Zombie bonds attack!

Stacey Vanek Smith Oct 29, 2010
Zombie bank iStockPhoto

Zombie bonds attack!

Stacey Vanek Smith Oct 29, 2010
Zombie bank iStockPhoto


Kai Ryssdal: Even though I personally am not gonna go near ’em, haunted houses are going to be big this weekend. Here at Marketplace, we’ve got a haunted house story of our own. Haunted housing market story, really. It goes something like this: Once upon a time, home prices were rising. Home loans were scooped up and bundled into mortgage backed securities. Investors bought those securities, the housing bubble burst, and the toxic asset was born. They terrorized the economy and made mince-meat out of our biggest financial institutions. But enter Uncle Sam, toxic asset slayer, with billions of dollars in taxpayer bailout money. Problem solved, right? Yeah, no.

Marketplace’s Stacey Vanek-Smith reports that like any good horror story, toxic assets have a sequel.

Stacey Vanek Smith: Just when you thought they were dead and buried, toxic assets are back.

Marilyn Cohen: This is banking at its worst, part II.

Marilyn Cohen heads up Envision Capital Management. She says the carelessness we saw during the home-buying mania spawned the latest crisis over foreclosures.

Cohen: Everybody wanted to buy homes, and so we had a mountain of paperwork that had to be processed by the mortgage originators and by the title insurance companies and by the banks. And they couldn’t keep up. And they cut corners beyond anybody’s worst nightmares. And it not only turned into a nightmare on Elm Street, but Maple Street and Main Street!

Now that the banks are trying to foreclose on people who aren’t paying their mortgages, all that corner cutting has come back to haunt them. So the first time around, mortgage-backed securities were toxic because the mortgage loans inside of them were bad. Now the same mortgage-backed securities are toxic again, but this time it’s paperwork?

Adam Levitin: Well, paperwork matters!

Georgetown Law Professor Adam Levitin says if loan documents weren’t properly created or processed properly, banks can’t prove they own a mortgage and can’t force a delinquent borrower out of the home. Banks have defended their moves to foreclose as legitimate. They say there are some paperwork problems, but that they can be fixed. But Levitin says it’s not so simple.

Levitin: You’re going to have to track down all the paperwork, and that’s not a simple task, especially as a number of the major institutions that were involved are out of business. There’s a question about even if you can find the paperwork, whether it’s possible to fix it as a matter of law.

Levitin says the complex machine financial institutions put in place to sell mortgage securities is backfiring. Because mortgage documents had to get passed through a complex web of lenders, packagers and investors, one clerical error along the way could raise questions about the rightful owner of a mortgage and could legally gut an entire mortgage-backed security.

Levitin: In some sense, they’re toxic because they might not be there. If the chain of title isn’t correct, it means that the mortgages never got transferred. So those mortgage-backed securities are actually now non-mortgage-backed securities.

That’s right, zombie bonds. Levitin says the only way those investors could get their money out is by forcing the bank that sold them the bonds to buy them back, which probably means lawsuits.

Meeting speaker: It’s a pleasure to welcome you to our conference this morning…

Earlier this week in Midtown Manhattan, law firm Grais & Ellsworth held a meeting for investors in mortgage-backed securities. It was a full house. Attorney Talcott Franklin was talking about his class action suit he’s organizing. He says investors have been flocking to him.

Talcott Franklin: We’re basically to the point where we’re signing up a couple of clients a day. This is just like a snowball effect.

Which could turn into an avalanche. Some heavyweights, including the New York Federal Reserve and bond-giant PIMCO are demanding Bank of America buy back more than $16 billion worth of mortgage loans that they say were mishandled. Scott Simon heads up PIMCO’s asset-backed securities team. He wouldn’t comment on the case, but says if the paperwork isn’t right, that’s on the banks.

Scott Simon: If the loans aren’t up to standards, the typical thing would be that they would buy them back. This is why contracts exist, right? So if I’m going to sell you a car for $25,000, and you bring me a Tonka toy car, I’m hoping that would be covered in my contract.

There’s no telling how many lawsuits there will be over these zombie bonds. Or how serious the paperwork problem is. Some estimates say the banks could be on the hook for more than $100 billion, far more than they’ve set aside, but far less than the first toxic asset crisis. In the meantime, banks, the federal government and would-be home buyers, are hoping that, like most sequels, toxic assets part II won’t be as scary as the original.

In New York, I’m Stacey Vanek-Smith for Marketplace.

There’s a lot happening in the world.  Through it all, Marketplace is here for you. 

You rely on Marketplace to break down the world’s events and tell you how it affects you in a fact-based, approachable way. We rely on your financial support to keep making that possible. 

Your donation today powers the independent journalism that you rely on. For just $5/month, you can help sustain Marketplace so we can keep reporting on the things that matter to you.