The Securities and Exchange Commission has issued additional subpoenas for documents from the big banks in a growing probe over servicer behavior and foreclosure fraud. They seem particularly interested in securitization, and whether the assets, i.e. the mortgage and the note, were ever properly conveyed to the trusts.

U.S. regulators have opened a new line of inquiry in their mortgage foreclosure probe and are asking big Wall Street banks about the beginning stages of mortgage securitization, two sources familiar with the probe said.

The Securities and Exchange Commission launched the new phase of its investigation by sending out a fresh round of subpoenas last week to big banks like Bank of America Corp (BAC.N), Citigroup Inc (C.N), JPMorgan Chase & Co (JPM.N), Goldman Sachs Group Inc (GS.N) and Wells Fargo & Co (WFC.N), the sources said.

The subpoenas focus on the earliest stage of the mortgage securitization process, said the sources, who requested anonymity because the probe is not public.

The sources said the SEC is asking for information about the role of so-called “master servicers” — specialized firms that oversee the selection and maintenance of the large pool of home loans that go into every mortgage-backed bond.

This is a very important development. The failure of the trustees to convey the loans to the trusts would mean that the mortgage-backed securities are backed by nothing. It would mean that the banks committed outright fraud on the investors. And it would make the trustees liable for taking back all the MBS from investors at par.

As Yves Smith says, more needs to be done here. The SEC should look at the automatic servicer software that generates additional late fees, and basically look at all the servicer practices known to be fraudulent. They need to understand how random Wall Street Journal reporters could get letters about loan modifications on properties where they have no mortgage. They need to examine the rot in the system. But this is a big and perhaps more costly step for the banks, because the investors are a worthy adversary for them, from a financial standpoint.

Meanwhile, in a separate incident, the overseer of the GSEs is resisting principal reductions for underwater borrowers, despite an Administration program designed to allow for that. Since Fannie Mae and Freddie Mac own so many loans – they own or guarantee about half of all mortgages – it’s crucial to get sign-off from the FHFA in order for the principal reduction program to succeed (the Administration has a few of them up and running). But this is where the FHFA’s Ed DeMarco’s insistence on reducing taxpayer losses has its negative side. It’s good that, as an investor in mortgages, he’s trying to put back illegal loans on the banks; it’s bad that he’s not allowing the write-downs needed for housing costs to come down, which would actually stabilize and save the GSEs money in the long term.

John Taylor, the head of the nonprofit National Community Reinvestment Coalition, says Fannie and Freddie could easily and quickly affect the overall housing market. “They have the greatest authority and portfolio to make an impact,” said Taylor. There are tens of thousands of loans “they can take care of tomorrow,” he said.

But data show that Fannie and Freddie don’t reduce principal, even if it might save them money in the long term. The reason: Their regulator won’t let them. (The regulator, the Federal Housing Finance Agency, declined to comment.)

The SEC investigation and Fannie and Freddie’s reluctance to reduce principal connect, in a way, because the banks will be rushing for a principal work-out when faced with the need to take back hundreds of billions in mortgages due to faulty processes. Fannie and Freddie will be on both sides of that equation; with the government basically owning them right now, they ought to make the choice.

UPDATE: There’s an amazing graphic in the Pro Publica story. Banks who own the loan outright reduce principal about 29% of the time. Private investors? 0.3% (632 principal mods out of 191,885 modifications). Fannie & Freddie? 0.0% (141 principal mods out of 287,171 modifications).

David Dayen

David Dayen