Don't Underestimate the Fauxclosure Mess

"Robo-signers and Fauxclosures" may sound like some type of straight-to-DVD movie, but they could carry serious consequences for investors.

On Friday, Bank of America (NYSE: BAC) became the first national lender to issue a moratorium on foreclosures in all 50 states. This follows its original moratorium, along with JPMorgan Chase (NYSE: JPM), to freeze foreclosures in the 23 states that require court approval in order to force delinquent homeowners out of their homes. Also on Friday, PNC Bank (NYSE: PNC) became the latest bank to issue a foreclosure freeze on those same 23 states, which should have investors wondering whether our country's other large lenders such as Wells Fargo (NYSE: WFC) and Citigroup (NYSE: C) are next.

Massive liability for banks
Washington Post writer Ezra Klein spoke with Congressman Brad Miller (D-N.C.) about what this mess could mean for the banks. According to Miller:

There is massive potential liability for the securitizers, which are mostly the biggest banks. The contract was that if mortgages didn't meet certain requirements, then the securitizer would buy them back. The mortgage servicers and trustees have exclusive control over the paperwork. Both the investors, the people who own the mortgage-backed securities, and the homeowners, really depend on them. There's been lots of litigation where investors try to get securitizers to buy back the bad mortgages because they were flawed, but that litigation has been stymied by procedural objections. If the private investors can break through that defense and require the mortgages that don't meet the requirements to be bought back, the liabilities for the biggest banks will be enormous.

The problem Miller describes dates back quite a few years, to when some of these loans were actually initiated. Banks were given a grace period to turn down loans to customers who overstated their income, or to veto loans with other problems in the documentation. Unfortunately, this didn't happen; lenders attempted to pass through as many loans as possible.

The banks that purchased these mortgages bundled them into to securities, which were then sold to investors. However, if many of these contracts are found invalid, the banks could be forced to buy back the mortgages one by one, which would be disastrous for the banks' balance sheets. The controversy also raises more questions about investment banks such as Morgan Stanley (NYSE: MS) and Goldman Sachs (NYSE: GS) that securitized these mortgages in the first place.

Housing prices 
Many commentators believe that taking so many homes off the market will help lift housing prices, but that thinking is extremely short-sighted. Pending home sales all over the country are being canceled, and states like Florida and Nevada, where a large portion of sales come from foreclosures, will be extremely hard-hit.

As the mess drags on, one has to imagine that housing sales will plummet even further. Old Republic International (NYSE: ORI), one of the nation's largest title insurers, has already announced that it will stop providing title insurance on homes foreclosed on by JPMorgan. It can't be too long before this moratorium includes other lenders involved in the mess, as well as other title insurers. It's one thing to buy a foreclosed house at a discount, but who will buy a home in foreclosure without title insurance?

Banking bottom line
The investigation into the fauxclosure mess is expected to heat up this week, with 40 states expected to begin a joint investigation into the fiasco. With election season in full swing, and another opportunity to pit Wall Street against Main Street, one can assume that no sound bite will be spared. Here at the Fool, we'll continue to look into the situation and its potential fallout. Personally, until I get more clarity on the issues involved, you won't find me investing in the banking sector.