The documentation problems surrounding mortgages originated during the housing boom just get uglier and uglier. One of the most recently surfaced worries is also one of the most serious. Bank analyst Josh Rosner envisions a doomsday scenario where banks would have to stand behind most private label mortgage-backed securities (MBS) that they had believed they had no exposure to. This would be disastrous.
The background here gets complicated, so I'll try to simplify. Basically, when creating a MBS, the bank who originally provides the mortgages to borrowers sells those mortgages to a trust through a legal process called a "true sale." The trust then sells bonds to investors, which are secured by those mortgages. Due to sloppiness, that true sale may never have been legally executed in most cases.
Why is this so bad? The investors who hold that MBS might be able to claim that the bonds they hold were not created properly, contracts were breached, and the bank that originated the mortgages needs to buy back the bonds. This, of course, would require many billions of dollars in capital in excess of that banks have lying around. And remember these aren't pretty bonds. They are mostly toxic and full of losses. Those losses would then be passed on to the banks.