A foreclosed home in Winchester, Va. (Jay Mallin/ZUMA Press)

Yesterday, Wall Street giant J.P. Morgan Chase announced a $4.4 billion profit in the third quarter. Wall Street analysts should have cheered. Instead, they golf-clapped, while the bank’s chief executive officer, Jamie Dimon, went on the defensive on an earnings call.

[Economy1] The reason: foreclosures, again threatening everything from homeowners’ security to banks’ bottom lines. In early September, an employee of GMAC Mortgage admitted he had signed as many as 10,000 affidavits, required in 23 states to proceed with foreclosure, a month. The affidavits attested that the employee had personal knowledge of homeowners’ financials before the bank foreclosed. Given that he obviously did not, the paperwork might have constituted fraud and the foreclosures were possibly illegal.

The scandal went big, embroiling mortgage-holding banks like J.P. Morgan Chase in a problem of possibly systemic proportions. Stories of banks lacking required title documentation and evicting the wrong families from homes flooded into the press. Financial companies, including J.P. Morgan Chase, halted foreclosures in the states that require judicial review, and then some halted them everywhere. Members of Congress announced hearings. Finally, yesterday, all 50 state attorneys general announced a probe into systemic problems with mortgage documentation.

On the J.P. Morgan Chase earnings call, Dimon promised that there was “almost no chance we made a mistake” with foreclosures. “We think we should continue and get done and make sure we do the right things for the consumers, the investors and the country. So it obviously will increase our cost a little bit and maybe we’ll have to pay penalties eventually to some of the attorneys general but we really think we should just continue.”

But the financial statement itself proved the lie. The bank said it was carefully checking 115,000 mortgage affidavits. It set aside a whopping $1.3 billion for legal costs. And it put an extra $1 billion into a now $3 billion fund for buying back bunk mortgages and mortgage products.

For banks like J.P. Morgan Chase, the issue is not just the legal headaches. It is the financial blowback. The mortgage-documentation scandal, housing experts warn, runs far and deep — involving not just foreclosure papers, but titles and rights and fiduciary contracts. And it has analysts on Wall Street and politicians on the Hill wondering whether the worst-case scenario might involve not just losses, but bank failures or government bailouts.

The pending mortgage problems resemble those that caused the failure of Lehman Brothers, the credit crunch and the ensuing financial crisis in October 2008: Every bank has problematic mortgage holdings on its books, and each bank is interconnected with every other. Before the bubble burst, investment banks bought up faulty mortgages, many of them subprime loans, from lending banks. Investment banks then bundled the mortgages into mortgage-backed securities, for sale to investors. But just as banks are now foreclosing without proper documentation, they were bundling mortgages without proper documentation — abdicating their fiduciary responsibility to investors and muddying the waters as to who actually owns the loans.

That means the investors who own mortgage-backed securities might argue that the products do not meet the contract standards. If those investors choose to sue the originating investment banks en masse, for breach of contract, they would force the banks to buy back the rotten mortgage-backed securities. That would cost in the hundreds of billions — swamping banks’ profits and sweeping away any cash they might be keeping on hand.

At least one mortgage analyst, Josh Rosner, a managing director at Graham Fisher & Co., has said that if investors force banks to take back the $1.3 trillion of mortgage-backed securities in question, it could create a kind of doomsday scenario pitching the markets back into crisis. Indeed, Rosner believes it could feel very much like 2008 again.

“This is poetic justice,” says Janet Tavakoli, of Tavakoli Structured Finance in Chicago. “The mortgages that seem to be most affected are by predatory lenders, or lenders who engaged in fraudulent practices, like appraising a home for twice its value. The careless investment banks were willing to overlook that fraud. But they just bred fraud into their mortgage-backed securities.”

She does not believe every bank will have face write-downs due to mortgage buy-backs. But she does believe the losses might be substantial. “It’s not clear to me that every mortgage has this problem,” she says. “But there’s no transparency on this issue now. And it is clear that we are dealing with massive, systemic fraud.”

One way or another, some on the Hill are bracing for the worst.

“[Banks will] have to buy back one mortgage at a time,” Rep. Brad Miller (D-N.C.) told The Washington Post. “Someone said there might be a second round of bank insolvencies because of this and there might need to be more TARP. There is no chance that Congress would pass more TARP. It’s hard even to see how it ends. But I’ve got to think it creates more uncertainty about the health of the banks.”

Rep. Alan Grayson (D-Fla.) has gone further, proactively asking the Financial Stability Oversight Council — created by the Dodd-Frank financial regulatory reform law — to step in to stop foreclosures and monitor the banks, just in case.

