Market volatility: Perhaps the best near-term play

Well I hope you’re following the mortgage fraud debacle in the US.  I can’t emphasize enough that this has the potential to throw financial markets into chaos in the near term.  It really is a HUGE issue, and it’s starting to gain traction in the mainstream media.

Some of the revelations starting to come out are truly staggering:

“In an effort to rush through thousands of home foreclosures since 2007, financial institutions and their mortgage servicing departments hired hair stylists, Walmart floor workers and people who had worked on assembly lines and installed them in “foreclosure expert” jobs with no formal training…”

“The depositions paint a surreal picture of foreclosure experts who didn’t understand even the most elementary aspects of the mortgage or foreclosure process — even though they were entrusted as the records custodians of homeowners’ loans. In one deposition taken in Houston, a foreclosure supervisor with Litton Loan couldn’t define basic terms like promissory note, mortgagee, lien, receiver, jurisdiction, circuit court, plaintiff’s assignor or defendant. She testified that she didn’t know why a spouse might claim interest in a property, what the required conditions were for a bank to foreclose or who the holder of the mortgage note was. “I don’t know the ins and outs of the loan, I just sign documents,” she said at one point.”

In perhaps the best overview of the significance of the mortgage fraud debacle, Gonzalo Lira wrote a great piece explaining the legal aspects of the mortgage fraud as well as the potential impact on real estate sales, bank lending, and the bottom line of US banks.

“Homeowners can only be foreclosed and evicted from their homes by the person or institution who actually has the loan paper—only the note-holder has legal standing to ask a court to foreclose and evict. Not the mortgage—the note, which is the actual IOU that people sign, promising to pay back the mortgage loan.”

Therein lies the rub.  In the hay-days of mortgage market lunacy pre-2006, mortgage lenders in the US were lending to virtually anyone.  These mortgages were basically bundled up and sold as Mortgage Backed Securities.  Prior to mortgage backed securities, the notes were held by local banks who could produce them if needed. If the banks sold those mortgages to someone else, a clear signature or endorsement had to be made indicating the new owner of the note.  This ‘chain of title’ is the issue in question.  If the chain of title is broken (i.e. one of the necessary signatures is not on the note), the person no longer owes money to the holder of the note.  And that is where things get wacky.

The process of securitization and the associated issues with chain of title are explained in brilliant simplicity by Lira.  You have to read it! Bottom line is that the securitization process has led to a broken chain of title in many cases.

As foreclosures mounted, people began questioning the chain of title and all of a sudden, the paperwork became a huge issue.  The banks hired firms to deal with the massive amount of foreclosures.  The firms recognized that there were chain of title issues and, as is becoming increasingly obvious, engaged in fraudulent behaviour (likely in full knowledge of the banks) in an attempt to correct the issue.

As a result of all of this coming to light, many of the big banks have stopped foreclosures in all states.  Title insurance companies have stopped insuring titles since they can no longer guarantee that a home is title free.  And of course, people will now stop buying foreclosed homes which make up 25% of all sales in the US, for fear of legal issues.

All of this means two things:  A bottom in US housing is now even further away, and expect increased volatility in the stock market as people start to realize what a huge mess this is for the banks and potentially to the flow of credit, the lifeblood of our messed-up economy.

If you’re looking to capitalize on volatility in the short term, look at VXX on the NYSE.  Earlier this week I picked a few lots at just over $15.  I expect them to be a nice short-term performer as volatility will be the name of the game until this mess is sorted out.  VXX is nasty volatile, purely speculative, and derivatives-based, so allocate no more than a few percent of your portfolio to it.  It’s a short-term hold, so don’t get attached to it.  Enjoy the ride!

Update:  On the lighter side of the foreclosure fraud scandal…

-B

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