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Foreclosure Fear: Q&A Risk Analytics Chris Whalen

Chris Whalen, Managing Director of Institutional Risk Analytics believes the big banks need to be restructured.



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JPMorgan Chase

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reported its third-quarter earnings and during the company's conference call, the CFO Doug Braunstein talked about the foreclosure document issue.

JPMorgan recently froze foreclosure proceedings in 23 states as it reviews improper documentation. Braunstein noted that 115,000 files are being reviewed for errors. He classified many of the issues as notary problems and procedural issues saying the review, "would be a very lengthy process." Braunstein went on to say that the foreclosure review wouldn't dramatically change the loan loss reserve number of $7 billion.


spoke with Institutional Risk Analytics managing director Chris Whalen about the foreclosures stoppages and the impact on banks.

TheStreet: JP Morgan shut down foreclosure in certain states, while Bank of America (BAC) - Get Bank of America Corp Report shut them all down. Freezing foreclosures can't be good for banks, right?

Chris Whalen

: Yes, but all the documents are questionable. You see, for the past 30 years home prices have been rising without interruption. There have been some modest corrections. But, by and large, collateral prices have been going up and up for both for residential and commercial. So the fact that Wall Street didn't want to spend an extra half point when they did a mortgage-backed security to send paralegals around the country to change the collateral lien on the mortgage - nobody noticed.

Whatever imperfections or failings were in the system no one noticed. Now we're noticing. That's because the value of the collateral has dropped a lot, 25% to 35% depending on where you are in the country. So you have all these people who are confronted with foreclosure and the bank or the agent shows up in court and they can't necessarily attest to who owns the mortgage.

The fact of bad documentation does not change the fact that the mortgage is bad.

TheStreet: Right, it won't change the fact of the foreclosure. It's just a step back to make sure the documents are in order.


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No, it's not that simple. If the lien wasn't changed, you can't go into court and foreclose. You can't stand up in front of the judge and say "I am the party who owns the mortgage your honor." He's going to look at the docket and if the record in the New York State courthouse doesn't say that he's the owner - he may not agree.

So when you have an imperfection in the record, you're in big trouble as a lender. You basically have an unsecured loan. That's the issue that's really going to commit the banks this year and next year. Investors are going to sue them because they were sold a security that was fraudulent. It was not collateralized. And the underwriter of the security did not take the steps required to go out there and perfect the collateral lien, because they wanted to keep the extra half point for themselves as profit in the underwriting instead of having it as the expense for the underwriting.

TheStreet: You've got issues on both sides. Not only the bank, but the people that bought the mortgage-backed securities?


Exactly. You have the original purchase by say,

Lehman Brothers

. You have the investor who bought the security. You have the borrower who originally took out the mortgage. All of these people have cause of action against the bank. This is going to be a mess for years.

TheStreet: When is this going to hit the banks books?


Well, it's hitting it now. We're barely through a quarter of the total foreclosures. So if you think about Bank of America - the claims they're facing from Fannie Mae and Freddie Mac for bad loans they have to repurchase. They have over a trillion dollars in footings. My number is $40-$50 billion in loan repurchase expense for Bank of America through the cycle. That is only about 3% of their total exposure to Fannie and Freddie. It's not a huge number and I think we'll easily get there.

The other issue is just dealing with these properties, which is going to overwhelm them. This is why you see banks walking away from properties. They are just handing the keys to the state or the city where the property is located and saying "here, this is yours - go sell it".

The problem I see here is two-fold. First this process of implosion in terms of real estate values, foreclosures and everything else is going to destroy the property tax base of many communities. The ad valorum tax base is the foundation of the United States financially. If that starts to shrink, you have to shrink services. You have to fire people. It's deflationary.

The other more important issue is the banks are going to have to be restructured and nobody in Washington wants to talk about this. So, you have the Fed keeping rates low and killing consumers with expenditures. Now, the real trick with quantitative easing is dollar devaluation.

If we do that, than everybody else in the world that uses the dollar as their reserve currency are going to see their central banks taking losses and they're going to see the markets in the U.S. shrinking in terms of their own currencies. The only choice they'll have is to also shrink their currencies. They're going to see shrinkage in revenue, in the value of assets and everything else.

The folks at the Fed are frozen in fear. They don't know what to do.

TheStreet: The banks keep getting mixed signals out of Washington. They have proposed recent legislation which allows for notary's to be recognized across state border. That was good for the banks...


Pure politics by

President Obama.

TheStreet:.. but then they are also being told to not foreclose on poor Americans. Then the White House says freezing foreclosure is not a good idea.


It's going to kill the market for homes. Think of it in terms of closings. If you were a title insurance company, would you write title insurance now?No way. So, if I can't get title insurance on a home purchase, I can't close. What the Obama administration and the Fed are doing in large part because they are being overwhelmed by issues where there's no give and no good choices. n

No matter what you do you're creating a problem somewhere else. So we have a situation where they're trying to pander to the consumer on the one hand, rhetorically, but they're still in the background trying to pander to the banks and this is subsidies from the Fed through interest rates and also the refinancing issue.

Fannie, Freddie, and the top three banks are essentially a cartel now. They are blocking refinancing for the homeowners out there who are performing and who should be refinanced to keep their costs low and reliquify these households. Instead, the banks are writing very few mortgages but they're putting four or five points on top compared to half a point back in 2006/2005 time frame.

That to me is the biggest problem of all. In the post war period every time the Fed dropped rates, households refinanced. Credit cards, mortgages, whatever. But now if you look at the charts the effective rates from Fannie and Freddie hasn't budged, whereas the cost of funds for the banks, for the GSE has fallen. So, there's no benefit going to the consumer. If this consumer led society of ours doesn't recover, then we're going to see unemployment go up again. We're going to see home prices fall further. We're going to be stuck in a classic deflation. In many ways we can't avoid this. It's baked into the pie. But I think there a policy steps that we could take - specifically restructuring these big lenders so that they stop shrinking.

We need to do a good bank/bad bank and tell the bond holders who have been essentially escaping the pains of the failure of lehman brothers - you guys have to kick in. This will make my friends at




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, very unhappy. But tough, because either way they're gonna lose. Either they lose through inflation or restructuring. I think restructuring is better because it stops the shrinkage. We could stabilize the situation and start to grow again.

But if we do nothing - if we just muddle along as Tim Geithner has apparently recommended to the president, then we're gonna have years of deflation.

I think Barack Obama is going to be the Herbert Hoover of the Democratic Party, because he's repeating all of Hoover's mistakes.

--Written by Debra Borchardt in New York.

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