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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.

By Ezra Klein  | October 20, 2010; 2:43 PM ET
Categories:  Housing Crisis  
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Comments

i'm thinking its somewhere between 2 and 3 and they're trying to keep it closer to 2 than 3. I won't go FDL looney and say property rights are gone etc but I do think that if these big players don't want these then there's something seriously wrong with them.

The question that's not being brought up here is how many future foreclosures are represented in those $47 billion in mortgage bonds? The answer to that may go some way in determining how bad and how long the housing market will be.

Posted by: visionbrkr | October 20, 2010 3:04 PM | Report abuse

There is more at work here than just fraudclosure.

When those mortgages were originated, assigned, sliced and diced, and resold to investors like Pimco; warranties and representations were made as to the quality of the loans. In some cases, those representations were false, (liar loans passed off as prime) giving rise to the right of the investors to require the originator to repurchase the loan. Many of these loans happen to be also the ones in foreclosure, but the investors have the right to require the originator to repurchase the loans irrespective of whether or not they are in foreclosure.

The foreclosure mess has arisen in large part because there are technical defects in either the assignment or the slicing and dicing process. These defects are probably curable in the vast majority of the cases, and the foreclosure will ultimately take place.

As I see it, what fraudclosure has actually put at risk is the sand in which our heads have collectively been buried. Bloomberg may be crowing about the success of TARP, but the fact remains that our banking system is insolvent and there are limits on how long "extend and pretend" can postpone the day of reckoning.

Posted by: bgmma50 | October 20, 2010 3:05 PM | Report abuse

On a related note. I've been wondering what Pimco was going to do with its inventory of MBS drek now that the Fed is apparently out of the business of buying it. I guess I've got my answer.

Posted by: bgmma50 | October 20, 2010 3:14 PM | Report abuse

It's a rousing game of follow the hot potato.

Posted by: bgmma50 | October 20, 2010 3:16 PM | Report abuse

Ezra,

What about option #4 (or #3, version 2):

It's a catastrophe, and the government does not step in.

If TARP, which Bloomberg reported today netted the government $25 billion on the bank part of the bill, is more toxic than a default swap on a Phoenix suburb, than what likelihood is there that Congress authorizes the money to support the mortgage industry, especially in a closely split post-November Congress? Will the Fed's hand finally be forced? Is this one more example that you've written about how Congress' inability to act cedes their power to the other branches of government?

Posted by: NickM2 | October 20, 2010 3:26 PM | Report abuse

Option 2.5 - It's meaningful, a lot of pseudo-money changes hands, banking as we know it falters, the federal government is powerless to interfere with (state-based) property rights but tries some ill-conceived academic tactics, and life goes on.

The pseudo-money aspect is interesting; however, the moral aspect is more important. No matter how many foreclosure sale signs are erected, no matter how many trades are made by banks, no matter how many laws are passed by Congress, a local Sheriff still has to evict the residents of a property.

A real question comes when few elected Sheriffs are willing to evict their voting neighbor citizens. More than a year ago, the Sheriff in Chicago refused to evict -- and the trend is spreading, raising moral questions. Does non-payer Granny Jones simply walk away, happy to be homeless? Does Sheriff Bob take Granny away in chains? Does the President send in the Army to bomb Granny Jones off her farm so that Goldman-Sachs can pay a bonus to its CEO? Do taxpayers pay to help homeless Granny Jones? Does Goldman-Sachs (and its peers and all of their investors) simply loose the $187 trillion of pseudo-money they THOUGHT they had?

Trading in non-existent assets wasn't wise... and those who did so (or allowed others to do so) will all suffer.

Posted by: rmgregory | October 20, 2010 3:30 PM | Report abuse

No on will be successfully criminally prosecuted similar to the financial collapse. The states attorneys general will get together and sign off on a settlement similar to the tobacco litigation. JP Morgan has already come up with a proposed cost to the industry as a whole of between 60 and 100 billion dollars. The banks with big obligations in this BofA, Wells, maybe JP Morgan, and Citi,etc. will be range bound for the coming year or so. You'll have a big "headline risk" but the banks are already putting together reserves against their earnings for this purpose.

Total resolution time: best case summer 2011, worst case summer 2012.

Posted by: 54465446 | October 20, 2010 3:32 PM | Report abuse

In your conversations with Barney Frank and others recently, is there any chance of outlawing securitization of mortgages when the big Fanny Mae/Freddie Mac reform is done in 2011?

Also, it will be interesting to see how the #3 option fits with Rep. Brad Miller's observation that "There is no chance that Congress would pass more TARP"

http://voices.washingtonpost.com/ezra-klein/2010/10/rep_brad_miller_there_is_no_ch.html

Posted by: jnc4p | October 20, 2010 4:18 PM | Report abuse

#2 for the most part. Some financial institutions will get hit harder than others so get ready to pick your way through the minefield.

Posted by: tuber | October 20, 2010 4:21 PM | Report abuse

Potion 4: It's a catastrophe & the government doesn't sign on to fix it because Tea Baggers who win Congressional seats revolt.

OK, so that's fantasy. The Tea Baggers loves them some major corporations over Mom & Pop institutions. But what if they just allowed those who couldn't pay to fail? Isn't that what the whole new Regs produced this summer where about? Let 'em fail & then have the Fed take 'em over?

Posted by: kindness1 | October 20, 2010 4:46 PM | Report abuse

Option 4 will be the case, as 2 other folks have commented. There was a bipartisan demand for TARP from the heights of our system, and they still had to re-vote and finagle their way through it. TARP turned out to save our economy and net a profit, so it was obviously great, yet they couldn't come even close to passing it today.

What makes anyone think that the Gov't is able to even consider a 2nd bailout? Granted, the market seems to think that, but that's just because they're so hopped up on Republican hopes and their own self-pity that they're sure a return to Wall St.'s former glory is just days away. But what's really days or weeks away is the Tea Party allowing the fraudulent mortgages to take down our economy.

Posted by: michaelh81 | October 20, 2010 5:40 PM | Report abuse

There will be no need for a bailout. A settlement will be put together and claimaints will get their money that way.

Posted by: 54465446 | October 20, 2010 8:52 PM | Report abuse


So, worst case scenario: "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."

Isn't socialism wonderful!

Posted by: AlanDownunder | October 21, 2010 5:13 AM | Report abuse

Mortgage refinancing means re-funding the mortgage loan with better terms as well as conditions, most likely from a different lender. It is one way to save money. Search online for "123 Mortgage Refinance" they found me 3.1% refinance rate and also gave free analysis of my mortgage.

Posted by: harryblack21 | October 21, 2010 7:08 AM | Report abuse

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