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The Mortgage Debacle Explained

|Includes: Bank of America Corporation (BAC), C, JPM

Panic has gripped the markets. Apparently, banks have not been observing the proprieties when foreclosing on delinquent home owners. This has cause some banks to halt foreclosure proceedings while proper due diligence is under taken and paperwork is processed in accordance with the stated rules and regulations. This has many investors selling their corporate bond and preferred holdings of large banks, especially Bank of America. Relax folks, although bank bottom lines could be hit due to increased legal expenses and overhead to properly process foreclosures, it is unlikely that the damage will be enough to sink any of the large banks, including Bank of America, worry warts.



            Remember back in 2009 when regulators required banks to raise what seemed like an unusually large amounts of capital (especially tangible common equity tier-1 capital)? This was done because government overseers were concerned of what could happen should government stimulus fail to stabilize the housing market and eventually push home prices higher. Currently, the large money center banks should have enough capital to weather another 2008, if necessary. This is one reason (the inability to securitize non-GSE-qualifying mortgages being another) that banks are reluctant to lend. They are hoarding capital. This is not to say that banks will be unaffected, poor earnings could be in their futures (for a variety of reasons), but corporate defaults large banks are an improbability at this time.

 Disclosure: Long C, BAC

            Investors in private label MBS, CDOs and SIVs have more to worry about than do corporate bond investors. It is not clear, in some cases, who actually owns a mortgage and who is just a servicer. There are situations in which banks may be foreclosing in propertied when the have no legal right to do so. This could be due to incomplete or incorrect documentation during the securitization process. If this can be proved, banks may have to take back at par the mortgage-backed vehicles currently held by investors. The problem is that many of these vehicles contain mortgages which have taken principal losses and will never be worth par no matter how long they are held. This is the main reason that suspending mark-to-market was not a permanent fix.


            Sure, it calmed investors’ fears as banks did not have to recognize unrealized losses, but now losses are being realized and many investors of finding that out the hard way. If one large group of investors can win a judgment versus an issuer, the flood gates could open for more litigation and lock up what is left of the mortgage market. That would practically kill the housing market. However, it is unlikely that these doomsdays scenarios play themselves out. It is more likely that foreclosures continue and many private label MBS issued from late 2005 through early 2008 will experience losses.


            Investors in debt (including preferreds) could be impacted by recent developments. If banks are force to absorb losses it is unlikely that they will exercise early capital event clauses afforded by the implementation of the Dodd bill. Instead banks could leave trust preferreds outstanding as long as they can be applied toward tier-1 capital. That means that trust preferreds could remain outstanding until at least 2013, if not longer.


            Many investors have become fearful of Countrywide bonds and preferreds. Investors need to understand that Countrywide debt and preferred securities are legal obligations of Bank of America. This is not the case with Merrill debt and trust preferreds. It is unlikely that BAC will default so Countrywide debt and preferreds should be alright, albeit a bit volatile. I would be more concerned about regional banks exposed to Florida and Nevada more than any of the large banks.



            Well there you have it. This is my take on the mortgage debacle as I see it at this time. If policymakers would only have permitted home prices to reset early in 2008 when mortgage credit was still available, real estate values probably would not have fallen as far as they have and regulators could have reigned in bad practices. Let’s hope that every one has learned from their mistakes.

Disclosure: Long BAC, C