Ezra Klein has a great interview with Janet Tavakoli, the founder of Tavakoli Structured Finance, on Foreclosure Gate.
Ezra Klein: What’s happening here? Why are we suddenly faced with a crisis that wasn’t apparent two weeks ago?
Janet Tavakoli: This is the biggest fraud in the history of the capital markets. And it’s not something that happened last week. It happened when these loans were originated, in some cases years ago. Loans have representations and warranties that have to be met. In the past, you had a certain period of time, 60 to 90 days, where you sort through these loans and, if they’re bad, you kick them back. If the documentation wasn’t correct, you’d kick it back. If you found the incomes of the buyers had been overstated, or the houses had been appraised at twice their worth, you’d kick it back. But that didn’t happen here. And it turned out there were loan files that were missing required documentation. Part of putting the deal together is that the securitization professional, and in this case that’s banks like Goldman Sachs and JP Morgan, has to watch for this stuff. It’s called perfecting the security, and it’s not optional.
EK: And how much danger are the banks themselves in?
JT: When we had the financial crisis, the first thing the banks did was run to Congress and ask for accounting relief. They asked to be able to avoid pricing this stuff at the price where people would buy them. So no one can tell you the size of the hole in these balance sheets. We’ve thrown a lot of money at it. TARP was just the tip of the iceberg. We’ve given them guarantees on debts, low-cost funding from the Fed. But a lot of these mortgages just cannot be saved. Had we acknowledged this problem in 2005, we could’ve cleaned it up for a few hundred billion dollars. But we didn’t. Banks were lying and committing fraud, and our regulators were covering them and so a bad problem has become a hellacious one.
To put this slightly differently, it is very possible that ForeclosureGate is the cover-up, not the crime. That is, banks may be fudging the foreclosures because they are discovering more serious problems with the underlying loan documents. In many states, those problems could undermine lenders’ claims to the houses against which they made loans, perhaps putting the banks in the position of ordinary, unsecured creditors rather than front-of-the-line mortgage holders. Improper or missing documentation may mean that banks lack the right to foreclose on delinquent loans in many jurisdictions.
If a cover-up of this kind of mortgage inadequacy is behind ForeclosureGate, the loan portfolios of some banks could be in for a shock. If banks cannot quickly foreclose—or they lack the right to foreclose at all—the recovery value on delinquent loans would drop precipitously. That would mean that banks would face another round of write-downs on their mortgage books.
It gets worse. If loans aren’t properly classified as mortgages because they banks lack recourse to foreclosure, they probably need to be booked as ordinary loans for the purposes of capital requirements. Under current banking regulations, banks would need to set aside twice as much capital for mortgages loans re-characterized as ordinary consumer.
Of course, we don’t know how widespread the problems with foreclosures really are. Bank of America has frozen mortgages in all fifty states. Wells Fargo, on the other hand, is indicating that it has no plans for a foreclosure freeze. We also do not know how much of ForeclosureGate is just minor technical issues with the foreclosure process—which is what the banks are saying now—or the tip of the iceberg to a deeper problem of mortgage inadequacy.
But it looks like we’re going to find out.
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