Sunday, December 12, 2010

A Perspective on the Mortgage Mess

Here is a succinct perspective on the mortgage mess.

1. Ultimately, the people who didn't pay their mortgages will lose their homes.

2. Ultimately, the losses resulting from mortgage defaults will have to show up on someone's books; but they will not show up all at once. Reports of the losses will be bled out quarter by quarter on the "frog in a pot theory" * so that the market is not shocked at the magnitude of the problem.

3. People who bought foreclosed properties and thought they had clear title will find, in significant numbers of cases, that they do not in fact have clear title to their homes -- because it is not clear who had a right to foreclose in the first place or the party who foreclosed and sold the property actually had no right to do so. Either could give rise to the uncomfortable situation in which two (or more) people claim title to the same property.

4. Ultimately, who owns any particular mortgage and note will be sorted out. That process will be tedious, lengthy and contentious as the falsifications, mistakes and systemic flaws surface and reveal that more than just homeowners will lose.

5. Many investors, including not only private parties but also public and private pension funds and corporate treasurers, who thought they bought mortgage-backed securities will find that, as a consequence of the systemic flaws in the MBS creation process, their securities were not in fact mortgage-backed, reducing their investment to an unsecured note of substantially lower value than they thought they had.

6. The parties in every step of the MBS transactions who insured their bonds with Credit Default Swaps -- will call upon their CDS counterparties to cover their losses arising from the mess. Unlike regular insurance, however, CDS counterparties do not ordinarily set aside reserves to cover their CDS obligations. (This ignores the additional problem that because CDS obligations are traded many times over, it is difficult to identify the real counterparty.) The likely tidal wave of CDS demands cannot be met from the capital of the counterparties (usually large banks, investment banks and hedge funds).  And the ensuing chaos from the uncertainty of who owns what will delay and defy resolution.

7. The investors will sue the CDS counterparties, MBS creators, sellers and brokers, the rating agencies, the accountants and the lawyers involved in creating the flawed instruments. Lawyers on all sides will get rich; everyone else will lose. The magnitude of the problem is measured in the $Trillions.

8. The Fed -- which has shown no reluctance to bail out banks, investment banks, hedge funds and commercial businesses by loaning printed money or by buying garbage at par -- will continue to backstop the system. Ultimately, while it could forestall another crash, the money printing and additional credit facilities could cause general price inflation or another bubble somewhere it is not wanted (the law of unintended consequences), either of which will end very badly for the economy. The public is becoming aware of the Fed's actions and is increasingly unhappy that the perpetrators of fraud are escaping prosecution and, instead, are receiving bonuses with public money while the consequences of their acts cause unemployment and decimation of the value of the one asset in which most citizens have invested their meager savings. With Ron Paul as the head of the Monetary Policy Subcommittee, the fireworks are likely to be significant. The efforts of the banks and the Fed to suppress any and all information in this regard will be huge. Fortunately, there is an internet -- where actual events (not just the opinions of bloggers) can be aired and facts checked -- that is, until the internet itself is constrained as a "security risk." (Shut those bloggers up for goodness sake! The truth will kill us all -- Joe Sixpack cannot possibly handle the truth: witness what he did in the last election!)

9. The stock and bond markets are anticipating all of the above. Real interest rates are starting to rise despite the efforts of the Fed to suppress them. And the stock market has recovered, more or less, from its 2008 lows, anticipating (somewhat scizophrenically) that the Fed's efforts to keep the economy afloat will restore consumer confidence.

10. The States, which collect transfer taxes on each real estate transaction (and which are in dire financial straits), are very, very unhappy that the banks created a system in which they tried to evade paying those taxes, even though title to local real estate changed multiple times.

11. Efforts to achieve a global settlement that would validate the flawed system, pardon the frauds, and compensate the States, investors, CDS counterparties and banks for their losses, will be very difficult if not impossible to achieve.

12. Because the underlying failures of the system have not been rectified and the health of our financial institutions restored, the economy and the stock market's hope for a substantive recovery remain fragile. You need to carefully (daily) monitor your investments and the financial news.


*The frog in a pot theory holds that if you put a live frog in a pot of cold water and gradually increase the heat, the frog will stay in the pot until it is cooked. But if you drop a frog in a pot of boiling water, it will jump out immediately.

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