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Will MBS Market Become Embroiled in the Foreclosure Crisis?

Will MBS Market Become Embroiled in the Foreclosure Crisis?
Ron DeLegge
October 15, 2010

SAN DIEGO ( Ė Like a never-ending nightmare the legal and financial problems facing the banking industry wonít disappear. Just when we thought the sub-prime mortgage crisis was over and banks could get back to work, a new crisis blindsides them. And caught in the middle is an important segment of the U.S. bond market called ďmortgage-backed securities.Ē

Letís analyze how the mis-foreclosure crisis could impact them.

During the residential real estate boom the business of securitizing mortgages was extremely profitable. Homebuyers would obtain a mortgage from originators that would sell the mortgages to another party. The mortgages would end up at banks or other financial institutions that would package them together with other mortgages to be minced into securities and sold. (Think of a sausage or hotdog factory but for mortgage loans.) As mortgage payments were made, they were processed by service providers and distributed as income to mortgage bond investors. 

While a sea of paperwork was involved in each step, the frantic pace of originating loans and securitizing them apparently got in the way. Even though loan documents were created to establish property ownership rights, mortgage payment obligations and the recourse for loan defaults, sloppy documentation still happened. Along the way, paperwork was mishandled, lost or in certain cases fraudulently executed.

Now in their haste to foreclose on delinquent borrowers, it appears banks (NYSEArca: KBE) could be on the hook for billions. Are they guilty of illegally evicting people from their homes because of faulty documentation and in certain instances outright fraud? Major banks like Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), PNC Financial (NYSE: PNC) and others arenít taking any chances and have temporarily stopped foreclosure proceedings.   

Impact on MBS market
There are many faces to this developing crisis. Like New Yorkís underground sewer system, itís an interconnected puzzle that leads to places most of us would never want to visit.

Residential mortgage-backed securities (RMBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans. Most RMBS are issued by the Government National Mortgage Association (Ginnie Mae), Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Some financial institutions like brokerages (NYSEArca: IAI), banks and homebuilders (NYSEArca: XHB) also securitized mortgages which are known as private-label mortgage securities.

As a consequence, residential mortgage backed securities are likely to become embroiled in the mis-foreclosure mess. What if mortgage securities contained within a mortgage sausage pool were created with inadequate loan documentation? What are the securities worth? And if theyíre worthless, how and when will it be reflected in bankís balance sheets? When will credit agencies begin their wave of credit downgrades or will they be late to the party like last time? Will this finally be the end of financial engineering or will it create a new chapter in financial perversity?

Foreclosure-Gate adds an entirely unexpected dimension to the financial crisis that began in 2008 and presumably long-ago ended. (What? You donít believe the worst is over because economists at the National Bureau of Economic Research told you the recession ended? Party pooper!)

In case youíre wondering, the Securities Industry and Financial Markets Association said there was $8.94 trillion in outstanding U.S. mortgage backed securities at the end of the second quarter. Around $6.73 trillion is in GNMA, FNMA, FHLMC mortgage backed securities and CMOs. What percentage of these trillions will become embroiled in this scandal? And will we need to buy bigger and higher powered calculators to keep count? 

Letís analyze a few key ETFs that contain mortgage-backed securities:

iShares Barclays MBS Bond Fund (NYSEArca: MBB)
MBB is linked to the investment grade agency mortgage-backed securities sector of the U.S. as defined by the Barclays U.S. MBS Index. MBB has increased in value by 6.21% year-to-date and carries a yield just over 3.50%.

MBBís underlying index measures the performance of investment grade mortgage-backed pass-through securities of GNMA, FNMA and FHLMC. The index includes fixed-rate mortgage pass-through securities issued by GNMA, FHLMC, and FNMA that have 30-, 20-, 15-year and balloon maturities as well as hybrid ARMs mortgage pass-through securities.

Vangaurd Total Bond Market ETF (NYSEArca: BND)
BND follows the popular Barclays Capital U.S. Aggregate Bond Index which attempts to reflect the yield and performance of the U.S. investment grade bond market. So far this year, BND has risen 7.81% and it carries a yield of around 3.50%.

Roughly 40% of BNDís underlying index is invested in residential mortgage-backed securities. Before you panic, itís important to remember that since the index only includes ďinvestment grade bondsĒ low rated mortgage debt isnít included. In other words, loans in default or sub-prime debt arenít part of BNDís underlying assets. This applies to other ETFs that follow this same index benchmark like the iShares Barclays Capital Aggregate Bond Index Fund (NYSEArca: AGG) and the SPDR Barclays Capital Aggregate Bond ETF (NYSEArca: LAG).

The November ETF Profit Strategy Newsletter analyzes other looming ramifications of the foreclosure crisis  for banks, the real estate market and the financial system.  

CommentsAdd Comment

David Pales said on October 30, 2010
  In this process, originating banks in many cases, do not pass on title custody to the R/MBS issurer -- i.e., Ginnie/Fannie/Freddie. This appears to be an effort to avoid taxes due on the transaction. Yet, the Fed. Securities Act requirements appear to be holding. Thus, if the originator has not conveyed chain of title to the R/MBS issuer, the R/MBS cannot be sold. Essentially, it is missing the "MB" in R/MBS. Thus, the loan originator has committed fraud under the act. I believe that in these circumstances, the Securities Act provides a 20 day response deadline to cure such deficiencies. Absent proof of chain of title, the underlying mortgage could be declared void along with the R/MBS. When this starts to happen -- challenges to the underlying mortgage and the obligation of borrowers, three things will happen: 1) Clarification of title custody, 2) Waiver of transaction taxes, 3) indemnity for banks. So doing means that all mortgage holders become indentured to the banks who avoided taxes, committed fraud, and intentionally lied on their corporate tax returns.
HackSaw2 said on October 18, 2010
  The banking industry, credit rating agencies, FDIC and ALL the political crooks that support them are already making plans to DOWNPLAY the significance of this MASSIVE NATIONWIDE Fraud Closure scandal. The RMBS market is just the tip of the iceberg, what about CMBS too? Now that's opening up a can of worms. Is there any way to make a multi-trillion problem such as this SOUND SMALL? If there is, you're hired! Downplay, deflect, ignore and pretend is the modus operundi.
dumbeconomist said on October 15, 2010
  Is this the Black Swan Nicholas Taleb warned about? Looks like another government bailout in the works. And taxpayers will get shelled like always.
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