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This gargantuan article from Bloomberg.com today details the dark underbelly of the housing sector, as evidenced by a huge security market called mortgage-servicing rights:

The four biggest U.S. banks by assets may have to take writedowns on $55 billion of mortgage-collection contracts after marking them up by $11 billion in the second quarter, casting a shadow over earnings.

Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. wrote up the value of the contracts, known as mortgage-servicing rights or MSRs, by 26 percent in the quarter as mortgage rates climbed by about 0.35 percentage point. The four banks control 56 percent of the market for the contracts, according to Inside Mortgage Finance, a Bethesda, Maryland-based newsletter that has covered the industry since 1984. Servicers collect payments from borrowers and pass them on to mortgage lenders or investors, less fees. They also keep records, manage escrow accounts and contact delinquent debtors. Net gains on the contracts added more than $1 billion to Wells Fargo's record earnings in the quarter and $1 billion to JPMorgan's first-quarter profit.

It's those "net gains" that are highly questionable, and yet without them, these big banks would not have been able to show any positive earnings last quarter, which helped drive up this stock market over the past 3-6 months:

The value of the rights depends largely on the expected life of the mortgage, which ends when a borrower pays off the loan, refinances or defaults. When rates drop and more borrowers refinance, MSR values decline. Banks typically hedge those movements using interest-rate swaps and other derivatives.

Under U.S. accounting rules in place since 1995, banks are supposed to report the value of their mortgage-servicing rights on a fair-market basis, or roughly what they would fetch in a sale. A bank must record a loss whenever it sells MSRs for a price below where they're marked on the books.

Because there's no active trading in the contracts (italics ours), there are no reliable prices to gauge whether banks are valuing the rights accurately, analysts said. Banks say there is no liquid market for the securities, as the volatility of the rights has pushed some smaller firms out of the market and record delinquencies have led others to shun mortgage assets. The banks list the rights as Level 3 assets, an accounting term for securities whose value is unclear, and they rely on internal models to determine their value.

"About 75 percent of residential MSR assets are owned by 10 firms, so when you've got that supply-demand dynamic that changes, there's not going to be a whole lot of trading," said Daniel Thomas, a managing director in asset sales at Mortgage Industry Advisory Corp. in New York. "When the market is dry like it is as far as trading volume, these guys have a lot of latitude for a Level 3 input valuation."

In fact, the banks say the same thing themselves!

"The valuation of MSRs can be highly subjective and involve complex judgments by management about matters that are inherently unpredictable," San Francisco-based Wells Fargo said in its second-quarter regulatory filing.

WTF!! So essentially, these banks get to price these securities at whatever level they think is "fair." And so, how much did these untraded securities add to each bank's bottom line last quarter? Since they hedge their exposure to losses in these securities, you have to count up the value of the hedges. If the MSR goes up in value, adding to earnings, the value of their hedges goes down, reducing their earnings, and the net difference makes up whether their holdings in MSRs adds or subtracts to earnings. Last year, you had these results:

Bank of America, which lowered the value of its rights last year by $6.7 billion, still added $2 billion to its earnings as hedges outperformed the declines. JPMorgan's hedges earned $1.5 billion more than the $6.8 billion it took in writedowns on its collection contracts in 2008.

And last quarter they had these results:

Wells Fargo wrote up the value of its MSRs by $2.3 billion in the quarter, the result, it said, of model inputs and assumptions. The hedges it used to offset the movement of the servicing rights fell $1.3 billion, resulting in a net gain of $1 billion to its $3.2 billion second-quarter profit.

New York-based JPMorgan, which wrote up its MSRs by $3.83 billion in the quarter, reported a $3.75 billion loss on its hedges, leaving it with an $81 million profit. Bank of America (BOA) based in Charlotte, North Carolina, gained $3.5 billion on the increase in value of its collection contracts. The bank didn't disclose the performance of its hedges. Citigroup, which marked up the value of its rights by $1.3 billion, also didn't disclose its hedges.

And why exactly didn't Citigroup and BOA report the value of their hedges? Are they hiding something? Could be:

"Nobody wants to point out that the emperor has no clothes," said FBR Capital Markets analyst, Paul Miller (who thinks Wells Fargo stock should be trading around $15, down from its current price of almost $30). "They all took massive hedging losses over the last quarter, mainly coming out of May, when rates shot up 150 basis points, and mysteriously MSRs were written up to match those losses." A basis point is 0.01 percentage point.

These MSRs provide a huge amount of earnings to these banks, though:

Servicing rights provide a steady stream of income. The four banks collected about $4.1 billion from fees in the second quarter. Much of that revenue, about $3.2 billion, was already accounted for in the valuations of the rights.

And the irony is that because 26% of homes across the U.S. are underwater (what's owed on their homes is greater than the value of their property), more and more folks are unable to sell their residencies, which means the fees for these MSRs will continue:

"Either because people are underwater, which means it's unlikely they are going to jump out of that mortgage, or they just aren't moving around as much, those mortgages are going to last a lot longer, and that would help the valuations," said Ray Pfeiffer, chairman of the accounting department at Texas Christian University's Neeley School of Business.

But that number - 26 percent of borrowers owe more than their home is worth (according to Karen Weaver, global head of securitization research for Deutsche Bank Securities in New York) is simply stunning, and is what really popped out in this story. In parts of California, Florida and Nevada, it's as high as 75 percent. Yikes!

It seems like the real estate meltdown has a long way to go until it's resolved, regardless of which way the stock market seems to be heading.

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