Foreclosuregate: playing with systemic fire?

Don't underestimate the risk foreclosuregate poses to the financial system.

So say Robert Shiller, the Yale professor who was a leading skeptic of the financial bubbles of the past decade, and New York City Comptroller John Liu. They spoke Tuesday at The Economist magazine's annual Buttonwood conference, where they discussed how to manage systemic risk under the new world of regulatory reform.

Much of the discussion focused on how to spot asset bubbles and the effectiveness of new rules such as July's Dodd- Frank Act. There was, inevitably, talk about whether the banks are undercapitalized even now, as Bank of England governor Mervyn King suggested yesterday, and about the risks posed by the massive side bets on markets through derivatives.

But the latest twist in the United States' long-running housing crisis got special attention. Shiller said the danger of foreclosuregate -- the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosures and related sales in doubt -- is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.

"Foreclosuregate is probably not an earthshaking event but works in the direction of destroying trust in business and the system," said Shiller. "It works in the direction of reducing trust and people's willingness to spend."

Fortune's Allan Sloan made a similar point here.

Liu, a Democrat, was, if anything, more emphatic, in spite of the large New York City presences of major foreclosuregate players such as Bank of America (BAC) and JPMorgan Chase (JPM).

"Foreclosuregate probably isn't the end of the world, but it's pretty bad," said Liu, who earlier shrugged off a question about limiting the size of giant financial institutions on the grounds that doing so wouldn't necessarily make the financial system safer.

"The financial system is supposed to work in an orderly fashion," said Liu. "If public confidence isn't there, the foundation of the whole financial system is shaken."