Deflation Interruptus, and Paths Out of the Great Recession

For a little over a year now, I've been writing this blog about the Great Recession -- how it began, and how it is likely to proceed.  Back then, I predicted a deflationary cascade, brought about by the collapse and panic surrounding the mortgage backed securities market.  I believed that, as the bad debts that existed in the market were recognized, the effect would propagate from one sector to another, until the system reset and was healthy again.

While I still believe this to be true, the deflationary cascade I predicted has been interrupted.  This is in part due to the unprecedented spending by the U.S. Government, and by the printing of money by the Federal Reserve Bank.  It is also due to certain policy decisions that have allowed much of the bad debt to simply be ignored.  For the moment at least, these actions appear to be working.

But the system remains precarious.  Today, there exists trillions of dollars in losses that have yet to be recognized, and there remain imbalances between nations on the international stage.  If any of these blow up, many large banks, insurance companies, and pension funds could fail, and many municipalities, states and governments could default.

Truth of the matter is, until we recognize the bad debts that were created in the mortgage bubble, our system will remain crippled and unhealthy.  In 2011, I believe we will finally see some movement on this front.

Over the last couple of months, we have started to see some details about the mortgage backed securities market that have significant implications about how we might resolve the current logjam.  It started out as an inquiry into "robbo signing," a claim that thousands of documents have been submitted to the courts, signed and attested to by people who were not qualified to make such claims.  Turns out, there is much more to this story ...

To create profitable mortgage-backed securities, the investment banks had to control two expenses:  taxes and recording fees.  To control taxes, they created the securities as a trust, and to control recording fees, they decided to ignore hundreds of years of legal precedent, and track ownership of mortgages through a new electronic exchange called MERS - Mortgage Electronic Registration Systems.  This would allow them to forgo the time and expense of filing original documents, and paying recording fees to counties throughout the nation.

While this decision saved the industry millions of dollars (at the expense of our counties), recent court decisions have found that MERS is not considered sufficient legal proof of ownership to have standing.  That the only way to prove you have the legal right to evict someone, is to have a properly recorded claim in the county where the property is located.

This is where the decision to create trusts causes problems.  In order to preserve the tax advantages of a trust, all assets of the trust must be held in the trust within so many days of its creation.  That time limit is now over.  The trusts can no longer add these notes without violating its tax exempt status.  In other words, a MERS entry cannot be "fixed" by simply recording a claim in the proper county.

Further, it appears likely that most if not all of the original documents were scanned, then destroyed.  This means that  the original "wet signature" document needed for recording purposes no longer exists.

What we end up with is a real mess.  The person who thinks they are owed money (the mortgage-backed securities holder), has no legal standing to collect.  The person who has standing to collect (the loan originator), has already been paid in full.  Worst of all, we are left with no easy way to resolve these issues.

Of course, the very act of selling a security that does not legally contain the items that you claim is considered securities fraud.  While the SEC and other regulators appear to be ignoring this crime, it is also something that can be challenged in civil court.  And that's exactly what's starting to happen, as Allstate sues Countrywide for exactly this tort.

Given all of this, I believe that the powers that be will have to address the bad debt that is stuck in the system.  Some possible solutions include 1) forcing all of the bad debt back onto the originating banks (then bailing them out), or 2) passing a law that retroactively allows the use of MERS, and absolves those guilty of this securities fraud (this has already been attempted once, but was vetoed by Obama).  Either way, we'll see many more bad debts resolved this year, allowing the deflationary cascade to work towards its natural conclusion.

In closing, all of this is speculation of course, and I encourage your comments.  In addition to the discussion list I announced last week, I'll also be posting this to a new public LinkedIn Group dedicated to Tranzitioning.  (either I've missed the public option before, or someone was listening :-).  Until next time.

Tranzitioning.com is a blog by Jay Fenello, principal and founder of BizPlacements.com, an Atlanta-based
Business Brokerage and Placement firm that helps people buy and sell small businesses and franchises.

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