US Bank fraud: US Bancorp and Wells Fargo sold homes they did not own!

The US stock markets dropped precipitously around 11 am when the Massachusetts Supreme court delivered a ruling that will have long lasting implications for the banking sector and the US economy. Dubbed the "Ibanez Case", it pitted US Bancorp and Wells Fargo against two homeowners. In a nutshell, US Bancorp and Wells Fargo foreclosed on and sold homes that they did not legally have the right to sell…obviously a big no-no! The case originally was filed because of a dispute about whether advertising in a state-wide newspaper met the requirement for notice, as opposed to placing an ad in a local paper. During this process the Judge realized that the banks may not have owned the properties in the first place.

The problem lies in the way mortgages were transferred during the securitization process. In order to save time and process more securitizations, mortgages were transferred with a blank endorsement. When transferred, the mortgage was signed "Endorsed to _____". As the mortgage passed through roughly eight different entities on its way toward its final resting place in a sub-prime MBS pool, the blank endorsement made it easy to transfer but impossible to prove who actually owned the loan at any given time. Herein lays the problem, if a bank cannot prove that it owns the loan, then it cannot foreclose and the entire foreclosure process halts.

The Massachusetts court case addressed this very problem and by ruling to void the foreclosures it has opened a giant can of worms. The Massachusetts Supreme Court ruled that neither US Bancorp nor Wells Fargo could prove they owned the property due to the blank endorsement. Which of course means the banks did not have any right to foreclose and sell the properties in question. In my view, this is more than just two homes in Massachusetts; this calls into question the entire originate-to-distribute model and every loan that has gone through this process. Additionally, this opens the door for more put-backs and thus more charges to the banks earnings.

It is likely that every mortgage going through foreclosure will now need to be examined to determine who actually owns the property and those homeowners who have already lost their home have a means to seek damages. In practice, it means the banks will be less willing to lend since they do not have clarity on this issue. In turn, this will be a drag on an already fragile economy.

The Massachusetts ruling was the catalyst for us to take our modest profits in bank stocks and establish a short position in the Financial ETF (XLF). In our view, this is a big problem that cannot be fixed by printing more money or an improving employment picture.

* This post was written by Brian Kelly, Kanundrum Capital founder and CNBC Contributor our guest blogger.