How Wall Street Perverted the 4 Cs of Mortgage Underwriting


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Editor’s Comment: 

For thousands of years since the dawn of money credit has been an integral part of the equation.  Anytime a person, company or institution takes your money or valuables in exchange for a promise that it will return your money or property or pay it to someone else (like in a check) credit is involved.  Most bank customers do not realize that they are creditors of the bank in which they deposit their money.  But all of them recognize that on some level they need to know or believe that the bank will be able to make good on its promise to honor the check or pay the money as instructed. 

Most people who use banks to hold their money do so in the belief that the bank has a history of being financially stable and always honoring withdrawals.  Some depositors may look a little further to see what the balance sheet of the bank looks like.   Of course the first thing they look at is the amount of cash shown on the balance sheet so that a perspective depositor can make an intelligent decision about the liquidity or availability of the funds they deposit. 

So the depositor is in essence lending money to the bank upon the assumption of repayment based upon the operating history of the bank, the cash in the bank and any other collateral (like FDIC guarantees).

As it turns out these are the 4 Cs of loan underwriting which has been followed since the first person was given money to hold and issued a paper certificate in exchange. The paper certificate was intended to be used as either a negotiable instrument for payment in a far away land or for withdrawal when directly presented to the person who took the money and issued the promise on paper to return it.

Eventually some people developed good reputations for safe keeping the money.  Those that developed good reputations were allowed by the depositors to keep the money for longer and longer periods.  After a while, the persons holding the money (now called banks) realized that in addition to charging a fee to the depositor they could use the depositor’s money to lend out to other people.  The good banks correctly calculated the probable amount of time for the original depositor to ask for his money back and adjusted loan terms to third parties that would be due before the depositor demanded his money.

The banks adopted the exact same strategy as the depositors.  The 4 Cs of underwriting a loan—Capacity, Credit, Cash and Collateral—are the keystones of conventional loan underwriting. 

The capacity of a borrower is determined by their ability to repay the debt without reference to any other source or collateral.  For the most part, banks successfully followed this model until the late 1990s when they discovered that losing money could be more profitable than making money.  In order to lose money they obviously had to invert the ratios they used to determine the capacity of the borrower to repay the money.  To accomplish this, they needed to trick or deceive the borrower into believing that he was getting a loan that he could repay, when in fact the bank knew that he could not repay it.  To create maximum confusion for borrowers the number of home loan products grew from a total of 5 different types of loans in 1974 to a total of 456 types of loans in 2006.  Thus the bank was assured that a loss could be claimed on the loan and that the borrower would be too confused to understand how the loss had occurred.  As it turned out the regulators had the same problem as the borrowers and completely missed the obscure way in which the banks sought to declare losses on residential loans.

Like the depositor who is trusting the bank based upon its operating history, the bank normally places its trust in the borrower to repay the loan based upon the borrowers operating history which is commonly referred to as their credit worthiness, credit score or credit history.  Like the capacity of the borrower this model was used effectively until the late 1990s when it too was inverted.  The banks discovered that a higher risk of non-payment was directly related to the “reasonableness” of charging a much higher interest rate than prevailing rates.  This created profits, fees and premiums of previously unimaginable proportions.  The bank’s depositors were expecting a very low rate of interest in exchange for what appeared as a very low risk of nonpayment from the bank.  By lending the depositor’s money to high risk borrowers whose interest rate was often expressed in multiples of the rate paid to depositors, the banks realized they could loan much less in principal than the amount given to them by the depositor leaving an enormous profit for the bank.  The only way the bank could lose money under this scenario would be if the loan was actually repaid.  Since some loans would be repaid, the banks instituted a power in the master servicer to declare a pool of loans to be in default even if many of the individual loans were not in default.  This declaration of default was passed along to investors (depositors) and borrowers alike where eventually both would in many, if not most cases, perceive the investment as a total loss without any knowledge that the banks had succeeded in grabbing “profits” that were illegal and improper regardless if one referred to common law or statutory law.

