Bailout II: The Sequel

cross-posted at dagblog

So, the story about bad mortgages, by which I mean not simply ill-conceived loans on houses that have hemorrhaged value but loan transfers with forged or non-existent paperwork, is beginning to make it into the daily news. We're going to hear much more about it, I'm afraid. As of today, all 50 state attorney generals are beginning to investigate fraudulent foreclosures and mortgage filings by the banks.

One obvious and huge problem is that people are losing their homes without due process. That is obviously unjust, and bad for the economy while we're at it. A second problem is that an outright moratorium on all foreclosures will, in fact, do destructive things to the economy. That is a sobering problem.

But there's a third problem, just beginning to creep into view: most of those mortgages have been sliced, diced and pureed into the infamous mortgage-backed securities we all remember so fondly from 2008. That securitization, the process of turning individual mortgages into the various bonds, CDOs, and other derivatives that they were turned into, means that the titles to the underlying mortgages were transferred several times between various financial entities. But if the transfers of the mortgages themselves were never legal, and it's becoming clear that illegal transfers were routine, then there it becomes unclear if these mortgages were ever legally sold, or who owns them. And most of these securities have clauses that force the original sellers to buy back the loans if too many of the underlying mortgages turn out to be bad.

Now, if this sounds like a recipe for everybody in the financial world to sue everybody else, it is. But it's worse, because it becomes quite unclear who owns any of those mortgages at all.

Are you excited yet?

Remember all those big financial firms who almost went under during the financial crisis two years back? Remember how they were in danger of going bankrupt because they were holding all of these complicated securities backed by crappy mortgages, and when those became, ahem, "distressed assets" by losing most of their alleged face value the banks were no longer actually solvent? How could we forget, right? Well, imagine that all of those terrible securities have now officially become hot potatoes that the banks can legally attempt to foist back on one another. The new game is about to become You never legally sold us this, so here. It's still yours.

And before you say that this is all about technicalities, ask this: what lawyer is going to let a client lose tens of millions of dollars when a "mere legal technicality" would prevent that loss? Which megabank is going to go under by voluntarily overlooking such technicalities while all of the other megabanks use them to wriggle toward survival? I think we all know the answers to those questions.

Back when those crappy securities were merely "distressed assets," the Federal government bailed out the owners of those companies so they could stay in business pretending to be solvent. Now those assets are likely ownerless, meaning more huge write-offs on balance sheets, and various huge firms are going to be trying to stick one another with massive losses. Meanwhile, no one is going to be ready to trust any of those firms, because no one knows who is going to come out a winner and who is suddenly going to end up eating a $2 billion loss. Basically, there's a real danger of repeating 2008: massive financial firms in danger of collapsing, and taking large chunks of the real economy down with them when they go, and a general financial panic in which uncertainty about who is about to go down makes everybody unwilling to do business and thus leads to even more firms actually going down.

Oh, and by the way, the TARP money that the Administration could use to bail out huge firms in a jam? Just expired. Isn't it ironic?

And here's the thing: we can't repeat the bailout process from two years ago. We also shouldn't, but more importantly we can't. It was massively unpopular then, and it's only grown more unpopular. The Republicans are currently building their entire program around their alleged loathing of the first bailout and trying to stick the Democrats with the blame for it. And no voter in the world could stomach the same firms coming back with their hats in their hands again, not so soon.

So our national leaders may face a stark choice sometime over the next year. TARP II will be out of the question. Letting big companies fail, which the Tea Party Republicans will insist on, will likely make TARP I look sensible by decimating our economy for the next thirty years, but if we make that mistake it won't be reversible. The only way to intervene to save the financial sector will have to be punitive: Obama would need to nationalize large financial firms, cut executive pay, send a couple of people Wall Street reveres to prison. The Republican opposition will of course try to prevent anything even remotely like that, and most of what will need doing will require Congressional approval. But if Obama tries anything else, he's done for. The only way to build popular support for a second intervention in the financial sector is to go in as the sheriff cleaning up town.

I have no idea what will happen if push comes to shove again. But what Obama does will be about the choices he perceives himself as having. He would never do anything resembling this except to avoid disaster. But disaster may be coming.