’t bought a ticket.

Having said that, Chris Whalen for some time has flagged putbacks by Fannie and Freddie to the major banks as a continuing drain on bank earnings.

But the banking industry is still in denial about the severity of its new headache, the foreclosure mess, from a legal and therefore monetary perspective. The battle lines are pretty clearly drawn. On the one hand, you have the industry apologists, as represented by the Wall Street Journal and some websites that I normally respect, such as Housing Wire, but in this case are taking up industry talking points verbatim.

A good piece by Max Abelson of the New York Observer discussed the yawning cultural divide:

A former member of the Goldman Sachs management committee was not so sure. “Don’t you think, out of 10 million data points, there will be 500 unbelievably screwy examples? It’s a little bit so what,” he said on Tuesday. “I don’t get it. It doesn’t feel like this is fraud. Maybe there is sloppiness, but at the end of the day, people took out mortgages they can’t pay back. Now I worry that if anything, the government is making something that is just a clerical error into something that would be nefarious or whatever.”

Yves here. We keep coming back to the “my dog ate your mortgage” excuse. It’s “sloppiness” or “error” (better yet, “clerical error”, those Masters of the Universe never got close to the operational stuff to be accountable, right?). And now the defenders will ‘fess up that there were abuses, but really it was very few people, so what’s the fuss? After all, as Reuters argues in an article that reads like dictation from the banks’ communications department, the borrowers were all deadbeats anyhow.

It has hit the point that the increasingly disconnected financiers are getting told they are way off base as far as little niceties like the rule of law, not by the usual pro-borrower sorts, but the Financial Times, in its editorial yesterday “Wall Street’s bad behaviour redux” (hat tip Richard Smith):

The growing scandal over the improper, and perhaps fraudulent, foreclosures on homes by US banks is becoming both a financial and a political hot potato. Wall Street is being forced to admit to yet more unsavoury practices linked to mortgage bonds….

The banks and their defenders mutter that this is all a bureaucratic technicality and much ado about nothing. Almost all the borrowers had defaulted on their mortgages, they point out, and the problem is simply of the paperwork being improperly prepared, which can be corrected.

They are wrong, and the fact that they regard court proceedings to repossess homes so lightly is a worrying reflection on Wall Street’s ethical standards, or lack of them. At worst, the banks may have been lying to courts over a vital safeguard in property law – the sanctity of documents.

This scandal is a mirror image of the lax and often improper lending practices that grew up in the years before the 2008 financial crisis as Wall Street raced to extend mortgages in order to have fodder for asset-backed securities. They never took seriously the importance of lending soundly and thoughtfully to homeowners.

In a sad bit of synchronicity, the World Justice Project published its Rule of Law index this week, and the US showed dismal rankings:

The world-wide study examined how nations implement and enforce its laws for ordinary citizens. And more importantly, whether the poor have equal access to civil justice remedies that are available to the wealthy. How did the U.S. measure up? Not good. The exorbitant costs of lawyers and limited access to civil justice placed the greatest country on earth at number 20 out of all 35 countries surveyed. The countries of Mexico, Croatia and the Dominican Republic treat their poor and disenfranchised better than we do when it comes to civil justice.

And a more pointed take came in comments from reader ABSGuy:

This has the makings of a mess of monumental proportions.

Back in 2007 when the ABX (the subprime MBS index) had fallen a few points, the Street came out in force saying this was a gross over-reaction. Losses would never be more than a few percentage points. Buyers of protection (like myself) were pooh-poohed as hysterical nut-jobs. Within a few months the ABX had dropped by a third, on its way to 40, and a short time later the entire banking system was on life support.

The lack of a perfected security interest in the mortgage loans on the part of the securitization trust (if true) is a very, very big deal. The requirements for the conveyance of mortgages is well-established, “black-letter” law. Anyone who says this is a “technical” problem is uniformed or lying.

The press accounts of analyst efforts to dimension the potential costs to banks of this escalating crisis, as we indicated, so far look way too light, but are completely in keeping with the “nothing to see here” party line. For instance, consider this take via the New York Times:

“I don’t see how it can be cleared up in a short period of time,” said Richard X. Bove, an analyst with Rochdale Securities. “The moratorium won’t last that long but the problem will last at least four or five years, maybe a decade.” In the short term, he said, “it could easily cost $1.5 billion per quarter.”

Yves here. Um, what do we consider “the problem” to be? If the trusts don’t have the standing to foreclose, the RMBS are at best unsecured paper (this may seem awfully counterintuitive, and lawyers might find this recap a bit imprecise, but a party has to have its rights perfected to a fairly high degree to be in a position to foreclose; a lesser degree of perfection of rights, as in showing clear intent but not completing the stipulated steps in full, may be deemed to pass muster by a lot of courts as far as the ongoing monthly mortgage payments are concerned). That alone will kick off the mother of all litigation, with the bank trustees as the biggest targets.

Just consider one element of collateral damage: second mortgages. The most likely resolution of this thorny situation is cramdowns or mass mods (which is an outcome most investors would prefer; better to take a 40% to 50% loss on a mod than a 70% loss on a foreclosure). That means seconds, which the four biggest banks are carrying at 80% to 90% of face value, will be wiped out. These are roughly $400 billion in total.

And if you think that is bad, consider what happens when investors who bought RMBS as secured paper and learn it to be something else start taking aim at the banks.

But the estimates thus far are almost entirely well below quite conceivable outcomes. For instance, Bloomberg notes:

Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia, raised his estimate for the cost of litigation and delays to banks to $10 billion yesterday from $6 billion…..

The New York Times did mention that this estimate excluded costs due to abusive foreclosure proceedings, which Miller put at an additional $3 to $4 billion.

One Bloomberg source does come up with big numbers, but then discounts it as very unlikely:

Wide-scale principal reductions may lead to “huge losses” for banks, said James Ellman, a former Merrill Lynch & Co. bank- stock portfolio manager who is now president of San Francisco- based hedge fund Seacliff Capital.

“You could potentially be talking about hundreds of billions of dollars in losses,” Ellman said. “Though it is a low probability, banks would have to go back to the capital markets for more capital.”

The credit default swaps market is starting to take note. Widening spreads indicate worries about funding stress and ultimately viability. Bloomberg again:

Credit-default swaps on Bank of America widened to 193 basis points, on pace for the biggest weekly rise since June 2009, according to data provider CMA. Contracts on JPMorgan are headed for their biggest weekly increase since May, to 92 basis points, and those on San Francisco-based Wells Fargo increased the most in a weekly period since June 2009, to 131 basis points, CMA data show.

We have focused on possible civil action, but more and more people are calling for criminal prosecutions, and those demands are likely to get more traction as this crisis drags on. Alan Grayson has asked the FBI and the US attorney to investigate possible criminal activities by banks operating in Florida. And the attitude presented by the Financial Times is likely to win out:

The correct approach is for states to hold banks to account, and show them that their slapdash and contemptuous approach to their legal responsibilities is unacceptable.

We can only hope we have enough of an independent judiciary left in this country to bring these miscreants to heel.