Capacity and credit are usually intertwined with the actual or stated income of the borrower.  Most borrowers and unfortunately most attorneys are under the mistaken belief that an inflated income shown on the application for the loan, subjects the borrower to potential liability for fraud.  In fact, the reverse is true.  Because of the complexity of real estate transactions, a history of common law dating back hundreds of years together with modern statutory law, requires the lender to perform due diligence in verifying the ability of the borrower to repay the loan and in assessing the viability of the loan.  Some loans had a teaser rate of a few hundred dollars per month.  The bank had full knowledge that the amount of the monthly payment would change to an amount exceeding the gross income of the borrower.   In actuality the loan had a lifespan that could only be computed by reference to the date of closing and the date that payments reset.  The illusion of a 30-year loan along with empty promises of refinancing in a market that would always increase in value, led borrowers to accept prices that were at times a multiple of the value of the property or the value of the loan.  Banks have at their fingertips numerous websites in which they can confirm the likelihood of a perspective borrower to repay the loan simply by knowing the borrower’s occupation and geographical location.  Instead, they allowed mortgage brokers to insert absurd income amounts in occupations which never generate those levels of income.  In fact, we have seen acceptance and funding of loans based upon projected income from investments that had not yet occurred where the perspective investment was part of a scam in which the mortgage broker was intimately involved.  See Merendon Mining scandal.

The Cash component of the 4 Cs.  Either you have cash or you don’t have cash.  If you don’t have cash, it’s highly unlikely that anyone would consider a substantial loan much less a deposit into a bank that was obviously about to go out of business.   This rule again was followed for centuries until the 1990s when the banks replaced the requirement of cash from the borrower with a second loan or even a third loan in order to “seal the deal”.  In short, the cash requirement was similarily inverted from past practices.  The parties involved at the closing table were all strawmen performing fees for service.  The borrower believed that a loan underwriting was taking place wherein a party was named on the note as the lender and also named in the security instrument as the secured party. The borrower believed that the closing could never have occurred but for the finding by the “underwriting lender” that the loan was proper and viable.  The people at the closing table other than the borrower, all knew that the loan was neither proper nor viable.  In many cases the borrower had just enough cash to move into a new house and perhaps purchase some window treatments.  Since the same credit game was being played at furniture stores and on credit cards, more money was given to the borrower to create fictitious transactions in which furniture, appliances, and home improvements were made at the encouragement of retailers and loan brokers.  Hence the cash requirement was also inverted from a positive to a negative with full knowledge by the alleged bank who didn’t bother to pass this knowledge on to its “depositors” (actually, investors in bogus mortgage bonds). 

Collateral is the last of the 4 Cs in conventional loan underwriting.  Collateral is used in the event that the party responsible for repayment fails to make the repayment and is unable to cure it or work out the difference with the bank.  In the case of depositors, the collateral is often viewed as the full faith and credit of the United States government as expressed by the bank’s membership in the Federal Deposit Insurance Corporation (FDIC).  For borrowers collateral refers to property which they pledge can be used or sold to satisfy obligation to repay the loan.  Normally banks send one or even two or three appraisers to visit real estate which is intended to be used as collateral.  The standard practice lenders used was to apply the lower appraisals as the basis for the maximum amount that they would lend.  The banks understood that the higher appraisals represented a higher risk that they would lose money in the event that the borrower failed to repay the loan and property values declined.  This principal was also used for hundreds of years until the 1990s when the banks, operating under the new business model described above, started to run out of people who could serve as borrowers.  Since the deposits (purchases of mortgage bonds) were pouring in, the banks either had to return the deposits or use a portion of the deposits to fund mortgages regardless of the quality of the mortgage, the cash, the collateral, the capacity or any other indicator that a normal reasonable business person would use.  The solution was to inflate the appraisals of the real estate by presenting appraisers with “an offer they couldn’t refuse”.  Either the appraiser came in with an appraisal of the real property at least $20,000 above the price being used in the contract or the appraiser would never work again.  By inflating the appraisals the banks were able to move more money and of course “earn” more fees and profits. 

The appraisals were the weakest link in the false scheme of securitization launched by the banks and still barely understood by regulators.  As the number of potential borrowers dwindled and even with the help of developers raising their prices by as much as 20% per month the appearance of a rising market collapsed in the absence of any more buyers.

