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Banks Facing Another Mortgage Crisis

Wall Street banks have paid back their federal bailout money and are on the road to recovery, but the financial crisis continues for Main Street banks that small businesses rely on for capital. According to this Barron’s article featured on Yahoo, banks could lose more than $100 billion in another mortgage crisis over the next few years as the backlash from the bailout begins:

The potential liability facing bankers arises from the $2 trillion in subprime, alt-A and option-adjustable rate mortgages that they underwrote and sold to investors, mostly as mortgage-backed securities during the home-lending boom of 2005 to 2007. The losses on the mortgages will be horrendous before the dust settles—over $700 billion on these and other so-called nonagency mortgage securities, according to New York mortgage-research specialist and broker Amherst Securities Group.

And now investors—from the federal housing giants Fannie Mae and Freddie Mac to major bond managers like closely held Pacific Investment Management and BlackRock —are fighting back. They are seeking to put back the mortgages to the banks from whence the investment flotsam came and force the banks to eat much of the mortgage losses.

The argument hinges on the arcane contract principle of representations and warranties, known as reps and warranties in legal jargon. Namely, did the mortgages go bad because of the unanticipated nationwide collapse in home prices (a so-called exogenous factor) or are the banks responsible for the mess because they “misrepresented” to the mortgage purchasers the shoddy quality of the mortgages they put in securities and pools?

Some buyers have seen a small amount of success in their putback efforts. Fannie Mae and Freddie Mac have returned more than $13 billion in defective mortgages and plan on more. When all is said and done, the banks may have to eat more than $30 billion in losses from Freddie and Fannie alone, because no bank in the mortgage business can afford to play hardball with the mortgage giants who own or guarantee about half of all the home mortgages in the United States.

Bank of America faces the biggest potential loss of all the major banks at $35 billion, according to Barron’s. That’s because BofA acquired large sub-prime mortgage originators Countrywide and Merrill Lynch during the mortgage bust. Compass Point Research & Trading, a mortgage-research boutique based in Washington D.C. estimates BofA’s net worth decreasing by 17% over the new few years. Their stock has already fallen 22.6% this year.

Undoubtedly, some of the major banks certainly deserve to suffer additional losses. In almost every case, they were either negligent or deliberately responsible for issuing mortgage loans that they shouldn’t have. The banks will try to recover their losses with large putbacks but more than likely, they will end up losing even more and will not have the government to assist them this time.