Posted by: Jeff | October 20, 2010

Wrapping My Head Around the Foreclosure Mess

I haven’t been keeping very close tabs on the unfolding foreclosure crisis because, frankly, the subject matter strikes me as just incredibly arcane. But this episode of The Breakdown brought me up to speed. And clearly I should have been paying closer attention, because the implications here look pretty remarkable.

In short, the foreclosure crisis is the return of the toxic asset in even more twisted form. If you remember, toxic assets — known in more technical terms as mortgage-backed securities — were one of the key components of the 2008 meltdown. Basically, they were financial instruments created from the mortgages of everyday American homeowners, which could then be bought and sold on Wall Street. And they weren’t just made up of mortgages, but of little pieces of mortgages — and every security contained lots and lots of these little pieces, all from different mortgages.

The practical upshot was that it became extraordinarily difficult to determine how any individual security worked; how it related to the many mortgages it involved, how likely default was in any particular mortgage, what the overall riskiness of the security was, etc. As a result of all that complexity — in combination with some faulty analytical assumptions — lots of mortgage-backed securities were rated AAA. Which meant they were being presented as virtually risk free. So they percolated through the entire financial system, and then when the housing market crashed and all those mortgages turned out to be not so risk-free after all, all the major financial institutions were stuck with these securities on their books. And they had no idea what the worth of these things were. So everyone wanted to sell, no one wanted to buy, and hello financial crisis.

Now, I think one of the more poorly understood aspects of the financial crisis — and something that has frustrated lots of regular Americans looking for some kind of accountability for the mess — is that all these dealings, while unethical, was also more or less perfectly legal. Until now. The significance of the foreclosure crisis is that it may reveal an aspect of the collapse that was genuinely, as opposed to merely rhetorically, criminal.

Whenever a mortgage is created — whenever the deal is struck between a bank or financial institution and the homeowner receiving the loan — a “note” is also created. The note is documentation that describes the terms of the deal for that particular mortgage, and for all the parties involved. And whenever the ownership of a mortgage changes hands — which is what happens whenever a mortgage-backed security is bought or sold — the note is supposed to go along for the ride. But due to the incredible complexity of these securities, it turns out that didn’t happen: Lots of the notes were simply lost, and are now nowhere to be found.

It also turns out that the institutions selling the mortgages had an incentive to “accidentally” lose the notes. Due to all the new capital pouring into the American housing market in the mid 2000s, you could make a (short-term) profit selling and securitizing a mortgage for just about anyone — no matter how unlikely it was that they’d be able to pay it back. So, in order to sucker homeowners into taking out mortgages they couldn’t afford, a lot of deception had to be committed and a lot of details fudged. And the notes document the evidence of those shenanigans.

The last critical detail is that the notes also defined the circumstances under which a homeowner could or could not be foreclosed on. So as the banks and financial institutions have proceeded with foreclosures over the last few years, they haven’t actually had the documentation to prove that what they’ve been doing is legal. And quite often, they’ve simply fraudulently claimed they did have it. That brings us up to the current moment, as all the major players in the market, as well as the government, are becoming cognizant of all this.

So now the federal government is opening an investigation into the whole mess, and the New York Fed is joining with other investors to demand that Bank of America either buy back billions of dollars worth of mortgages it sold, or they’ll sue. So it’ll be interesting to see what develops in the next few weeks. The scary part is that if the foreclosure crisis sufficiently disrupts the financial system, it could throw us back into another 2008-style tailspin. And should things reach that point, the only steps the government could take to stave it off would likely infuriate voters even more than the TARP bailout did. So hold onto your hats, everyone.

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