“There are now trillions of dollars of securitizations of these loans in the hands of investors,” Grayson wrote in a letter (PDF) to the Council, which includes Treasury Secretary Timothy Geithner and Federal Deposit Insurance Corp. Chair Sheila Bair. “The trusts holding these loans are in a legal gray area, as the mortgage titles were never officially transferred to the trusts. The result of this is foreclosure fraud on a massive scale, including foreclosures on people without mortgages or who are on time with their payments. The liability here for the major banks is potentially enormous, and can lead to a systemic risk.”

And it seems the banks — if not J.P. Morgan Chase — are also acknowledging that risk. Josh Levin, an analyst with Citigroup Global Markets, described three potential outcomes to investors, citing work by Georgetown law professor Adam Levitin. The first is that courts consider the erroneous foreclosures technicalities, and the losses are minimal. The second is that banks face significant legislation, but ultimately aren’t forced to buy back mortgage-backed securities.

And the third? “In the worst-case scenario,” he said, “the aforementioned issues become a ‘systemic problem’ which causes the mortgage market to grind to a halt.”

But at The Atlantic, Daniel Indiviglio builds the relevant chart. Starts remain low — appropriately low — given the weakness in the housing market. They are just 2.2 percent higher than the pace from a year ago. Given the overhang of foreclosed homes and the fact that the United States just came through the wake of a massive housing bubble, building should remain low for some time.

Last month, housing slumped to its worst state in decades. The National Association of Realtors said home sales declined 27 percent to a 15-year low. And the Commerce Department said sales of new single-family houses dropped 12.4 percent between June and July, to the lowest level in the 47 years the department has kept the data. Foreclosures remain high. And many economists predict a second national decline in home prices.

Reviving the Obama tax credits might halt or slow that second leg down, and it might be worth doing for that reason. But some data indicates the credits merely convinced people who were going to buy houses anyway to buy sooner, rather than bringing in new juice. And mortgage reduction seems a better way to keep families in homes and stabilize housing.

Reform will prove difficult and will happen slowly because Fannie and Freddie control or backstop so much of the housing market. The two entities guarantee about three-quarters of mortgage-backed bonds — and the government backstops all but just 3 percent of mortgages. Reform them too quickly, and risk cratering the nascent, if extant, housing recovery. “It’s like building an airplane while you’re still flying it,” said David Ledford of the National Association of Home Builders told Bloomberg.

But politicians are eager to make clear they have every intention of returning housing risk to the private market. In his opening remarks, via Politico, Treasury Secretary Timothy Geithner says:

“Fixing this system is one of the most consequential and complicated economic policy problems we face as a country. … We will not support returning Fannie and Freddie to the role they played before conservatorship, where they took market share from private competitors while enjoying the perception of government support.

“We will not support a return to the system where private gains are subsidized by taxpayer losses. We need to delineate more clearly the public policy goals of how best to promote reasonably priced and stable mortgage costs for most Americans from how best to provide access to affordable housing for lower income Americans. […] The failures that produced the system we have today were bi-partisan. The solution must be as well. This is a test for Washington. The stakes are high. The housing industry supports millions of jobs. For many Americans, their home is their largest financial asset.”

Still, while banks foreclosed on more homes, the total number of filings has continued to fall, a sign that the foreclosure crisis might have peaked. Last month, 325,000 homes received a notice of default, auction or repossession — up 4 percent from June and down 10 percent from 2009.

All in all, it has been a horrible day in economic news, and housing news especially. Another report from Moody’s Analytics says the chance of a double dip — a return to technical recession, with the economy contracting rather than growing — has risen from 20 percent to 25 percent. Moody’s says that another drop in home values might catalyze a broader downturn, as economic growth is already slowing. During a double dip, home prices might fall a further 20 percent. They are already about 30 percent off their peak — more than 50 percent in Nevada.

The New York Times has a series of op-eds on the subject, and taken together, they are a good primer on the intractable problems facing legislators. Take this argument from the former president of the St. Louis Federal Reserve Bank, William Poole, advocating for total phase out of Fannie and Freddie:

If the home finance market were fully private, then it would bear the losses from its own mistakes in pricing and insurance. The proper government role is regulatory oversight and not direct operation of financial firms. Fannie and Freddie could not be shuttered immediately; they are too large. A sensible transition plan would have them stop buying new mortgages, and their portfolios would decline as the mortgages they own are paid down. Within 10 years, the portfolios would shrink to insignificance. Their securitization business, whereby they purchase mortgages and issue securities against them, should likewise be wound down. A practical approach would be to set a gradually rising schedule of fees, motivating private companies to enter the securitization business. In 10 or 15 years, the companies would be gone, closing a chapter in American financial history that enjoyed considerable success but ended very badly and at great taxpayer cost.

