The Foreclosure Mess: The Start of Another Bank Bailout?

Last Updated Oct 20, 2010 10:16 AM EDT

The foreclosure mess suddenly turned messier yesterday when a group of heavyweight investors, including the Federal Reserve Bank of New York, demanded that Bank of America buy back toxic mortgages that a subsidiary had sold them during the housing bubble. BlackRock, the world's largest investment company, and Pimco, the world's largest bond manager, joined the New York Fed in arguing that shoddy record keeping and other missteps by Bank of America subsidiary Countrywide Financial amount to a breach of their contract. Such a breach would allow the investors to sell the mortgages back to the bank at full price. The investors' claims, which became public yesterday, probably marks the opening shot in a long legal battle that could cost B of A billions and possibly push it into insolvency.

"This isn't the other shoe dropping," says Barry Ritholtz, a lawyer and investment expert and the CEO of Fusion IQ. "This is the third iceberg." The investors in question bought $47 billion worth of mortgage bonds packaged, or "securitized," by CountryWide, which Bank of America bought in 2008. Bank of America will be lucky to get a away with a couple of billion dollars in losses over this issue, Ritzholtz says. In the worst case, he predicts, the cost of buying back those securities could drive B of A to seek another bailout.

That, in turn, could cause the financial markets to seize up again, and at the very least slow the recovery, if not send the economy back into recession.

Securitization has played a huge rule in the financial crisis. Instead of holding on to mortgages issued during the housing bubble, banks sliced them into hundreds or thousands of pieces and sold them to investors. This process divorced lenders from the risk that a borrower might not be able to pay up, and led to the explosion in irresponsible housing loans that inflated the housing bubble. When home prices collapsed and mortgage defaults skyrocketed, investors like Pimco and BlackRock were left holding securities now worth far less than they paid for them. Through their lawyers, they are now crying foul.

That adds a new dimension to the foreclosure mess, which the banks had been hoping to put behind them. Banks and others had argued that maybe some i's weren't dotted and a few T's might have misplaced crosses on mortgage documents, but those were just technicalities. The bottom line is that people didn't pay their mortgages and foreclosures should be allowed to proceed. The Wall Street Journal editorial page recently declared: "We're not aware of a single case so far of a substantive error." But now some of the world's savviest investors are joining defaulting homeowners in claiming that too many T's are missing crosses. Unlike defaulting homeowners, most of whom will eventually lose their homes to foreclosure, the investors may succeed in winning concessions from the banks. And if the courts agree that Bank of America must make the investors whole, it could be more than the bank's fragile finances could bear.

Of course the Bank has no plans to write a $47 billion check. Late yesterday the bank said it was not responsible for poor performance of the loans related to the bad economy, and promised to "vigorously" defend itself. CEO Brian Moynihan told Bloomberg "If there was mistakes made and we owe the money, we'll do it," meaning the bank would buy back the mortgages. And B of A is far from alone in this mess â€" J.P. Morgan Chase also has set aside money for repurchasing mortgages, and may face more demands if investors smell blood.

Roben Farzad, a business commentator and senior writer at BusinessWeek, argues that the whole case is the Wall Street equivalent of fighting a speeding ticket by claiming the officer didn't sign it correctly. He thinks the parties are likely to settle the case, which seems especially likely given the incestuous back story here: Bank of America owns 34 percent of BlackRock, and BlackRock is one of the largest shareholders in the bank.

The ultimate lesson in all this? Ritholtz sees it as further proof that when a firm screws up, taxpayers should not ride to the rescue. "This goes back to why you don't bail out banks," he says. "You don't know what other shortcuts were on the books."