Possibly the most important fact bearing on the consequences of massive foreclosure fraud is that we don't yet know what they will be.

We don't know the full extent of the frauds. We don't know the effect of the ongoing exposure of fraud on the behavior of people with mortgages. We don't know the full extent of the losses by banks and investors in mortgage-backed securities as delinquencies mount and foreclosures fail.

We don't know how the documentation snafu may be resolved.

From an economic standpoint, not knowing is not good news.

It appears that many millions of mortgages lack a chain of ownership sufficient to establish who actually owns the note. It appears that in many cases, this deficiency has been made up illegally, with forged, falsely notarized, or otherwise irregular documents. It appears that more than 60 million mortgages are registered in an electronic system that has subverted the legal recording of property deeds and liens (and also evaded payment of fees required for this purpose). It has been argued that this entity, known as MERS, which is charged by the ultimate lien-holder with initiating foreclosures, lacks standing to do so.

Exposure of these practices has provoked major banks to suspend new foreclosures – or at least to claim to have done so. Either way, this action sends a powerful signal.

Foreclosure is a brutal business – a fact that demands that foreclosures be fair and according to law. At the same time, the threat of foreclosure is the glue that holds the system of housing credit together. Without it, nothing obliges a homeowner to pay on the mortgage.

Thus the failure of the banks to respect legal procedure in extending and securitizing mortgages, with the necessary consequence of gumming up the foreclosure process, can only lead more homeowners to consider suspending payments. Most will not do so but some will. Prospective losses to the banks are of three separate types:

-losses due to foreclosure sales that cannot be realized on defaulted homeowners because foreclosures are blocked up.

-losses due to additional delinquencies taking advantage of the breakdown in the foreclosure process.

-losses due to suits by investors (and to actions by Fannie Mae and Freddie Mac) forcing banks to take defective residential mortgage-backed securities back onto their own balance sheets, and to absorb losses they thought to have passed along to those investors.

Again, we do not know the scale of these losses, but the third type may pose the most direct and immediate threat to bank balance sheets. The others will unfold over time.

Next, let's consider the effects on the housing market. One is that some houses that would otherwise fall vacant will stay inhabited and off the market – a good thing, at least for now. A second is that some houses previously foreclosed may become unsaleable, owing to doubts about the integrity of title. This effect could impair the sale of all houses with mortgages registered electronically, since the release of a mortgage at time of sale can be definitive only if, in fact, the system reliably tracks the claims.

If title insurance claims then become a major problem, we may need to worry about the title insurance companies – and therefore about the viability of all sales of existing homes.

Following this logic, the most likely effect on most home prices is to push them down, increasing the number of underwater mortgages and the temptation to strategic default. However, there may be a contrary price effect for some homes – those with clear title and especially those not mortgaged – as potential buyers seek to protect themselves from title risk.

There are three silver linings in this very dark cloud.

First, the foreclosure-fraud crisis focuses new attention on the practices and on the financial condition of the very large banks. It may give the administration new reason to revisit the disastrous "save the banks at all costs" strategy of early 2009, and force a move toward receivership, restructuring, compensation reform and downsizing in important cases. This are necessary steps before we again have a functional, competitive financial sector.

Second, it lends new urgency to mounting demands for a serious effort to investigate and prosecute mortgage and foreclosure fraud. Plainly, the ongoing failure to pursue the massive frauds in mortgage originations, ratings, and securitization has left in place people and institutions with little respect for law. But such respect can be restored - if the government decides to do so.

Third, as homeowners default, the interest and principal otherwise spent on servicing a mortgage are spent on groceries and fuel. The losses to investors and bank shareholders are (dollar for dollar) gains to economic activity. Over time, this can be a significant source of economic recovery, rooted in families that would otherwise be displaced and homes that might otherwise be destroyed.

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Federal housing promotion policies over-stimulated the supply and demand for housing and that destabilization continues. Efforts to make home ownership a “human right” are partly responsible for our financial crisis – with too many people owning houses that are worth too little. Prior to the foreclosure crisis, housing markets seemed slowly moving back toward equilibrium. Construction was down, sellers were lowering prices, and banks were moving to foreclose mortgages in default. Since little has yet been done to eliminate the housing subsidy, these trends have been far too slow. Congress and the Administration continue to keep one foot on the gas pedal, while reality is slamming on the brakes.

Still, it did appear that at last housing markets were re-equilibrating – seller expectations were becoming more realistic, banks were beginning to move again “homeowners” in default. Since they’d been careless in expanding housing, we should not be surprised that their procedures might be equally sloppy in this reduction phase.

And those adjustments are critical if home construction and the mortgage markets are ever again to become viable. Banks already have too many incentives to exercise “forbearance.” Too many people “owning” too large houses that they could not afford have acted like bad poker players – I can’t quit now Its my money in the pot! At last, some are accepting bankruptcy. These methods - foreclosures and bankruptcies – are the best tools to bring about the price adjustments needed to restore rationality to capital markets.

And, while foreclosure documents that violate mortgage contracts or which have serious flaws, should be reviewed, it is likely that in most cases the outcome will remain the same. The owners will give up the house, the banks will write down the loan. The sooner this happens the better. Unfortunately, the push by AGs and other politicians to offer new false hopes to those facing foreclosure will merely prolong the misery and slow the economic recovery.

It will also further destabilize capital markets. Few people extend loans on non-recourse terms. Slowing further foreclosures or making them much more costly moves mortgages very much in that direction (Justice delayed is justice denied!) And since these mortgages tend to be securitized and sold to foreign investors, pension funds, and others, this increases the political risk of capital markets more generally. Avoiding homeowner losses is all too likely to increase many other losses elsewhere in the system both now and in the future (as capital availability declines further).

All this may be inevitable in any case, given Congress’ and the Administration’s refusal to correct existing housing subsidy policies, but using the foreclosure crisis to further delay housing market adjustments will exacerbate the situation. And if these actions push even more financial firms into disaster (local, state and private pension funds are already in trouble), then we may face another political and economic destabilizing wave of bailouts and a further lengthening of the recession.

The Fed and the Administration’s financial team should do everything possible to get the foreclosure system moving again as rapidly as possible. Pain delayed is pain increased!

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