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Bank of America Case Hurtles Toward the Great MBS Unwind

A little over a week ago, I wrote a story about how a personal bankruptcy case in New Jerseymight affect the mortgage repurchase fiasco currently underway in many of the big banks.

A Bank of America trader inside the NYSE.
Oliver Quillia for CNBC.com
A Bank of America trader inside the NYSE.

The upshot of the story is this: A Bank of America executive testified under oath in a bankruptcy hearing that Countrywide Financial did not properly transfer a mortgage note. Proper transfer of that note was required to maintain compliance with the legal terms of a document called the pooling and servicing agreement, which governs how individual loans are turned into mortgage-backed securities.

Moreover, the Bank of America executive, in the words of court documents "testified further that it was customary for Countrywide to maintain possession of the original note and related loan documents."

So it would seem Countrywide Financial didn't transfer the note as a matter of policy—not simply as a one-off mistake in the case being heard before the New Jersey bankruptcy court.

Bank of America attorneys later stated that this was not a matter of policy at Countrywide Financial—and that Countrywide's policies and practices always maintained compliance with the terms of the pooling and servicing agreement.

I later followed up on the story in light of Bank of America's statement.

(Countrywide financial is of course now owned by Bank of America —which, presumably, is now legally responsible for Countrywide Financial's future economic liabilities.)

Today, Bloomberg News picked up the story.

(Note: The original story, based on court documentsseems to have been broken by Gretchen Morgenson at the New York Times. Tracy Alloway at The Financial Times Alphaville, and later Naked Capitalism picked up the story as well.)

The Bloomberg article observes: "The Kemp [bankruptcy] case is also being examined by lawyers for investors in mortgage-backed securities.

Owners of the bonds have been cooperating in an effort to force sellers to take back loans, saying they were misled about their quality. The [Judge] Wizmur ruling may give investors an additional opportunity to push for mortgage buybacks on grounds that the bonds weren’t created in keeping with securitization contracts. "

In the Bloomberg article, Kurt Eggert, a professor at Chapman University School of Law in Orange, California goes quite a bit further: "It may mean investors who think they bought mortgage-backed securities bought securities that aren’t backed by anything."

While Professor Eggert's scenario may seem unlikely, it does perhaps illustrate how raw the nerves surrounding the case have become. (And, in fairness to the professor, it is worth noting that the comment cited above doesn't include the context of his remark: Eggert may have been speaking strictly about legal theory rather than practice.)

In an anticlimactic coda, Bloomberg News notes: "The potential impact of DeMartini’s testimony may depend on the outcome of a broader dispute between homeowner and industry lawyers about whether missing or incomplete paperwork subsequently can be fixed, Eggert said."

Well, yes: Of course.

It seems unlikely that a basic principle of home ownership would be overturned on a technicality. Especially a technicality of the kind discussed here—the mechanics of proper note transference during the mortgage securitization process.You don't need to be a law professor to figure that one out.

When non-attorneys begin speculating about legal issues, it is typically a path fraught with peril. (Which explains why I defer to my colleague—and former securities lawyer— John Carney on matters of the law.)

But sometimes a non-lawyer can cut through the endless legal navel gazing and pontification.

So this is how I see it: Federal judges tend not to be the sort of renegade lunatics who enjoy smashing up civil society for the sake of a perverse intellectual thrill. (Not without accident are judges held up to be pillars of that society.) So the probability of the federal judiciary disposing of not merely well-established business practices—but the intent of the law itself —seems remote. Especially when the ramifications of such a decision could destroy the very backbone of middle-class America: Homeownership. Pace Professor Egger remarks, don't look for those bonds to be backed by nothing anytime soon.

That said: Bonds have a broad valuation range between par and zero.

Specifically, the level of impairment creditors may ultimately face as a consequence of flawed documentation and securitization practices is unknown. Also unknown are the potential penalties that banks may face —through regulatory action, litigation, or otherwise—as a consequence of their securitization practices.

As the concentric circles of the repurchase fiasco widen there are broader unknown quantities. Perhaps the ultimate question is this: Who will bear the costs in the event of a meltdown?

But, upon further reflection, perhaps the answer to that question is not quite as nebulous as it seems.

Because in the final analysis it may well be a distinction without a difference.

What if Fannie Mae and Freddie Mac require more capital to survive?

What if the banks are suddenly forced to repurchase a huge chunk of mortgage backed securities—and then need another bailout?

In either case, who do you think covers the tab?

In the end, the U.S. taxpayer is the ultimate guarantor—and, if necessary, will be called upon to erect the final backstop.

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