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.”

“There are encouraging signs in the first-quarter numbers,” Sheila Bair, the head of the FDIC, said in a statement. “Industry earnings are up. More banks reported higher earnings, and fewer lost money. … [The $18 billion] is more than three times as much as banks earned a year ago, and it is the best quarterly earnings for the industry in two years.”

That said, the FDIC’s “problem list” of banks rose to 775, up from 702 last quarter, and the assets of these “problem” institutions grew 8 percent. During the first three months of the year, 41 banks failed. These are the worst numbers since 1993.

All in all, the report paints a picture of a banking sector bolstered by low interest rates and government backing, but one in which the haves — mostly bigger banks — are pulling away from the have-nots — smaller and community banks. Those smaller banking institutions with thin capital cushions will continue to face serious hardships due to delinquent loan, foreclosure and other losses.

Additionally, the number of FDIC-backed banks fell below 8,000 for the first time in the agency’s history, as banks failed or merged with one another.

In a statement, Bair said, “We must recognize that not only did market discipline fail to prevent the excesses of the last few years, but the regulatory system also failed in its responsibilities. There were significant shortcomings in our approach that permitted excessive risks to build in the system. Critically, the lack of an effective resolution process for the large, complex financial institutions limited regulators’ ability to manage the crisis. As we now know, early planning and preparation is the key to avoiding bailouts. This [resolution] moves us forward to address these gaps.”

The FDIC plan would affect banking subsidiaries with more than $10 billion in assets controlled by parent companies with more than $100 billion in assets — essentially the 40 or so biggest banks. The FDIC says its plan will complement, rather than make redundant, a similar measure in Sen. Chris Dodd’s (D-Conn.) financial regulatory reform proposal. As part of the regulatory reform negotiations, Senate Democrats agreed to drop a $50 billion resolution authority fund, but banks still need to show regulators how they would break up into viable, sellable pieces.

Bair, known as a tireless consumer advocate, argues that pushing derivatives trading outside of banks will make the system riskier:

I urge you to carefully consider the underlying premise of this provision — that the best way to protect the deposit insurance fund is to push higher risk activities into the so-called shadow sector….

Banks are not perfect, but we do believe that insured banks as a whole performed better during this crisis because they are subject to higher capital requirements in both the amount and quality of capital…. If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less regulated and more highly leveraged venues. Even pushing the activity into a bank holding company affliate would reduce the amount and quality of capital required to be held against this activity…. By concentrating the activity in an affiliate of the insured bank, we could end up with less and lower quality capital, less information and oversight for the FDIC, and potentially less support for the insured bank in a time of crisis. Thus, one unintended outcome of this provision would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund, which I know is not the result any of us want.

Thus, opposition to the spin-off provision comes both from the consumer advocacy and the investment banking sides. Banks do not want to spin off the derivatives business because it is lucrative. Regulators do not want banks to spin off the derivatives business because it is dangerous, and better held within institutions with more government oversight and higher capital requirements.

One way to help manage the commercial loan distress, Geithner said, is through the $30 billion fund proposed by President Barack Obama to provide money to midsize and community banks if they boost lending to small businesses.

He did not clarify how giving money to some banks for an entirely unrelated purpose would solve a commercial real estate crisis.

Earlier in the day, TARP Congressional Oversight Panel chair Elizabeth Warren warned that more than half of commercial real estate would be underwater by the middle of 2010.

“They are [mostly] concentrated in the mid-sized banks,” Warren told CNBC. “We now have 2,988 banks—mostly midsized, that have these dangerous concentrations in commercial real estate lending.”

In February, Warren noted that $1.4 trillion in commercial real estate loans would need to be refinanced between 2011 and 2014 when the shorter-term commercial real estate mortgages end, and a significant proportion of those are underwater already. More than $50 billion in commercial real estate mortgages are already in default or foreclosure — both figures are far larger than Geithner’s $30 billion plan to extend credit to small businesses. Sheila Bair, the chair of the FDIC, expects that commercial real estate defaults and losses will be the number-one factor that drives small and medium-sized banks into failure this year at a higher rate than they experienced in 2009. Extending credit to small businesses to the tune of $30 billion doesn’t seem like the best solution to the coming commercial real estate crisis or its downstream effects on businesses or the banks holding the loans.

The home mortgage crisis might be more or less “over” — unless you’ve already lost your home or, like the vast majority of applicants, been denied entry into Obama’s vaunted mortgage modification program — but Warren’s panel says there’s a new one about to begin. There are $1.4 trillion in commercial real estate loans that need to be refinanced between 2011 and 2014 and, like many homeowners before them, commercial property owners took out mortgages on expensive property, only to watch prices drop.

