Mortgage Mess Means Trillions in Losses for Wall Street Banks

 |  Includes: BAC, GS, JPM, KBE, MS, WFC, XLF
by: Avery Goodman

There is now a temporary "suspension" on foreclosures. The moratoria have been imposed by the servicing divisions of various Wall Street banks, but the banks do not own the vast majority of the mortgages on these properties. Instead, the properties are technically owned by trillions of dollars worth of securitized mortgage-backed bonds.

When these flawed securities were created, many banks appointed themselves as servicing agents, seeking to make additional profits that way. But pension funds, insurers and smaller banks actually bought this toxic waste, and they are the ones that own the mortgages, not the banks. In yet another episode of uncontrolled greed, Wall Street banks who securitized mortgages happen to have forgotten about little niceties like perfecting mortgage liens. Some, or even many, of these supposedly "mortgage-backed" securities contain either improperly transferred mortgages, or mortgages that were never transferred at all.

Since the securities were supposed to be fully backed by mortgages at the time of their sale, it doesn't matter if the correct paperwork is eventually done. From a legal standpoint, to get a refund of the full purchase price, buyers will not need to prove fraud. The law does not require them to prove anything other than the fact that material misstatements of fact occured during their sale. The issuers do not even need to know that their representations were false. Securities sold upon the basis of false representation, intentional or not, can be returned to the seller under the provisions of the Federal Securities and Exchange Act of 1934 and under “Blue Sky” laws of most states. These laws require a full refund of the original purchase price, regardless of whether the securities in question have gone up or down, in the interim.

Issuers of defective securities, under most circumstances, are also required to reimburse both costs and attorney’s fees incurred by buyers in the process of returning them for a refund. Only those claimants who seek punitive or triple damages would need to prove intentional misconduct. The case involving the defective mortgage securities, in fact, is so simple that many lawsuits and/or arbitrations, are going to be ending in a summary judgment. It is possible, therefore, that even the normal slowness of the legal system won't protect the errant banks.

The damage will be astronomical. Most of these mortgage securities have deeply depreciated in price. No logical buyer wouldn't try to return them for the purchase price. Since the law provides a full refund of the purchase price, there is a huge incentive to demand a refund. What should be most frightening to any big bank shareholder is the fact that, at its peak, the amount of outstanding non-agency guaranteed mortgage securities reached $2.3 trillion in June 2007 (see here). This omits Fannie Mae and Freddie Mac securitizations, which were created and processed by the same Wall Street banks. If we add those, the amount is about $5 trillion more, for a total of about $7.3 trillion.

Clayton Holdings is a Connecticut-based firm that analyzes home mortgages for banks, hedge funds, insurance companies and government agencies (see here). After reviewing a sampling of 10,200 mortgages at Bank of America, it found problems in 30% (see here). Assuming a 30% rate, big bank securitizers have an exposure to about $2.19 trillion, with an unknown amount of additional costs and attorneys fees.

The banks don’t have that kind of money. The money they made by selling these flawed securities went mostly into the pockets of bank executives, long ago, in the form of bonus payments. Not even their slush fund (a/k/a Federal Reserve) has that kind of cash. Such money cannot even be raised by the Fed's money printing habit (a/k/a "quantitative easing") without destroying the U.S. dollar. So, what can be done?

The only alternative will be to close down the "too-big-to-fail" banks that caused this problem and so many others. The sooner the better. "Too-big-to-fail" banks are too big to exist. It is abundantly clear that, even with huge bailouts and money transfers from the American people to the banks, orchestrated by the Federal Reserve and Treasury, these ungovernable entities are irretrievably bankrupt,

Because they cannot be closed down in a normal way, the big banks that have gotten themselves into this situation must be closed by being nationalized. They are already wards of the state (in spite of their claims to have "repaid" TARP), so the situation really won't be much different than now, except that the top executives will need to be fired this time. Their deposit base will have to be transferred to more responsible banks, or paid off by the FDIC.

Pieces of the banks should be sold to the highest bidders in order to get the financial system back into private hands as soon as possible. Strong anti-trust laws should be passed, immediately, in order to make sure that banks never get so big again. We will also need to enact new laws to facilitate shareholder lawsuits and clawbacks from the incompetent executives like Henry Paulson, Lloyd Blankfein, and others, who ran their institutions into the ground, while they collected hundreds of millions of dollars worth of unjustifiable salary and bonuses.

Given that shareholders will now be impoverished as a result of the actions or inaction of incompetent bank executives, it is time to take ill-gotten gains away from them. One thing is sure. I would not want to be a shareholder in any of the big banks right now.

Disclosure: No positions