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Bank of America: Bondholders' Naked Play for a "Do-Over" on Mortgages

Yesterday's Bank of America (BAC) bond scare was an interesting reminder of just how much of a mess the foreclosure crisis really is. It may not be the same kind of swoon we experienced two years ago, but the vulnerabilities created by the shoddy mortgage origination and servicing industry will probably haunt the financial system for years to come -- like war reparations.

It took a while for the financial world to sort out the meaning of the letter PIMCO, Blackstone and the New York Federal Reserve Bank sent to Bank of America yesterday asking that $47 billion in bonds be "put back" to the bank because of deficient servicing by Countrywide, the Bank of America subsidiary that originated the loans. The markets and the journalistic community can be forgiven for over-reacting.

This round is merely the bondholders checking a box in a long process of litigation that will take years to resolve. Bank of America's CEO Brian Moynihan was hardly blind-sided by the letter.

Most claims "don't have the defects that people allege," Moynihan said on Bloomberg Television, referring to so-called putbacks, in which guarantors or investors in mortgage-backed securities ask to return bad loans. "We end up restoring them, and they go back in the pools."
Moynihan essentially argues that PIMCO and Blackstone merely bought a car and are now disappointed that it didn't live up to their dreams. A better metaphor might be that the bondholders gorged themselves at a restaurant, but now want to send back the entire meal as undercooked.

The story might not have received nearly so much attention without the signature of the New York Fed on the letter. With the Fed's presence, and PIMCO's status as the government's adviser, the threat of a $47 billion put-back seemed much more credible than it is. The New York Fed is only there because the Bear Stearns collapse two and half years ago left some mortgage bonds on the Fed's balance sheet. Although it is kind of surprising that no one had the foresight to anticipate the effect of the Fed's signature on investors.

The string that's unraveling here is the mortgage industry's failure to accomplish its primary responsibility: creating a system whereby mortgages, property titles and securitized bonds could all be tracked and transferred when needed. On the foreclosure side, the absence of paperwork is threatening the bank's standing when it goes to repossess its asset. The missing paperwork threatens to invalidate the loans which would in turn make any mortgage -- or bond built out of that mortgage -- into a complete loss.

On the bondholder side, the PIMCO/Blackstone letter attacks the credibility of the loan origination. The bondholders are trying to find a sufficient number of ineligible loans -- say a mortgage on a rental property when the terms of the bond required only mortgages to owner-occupants -- that were packaged into the bonds they hold.

Of course, this is a naked ploy. It's not just that the bondholders are asking for a do-over fairly late in the game. These same securities have been trading to distressed debt investors who are also pursuing a legal strategy to force the banks to honor the bonds at face value. In many ways, it's shaping up to be a replay of the government's decision to pay off AIG's counter parties at full face value. Here's the New York Times's Nelson Schwartz with the money shot:

"Any hedge fund with a distressed desk is contemplating this trade," said one analyst who insisted on anonymity. "The idea of bottom-fishing vulture funds buying this stuff up for a nickel on the dollar so they can sue the banks to get 100 cents must be pretty odious for the Treasury, which bailed out the banks in the first place."

Indeed, the group that includes the Fed is one of two coalitions that is gearing up for a fight with the banks.

Bill Frey, chief executive of Greenwich Financial Services, leads a group of investors that holds just under $600 billion worth of mortgage-backed securities.

But it is the recent controversy over foreclosures that has jump-started interest by pension funds, hedge funds and other players. "In the last two weeks, there has been a flood of new investors," Mr. Frey said. "We haven't even had a chance to do the arithmetic, that's how fast they're coming in."

Even if these legal actions are coming from opportunists and those with buyer's remorse, it shouldn't distract from the real scandal. There was a very large industry created during the past decade around originating, processing and servicing mortgages which centers on handling the titles properly. A lot of money was paid to ensure this was done.

Just as the mortgage bubble was predicated on the assumption that housing values would rise indefinitely, the paperwork bubble seems to have been built upon the naive -- untested -- assumption that foreclosures would be minimal and the undeserving defaulters would never be in a position to question the paperwork.

Only because the number of foreclosures has become so large has a varied and resourceful group grown up around examining the loan servicing industry and its incompetence. It turns out debtors too can pound their chests about the rule of law when it plays to their advantage.

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