Banks and the N Word (Updated)

I must say I am becoming increasingly concerned about the unfolding story of slipshod, sloppy, and, possibly, fraudulent practices in the processing of foreclosures that is being referred to by some as “foreclosure gate”. Dan Indiviglio at The Atlantic explains the worst-case scenario:

Basically, when creating a MBS [ed. mortgage-backed security], 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.

What might be the outcome?

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.

Consider:

• Hiring unskilled and untrained “robo-signers” to authorize foreclosure documents almost certainly constitutes a pattern of behavior.
• The practices being reported, to the extent that they are related to MBS, certainly sound like securities fraud to me.
• Many if not most of the institutions involved are publicly traded companies. Ignorance of the state of affairs on the part of top management would be no excuse.
• The behavior that is being alleged to have taken place took place after the near-meltdown of the financial system beginning in 2007.

In short following a near-death experience the banks apparently carried right alone with exceedingly risky or outright illegal behaviors. Could there be stronger proof positive of the moral hazard that was created in the actions taken by the federal government from 2007 through the present?

If yet another bailout is required, the banks will have demonstrated that they are incapable of looking after their own affairs properly. As the New York Times says in its editorial on the mess this morning:

The banks that got us into this mess can’t be trusted to get us out of it.

And to quote a Swedish bank official in 1992 at the time of Sweden’s financial crisis “the public will not support a plan if you leave the former shareholders with anything#148;.

The “N word” of my title is nationalization. If the foreclosure mess induces another federal bailout of banks, that won’t be nearly enough. The banks should be nationalized and handled as Sweden handled its banks. Sweden now has a private, reasonably stable banking system. This contrasts with Japan, whose model we have largely been emulating. Further, where applicable civil and criminal prosecutions should take place under Sarbanes-Oxley and the Racketeer Influenced and Corrupt Organizations Act. Incompetents and miscreants should not be allowed to abscond with the proceeds of their misdeeds.

Update

Tigerhawk wonders where the heck the auditors were in all of this and points to the entire fiasco as proof that Sarbanes-Oxley is not only ineffective but counter-productive. I am as unhappy with Sarb-Ox as the next guy but we’re going to need to prosecute a few more CEOs to encourage the others. Clealry, saving their rear-ends isn’t cutting it.

Update 2

Megan McArdle articulates some of my concerns:

Take the investors in these mortgage bonds. Most of these securities have clauses that allow investors to force the banks to take back loans in the case of fraud. When did the fraud start? You can expect to see that extensively legislated [ed. I presume she means “litigated” here]–and I doubt that many of the originators have the capital to withstand a mass wave of such loan repatriations, especially since you can expect that they’ll only be forced to take the bad ones. This is going to be an expensive mess for the courts to sort out, could lead to another wave of bank failures, and doesn’t have any obvious legislative fix.

I have seen estimates of Bank of America alone’s exposure in this arena as being from tens of billions to hundreds of billions of dollars. Combine this with the amounts that the other large banks may be on the hook for and you’re starting to talk about real money.

Update 3

Barry Ritholtz outlines the problems that the foreclosure mess reveals. Here are his remarks in bullet form without elaboration.

1. Errors in Securitization
2. Securitization Warranties
3. MERS
4. Assembly Line Financial Services
5. Regulatory Oversight
6. Selling REOs & Foreclosed Properties
7. Government Ownership of Banks Is Bad
8. Bailouts Are Bad

to which I would add that the uncertainty that’s being produced will further depress spending at least at the margins. Do read the whole thing.