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.

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.

Banks cannot hope for the best from litigation here, because courts need to decide the issue on a mortgage-by-mortgage basis. We're talking about millions of mortgages affected, so it's simply not feasible to endure those legal costs. That's why you'll see them settle. But how much will each investor demand from each bank?

You can see how much uncertainty the market might have to deal with here. Will some banks become insolvent? Will investors withdraw funding if they're worried about the magnitude of losses they could incur? If one giant bank fails will it bring down the rest of the sector with it?

In one sense, the problem here could be even more dangerous than before, because we have absolutely no idea what role the government can play. Supposedly, it cannot bail out an institution, due to last summer's financial regulation bill. Even if a bailout is legally permissible, you can bet that the divided Congress with a staunch no-bailouts-under-any-circumstance contingent won't let that happen.

Instead, the Federal Deposit Insurance Corporation will attempt to wind down big banks on the brink of failure. For all we know, it could be making mulling whether to begin its work with Bank of America right now. Will this process really work as well as the regulator hopes or will it cause a huge disruption in the markets and exacerbate the panic?

A Missed Opportunity in 2008

In fact, this entire problem is just a continuation of the toxic mortgage security disaster that led to the first financial crisis. At that time, Treasury Secretary Hank Paulson conceived of a bailout plan through which the Treasury would purchase troubled mortgage securities to sort of suck the poison out of the financial system. Unfortunately, the former CEO of Goldman Sachs couldn't figure out a way to implement this strategy quickly enough to respond to the growing crisis. So instead, he threw money at the banks until the market relaxed, assuming that the government wouldn't let any fail.

But if he had managed to get these mortgage securities off of the balance sheets of banks and investors, then we might not be worrying about this problem right now. Instead, the government would own the bulk of these securities and probably wouldn't be going after the banks so aggressively to cover its losses. After all, the entire purpose of a bailout is to rescue banks, not try to squeeze as much money out of them as possible.

Instead, these toxic securities continue to plague the financial system. And now that their disease is back, with home prices continuing to give way, investors are trying to push them back to the banks. If the market can't come to a quick, tidy solution itself over the next couple of months to end this problem for good, then the government may have to intervene again -- if it can.

Image Credit: REUTERS/Lucas Jackson