Will Washington Let the Mortgage Put-Back Fiasco Escalate?

The mortgage put-back mess is getting more serious. Yesterday, we learned that several major investors demanded that Bank of America buyback mortgage bonds due to its shoddy servicing and process failures. If the bank refuses, the next stop is likely a court. And other banks might soon also be targets of investors. Wall Street is beginning to notice as the securitization market is beginning to seize. Again. Will Washington allow another crisis?

CNBC's NetNet has been on top of this fiasco. Lori Ann LaRocco provides a great interview with portfolio manager David Ellison on the problem. He says that the securitization market is beginning to freeze. And that includes loans other than just mortgages, like those for cars:

There are two parts to this. If you are originating a loan that's going into securitization, that system I think been slowed down dramatically because the banks will need additional stuff and make sure it has to be done right. Non-securitized loans have not been impacted.

So the contagion here is real. Banks, issues, and investors are all more concerned with the securitization process in general. And since so many loans these days depends on the asset-backed market, this will almost certainly have a significant affect on lending.

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Wall Street is beginning to worry because it isn't only private investors demanding repurchase of mortgage bonds. The New York Federal Reserve and Freddie Mac are also part of the group. Federal investigators have also launched a criminal probe. If the government is against the banks on this one, then the market is in serious trouble.

For mortgages, in particular, it would be very serious if Fannie, Freddie, and the Federal Housing Authority (FHA) band together against the banks. They are sold or stand behind somewhere in the ballpark of 90% of mortgages originated at this time. If they demand buybacks in chorus, or even require new procedures before buying or insuring additional mortgages or bonds, then the mortgage market will grind to a halt.

Yet, it's unclear where the government really stands. After all, the Treasury controls Fannie, Freddie, and the FHA, while the Federal Reserve System on a whole could have some influence over the NY Fed. If the Treasury and Fed are okay with these buyback demands, then it's hard to see how a crisis could be averted.

But it's also hard to imagine that the Treasury and Fed would allow that to happen. They worked very hard over the past few years to stabilize the financial system. And they took very controversial measures to do so then, so they would likely consider additional unpopular methods to do so again. The Treasury could promise the mortgage agencies more capital to cover losses to eliminate the need for buybacks. The Federal Reserve could even restart its Term Asset-Backed Securities Loan Facility (TALF) program as a part its widely expected new asset purchase plan to ensure that non-mortgage loans will obtain funding if investors blink.

Of course, such measures will be terribly unpopular -- possibly even more unpopular than the bailout was. At least with the bailout, there wasn't clear wrongdoing on the part of banks. They were able to claim that borrowers took on mortgages they couldn't afford and the financial industry was a victim of fear and panic. This crisis would be the direct result of sloppy work that appears to show much clearer negligence.

With an election just a few weeks away, Democrats have to be praying that this mess doesn't escalate quickly to require Treasury involvement. It's a no-win situation politically. Providing aid to the banks will certainly anger voters, while doing nothing could cause a renewed financial crisis as credit dries up.