Foreclosuregate

The S&P500 melted up another 1.65% last week.  The rise is being fueled–explicitly–by the eagerly anticipated round of quantitative easing (or electronic money printing) by the Federal Reserve.  That’s pretty much it.  No real fundamental improvement in the economy (jobs and organic incomes), no strong sales growth of US corporations, no growth at all in US consumer borrowings.  Nope.  It’s all about another round of money printing and the debasement of the US dollar.  As the dollar falls, stocks rise.  So far.

As mentioned, the news from the economy was mostly bad.  Factory orders fell more than expected.  Pending home sales were down 20% in August vs. August 2009.  And distressed sales made up over 35% of these terribly low levels.  In other words, normal home buying is pitifully low.  ISM services were slightly better than expected, but–at 53.2–they were at the second lowest level of 2010.  Initial jobless claims were still stuck in the 450 thousand range normally associated with recessions.  Consumer credit shrank–again.  Nonfarm payrolls were worse than expected.  18,000 jobs were LOST in September, when economists were expecting that 70,000 jobs would be GAINED.  The headline unemployment rate did not change, but only because the hiring environment was so poor that people left the workforce (ie. they became discouraged, so they did not count as being unemployed).  The broader U-6 measure does capture these people, and this rate soared from 16.7% to 17.1%.  Average hourly earnings were unchanged; they were expected to rise.

Technically, on the daily charts, there are negative divergences everywhere.  While stock prices have been melting up over the last several weeks, several momentum and oscillator indicators are not rising as much.  In other words, they’re diverging from the price action and suggesting that this latest price increase is getting tired.

Seemingly out of nowhere, a new scandal–some are dubbing Foreclosuregate–has erupted.  Bank of America has suspended foreclosures in all 50 states.  Other mortgage originators, such as Ally/GMAC, have suspended foreclosures in almost half of the nation’s states. 

These too-big-to-fail financial firms are portraying this mess as mere set of technicalities:  poorly handled mortgage documents (from origination to MBS securities) and innocent errors during foreclosure proceedings.

The reality is far, far worse.

One financial expert has called this “the biggest fraud in the history of capital markets”. 

Why is this such a big deal?

One, thousands and even perhaps millions of homes may have been taken–via foreclosure–from homeowners by entities that did NOT have the right to foreclose.  It’s that simple. 

This has nothing to do with the fact that most of these homeowners failed to make their mortgage payments, in full and on time.  They failed to do so.’

What is does mean is that the rule of law was ignored.  Banks were essentially breaking the law to take back houses.  So banks could be found to be criminally liable for this.  They could also be liable for penalties.  At the very least, they will spend huge dollars addressing this part of the mess.

Second, and perhaps more devastating to the banks, is the issue of selling DEFECTIVE mortgage-backed securities to investors–pension funds, insurance companies, endowments, and many other institutional investors in the US and around the world.

These too-big-too-fail mortgage originators knowingly created MBS securities that they knew were out of compliance–with the security terms–and sold them to investors as if they were good.  On top of all, the terms of these securities permit only 90 days from origination to FIX any defects.  Since these securities are almost all one to five years old, they CANNOT be fixed.  And if they cannot be fixed, IRS tax-exemption benefits could be rescinded.  So defrauded investors AND the IRS could be filing claims against these banks.

How large could the damages get?  Assuming even 50% loss rates on the underlying mortgages, some analysts have estimate that total losses and claims could exceed $3 trillion.

That would instantly bankrupt all of the too-big-to-fail banks.  They have far less than $3 trillion in equity capital.

Luckily the new Frank-Dodd financial regulation bill provides for the break up of these banks in situations such as this one.

Are we looking at the possibility of seeing a firm like Bank of America getting broken up and sold off in pieces, wiping out all shareholders and some of the debt holders?

The odds are getting stronger every day.

This scandal could be “bigger” than the original sub-prime crisis.  This scandal could trigger another global financial panic.  Yikes!

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