Three options for the mortgage mess
The news that the largest bond fund in the world, the largest money manager in the world and the New York Federal Reserve are demanding that Bank of America repurchase $47 billion in mortgage bonds is scary stuff. As Daniel Indiviglio says, "these investors aren't exactly Moe, Larry, and Curly. This is serious."
I've been interviewing a lot of different people about this, and opinions range from apocalyptic to sanguine. I've rarely encountered a major issue, actually, where there's so little consensus. That the market seems basically unbothered, however, has led me to think that there are basically three possible outcomes here:
1. This isn't a big deal. There are some lawsuits, maybe a few banks have to buy back a few bonds, but nothing much comes of this. It turns out to have been more smoke than fire.
2. It's meaningful, but not huge. A fair amount of money changes hands in the courts, but not so much that the banks can't handle it. The problems that are severe enough to litigate turn out to be rare enough that the mortgage market doesn't face long-term disruption, much less collapse.
3. It's a catastrophe, and the government steps in. If we're really in a world where our system of property rights is in jeopardy, we're in a world where the government is going to figure out a way to marry the electronic record-keeping with the legally binding records and force the mortgage market to see its way out of this and figure out a new system for the future. That's ugly, but it's a world in which the losses are managed.
So not-that-bad, sorta-bad, and bad-enough-that-we-won't-let-it-happen. I've run this by some people and they seem to think this is about right. The market's relative serenity reflects the fact that it thinks the likely outcome is between not-that-bad and sorta-bad, and they'd already priced a fair amount of risk into everything connected to the mortgage market. If things take a turn for the catastrophic, well, that's a big problem, but it's also a problem that the government is likely to solve, not a problem that the financial system is likely to eat.
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