Financial Crisis 2.0: Could Bad Mortgages Derail the Economy Again?

It's starting to feel a lot like 2008, as new uncertainty begins to plague big banks. But this time, the government might not be able to help.

600 traders 2011-08 REUTERS Lucas Jackson.jpg

Since August 1st, in just six days of trading, the Dow Jones Industrial Average has dropped 1,334 points or 11%. Hiring has slowed, with the past three months averaging just 72,000 jobs created. Economic growth in the first half of 2011 was a measly 0.8% -- far lower than economists had anticipated. Small business sentiment is down for the fifth month straight.

The list goes on, but you probably get the point. The U.S. economy is at a crucial crossroads. If sentiment picks back up, then the recovery may resume. But if another significant shock hits the economy, then a double dip may be inevitable. What's one of the worst possible sort of events that could jar the markets? How about another financial crisis?

The Origins of the "Put-Back" Problem

At this point, seeing a financial crisis as severe as the one in 2008 isn't likely. Banks have stronger capital cushions now than they did then, and a fair amount of the risk has worked its way out of the financial system. But a dangerous problem appears to be brewing that could eventually lead to market panic.

Back in October, investors began to demand that banks buy back mortgage securities that they sold. The investors argued that these institutions made mistakes when putting the mortgage deals together that breached their representations and warranties. As a result, investors sought to put these securities back to the banks that created them.

Of course, these investors wouldn't have been interested in pushing these securities back to their creators if their underlying mortgages were performing well. They weren't. The losses had begun to mount again, since home prices had begun to decline again after the home buyer credit expired. With their illness having returned, these securities turned toxic again and became hot potatoes that investors were trying to throw back to the banks that crafted them.

Why It's a Problem

In order to achieve some remedy, investors sued banks. So for some months, the problem slept. Then, in June a tidy resolution appeared to have been reached. The biggest mortgage originator of them all, thanks in large part to its acquisition of Countrywide, Bank of America agreed to pay $14 billion so that the problem would go away. A bunch of big investors agreed to this settlement. Other banks would likely come to similar settlements, but none as large as Bank of America's.

On Monday, however, we learned that this problem is a stubborn one. AIG is now suing Bank of America for $10 billion. It was not among the large investors content with the June settlement. Separately, last week Bank of America said that Fannie Mae wanted more money, removing the bank's previously estimated $3 billion cap for those losses.

Investors haven't shrugged off Bank of America's problems. In fact, they appear to be deeply concerned. Since July 22nd, in less than 3 weeks, the company's stock price is off 36%. Trading for just $6.51 per share at market close on Monday, the stock was at its lowest price since March 2009.

Financial Crisis 2.0?

AIG also plans to sue other big banks, and additional investors could follow. If the big banks begin to experience similar lawsuits due to mortgages deals that they issued, even on a smaller scale, then the market could begin to panic. Remember, the financial crisis was all about uncertainty over mortgage securities. The put-back fiasco renews precisely that problem.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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