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Foreclosure-Gate Fallout: How Bad Can It Get For Wall Street?

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Foreclosure fraud is ruffling a lot of feathers on Wall Street, and while the full scope of losses remains unclear, even major banks are now acknowledging that this is a multibillion-dollar disaster, not just a set of minor paperwork headaches.

So how bad will it get for Wall Street? There are several disaster scenarios in which the housing market simply shuts down, where the potential losses for Wall Street are simply incalculable. But even situations that do not directly rip apart the basic functioning of the mortgage system could be enough to shut down one or more big banks, creating serious trouble for the financial system, and a major test of the recent Wall Street reform bill.

JPMorgan Chase loves using its research department to push its political agenda, and the bank is currently characterizing the foreclosure fraud outbreak as a set of "process-oriented problems that can be fixed." That puts them in the rosy optimist camp for this crisis, and they're projecting a total of $55 billion to $120 billion in losses for the entire industry, spread out over a few years.

But take a look at the analysts' methodology. The actual scope of losses gets drastically larger if you just change a few arbitrary assumptions.

JPMorgan's analysts look at about $6 trillion in mortgages issued between 2005 and 2007 -- this is the height of the bubble, but it excludes plenty of lousy loans issued in 2003, 2004 and 2008. They then estimate defaults of $2 trillion and losses of $1.1 trillion on those defaults.

So far, these estimates are reasonable. According to Valparaiso University Law School Professor Alan White, banks lose about 58 percent of the value of a subprime loan at foreclosure. JPMorgan is estimating 55 percent. The notion that one-third of mortgages issued at the height of the bubble will default may seem extreme, but the analysis includes both first-lien mortgages and second-lien mortgages (home-equity loans). For houses with multiple mortgages, there's going to be a double-hit when the first lien goes bad. Right now, the official statistics from Mortgage Bankers Association indicate that 14 percent of first mortgages are delinquent or in foreclosure. The longer unemployment stays near 10 percent, the higher that figure will go.

Things don't get out of control until JPMorgan's analysts start deploying their assumptions. First, they assume that Fannie and Freddie will attempt to sack banks with losses from 25 percent of the defaults they see. Of those 25 percent, they assume Fannie and Freddie will successfully force banks to eat losses on 40 percent, leading to total losses of 10 percent. Why 25 percent? Why 40 percent? The analysts don't say. JPMorgan expects private-sector investors to be able to saddle banks with just 5 percent of foreclosure losses, citing a host of technical legal hurdles that make it hard for investors to have their cases heard in court.

So JPMorgan's loss projections are nothing more than a guess -- and a low-ball guess at that. JPMorgan is assuming that only five to 10 percent of looming foreclosure losses will actually hit big banks. Change that assumption -- 20 percent, 60 percent, 80 percent -- and things get far worse for Wall Street than JPMorgan's "worst-case" scenario predicts.

Let's consider the exposures of a single bank to put things in context, and let's pick Bank of America, since analysts seem to agree that BofA has the most to worry about right now. They were a big issuer of mortgages themselves, but they also purchased the notoriously predatory Countrywide Financial and also picked up securitization behemoth Merrill Lynch in 2008, giving them far more problems (hilariously, BofA actually paid cash to acquire these balance-sheet-busters).

The most dire estimates for losses on Fannie and Freddie loans at BofA have come from Christopher Whalen at Institutional Risk Analytics and Branch Hill Capital. Whalen has estimated $50 billion in Fannie and Freddie losses for the megabank, while Branch Hill has estimated $70 billion.

The trick is, BofA has $2.1 trillion in total exposure to Fannie and Freddie, according to Whalen. That means even Branch Hill's massive loss projection only amounts to a loss rate of about 3.5 percent.

As of July 2010, Fannie Mae had a serious delinquency rate of 4.82 percent -- these are loans where families have missed at least three payments, but haven't been evicted. For Freddie Mac, the number is 3.83 percent. Not all of those losses can be pushed back on the banks, but those numbers will go up as the unemployment rate stays high. Tip the scales just a few percentage points and it's easy to envision catastrophic losses for banks.

But there's reason to believe that Bank of America is in even worse shape with regard to Fannie and Freddie than any of its peers. Countrywide was the single largest provider of loans to Fannie Mae during the housing bubble. Literally 28 percent of the loans Fannie Mae bought up in 2007 came from Countrywide. Fannie even featured a full-page, smiling photograph of Countrywide CEO Angelo Mozilo in their 2003 Annual Report (.pdf, see page 16).

It's much easier for banks to lose money on bad loans they sold to the GSEs than it is for them to lose money on securities they sold to purely private-sector investors. The fact that Bank of America's most notorious wing was the top provider to Fannie Mae during the peak years of the housing bubble does not bode well for the bank's balance sheet.

But this is just exposure to Fannie and Freddie. The private sector is angry about all kinds of things--from wronged borrowers to deceived investors. Investors are already organizing against both mortgage servicers -- for improperly handling troubled loans -- and against investment banks -- for selling them garbage. They aren't just angry about fraudulent foreclosures -- evidence is mounting that mortgage servicers can't even handle the profits from mortgages correctly, and aren't sending investors reliable, verifiable payments.

Yesterday investors sent a letter pressuring Countrywide's servicing arm to push losses from bad mortgage bonds back on the bank that sold them. Legally, it's a complicated maneuver, since Countrywide itself issued those bonds -- but that just shows the multiple levels at which megabanks like BofA are exposed to fraud losses. Their original sale of mortgages to borrowers, the packaging of those mortgages into securities, the handling of payments and foreclosures, and the accounting for all of these activities -- all of this is about to be subjected to serious fraud examinations by people who are trying to make money.

Up until yesterday, big banks thought they had a get-out-of-jail-free card on investor lawsuits. Investors have to bring together 25 percent of the buyers of any mortgage bond in order to sue the bank that issued it -- even if the actual lawsuit is an open-and-shut fraud case. Investors had not been cooperating. But yesterday's letter to Countrywide is a big deal -- even though it's not (yet) a lawsuit, some of the biggest names in finance were going after Countrywide's cash: BlackRock, PIMCO and even the New York Federal Reserve.

Bill Frey, who runs the hedge fund Greenwich Capital, has organized a massive clearinghouse of mortgage investors for the express purpose of bringing lawsuits against big banks that issued bogus mortgage-backed securities. He told me this afternoon that he's about to move: In the next couple of weeks Greenwich and other investors will bring big lawsuits against major banks.

Will these combined troubles be enough to sink any big banks? If investors can win a couple of lawsuits, easily.