Watching the US foreclosure crisis unfold brings a sense of déjà vu of early 2007 when we first heard about the subprime crisis. Only a handful of independent analysts said it was a serious problem while the people in leadership like Ben Bernanke and Henry Paulson assured everyone that the subprime crisis was contained.
The big banks involved in the foreclosure crisis are currently portraying the foreclosure problems as mere “technicalities” which can be easily resolved. CEO of JP Morgan bank Jamie Dimon has said he thinks it is just a blip which can be resolved in a few weeks. He is confident that the cost of sorting out these foreclosure problems will only be “incremental” and his bank has only set aside a mere $1.2 billion to handle the extra costs expected. Bank of America Corp.’s head of home lending Barbara Desoer said outside estimates of costs stemming from delays in foreclosures are “grossly distorted.” Citigoup’s chief financial officer John Gerspach said his bank had reviewed its foreclosure documentation process and concluded it was “sound.” At the same time some bearish analysts are predicting that the cost from the foreclosure crisis will be so great that it could make these same big banks insolvent!
So who is right? Only time will tell as more information is uncovered. Are the foreclosure problems due to simple errors in the paperwork or outright fraud? If it turns out to be fraud, the implications can become very serious. The foreclosure crisis has also been dubbed “foreclosure-gate” after the Watergate scandal which cost a US president his job.
While lawsuits from individual homeowners who have been wrongfully foreclosed may not be a big cost to the banks, the cost of “put backs” or repurchasing mortgage backed securities (MBS) could be HUGE as there is literally trillions of dollars worth of mortgage paper out there. When the subprime crisis erupted, it was MBS investors who took the biggest hit as most of the subprime loans were bundled inside the securities that they bought. These investors, mainly pension funds, lost a lot of money as these securities fell dramatically in value. Investigations into problem foreclosures have revealed that in many cases, the subprime mortgages were never officially transferred to the trusts that have been set up to own the MBS. If the mortgage securitization process has not validly transferred rights in the underlying loans, investors in the mortgage securities have the right to force banks to buy back all the securitized loans, and this looks like the biggest risk the banks are facing. PIMCO and other large institutional investors have started the ball rolling by asking Bank of America to repurchase $47 billion of mortgage bonds which were sold to them by Countrywide Financial.
At this point, no one really knows how this will turn out. Both sides have strong arguments. The critics of banks can point to long-standing rules about property and mortgage transfers, as well as the letter of the law in many jurisdictions. The defenders of the securitization can argue that it’s unlikely and unfair for courts to vitiate standard business practices. Investors in general do not like uncertainty and many have decided to “sell first, ask questions later”. Share prices of the big banks fell dramatically last week, in the midst of an overall share market rally.
Should we as investors be worried? I think we should be cautious and we should definitely watch the foreclosure crisis closely as the last time there was a banking crisis in the US, the whole global financial system was brought to its knees. Our SMSF has decided to stay away from financial stocks as explained in an earlier post Why we do not hold bank stocks. The Naked Capitalist blog is a good place to go to keep up with this unfolding crisis. So far all the big US banks do not seem to be too worried. They were “too big to fail” before the subprime crisis and after swallowing up their competitors who were small enough to fail, they are now even bigger. They probably think that if they run into problems again, all they need to do is to play their “systemic risk” card and they would surely be bailed out again with TARP II. However, since the first banking crisis, a financial reform bill has been passed which gives federal regulators the tools to take control and set things right. The Kanjorski amendment allows federal regulators to pre-emptively break up large financial institutions that pose a threat to U.S. financial or economic stability. So who knows, we may have a different end to the story this time if the foreclosure crisis does turn into subprime II.
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