By David S. Hilzenrath
Washington Post Staff Writer
Friday, October 15, 2010; A15
Stocks of major banks declined sharply Thursday amid concern that widespread corner-cutting in the foreclosure process could saddle the financial system with a costly and paralyzing mess.
The sell-off was one of the most vivid indications yet that, just as banks were recovering from the financial crisis of recent years, foreclosure problems could take a new toll. Indeed, J.P. Morgan Chase said Wednesday it had set aside $1.3 billion of new reserves for litigation, "including those for mortgage-related matters."
Share prices declined Thursday by 2.8 percent for J.P. Morgan, 4.2 percent for Wells Fargo, 4.5 percent for Citigroup and 5.2 percent for Bank of America. In contrast, the Dow Jones industrial average was down by 0.01 percent, and the Standard & Poor's 500-stock index, a broader market gauge, was down by 0.4 percent.
Several major lending institutions have frozen foreclosures in response to evidence that employees in what were essentially foreclosure mills signed the paperwork to seize homes without checking whether the evictions were justified.
Meanwhile, a similar but potentially broader concern has cast an additional cloud over the system. Some analysts are concerned that securities based on huge pools of mortgages might be defective.
Mortgages are routinely pooled and packaged into securities that are traded around the world like stocks and bonds. The securities are widely held by investors, including mortgage finance giants Fannie Mae and Freddie Mac, which are wards of the government. Court documents show that in many cases the paperwork transferring legal ownership of those loans to the pools was lost, ignored or even forged.
It is not yet clear what the consequences will be if large quantities of mortgage-backed securities turn out to be flawed - or how the problem could be solved.
"If the basic principles of property law have been violated here . . . it may be extremely difficult to fix," said a source involved in government oversight of financial institutions who spoke on the condition of anonymity because of the uncertainties involved. "There is a chain of questions that no one seems to know the answer to."
Banks and other players in the mortgage industry could face substantial penalties from state law enforcement officials and potentially extensive litigation from homeowners over the disputed foreclosures, as well as from investors who bought the mortgage securities.
Analysts are divided over what the final cost will be to big financial firms. Some predict the cost could run into the tens of billions of dollars. A few say the foreclosure debacle could evolve into a major crisis for the entire financial system.
In a note to investment clients Thursday, Paul J. Miller, an analyst at FBR Capital Markets, estimated that lenders could see a hit of $6 billion to $10 billion, a large sum but one the industry "could comfortably absorb."
Much depends on how courts approach the issue. Companies that service mortgages "may be in uncharted waters as they have never been challenged by the judicial system as extensively as they are now," analysts at FBR wrote.
The stock market did not provide the only sign of investor anxiety.
Another barometer - the cost of insurance contracts known as credit default swaps, which are used to protect holders of a firm's debt in case that company collapses - shows that investors see a growing risk that banks will default on their obligations.
For example, as of Thursday afternoon, the cost of insuring J.P. Morgan debt had risen 29 percent this week, said Jim Vogel, a debt analyst at FTN Financial.
Meanwhile, Maryland's top court proposed an emergency measure Thursday that grants county circuit courts the authority to review foreclosure documents and take action if they spot irregularities, including dismissing the the foreclosures.
The announcement by Maryland's Court of Appeals comes a few days after Gov. Martin O'Malley (D) and the state's lawmakers in Congress sent a letter to the court's chief judge asking him to halt foreclosures in the state for at least 60 days.
The measure giving county courts new authority could pass Friday, when the rules committee that governs the courts votes on it.
"Preliminary audits have shown that hundreds of such bogus affidavits have been filed in Maryland circuit courts," Alan M. Wilner, the retired judge who runs the rules committee, wrote in a memo to his panel. "The judges are alarmed at this development, which is an assault on the integrity of the judicial process."
At least two Maryland courts already plan to take action. In Prince George's County, the Circuit Court expects to start reviewing such cases in early December. The Montgomery County Circuit Court is putting on hold roughly 400 foreclosure cases with similar problems.
During the quarter that ended Sept. 30, one in every 139 housing units in the United States was at some stage of the foreclosure process, RealtyTrac reported Thursday. That was up nearly 4 percent from the previous quarter but down 0.8 percent from the third quarter of 2009.
Staff writer Dina ElBoghdady contributed to this report.