Halloween is right around the corner. So it’s only appropriate that — just like some bad horror movie character — the mortgage monster keeps coming back to haunt bankers. Indeed, major financial institutions like Bank of America got pummeled this week amid fear of even MORE losses tied to the mortgage debacle.

What’s at stake? How will this impact the markets? Why do these home loan zombies refuse to die?

Take my hand and I’ll escort you through the graveyard …

Sloppy Work, Securitization Boom
Leads to Mortgage Questions

Right now, two major issues are plaguing the banking industry. The first stems from just plain sloppy work and the securitization boom.

You see, the mortgage system that evolved in the 1980s, 1990s, and 2000s is a lot different from the one you see in the movie “It’s a Wonderful Life.” There’s no Bailey Building and Loan Association giving you a mortgage, then holding it in its portfolio for 30 years while you slowly pay it off.

Instead, borrowers typically get loans from mortgage brokers or banks. Those parties turn around and flip those loans to larger institutions. And those institutions package those loans together into mortgage backed securities (MBS), which are then bought by pension funds, mutual funds, and other big money investors. They get the cash flows from your monthly mortgage payments.

Bottom line: The “securitization” process is the means by which lenders raise money to give you and I mortgage loans. It started off slowly many years ago. But at the height of the housing boom, hundreds of billions of dollars of loans were funded this way.

As business ramped up, lenders realized they needed to come up with an easier way to facilitate the transfer and processing of loans. Their solution? Mortgage Electronic Registration Systems or MERS. It acts as an agent for the companies that own the underlying loan. Parties can also use the MERS system to track the transfer of interests in that loan between parties.

So what’s the problem? Many attorneys are now challenging foreclosures on the grounds that MERS doesn’t have the right to do what it does. Without getting bogged down in all the nitty-gritty details, suffice it to say that some people are claiming that mortgages may actually be invalidated because of sloppy work by banks or legal technicalities involving MERS. Others are claiming that even lenders who didn’t use MERS failed to properly establish a paper trail that puts them in position to foreclose.

My take? There is no way that state courts are going to start willy-nilly invalidating loans. Or that the federal government and the banking industry will just sit by as the whole multi-trillion dollar lending and borrowing business is basically declared illegal because of technicalities involving paperwork.

Fines will be paid. Some cases will be lost here and there. It’ll be like Congress passed the “Full Employment Act for Lawyers of 2010.” But a collapse in the mortgage market stemming from MERS or other sloppy paperwork errors? Not likely.

“Put Backs”: The Real Ghoulish Problem
Plaguing the Banking Industry

No, the REAL ghoulish mortgage problem plaguing the banking industry is “put backs.” They have bank investors quaking in their boots.

Here’s the crux of the issue: Lenders that bundle loans into MBS make certain representations and warranties about those loans. They might say that no more than 30 percent of the loans in a given pool are to non-owner occupants (think real estate investors rather than traditional homeowners). Or they’ll tell investors that the average debt-to-income ratio of the borrowers in the loan pool is 35 percent.

As a MBS investor, this is valuable information. The more investor loans in a mortgage security, or the higher the debt-to-income ratio of the borrowers whose loans are in that security, the riskier it is. Investor-owners are more likely to walk away from their obligations in a tough economy than primary homeowners, while borrowers with higher debt ratios have less financial flexibility.

During the bubble, bond investors happily bought up just about anything and everything the banks sold them. And if those securities kept performing as expected, everybody would’ve made money and there’d be no scandal.

But as we all know, the markets imploded. MBS investors have lost untold billions of dollars as result. So now they’re acting like casino gamblers who bet more than they could afford to lose, and trying to find someone else to blame for their bad investment decisions.

That’s where institutions like Bank of America come in. Investors have hired expensive, high-powered attorneys to go after them. They’re claiming that the banks misrepresented the quality of the loans in the pools, or that they should have known borrowers were lying about their residential status, income, or other things.

In short, they’re trying to “put” those loans back to the banks — make them buy the loans back out of the MBS. That can be expensive because the banks would have to pay far more for those loans than they’re currently worth.

Bank of America grabbed headlines over the issue this week because it’s being pushed to buy back loans by none other than the Federal Reserve Bank of New York! The regional Fed bank owns interests in bum loans by virtue of the Bear Stearns bailout, and it’s working with large MBS owners such as Pimco and BlackRock to recover money.

You have to appreciate the irony here. The Fed is trying to extract money from Bank of America … a bank that received tens of billions of bailout dollars from the federal government and that has been artificially propped up by the Fed’s easy money policy! And the money management firm that’s going after Bank of America, BlackRock? It’s 34 percent owned by Merrill Lynch, which is … you guessed it … a Bank of America subsidiary! You can’t make this stuff up.

There’s no telling what the ultimate cost will be to BofA or its big bank brethren. BofA is currently being forced to buy back about $500 million in loans every quarter. JPMorgan Chase recently forecast buy back costs at $1 billion per year. Outside estimates for the industry as a whole range from a few billion dollars to tens of billions of dollars, spread out over the next few years.

What it Means for the Markets

Clearly, the mortgage monster is still stalking the lending industry. The total dollars involved here aren’t enough to sink the entire banking sector, or cause massive banking failures on their own. But we’re not talking about chump change either.

The cost of sorting this whole mess out is already adding up — and will continue to do so. That’s just one more reason not to buy and hold most major bank stocks. If you’re going to invest in the sector, stick with institutions that aren’t going to face huge claims related to put backs.

Oh and just one historical footnote: Many of Bank of America’s problems stem from its acquisition of Countrywide Financial a few years back. Martin and I warned several times that the company was on a collision course with bankruptcy — and that buying Countrywide was one of the stupidest things BofA ever did. BofA claimed it was getting great assets at a bargain price. I think it’s pretty clear who has ultimately been proven right.

Until next time,

Mike

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Quotable

“We should protect our company on our own … but I think (the yen’s current situation) is out of our control…I hope that (the government) will hear the cries”

Osamu Suzuki

The equities market reversed to the upside Wednesday posting a light volume broad based rally. Remember light volume tends to have a neutral to upward bias on stocks, But it was mainly the sharp drop in the dollar which spurred stocks and commodities higher.

Today’s bounce was not much of a surprise for several reasons…
• Overall trend is up, one day sell offs are generally profit taking
• Panic selling on the NYSE tipped us off that the market was oversold
• I don’t think they will let the market fall before the November election
• Intermediate cycle is turning up this week, 3 weeks of upward momentum…

What is the most likely cause today of civil unrest? Immigration. Gay Marriage. Abortion. The Results of Election Day. The Mosque at Ground Zero. Nope.

Try the Federal Reserve. November 3rd is when the Federal Reserve’s next policy committee meeting ends, and if you thought this was just another boring money meeting you would be wrong. It could be the most important meeting in Fed history, maybe. The US central bank is expected to announce its next move to boost the faltering economic recovery. To say there has been considerable debate and anxiety among Fed watchers about what the central bank should do would be an understatement. Chairman Ben Bernanke has indicated in recent speeches that the central bank plans to try to drive down already low-interest rates by buying up long-term bonds. A number of people both inside the Fed and out believe this is the wrong move. But one websiteseems to believe that Ben’s plan might actually lead to armed conflict. Last week, the blog, Zerohedge wrote, paraphrasing a top economic forecaster David Rosenberg, that it believed the Fed’s plan is not only moronic, but “positions US society one step closer to civil war if not worse.” (See photos inside the world of Ben Bernanke)

….read more HERE