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Foreclosure Crisis: The Worst-Case Scenario

Stocks in this article: BAC JPM C WFC USB PNC GS

Rick Sharga, senior vice president of RealtyTrac, which closely monitors foreclosure data, says that in recent months banks had been careful to initiate new proceedings only as quickly as they repossessed and sold other homes. Now that new moratoriums have been implemented, Sharga predicts there will be a superficial decline in foreclosures through at least the end of 2010, followed by an accelerated pace in the spring. In the worst-case scenario - if, say, another nationwide moratorium is put in place for an extended period - Sharga says it could have dire effects for the housing market and broader economy.

"This is one of those cases where you have to manage the recovery and allow these losses to be absorbed in a more gradual manner so you don't accidentally take down the banking system," says Sharga. "We're probably talking about, from peak to trough, a couple trillion dollars in lost value that has to be recognized somewhere."

"If you rip this Band-Aid off," he concludes, "you might tear off the sutures and the patient could bleed to death."

The other lurking danger for big banks is private litigation stemming from the tangled web of mortgage securitization.

At issue is the practice of "robosigning." Bank employees had been scribbling autographs on thousands of foreclosure documents without verifying all the information. Although the homeowner may have defaulted, attorneys general are claiming "crime on the court" because proper procedures weren't followed. Investors who have taken big hits on defaulted mortgage bonds may claim that they still have legal rights to the foreclosed-upon homes.

Joseph Lynyak, a partner in the financial services practice of Venable LLP, says those cases are what should have big banks really worried.

"If you're an investor, you're sitting back, saying, 'Wait a minute. We hired you to do this properly and you haven't done it. We may be sued and you've got to indemnify us,'" says Lynyak, who advises large banks and mortgage servicing firms. "It could get very, very sticky."

As the mounting troubles became clear in recent weeks, big banks hit the "pause" button on foreclosures.

The largest mortgage servicer, Bank of America (BAC), has halted proceedings completely, while competitors have done so in selected states. JPMorgan Chase (JPM) is reviewing 115,000 documents for potential errors. GMAC Mortgage faces lawsuits from the Ohio State Attorney General, as well as a group of homeowners in Maine. Citigroup, Wells Fargo (WFC), PNC Financial Services (PNC), U.S. Bancorp (USB) and Goldman Sachs' (GS) loan servicing division have all gotten roped into the "robo"-scandal in one way or another, too.

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