The Greatest Election Issue Never Discussed: What to do with Insolvent Megabanks?

The above chart shows that Bank of America stock swooned in mid-October after getting hammered over the last six months. The stock (like the entire megabank sector) woefully underperformed the market as whole, particularly recently. As the news of the banks' reckless practices slowly seeps into the marketplace, expect more price declines and eventually an overall market reaction to the expected losses that could prove violent and dramatic.

Indeed, after looking at the intensifying trouble in the mortgage market, after ruminating on the Robo-signing scandal, after reflecting on MERS Madness, after looking at the possibility of a mortgage bond meltdown, and, after recovering from the shock of lost and destroyed notes, I conclude that the market vastly underestimates the trouble ahead. While some analysts and economists certainly see the gravity of the problem, for the most part a full reckoning of costs is now impossible, particularly without in-depth legal analysis. Thus, the financial markets remain in deep denial. And, the banks insist that all (or nearly all) is well. Which banks will suffer what losses is not known; still, large losses to the system as a whole are virtually certain.

Let me be clear: this foreclosure fiasco is fundamentally a legal problem. The law must finally be followed with respect to bank misconduct and if it is followed here the banks will take massive (but ultimately unknowable) hits to their capital. In fact, just today the Florida court of appeals ruled (in a rather pedestrian application of the law) that a bank must produce the original note before a court may order a foreclosure as required under the UCC. The Attorney General of the District of Columbia has issued an interpretive release under DC law that appears to prohibit foreclosures in the name of MERS. The Maryland courts recently revised foreclosure rules to clarify that fraudulent affidavits can no longer support a foreclosure and instead the foreclosing bank bears the burden of demonstrating the authenticity of documents supporting foreclosure. Meanwhile, investors continue to organize and retain counsel to press rights for put-backs to banks of defective MBS.

All of this means the banks' jig is up. They are not going to be able to steamroll courts into wrongful foreclosures. Thus, hopefully the law can now function to prevent the kinds of travesties of justice that are now manifest. The banks need to put up or shut up: stop soft-peddling the huge mistakes that have been made and start producing legally enforceable notes and mortgages under law.

This is what a well-functioning rule of law looks like. It means that legal rights and remedies are enforceable even against the most economically powerful in a given society--like the megabanks. It means that even megabanks cannot achieve judicial remedies through pervasive fraud. Even megabanks must show they are entitled to foreclosure before seizing homes.

We should now expect the bank apologists to claim the banks need special exemptions from the rule of law and competitive markets. That somehow we need the megabanks to strangle our economy and hoard capital. They will claim we again have no choice but to bailout the megabanks and permit them to continue to pay megabonuses to their senior managers. The greatest risk to our economy right now is the continued control of the reckless bankers over far too vast a hoard of precious capital.

Do not believe for a moment that bailing out the senior managers is needed. As I will explain in my next post, it is time to fire up the Dodd-Frank Orderly Liquidation Authority to take down these megabanks through receivership, shatter them into 10,000 pieces and terminate the reckless managers--and in appropriate cases sue managers for gross negligence. That will restore proper incentives and end the infinite recklessness at the apex of our economy. And it vindicates the rule of law--finally.

The decision to apply the full force of the law is the greatest economic decision now facing the nation. It will determine the course of our economy for years to come. Unfortunately this issue remains completely unaddressed in this election.