Felix Salmon starts to bring out why the foreclosure mess is much bigger, and potentially much messier, than the banks or politicians are letting onto now. In The enormous mortgage-bond scandal:

You thought the foreclosure mess was bad? You’re right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren’t properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it’s looking very much as though none of the notes were properly transferred.

But that’s not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there’s a pretty strong case that they lied to the investors in many if not most of these deals.

I mentioned this back in September, and I’ve been doing a bit more digging since then. And I’m increasingly convinced that the risk to investment banks isn’t only one of dodgy paperwork; there’s also a serious risk of massive lawsuits from the SEC or other prosecutors, as well as suits from individual mortgage investors.

The key firm here is Clayton Holdings, a company which was hired by various investment banks — Goldman Sachs, Bear Stearns, Citigroup, Merrill Lynch, Lehman Brothers, Morgan Stanley, Deutsche Bank, everyone — to taste-test the mortgage pools they were buying from originators…

The banks, yes, the too-big-to-fail banks, the usual suspects, the ones we bailed out just 2 years ago, could easily be in deeper trouble this time.  The trusts that handled and sold the MBS bonds, the trusts where the banks dumped the mortgages may not have actually (as in legally) ever have been in possession of the mortage notes.  That means the banks committed fraud on investors when they sold the MBS bonds.  Who were those investors? Just about everybody: pension funds, foreign banks, state and local governments, your 401(k) or IRA.  How much is potentially at risk?  Try in the TRillions of dollars invested in this MBS bond market.  That’s a lot of uncertainty and potential loss. It’s beyond the scale of the Lehman and AIG failure two years ago.

Check out Part 1, Part 2, Part 3, Part 4, and Part 5 of my posts on this topic.