The problem is, were the government — via Fannie, Freddie and the Federal Housing Administration — to stop buying mortgages, it would crater the housing market. The government currently backs 19 in 20 new mortgages. A decade seems far too short a time frame for pulling out, given how weak housing is.

All in all, 1.6 million properties received some form of foreclosure notice between January and June. Nevertheless, the report shows that foreclosures seem to have peaked and stabilized, at least for now. The number of foreclosure notices dropped between the last half of 2009 and the first half of 2010. And foreclosure filings have declined in recent months as well.

Still, RealtyTrac warned about continued, severe problems in housing. “The midyear numbers put us on pace to exceed 3 million properties with foreclosure filings by the end of the year, and more than 1 million bank repossessions,” James Saccacio, the head of RealtyTrac, said in a release. “The roller coaster pattern of foreclosure activity over the past 12 months demonstrates that while the foreclosure problem is being managed on the surface, a massive number of distressed properties and underwater loans continues to sit just below the surface, threatening the fragile stability of the housing market.”

Notably, foreclosure tracks closely with unemployment, and the two feed into one another. Regions with higher rates of joblessness have more families that cannot afford their mortgages. Regions with more homes in foreclosure have more families that cannot move to find work.

More than one in seven homeowners with loans in excess of a million dollars are seriously delinquent, according to data compiled for The New York Times by the real estate analytics firm CoreLogic. By contrast, homeowners with less lavish housing are much more likely to keep writing checks to their lender. About one in 12 mortgages below the million-dollar mark is delinquent.

Though it is hard to prove, the CoreLogic data suggest that many of the well-to-do are purposely dumping their financially draining properties, just as they would any sour investment. “The rich are different: they are more ruthless,” said Sam Khater, CoreLogic’s senior economist.

That the rich would default strategically more often makes plenty of sense. First of all, if you are lower-income, you might be less willing to default because your home is your biggest asset. (That is, if you get rid of your house without making anything off of the sale, you might end up broke on paper, unlike a wealthier person with a 401k and investments.) If you are lower-income, your mortgage is probably a higher percentage of your monthly take-home pay — meaning your default is more likely to be out of financial necessity than financial ruthlessness. Finally, the wealthy are likely more financially savvy.

That said, this article epitomizes my broader frustrations with the debate over strategic default. It fails to define strategic default — setting out what distinguishes a canny defaulter from one tapped-out and a few months away from insolvency. It says one in seven homes with a million-dollar loan is on the verge of foreclosure — but provides no data as to why that means that their defaulters are strategic. What demonstrates that those homeowners are choosing to give up their mortgages, rather simply realizing they cannot afford them anymore, other than anecdotes?

“Existing-home sales that close in June will remain elevated, but we’ll then see a notable decline for July and August,” Lawrence Yun, NAR’s chief economist, said in a statement. “Without the tax credit, there will be more aggressive price negotiations between buyers and sellers. The key test on whether the housing market can stand on its own without stimulus medicine will depend critically on private sector job creation in the second half of the year. We’ll also keep a close eye on market conditions on the Gulf Coast.”

He stressed that home prices depend on unemployment starting to decline. And this is one more sour report in advance of tomorrow’s June unemployment report.

For one, their scale of involvement in the housing market is massive. “Fannie Mae and Freddie Mac took over a foreclosed home roughly every 90 seconds during the first three months of the year,” the piece notes. “They owned 163,828 houses at the end of March, a virtual city with more houses than Seattle.” Most of their activity, naturally, is concentrated in the sand states (Nevada, Arizona, Florida, California) and Michigan, where most foreclosures take place. “The two companies together accounted for 17 percent of real estate sales in Arizona during the first four months of the year,” Appelbaum reports.

And bailing out Fannie and Freddie might end up costing the federal government more than bailing out the financial sector: “So far the tab stands at $145.9 billion, and it grows with every foreclosure of a three-bedroom home with a two-car garage one hour from Phoenix. The Congressional Budget Office predicts that the final bill could reach $389 billion.”

The piece also notes that Fannie and Freddie do not just eat the costs of foreclosed homes. They pay to take care of them:

Selling a house generally costs the government about $10,000. The outsides are weeded and the insides are scrubbed. Stolen appliances are replaced, brackish pools are refilled. And until the properties are sold, they must be maintained. Fannie asks contractors to mow lawns twice a month during the summer, and pays them $80 each time. That’s a monthly grass bill of more than $10 million. All told, the companies spent more than $1 billion on upkeep last year.