Felix Salmon is right. This is going to be a big, big problem for the financial institutions.
A group of investors holding $16.5 billion of mortgage bonds took a step toward a possible suit against a Bank of America Corp unit for failing to correctly handle loans that were packaged into bonds.
The investors said that some mortgages should never have been included in the bonds in the first place, and that the Bank of America unit, Countrywide Home Loan Servicing, should force the original lender to buy them back.
The salvo is the latest effort from investors to push losses from mortgage securities back onto banks that made the original loans. Investors say the loans did not meet the standards that bondholders were promised when they bought the securities.
I would venture that this is the issue we should be watching if there is going to be a disorderly outcome in the MBS space. You can assume that the government might protect the banks from a lot of Fannie and Freddie put backs if they thought it would put banks’ capital at risk. Remember the Obama Administration has banked Obama’s presidency on doing "deeply, deeply unpopular things" that would right the economy. If the big banks are forced into an under-capitalized position, you have a big mess on your hands economically.
See Felix comments below:
- The enormous mortgage-bond scandal
- Mortgage mess TV
- The historical echoes of the mortgage bond scandal
- The mortgage bond scandal FAQ
- The BofA tail-risk discount
The CNBC video with the investors’ attorney is below.
Update: Here is another video talking about the impact of the potential lawsuit on BofA and other large banks. Of note are the comments about the ability to take these earnings hits over a longer period and the banks’ being well capitalized under Basel III standards. Even if the banks get these bonds put back, they could hold them to maturity and don’t have to write them down according to new FASB rules.
The bottom line is that, unless we see more defaults that absolutely require writedowns, the banks are probably going to get through this particular issue without systemic risk. Nevertheless, I think upside for the banking sector is capped, with lower leverage, lower market volume, lower credit growth, so many writedowns still in the pipeline and so many legal issues looming.
Update 2: Below is the letter which the investors’ attorney sent to Bank of America (h/t Deal Book)