If, like too many homeowners before them, the commercial real estate owners default on their loans, Warren thinks the whole, nasty financial crisis cycle could well start up again.

When commercial properties fail, it creates a downward spiral of economic contraction: job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities.

Unlike the home mortgage crisis, however, the banks serving those communities aren’t large, out-of-state Wall Street giants: they’re quite often local community banks. Those banks are a cornerstone of Obama’s strategy to ease credit restrictions to allow businesses to hire more people and to help individuals stay in their homes. They are also the cornerstone of Arianna Huffington’s “Move Your Money” campaign to encourage people and state and local governments to transfer their money to smaller, local banks in an effort to benefit local economies.

Warren suggests that, despite the political improbability of another round of bailouts, some banks might need to be bailed out or will simply fail. No wonder Sheila Bair and the FDIC made sure their books were back in the black before the start of 2010.

This week, Rep. Barney Frank (D-Mass.), the House Financial Services chairman whose systemic-risk legislation includes the after-the-fact fees urged by Geithner, says he’s now leaning toward the Bair plan. Indeed, The Wall Street Journal reports today that “a Frank aide on Friday said he now favors amending the measure to create a prepaid fund.”

There will be plenty of time to make the changes. Frank’s committee will meet tomorrow to begin marking up the bill, with debate on amendments not expected until Thursday, the Journal reports. No doubt some lawmakers are drooling at the chance to tweak the bill.

A timely, orderly resolution process that could be applied to both banks and non-bank financial institutions, and their holding companies, would prevent instability and contagion and promote fairness.

But Bair, echoing a common message from House lawmakers, is opposing a provision to reimburse taxpayers for bailouts by taxing the solvent competitors of the bailed-out firm — a tax the White House wants to apply only after the government steps in to euthanize the troubled company. Treasury Secretary Tim Geithner said yesterday that collecting the tax beforehand — effectively creating an insurance fund to pay for industry bailouts — would only encourage large institutions to make the risky bets that were largely responsible for the recent global collapse.

People will live the expectation where the government will come in and protect them. We don’t want to create that expectation. That’s why we think it’s better to do it after the fact.

Bair disagrees. “To be credible, a resolution process for systemically significant institutions must have the funds necessary to accomplish the resolution,” she told lawmakers.

It is important that funding for this resolution process be provided by the set of potentially systemically significant financial firms, rather than by the taxpayer.  To that end, Congress should establish a Financial Company Resolution Fund (FCRF) that is pre-funded by levies on larger financial firms — those with assets of at least $10 billion.

The reason to pre-fund?

It allows all large firms to pay risk-based assessments into the FCRF, not just the survivors after any resolution, and it avoids the pro-cyclical nature of requiring repayment after a systemic crisis.

There’s still a long ways to go to iron out these differences. The “too-big-to-fail” bill unveiled this week by House Financial Services Chairman Barney Frank (D-Mass.) is just a discussion draft. The actual language isn’t expected until next week, when a markup is also likely. Expect a lot of amendments.

Imagine how the Federal Deposit Insurance Corporation must feel these days. The same agency that now says it needs to borrow $500 billion in emergency funds to take over failed banks collected no insurance premiums from most banks for nearly an entire decade, The Boston Globe reports.

The practice lasted from 1996 to 2006, according to The Globe.

The Federal Deposit Insurance Corporation, which insures deposits up to $250,000, tried for years to get congressional authority to collect the premiums in case of a looming crisis. But Congress believed that the fund was so well-capitalized – and that bank failures were so infrequent – that there was no need to collect the premiums for a decade, according to banking officials and analysts.

Now with 25 banks having failed last year, 17 so far this year, and many more expected in the coming months, the FDIC has proposed large new premiums for banks at the very time when many can least afford to pay. The agency collected $3 billion in the fees last year and has proposed collecting up to $27 billion this year, prompting an outcry from some banks that say it will force them to raise consumer fees and curtail lending.

This practice doesn’t look too smart these days, now does it? Here’s how FDIC Chairman Sheila Bair explains what happened:

Last week, Bair wrote to Senate Banking Committee chairman Christopher Dodd, a Connecticut Democrat, that her agency could need more money because the existing fund “provides a thin margin of error” given the government’s responsibility “to cover unforeseen losses.” The March 5 letter, provided to the Globe, said the additional borrowing authority is necessary to “leave no doubt” that the FDIC can “fulfill the government’s commitment to protect insured depositors against loss.”

