Turn On The Lights, Watch The Roaches Scatter, Part 31

Even my new favorite CNBC punching bag John Carney has figured out Foreclosuregate can very well be the catalyst that knocks us back into economic depression.  The problem of course is that he still thinks it's a minor paperwork snafu...and of course the moratorium is keeping all those borke people in their houses, the scumbags.

The paperwork problem is curable. Banks can go back through the chain of ownership of loans and liens to correct lapses.

But this process is time consuming and costly, especially when some of the original mortgage lenders or intermediary owners of the mortgages have gone bankrupt or been merged into other banks.

In the meantime, borrowers who have defaulted on their loans will likely be able to keep their homes for longer than they otherwise could. What’s more, banks are likely to find that more foreclosure actions are contested by borrowers as the public and attorneys eager to collect legal fees by fighting foreclosures become more aware of the documentation problems.

All this means that banks will find themselves with more bad loans on their books. The normal pace of run-off of bad loans—delinquency to default, default to foreclosure, foreclosure to sale—has meant banks have not been able to recover revenue on non-performing loans for upwards of a year and a half in much of the country. The new pace of run-off will likely mean that banks are stuck with the non-performing loans for far longer.

The longer it takes for banks to exit bad loans and recover cash, the higher the level of bad loans on the books of banks will get. As the non-performing loan portfolio grows, banks will need to set aside an increasing amount of capital to balance. This will, in turn, mean banks will make fewer home loans until the backlog of bad loans can be cleared up.

In short, the foreclosure crisis has the potential of creating a liquidity crisis for home loans. The actual number of defaults is not necessarily increasing—it’s just taking longer than usual to clear the old non-performing loans. But this means that banks aren’t generating revenue from the foreclosures. It also means that the loan portfolios will appear to be worsening as the percentages of non-performing loans grow. 

As usual, Carney shows he understands the outcome, but not why.  The issue is not a paperwork snafu, but a fundamental confidence issue in the banks.  The foreclosuregate mess was created because all the banks were cutting corners on the paperwork and claiming they still had the document chain for each loan intact...when they do not.  We can't be sure.

Banks can't be sure what they own.  That means their hedge fund investors can't be sure what they own now.  That's the real death spiral.  Yes, the problem Carney describes will almost certainly come to pass, but it will be because the banks have been caught defrauding the public and they have been for years.

It's not sloppy paperwork.  It's institutionalized mortgage fraud.  There's a difference.