The other shoe is about to drop

The financial crisis was bad.  Round two will be worse.

This crisis was caused by bankers who made risky mortgage loans and then re-sold them as safe investments (CDOs.)  In round one the banks got bailed out and the people on Main Street were thrown a bone (HAMP, which I can personally attest is a huge sink-hole of bureaucracy and incompetence.)  In round two the investors who bought the CDOs will get thrown a bone while the banks get bailed out again.  Or the market as we know it will not survive.

The banks engaged in a risky game of fraud.  They gave mortgages to people who could not afford them, and then repackaged and sold those risky mortgages with AAA credit ratings.  Investors bought those CDOs thinking that they had little risk.

The banks were in a hurry to make as many of these mortgages as they could.  And the loans didn't really meet lending standards anyway.  So the banks didn't actually do their paperwork properly on those mortgages.

Borrowers have been aware of this for years.  Many people have successfully fought foreclosure by arguing that their bank could not show that they have the right to foreclose because they didn't have the paperwork showing that they owned the property.

In an effort to counter that argument, banks have been arguing to streamline the foreclosure process.  They have taken to having a "qualified" employee evaluate the paperwork and sign a legal affidavit saying that the paperwork is all in order.  They succeeded in getting some courts in some jurisdictions to accept their signed summary and foreclose on property without demonstrating the actual paperwork in court.  This practice is now being called "robosigning" because there is strong evidence that these employees are not looking at any paperwork whatsoever and are bald-faced lying to these foreclosure courts.

We know this because there have been numerous cases where the summary documents were quite wrong, and banks have foreclosed on the wrong homes.  Foreclosure agents have literally picked locks and entered homes, with genuine legal paperwork in hands from the foreclosure courts, where the home in question was owned outright by the person living there.  They didn't have a mortgage, and they certainly didn't have a mortgage with the bank that had foreclosed on their home.

Lawsuits followed, of course.  The depositions from those lawsuits revealed the robosigning practice.  And that led directly to the current moratorium on foreclosures for many banks.

The moratorium has caused the investors to get quite nervous.  They have started reviewing the paperwork that the banks gave them.  What are they finding?  The second shoe.

Surprisingly enough, the banks who did shoddy paperwork on the mortgages also did shoddy paperwork on the CDOs that they sold.  So instead of buying tranches of secure mortgages, the investors bought tranches of incomplete paperwork that fail to meet the standards of being "mortgages" in a court of law.

At this very moment investors are consulting their lawyers to determine what to do.  If all investors could somehow agree to not sue the banks for fraud then everyone and everything would be fine.  As long as their is no lawsuits from the investors' side then the banks will find a way to conduct business as usual and will pay those investments in a reasonable manner.  But that is a classic prisoners' dilemma game--a scenario where the first one to defect wins.  Someone will understand that and sue--any minute now.

These lawsuits will cause a huge problem for the banks.  There isn't any way to look at the physical evidence and not see systemic, intentional, wide-spread, large-scale fraud.  Trillions of dollars worth of fraud.  Their only defense is pleading gross negligence and incompetence.  And no one will buy that defense.

The only hope that the banks have is that the federal government still has their claws dug in.  In some of these cases the federal government will be listed as a co-defendant because the federal government owns a large stake in the bank.  And the federal government has a long history of writing ex post facto laws to legalize past bad behavior, especially for the banks.

The moral dilemma here is that convicting those banks of fraud and punishing them appropriately will crash the economy.  The 1930s will look fun by comparison.  Thirty percent unemployment.  Trillions of dollars will be lost.  No one will benefit except the lawyers.  We would genuinely be better off if we could avoid that fate.  But the only way to do it would be to let the crooks get away with fraud.

If you can think of a solution that brings the crooks to justice, keeps the investors from losing everything (even pennies on the dollar would work), and doesn't crash the market, then please speak up.