Bair said yesterday that the agency’s failure to collect premiums from most banks “was surprising to me and of concern.” As a Treasury Department official in 2001, she said, she testified on Capitol Hill about the need to impose the fees, but nothing happened. Congress did not grant the authority for the fees until 2006, just weeks before Bair took over the FDIC. She then used that authority to impose the fees over the objections of some within the banking industry.

“That is five years of very healthy good times in banking that could have been used to build up the reserve,” Bair, a former professor at the University of Massachusetts at Amherst, said in an interview. “That is how we find ourselves where we are today. An important lesson going forward is we need to be building up these funds in good times so you can draw down upon them in bad times.”

Yes, a very “important lesson.” Although, I think it’s a bit of an understatement, considering the FDIC — whose primary mission is to provide insurance for bank deposits — failed to, you know, collect insurance premiums from the banks it insures. Oh, well. Live and learn.

And we should probably hope that not too many more banks need to be taken over by the FDIC.

(Via Balloon Juice)

That’s important, because Bair is the leading proponent of massive restructurings of mortgages. She wants Treasury to move forward with using $40 billion to $50 billion in financial bailout money to guarantee as many as 3 million restructured loans. So far, the Treasury Department and the White House are resisting that idea.

Bair didn’t attend Tuesday’s news conference to announce the loan-modification program by Fannie and Freddie. She issued a statement saying it would fall short of stemming home foreclosures.

Under the Fannie and Freddie modification plan, homeowners at least 90 days delinquent would be eligible to have their monthly payment reduced to 38 percent of their gross monthly income, under certain circumstances. That would be accomplished mainly through interest-rate reductions and by extending the length of the loans.

The government remains a bit vague on the details. The worry among housing advocates is that the plan is being pushed as an alternative to Bair’s more sweeping proposal.

I had a different reaction — but it may reflect my generally low expectations for mortgage-loan modifications. The plan calls for paying servicers to do modifications, which I think is a great idea. These people aren’t motivated by altruism, and they usually get paid for foreclosing a home, not for working out troubled loans.

I also recognize that the program wouldn’t help a large swath of borrowers. But unless the government steps in with a huge, Depression-era program to buy up delinquent mortgages, or unless it finds some way to order investors to sign off on loan modifications, there’s only a patchwork of solutions out there?

Helping some people in small ways isn’t the worst thing in the world. Housing advocates, lenders and mortgage servicers all are getting better at loan modifications than they were, say, a year ago. That’s progress, however modest.

Tuesday night, I checked in with Ellen Seidman of the New America Foundation, who specializes in the financial services industry, to find out her reaction. Seidman, who closely follows loan modifications, said that people don’t really understand that the Fannie and Freddie plan is aimed at heading off foreclosures among prime borrowers — the next segment of homeowners in danger of defaulting on their mortgages. In that sense, the program has some merit.

Seidman explains on her blog today some of the reasons for the consternation over the plan, despite its attributes. She believes the negative reaction has a lot to do with way it was presented. She described the news conference as a “really inept rollout.”

From Seidman:

The rollout was marred (that’s being kind) by the Treasury trying to sell this for far more than it is, intimating that it is a substitute for aggressive action on a broader range of loans, including sub-prime and Alt-A loans and loans not yet seriously delinquent, such as the guarantee program that FDIC Chairman Sheila Bair has been pressing the Treasury to implement. The fact that Bair wasn’t around for the announcement, and the Treasury spokesmen literally ran out of the briefing room to avoid answering questions, didn’t exactly help the picture.

Despite the PR debacle, Seidman said the plan has merits, including breaking the logjam that has kept Fannie Mae, in particular, from doing a lot of loan modifications. If the loan modifications work well, and the agencies keep good records on successes and repeat defaults, that would offer strong evidence to convince lenders it’s in their interest to modify their loans rather than foreclose, she said.

All sorts of competing loan-modification plans are out there. Citigroup, JPMorgan Chase and Bank of America have their own variations. They’re all voluntary, and they all haven’t broken through the problem of redoing loans that aren’t in a lender’s portfolio, but are sliced into pieces and scattered around the globe in mortgage-backed securities.

Until investors begin buying into the loan-modification idea, don’t get your expectations too high for any particular program. Just consider each new rollout, however ineptly handled, as one more attempt to chip away at a problem that still seems as insurmountable as ever.