Foreclosure doomsday scenario?

Here's why people are getting so nervous: The investors who got suckered into those toxic mortgage-backed securities might now have an opportunity to challenge the screwed-up process by which their bonds were prepared and sold. That opening could, in theory, require the banks to buy back those bonds, creating a liability so massive that the government might be forced to intervene. That's right, TARP II. From Bloomberg:

There are three possible outcomes for the crisis, Josh Levin, a housing industry analyst with Citigroup Global Markets Inc. in New York, wrote yesterday in a note to investors, citing an analysis by Adam Levitin, associate professor of law at Georgetown University in Washington. The best scenario is that the disputes are deemed as legal technicalities, which would cause a one-year delay in foreclosures. In the medium case, years of litigation will ensue. In the worst case, the problem becomes systemic, causing "the mortgage market to grind to a halt as title insurers refuse to insure mortgages involving existing homes."

Of course no one knows, and other analysts are not quite as concerned. Paul Miller of FBR Capital Markets assumes that the banks will suffer losses, but not large enough to create major problems. From his note (via Market Beat)

Further, it is unlikely that freezing the foreclosure process is the goal of investigations into foreclosure practices; rather, state officials are probably aiming to compel lenders to reduce principal loan balances, especially ahead of the mid-term elections. While we had previously believed that this was an election issue, we now think that this could materialize into a longer-term concern. Overall, we believe that the real cost to the industry is going to be the drag on the foreclosure process, which could delay any recovery in the housing market that might be on the horizon.