This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

You may have been hearing about the various mortgage fraud scandals ripping through Wall Street and the economy. We believe the problems are real, though their full extent remains unknown. At the Dada portfolio, we've decided to put a little bit of capital into betting against two of the biggest apparent culprits.

Bank of America (NYSE: BAC)
The megabank -- particularly its acquisition Countrywide -- could face a number of challenges, including ...

  • Allegations of origination fraud: Countrywide allegedly created poor-quality loans, which it then sold off to investors as good-quality investments during the mortgage boom. Though potential lawsuits could be difficult to win against originators, well-heeled investors could exact a long fight or a costly settlement.
  • Consumer abuse and fraud accusations: Mortgage servicers such as Bank of America, JPMorgan Chase (NYSE: JPM), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC) have an incentive to foreclose on homeowners, even when a restructuring makes more sense from the perspective of investors, or is required under HAMP because of the fees they can charge throughout the foreclosure process. In some cases, speeding through foreclosures may have the added benefit of whitewashing alleged origination fraud. But some state attorneys general aren't happy about consumer abuses; Arizona and Nevada recently filed suits against Bank of America that charge the company with misleading and deceiving homeowners, pretending to modify their loans to extract extra payments before eventually foreclosing. Unlike at the federal level, there's no love lost between many state AGs and megabanks -- Nevada called Bank of America's behavior "callous."
  • Lousy record-keeping: Given the vast potential abuses already discussed, and the overriding desire for speed and volume during the housing boom, if you think Wall Street didn't keep careful records of its activities, give yourself a gold star. In particular, it appears that critical documents such as the Note -- the IOU that homeowners sign at the time of borrowing -- were not properly transferred to the trusts that own the mortgages. This is significant, because possession of the Note is a requirement for foreclosure, and failure to convey the Note within the specified time frame could constitute a violation of legal agreements governing many trusts.

    Although Bank of America has disputed the testimony, a Countrywide employee recently testified that it was customary for the company not to transfer the Note. If you have good eyesight, here's a helpful visualization of the problem, courtesy of Mike Konczal:

    Without the Note, the mortgage-backed securities investors thought they were buying may not have actually been mortgage-backed. Investors who already are smarting over the losses they took on these securities won't be happy to learn that originators and trustees may have systematically lied to them, and they could see an opportunity to demand that banks buy back lots of bad mortgages. For their part, courts and states are getting wise to possible foreclosure fraud; all 50 state attorneys general are investigating. Which brings us to the second company on Dada's list ...

Lender Processing Services (NYSE: LPS)
Since so many of these Notes appear to have been lost, destroyed, or never transferred to trusts, servicers are resorting to hiring law firms to sign affidavits testifying that all the documents are in order. Speed and cost, rather than accuracy, being the primary financial concern, many of these firms are reportedly engaging in a practice known as "robo-signing," whereby employees (who in some cases may not even be supervised by licensed lawyers!) are signing thousands of affidavits per week.

But because it takes a considerable amount of time to properly evaluate the paperwork that they're testifying is in order, there's literally not enough time in the day for many robo-signers to have properly reviewed the foreclosure documents. In addition, the same robo-signer's handwriting is in many cases inconsistent, and the documents to which they are attesting personal knowledge appear to be frequently missing or non-extant.

Lender Processing Services, a back-end mortgage processing firm that assists mortgage servicers, is alleged to be highly involved in these potentially fraudulent processes. (Yves Smith of nakedcapitalism has written extensively on the company.)

As much as half of LPS's revenue may derive from foreclosure processing, and the company is leveraged 2.5:1. Possible problems include:

  • Alleged creation of phony documents: Former subsidiary DOCX was apparently caught literally providing a fabricated document pricing sheet. One of the most blatant items on the sheet appears to be "Recreate Entire Collateral File: $95.00+TPC," since that would presumably involve recreating the Note, which requires a wet ink signature from the homeowner. Here's a snippet of DOCX's pricing sheet -- I like that it offers discounts for bulk orders for sloppy/missing document "fixes":

    While the company shut down DOCX after the Department of Justice launched an investigation into its processes, a Reuters investigation recently claimed to have uncovered improprieties in at least one of LPS's own offices.
  • Class action lawsuits: LPS has been named in a number of class action lawsuits, which charge its executives with making false and misleading statements regarding these practices.
  • Possible collection of impermissible legal fees: LPS has been described as a sort of general contractor that refers robo-signing services pro bono to its customers (mortgage servicers) and collects revenue from the robo-signing firms themselves. This revenue may be illegal if it means that the robo-signers are sharing legal fees with non-lawyers.

Bottom line
The Dada Portfolio plans to split $800 between LPS puts and a Bank of America short.

While my Foolish colleague and banking expert Anand Chokkavelu provides a rather compelling bullish case for Bank of America and JPMorgan, on the grounds that their stocks are cheap and the government will find a way to bail them out, we think there could be further downside.

President Obama has already vetoed HR 3808, the Interstate Recognition of Notarizations Act of 2010 (aka the Notary Fraud Condonation Act of 2010). While there could be other actions at the Federal level to forgive servicers, originators, and robo-signers -- for example, the Federal Reserve is inexplicably considering weakening consumer protections for homeowners -- to a large extent, these issues fall under state jurisdiction.

States appear to be somewhat more determined than federal officials to actually get to the bottom of potential fraud and abuses. Earlier this month, Iowa Attorney General Tom Miller, who is leading the 50-state investigation, promised a group of homeowners that "we will put people in jail."

It'll be fun to take a small short position in these guys as we watch just how much dirt gets uncovered. You can follow the Dada Portfolio on Twitter @TMFDada, or visit our discussion board here.

Ilan Moscovitz doesn't have an interest in any companies mentioned in this article. BlackRock is a Motley Fool Inside Value recommendation. The Fool owns shares of Bank of America, JPMorgan Chase, and Legg Mason. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.