Scum Covered Pond of MBS
Research for Online Investors

by John Dalt

10/18/10

Fallout from the mortgage-gate crisis keeps the water swirling in the scum covered pond of mortgage backed securities (MBS) market.  Bloomberg reports that the big banks had $47 billion in market cap erased in the last two days ending Oct. 15.

We don’t know where it will end, but we gave you a good beginning to understand the problems on Friday.  We have come across some more news that will fill in some gaps.  I picked this up from an email subscriber A.M sent over the weekend.  This comes from David Kotok of Cumberland Advisors, one of the sources he trusts.

Mr. Kotok explains the process of creating an MBS and assigning the different levels of risk (tranches) so the rating agencies can assign a rating and buyers can purchase an investment that matches their risk tolerance.

No one knew which mortgages were the riskiest; they were not assigned that way.  When a mortgage went bad it became a liability of the lowest tranche, but they were never assigned.

This is where the Mortgage Electronic Registration System (MERS) came in, that we wrote about on Friday in Mortgagegate Mess.  MERS was jointly owned by Fannie Mae and Freddy Mac.  In one of the funniest lines Mr. Kotok refers to these two government sponsored entities (GSE) as the “chlamydia and the gonorrhea of the financial world-you cure ‘em, but they just keep coming back.”

The problem is one of “chain of ownership.”  The mortgages were not actually owned by MERS, nor were they assigned to the Real Estate Investment Mortgage Conduits (REIMC).  These REIMCs were created to gather the mortgage so they could be sliced and diced into securitized mortgages.

But REIMCs could not actually own the mortgage as they had to be “mortgage remote” in order to get the ratings agencies blessings on the different tranches of the MBS.

The “chain of ownership” of the mortgage note is in question.  It was never assigned, kind of like everybody owns it when it is good, and nobody wants it when it is bad.

A mortgage note can be assigned again and again, but if the ownership is in question, you cannot foreclose on it because you can’t prove you own it.  If the chain of ownership is broken, the borrower does not owe money on the loan.

Along with the problems of recording I pointed out on Friday, some of the banks hired “foreclosure mills.”  These “foreclosure mills” faked and falsified documents to make the “chain of title” appear unbroken.  There were some problems, like people facing foreclosure on falsified documents, that didn’t even have a mortgage.  But, these were being handled, according to Mr. Kotok.

The proverbial “s*?t hit the fan” when title insurance companies refused to insure titles on previously foreclosed real estate.  They were not going to risk their capital insuring a clear title whose foreclosure could be reversed because of a bad “chain of title” problem.

We don’t know how many mortgage foreclosures have been carried out with bad documents, resold and now could be subject to lawsuits by former owners.  But, how many is too many?  Musical chairs with real estate can be a costly game.  Now you own it, now you don’t, ring around the rosy…

I would like to believe in the integrity of the U.S. population, but how many will call their mortgage service provider and ask for a copy of their mortgage note?  How many will continue to pay their mortgage if the paperwork is questionable?

We would prefer to sit in the stands on financials while this game is played out.  We can cheer for our favorites, but we don’t believe in betting on sporting events.

To the mailbag:
Liked the article today on Mortagegate. Is this going to drag down the banks like the original mortgage crisis did?  Could this problem affect the capital that banks are required to carry? What is the worst case? Are all banks affected or just the few big mortgage banks, like BOA?  How can we protect our portfolios? ---subscriber B.L.

John’s reply:  I think an overabundance of caution is warranted.  It is hard to imagine this getting out of hand because of the damage it could do.  But, the players are not controlled by the Fed, Treasury or any other national entity.  State's Attorney Generals will follow their interests, and that is to go after the banks and the process.  I don't see a way to stop it like the Treasury did the first Credit Crisis.  I didn't agree with TARP, and as it ended up the money wasn't even used to buy Troubled Assets  This is a "process" problem (paperwork), not a rolling wave of defaults.  The ramifications of it could be worse.  BAC, C could be the hardest hit.

I like your idea of the SKF, but scary to go against Brainiake Bernanke!---paid up subscriber T.M.

John’s reply:  I don’t want SKF to sound like a recommendation.  The banks are already beat down, any regulatory relief would uncoil the spring to go higher.  Take this as a cautionary warning; stay clear of banks until we understand more.  Right now, it is just a gamble not an investment or a trade.

Editor’s note:  We closed out trades today for 11.6% and 5.8% gains in SwingTrader.   That is five winners out of seven closed trades this month!  Why not join?

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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