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Are U.S. banks suffering because of their level 3 assets

Over the past 6 months, and unnoticed by most is the weakness of the U.S. banks share price. One issue, often forgotten is the level 3 assets held (either willingly or unwillingly) by America's largest banks. A good portion of these level 3 assets related to Mortgage Back Securities of one form or another. During the pre-2007 days banks would often keep some of the juicier tranches (higher rating with good coupons).

Over the 2007/10 period many of those securities saw a rehabilitation in their price for a variety of reasons; (1) oversold, or (2) Armageddon, in the form of massive write-offs, didn't occur! Now a new reality is emerging. First, that loan recoveries (that were in the past around 60/70% are now in the 10/20% range -- in some areas the recovery is below zero -- trust me its possible), secondly in many cases the title chain has been broken. Most famously by Countrywide which as of 2002 decided that transferring title was too much trouble (actually admitted this in court).

There's a double impact there: first without clean title transfer, ownership of the loan is difficult to establish (hence the robo-signing). More serious (for the note holders) is the tax implications. The impact of not transferring the mortgage title has a very serious consequence on the MBS notes tax position. MBS benefit from a favorable tax treatment, that other debt instrument do not have. For the IRS, it becomes a binary situation, and since they care little for who owes what, but rather the tax position, the IRS will take the view that "forged" documents are illegal (I know it should be obvious but many courts "admitted" in evidence and acted upon documents that were clearly forged - most amusingly signed transfer documents by parties that no longer legally existed).

Hence since February 2011 (whey many US banks began writing back loan loss provisions) the value of investment grade MBS has been dropping dramatically. The AAA tranches 45 to 35, AAA rated CMBS from 97 to 91 and the AA rated tranch from 80 to 55. No only are the banks' top lines not doing great, but now they will have to take on additional provisions for these loans.

[Added June 14] Today the IRS announced that they will not pursue for tax those RMBS and CMBS structures where the lien was not perfected (or the mortgage note was not transferred), they will treat such failures as benign neglect issue, and will therefore not pursue investors for "tax due" on unsecured transaction that were booked as mortgage backed. Little consolation for investors (although rumors are that BoA is taking on huge additional provisions for its mortgage portfolio.

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