Since all the banks involved were holding an Ace High Straight Flush, they were able to place bets using insurance, credit default swaps and other credit enhancements wherein a movement of as little as 8% in the value of a pool would result in the collapse of the entire pool.  This created the appearance of losses to the banks which they falsely presented to the U.S. government as a threat to the financial system and the financial security of the United States.  Having succeeded in terrorizing the executive and legislative branches and the Federal Reserve system, the banks realized that they still had a new revenue generator.  By manufacturing additional losses the government or the Federal Reserve would fund those losses under the mistaken belief that the losses were real and that the country’s future was at stake.  In fact, the country’s future is now at stake because of the perversion of the basic rules of commerce and lending stated above.  The assumption that the economy or the housing market can recover without undoing the fraud perpetrated by the banks is dangerous and false.  It is dangerous because more than 17 trillion dollars in “relief” to the banks has been provided to cover mortgage defaults which are at most estimated at 2.6 trillion.  The advantage given to the megabanks who accepted this surplus “aid” has made it difficult for community banks and credit unions to operate or compete.   The assumption is false because there is literally not enough money in the world to accomplish the dual objectives of allowing the banks to keep their ill gotten gains and providing the necessary stimulus and rebuilding of our physical and educational infrastructure.  

The simple solution that is growing more and more complex is the only way that the U.S. can recover.  With the same effort that it took in 1941 to convert an isolationist largely unarmed United States to the most formidable military power on the planet, the banks who perpetrated this fraud should be treated as terrorists with nothing less than unconditional surrender as the outcome.  The remaining 7,000 community banks and credit unions together with the existing infrastructure for electronic funds transfer will easily allow the rest of the banking community to resume normal activity and provide the capital needed for a starving economy. 

See article:

Garfield Continuum White Paper Explains Economics of Securitization of Residential Mortgages

SEE The Economics and Incentives of Yield Spread Premiums and Credit Default Swaps

March 23, 2010: Editor’s Note: The YSP/CDS paper is intentionally oversimplified in order to demonstrate the underlying economics of securitization as it was employed in the last decade.

To be clear, there are several things I was required to do in order to simplify the financial structure for presentation that would be understandable. Even so, it takes careful study and putting pencil to paper in order to “get it.”

In any reasonable analysis the securitization scheme was designed to cheat investors and borrowers in their respective positions as creditors and debtors. The method used was deceit, producing (a) an asymmetry of information and (b) a trust relationship wherein the trust was abused by the sellers of the financial instruments being promoted.

So before I get any more comments about it, here are some clarifying comments about my method.

1. The effects of amortization. The future values of the interest paid are overstated in the example and the premiums or commissions are over-stated in real dollars, but correct as they are expressed in percentages.

2. The effects of present values: As stated in the report, the future value of interest paid and the future value of principal received are both over-statements as they would be expressed in dollars today. Accordingly, the premium, commission or profit is correspondingly higher in the example than it would be in real life.

3. The effects of isolating a single loan versus the reality of a pool of loans. The examples used are not meant to convey the impression that any single loan was securitized by itself. Thus the example of the investment and the loan are hypothetical wherein an average jumbo loan is isolated from the pool from one of the lower tranches and an average bond is isolated from a pool of investors, and the isolated the loan is allocated to in part to only one of the many investors who in real life, would actually own it.

The following is the conclusion extracted directly from the white paper:

Based upon the foregoing facts and circumstances, it is apparent that the securitization of mortgages over the last decade has been conducted on false premises, false representations, resulting in intentional and inevitable negative outcomes for the debtors and creditors in virtually every transaction. The clear provisions for damages and other remedies provided under the Truth in Lending Act and Real Estate Settlement Procedures Act are sufficient to make most homeowners whole if they are applied. Since the level 2 yield spread premium (resulting from the difference in money advanced by the creditor (investor) and the money funded for mortgages) also give rise to claim from investors, it will be up to the courts how to apportion the the actual money damages. Examination of most loans that were securitized indicates that they are more than offset by undisclosed profits, kickbacks, fees, premiums, and rebates. The balance of “damages” due under applicable federal lending and securities laws will require judicial intervention to determine apportionment between debtors and creditors.



