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At the risk of using hyperbolic Halloween metaphors too early in October, I’d like to point out an issue that has, until very recently, received very little attention in the mainstream media. It’s the resurgence of trouble in the banking sector due to toxic mortgages that caused the Nightmare on Wall Street in 2008. You wouldn’t know it from the best September stock market performance since 1939, but the mortgage monster that terrorized global financial markets may be ready to trounce Manhattan once more.

Many have been warning that central bank and government interventions could divert attention from the toxic assets on bank balance sheets for awhile, but that they wouldn’t get rid of them once and for all. Like the millions of barrels of oil in the Gulf of Mexico, trillions of dollars in faulty mortgages are still floating around out there. Capping the well doesn’t mean the problem is solved, but in today’s attention deficit society, out sight is out of mind.

3 Horror Shows to Watch

There are a few people who have been warning about the resurgence of trouble in the housing market. Chris Whalen, Co-Founder and Managing Director of Institutional Risk Analytics, has led the charge. He recently did an interview, along with Jim Rickards, Senior Managing Director of Market Intelligence, in which they issued a Tsunami Warning for Banks. According to Rickards, there are 3 components to this perfect storm:

  1. Strategic Foreclosures: Many people owe more on their mortgage principal than they can ever hope to recoup. Rather than continuing to make the payments on a losing investment, they purposely default, leaving the bank to clean up the mess. Chris Whalen recently cited a study that estimates that 1 in 5 U.S. residential properties could eventually go into foreclosure. This would represent a huge hit to the capital of several large U.S. banks.
  2. Put-Backs: You will recall that a lot of the trouble that banks had during the 2008 crisis stemmed from the securitization of residential mortgages. Financial institutions packaged mortgage loans into RMBS (Residential Mortgage-Backed Securities) and sold them to investors around the world. Many of those investors are now looking at what’s in those loan portfolios to find defects that will allow them to force the financial institutions to buy back these loans.

    Obviously, the prospect of taking these balance sheet-eating loans back is not appealing to the banks, and they have their hands full trying to repel them. This is a trillion dollar game of hot potato that will not end well for the financial institutions that underwrote these toxic products. Of course, many of those entities have either disappeared or been absorbed into larger institutions. Bank of America (BAC) is the name that I’ve heard mentioned most often in this regard. Remember that they bought both Countrywide and Merrill Lynch, two of the most prolific purveyors of poisonous potatoes out there.

  3. Faulty Foreclosure Process: You can imagine how hard it might become to foreclose on a property when it’s not clear who owns the loan. Indeed a tangled cluster of problems are just now seeing the light of public scrutiny. Foreclosures are being halted in some states and by some financial companies because of accusations of fraud at multiple levels. Now on some level, this may be a positive in that foreclosure stats will likely slow. Be aware, however, that the problems are still there. The New York Times reported on flawed bank paperwork on Monday, reflecting the complexities of the situation as a result of the sheer volume of underwater homeowners out there.

    Accusations range from document fabrication to the use of robo-signers, who sign off on foreclosure documents even though they have little or no knowledge of the loans in question. According to Bloomberg, bond-insurer Ambac is suing Bank of America “over $16.7 billion of mortgage-backed securities, saying the bank’s Countrywide Financial Corp. unit fraudulently induced Ambac to insure bonds backed by improperly made loans.” Stories like these are beginning to scurry across cyberspace like cockroaches right now, and I suspect the old roach aphorism (there’s never just one) will prove true once more.

How Will This Movie End?

Bank of America, Wells Fargo (BWF), JP Morgan (JPM), Citigroup (C), and GMAC (now Ally) are some of the institutions mentioned by Whalen and Rickards as having higher exposure to these toxic assets. They speculate that some of these banks, and perhaps many more, will be forced to seek help once again from the government. This time, we will need to do the restructuring we should have done during Nightmare on Wall Street I. The bad loans will have to be separated from viable assets, and bond holders will need to take significant haircuts.

At some point, the mask will come off and the ugly reality of these asset-backed securities will be revealed. Whalen and Rickards expect financials to feel the impact of these balance sheet blows by late in the first quarter of 2011. They state that we are currently in a Depression that may last until 2012 or 2013 – longer if we throw in some policy miscues. In this environment, Whalen recommends that “investors should be looking at liquid, government-covered vehicles to preserve principal through deflation, then stocks when the inflation updraft begins.”

Rickards assesses the situation this way: “Best case is Japan of the 90′s. Ten years of no growth. Worse case is we let the forces play out and we find a bottom. Good news with that is then you can start to grow. But the bottom will be ugly.”

So, the financial problems emanating from the U.S. housing market continue like a horror film villain that just won’t die. The bad news is that this is no movie. It’s all-too real. The good news is that it will end at some point, and we can hopefully transition out of the horror genre for a while.

Source: Nightmare on Wall Street II