The Bad Mortgage Mess

Citigroup just disclosed in a regulatory filing that it was being sued by several investors who want to force Citigroup to buy back soured mortgages. The investors contend these bad mortgages did not conform to proper underwriting standards. These aren’t just ordinary investors suing Citibank but big names – Charles Schwab and the Federal Home Loan Bank of Chicago.

Wall Street worries that efforts to force the banks to buy back defaulted mortgages could blow into gigantic proportions, and actually cripple the banking industry for quite some time. We contend that the banks should not have originated the loans in the first place. Even a 6th grader will tell you of conflicts of interest; if you are going to make a loan and keep it (hold it on your books) you’ll do your best to make sure the debtor will be able to pay you back before you hand over the money.

If you are going to immediately sell that loan to someone else so that any problems lie on their doorstep, your loan standards will certainly decline over time. In fact, you’ll have an incentive from the start to originate bad loans in order to collect the fees. As you get used to doing this, your standards will start to slip more and more as you put increasing pressure on your staff to produce more volume.

And that, dear reader, is exactly what happened.