Foreclosure-Gate's Doomsday Scenario

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.

Rosner imagines this leading to a Lehman-type weekend, where the financial industry again nears collapse. That might be a little melodramatic, but it isn't impossible. If these investors have the legal standing that Rosner thinks, they would be sort of crazy not to force banks to take back these bad deals. After all, it's better for the investors that they force these losses back to the banks who wrote the mortgages.

If this problem turns out to be real, and the worst-case scenario that Rosner imagines come to be, then it's hard to see how the government could fix it simply without tramping over contract law. Instead, more aggressive approached would be required.

For example, it could recapitalize the banks through a sort of TARP II so they could afford to repurchases these bonds. Another possibility might be to get Fannie and Freddie involved and having them buy the MBS from these investors instead, which would cause the GSEs to incur more big losses. Finally, the Fed could get involved, perhaps by purchasing those MBS as part of a new quantitative easing effort -- a sort of two-birds with one stone approach. Of course, losses would again likely result -- this time for the Fed. In all scenarios, taxpayers would ultimately suffer.

For more of the technical aspects of this problem, check out this article at Bloomberg and this post at Naked Capitalism.