Could faulty mortgage paperwork lead to a new financial crisis?

Concerns are rising that faulty mortgage paperwork may spawn a boom in lawsuits against big banks. For now, a second financial crisis seems unlikely – but not impossible.

By , Staff writer

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    Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) panel members listen to Phyllis Caldwell, chief of the Homeownership Preservation Office of the Treasury Department on Capitol Hill in Washington Wednesday.
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Does the US banking system, still recovering from the financial crisis that roiled Wall Street two years ago, face a new emergency?

The Obama administration says no, at least for now. But the words "systemic risk" are being heard again in congressional meeting rooms, just months after President Obama signed a law designed to head off future crises on Wall Street.

The reason is that an uproar over faulty paperwork in the mortgage business may spawn a boom in lawsuits against big banks.

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And it's not just ordinary people struggling with foreclosure who are suing. The larger concern, industry analysts say, is lawsuits by large investors, seeking to pass home-loan losses back to the banks that managed the loans.

The problem isn't large enough to jeopardize the survival of big banks, many finance experts say. On Wednesday, a US Treasury official voiced a similar view.

"At this time, there is no evidence that there is a systemic risk to the financial system," Phyllis Caldwell, the Treasury's chief of homeownership preservation, told the Congressional Oversight Panel in a hearing focused on the Obama administration's mortgage policies.

The problem is, it's hard to know for sure how exposed the banks are.

Ms. Caldwell herself said, "We're still very early in this issue and are monitoring closely."

In one pending case, Bank of America is under pressure from institutional investors such as BlackRock and Pacific Investment Management Co., known as Pimco, to buy back troubled loans because of improper servicing.

The bank is fighting the allegations, but its foes also include the Federal Reserve Bank of New York, which owns slices of the mortgage deal as a result of its role in bailing out insurance firm AIG.

The case could end up in court, and Bank of America could owe billions of dollars if the investors win.

Citing that case and the prospect of others like it, Damon Silvers, a member of the five-person oversight panel, asked Caldwell if she wished to retract her statement, adding, "It is not a plausible position that there is no systemic risk here."

Already, banks have had to pay nearly $3 billion to repurchase mortgages in the first half of 2010.

It's a new phase of the housing bust, in which banks and large investors are battling over who should bear the losses on masses of loans that borrowers have defaulted on.

The number of investors considering such repurchase or "putback" claims appears to be swelling. Securities lawyers met Wednesday with more than 50 large mortgage bond investors to try to persuade them to fight banks, according to a Reuters report.

Putback efforts are distinct from another document-related problem in the news lately: the allegation that many foreclosures against borrowers have been processed with faulty paperwork.

But the two issues are related. In both instances, mishandled documents or potentially fraudulent representations by loan-servicing firms (often arms of giant banks) may provide the groundwork for lawsuits.

In a dire scenario, flaws in the process by which loans were transferred into pools (and then sold to investors) could raise doubts about who really owns a loan.

"Chain of title problems have the potential to expose the banks to investor lawsuits and to hinder their legal authority to foreclose," Katherine Porter, a legal scholar visiting at Harvard University in Cambridge, Mass., said in a statement prepared for the oversight panel.

Another witness before the panel, however, cited a more prevalent view within the financial industry – that the legal foul-ups won't prove large enough to destabilize the banking system.

"The emerging view in the mortgage industry is that foreclosure problems are largely procedural and can be corrected fairly quickly," said Guy Cecala, publisher of Inside Mortgage Finance.

Mortgage-bond analysts at J.P. Morgan Securities recently estimated that US banks may ultimately incur $55 billion in putback losses, or $120 billion in a higher-loss scenario. That's a big hit, but not devastating to banks, especially because the legal judgments might be spread over several years.

Investor lawsuits could encounter several hurdles, the analysts noted. For instance, if a mortgage security was issued under a "private label" (not backed by Fannie Mae or Freddie Mac), investors must prove not just that a misrepresentation or breach of rules occurred, but also that the problem had a material impact on the performance of the investment.

The J.P. Morgan analysts looked at $5.9 trillion in mortgage securities issued between 2005 and 2007, a time period that corresponds to high risk of both shoddy paperwork and borrower default. They estimate a default rate of 33 percent. Then they tried to estimate the severity of losses when homes are sold in foreclosure (an average 58 percent loss on the loan value), the likelihood of a putback attempt by investors, and the likelihood that the putback effort would succeed.

The result was their forecast of losses to banks totaling $55 billion. But that estimate hinges on multiple assumptions that could prove high or low.

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