How the Foreclosure Mess Could Cause Banks to Crash

Since the "robo-signing" scandal jammed on the financial industry's brakes, it's been morbidly fascinating to watch the resulting chain collision.

Three decades' worth of fraud, greed and incompetence -- the emergence of mortgage-backed securities in the early 1980s; growth of subprime lending in the '90s; leverage-fueled housing binge in the aughts -- piling into each other before inevitably careening into that foreclosed property on the corner. Newton's third law wins again.

The obvious question: Will the latest wreck end in an even bigger collision that makes 2008 look like a fender-bender? Beyond depriving homeowners of their legal rights, the foreclosure mess also could force banks to do something they've been avoiding since the financial crisis began -- recognize the full extent of their mortgage-related losses. In a recent presentation at the American Enterprise Institute, a Washington think-tank, bank analyst Chris Whalen of Institutional Risk Analytics painted this dire scenario:

The U.S. banking industry is entering a new period of crisis where operating costs are rising dramatically due to foreclosures and defaults. We are less than Â¼ of the way through the foreclosure process.

Rising operating costs in banks will be more significant than in past recessions and could force the U.S. government to restructure some large lenders as expenses overwhelm revenue. [Bank of America, JPMorgan Chase, GMAC Mortgage] foreclosure moratoriums only the start of the crisis that threatens the financial foundations of the entire U.S. political economy.

The largest U.S. banks remain insolvent and must continue to shrink. Failure by the Obama administration to restructure the largest banks during 2007"2009 period only means that this process is going to occur over next three to five years â€"- whether we like it or not.

Impending operational collapse of some of the largest U.S. banks will serve as the catalyst for re"creation of RFC"type liquidation vehicle(s) to handle the operational task of finally deflating the subprime bubble. End of the liquidation cycle of the deflating bubble will arrive in another four to five years.

Investors may feel less apocalyptic, but they're obviously nervous. Bank stocks are dipping, while the cost of buying credit insurance on financial firms is rising. As during those dark days in the fall of 2008, when no one knew for sure how bad the damage could be, experts are all over the map in calculating the potential hit to banks resulting from the foreclosure affair. Estimates range from $1.5 billion a quarter for the entire industry to $70 billion for a single company, Bank of America (BAC).

Indeed, not everyone predicts doomsday. Paul Miller, a respected bank analyst with FBR Capital Markets, expects industrywide losses of no more than $10 billion, including the cost of delayed foreclosures and legal liabilities. He said in a research note Thursday:

Overall, we believe that the real cost to the industry is going to be the drag on the foreclosure process, which could delay any recovery in the housing market that might be on the horizon.

For banks, the greatest threat isn't from homeowners wrongly kicked out of their homes. It's from uncertainty over who really owns the loans underlying mortgage-backed securities. If faulty paperwork destroys the chain of ownership, MBS investors could force financial institutions not only to repurchase shoddy mortgages, but also legally contest the entire securitization. As Joshua Rosner, managing director with investment research firm Graham Fisher, told Bloomberg:

"If plaintiffs bring suit it could rock the market," Rosner, 44, said in a telephone interview. "If courts allowed those suits to proceed it would well feel much like 2008," when the bankruptcy of Lehman Brothers Holdings Inc. led to the biggest market collapse since the Great Depression, he said.

The other great uncertainty in all this is how our political leadership would respond to a new cascade of losses on Wall Street. Throughout the financial crisis, lawmakers have pursued a policy of "extend and pretend," recapitalizing big banks with taxpayer money and allowing them to avoid massive write-downs on mortgage loans.

Regrettably, the Obama administration's handling of the robo-signing mess continues that policy. It has refused to act more forcefully to slow the tide of foreclosures. How? By failing to press loan servicers into offering mortgage relief. By allowing banks to keep refinancing costs inordinately high despite a torrent of cheap money courtesy of TARP and the Federal Reserve. And now by rejecting calls for a temporary halt on foreclosures, even as state legal officials take the obvious step of interrupting that process.

Could all of these maneuvers have a single goal -- helping banks hide their debt? Better buckle up.

Image from Flickr user SliceofNYC
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Alain Sherter

Alain Sherter covers business and economic affairs for CBSNews.com.

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