Is A Mortgage Bond Meltdown Imminent?

The above charts show that our mega-banks suffer from higher perceived risk of default, as the market prices of credit protection have soared--in response to the threat to bank capital from MERS Madness and the Robo-signing fraud. Many commentators, however, believe that these scandals pale in comparison to a fast-approaching meltdown in the entire private label mortgage bond market. Essentially, we appear to be on the brink of a flood of claims that the mega-banks simply did not package and sell loans in accordance with their representations and warranties at the time of sale and withheld material information.

Today, the New York Fed announced that they and other major investors are seeking $47 billion from Bank of America for precisely this kind of claim and credit default protection on BOA bonds has now soared to 15 month highs. Chase analysts estimate that the mortgage bond buybacks could cost the banks $120 billion.

But so far, the claims seem to me to be the tip of the iceberg. For example, here is the gist of the claim brought by the FHLB of San Francisco:

In its amended complaints, the Bank is seeking to rescind its purchases of 136 securities in 116 securitization trusts, for which the Bank originally paid more than $19.5 billion.

The amended complaints reflect the Bank's further investigation of specific loans in the 116 trusts. The amended complaints allege, on a trust-by-trust basis, that the defendant dealers made untrue or misleading statements about the loan-to-value ratios of the mortgage loans in the trusts, the percentage of those loans that were secured by the primary residence of the borrower, and the extent to which the originators of those loans departed from their disclosed underwriting standards in making the loans.

Similar suits have been brought by the FHLB of Seattle, the FHLB of Chicago and no doubt many others will emerge. But perhaps the biggest suits will be those arguing that when you sell mortgage-backed securities you need to include mortgages--enforceable mortgages, no less. In other words, the MERS Madness also rears its ugly head here, in the form of yet another basis for investors to pursue claims against the mega-banks. Given that MERS infects 60 percent of all mortgages and that there over two trillion dollars of private label securitizations outstanding it is really hard to imagine that this is only a $120 billion problem. Similarly, the lawyer at ground zero of this particular fiasco states that 50% of all loans tested did not meet the representations and warranties made by the issuer. So the Chase estimate reminds me of the false confidence displayed in the early stages of the last crisis. Perhaps global capitalism will survive, but more than $120 billion in losses will hit bank capital as a result of this meltdown; indeed, BOA may take a $74 billion hit alone.

Now some pundits claim that the US Government will come to the rescue. And, I do not want to underestimate the power of money in politics. But if the Democrats lose control of either House we are facing deep gridlock. There will be no rescue.

Dodd-Frank does authorize Fed and FDIC bailouts. It also authorizes a reasonable Orderly Liquidation Authority. Nevertheless, the bankers defanged the OLA, and the Fed and the FDIC may actually lack the firepower to pull off another bailout without a sentient Congress. This will be a forthcoming blog topic.