  • any imaginary person or thing spoken of as though existing
  • any fictitious story, or unscientific account, theory, belief, etc.
  • Kudos to investigative journalist Kevin Hall with McClatchy Newspapers for inserting himself into the so called “loan modification” process and exposing the farce that is being perpetrated on the American public in the article below. Why is this happening? Pretty simple, two reasons, first the fact is that in almost all cases where you have a mortgage that has been securitized, you the homeowner or you the lawyer representing the homeowner are not dealing with a party that has authority to modify the loan and second they NEED a default. One of the many missions of this site is exposing the truth, hence the name “Livinglies.” The reality is that they, the “pretender lender,” know the debt is unenforceable, the real party in interest is unidentifiable in most cases, and the title to the property has a cloud on it. So what do they REALLY need:

    1. They need new paperwork and they need new signatures on something they can represent as your affirmation of the debt….to THEM… not the party that actually funded your loan who may be damaged by a default or even the party still on the deed or mortgage at the county recorders office. 
    2. They need you to waive any rights and claims you could assert because the “real lender”  or “real party in interest” and/or various parties in the chain of securitization assumed liablity for those claims you could assert as the notes flowed up the chain.
    3. Here’s the biggie, they have insurance in the event of default, they can’t collect on the insurance, credit default swaps, PMI, etc.  in the event of modification.

    Insurers have a habit of including exclusions into policies of all types and credit default insurance policies are not different. Here is a little sample of a PMI exclusion:

    “Notwithstanding any other provision of this Policy, the coverage extended to any Loan by a Certificate of Insurance may be terminated at the Company’s sole discretion, immediately andwithout notice, if, with respect to such Loan, the Insured shall permit or agree to any of thefollowing without prior written consent of the Company: (1) Any material change or modification of the terms of the Loan including, but not limited to, the borrowed amount, interest rate, term or amortization schedule, excepting such modifications as may be specifically provided for in theLoan documents, and permitted without further approval or consent of the Insured.“*

    *Radian Guaranty Master Policy, Condition 4.C, at Master_Policy

    So who is the “insured”? Well, the bondholders who put up the money that was actually used to fund your loan, reality is they are the only other party other than you that has been damaged in this whole mortage meltdown. Every other party between you and them was an intermediary, who made a killing, and had no capital at risk. The truth, there is no incentive or reason to modify your loan. In order to collect on the insurance they need a default, not a modification.

    Why do you think they want you to use the “fax” to resend them your “modification” paperwork for the umpteenth time? So they can “lose” it again. If they allowed you to scan and email it to them or send it Certified Mail Return Receipt Requested you would have evidence that a) they received it b) who received it and c) when they received it. Then all of a sudden you have a timeline, then all of a sudden someone has to be accountable and explain why they received your information 3 months ago and you haven’t heard “boo” since…

    They know that 60% of these “modifications” are back in default within a year so they need to clear the deck to foreclose when that happens. Meantime, with regard to these “trial” modifications, the paperwork I have seen explictly says that the payments will NOT be credited to your loan account but will be placed in a “suspense” account until after the trial modification period is done. Now, if you fail to complete the trial period or when the “trial” period is completed and you did comply, but they tell you they cannot approve your for a modification…who do you spose keeps that money sitting in the suspense account?

    Bottomline folks, even if you are “working with your servicer on a loan modification” you need to consult a competent attorney, don’t wait until the wolf is at the door to start looking for one.

    If you are a competent attorney, practicing in this area and not on our list of “Lawyers that Get It” we want to hear from you.

    Homeowners Often Rejected Under Obama Plan

    By Kevin G. Hall G. Hall | McClatchy Newspapers

    WASHINGTON — Ten months after the Obama administration began pressing lenders to do more to prevent foreclosures, many struggling homeowners are holding up their end of the bargain but still find themselves rejected, and some are even having their homes sold out from under them without notice.

    These borrowers, rich and poor, completed trial modifications of their distressed mortgage, and made all the payments, only to learn, often indirectly, that they won’t get help after all.

    How many is hard to tell. Lenders participating in the administration’s Home Affordable Modification Program, or HAMP, still don’t provide the government with information about who’s rejected and why.

    To date, more than 759,000 trial loan modifications have been started, but just 31,382 have been converted to permanent new loans. That’s averages out to 4 percent, far below the 75 percent conversion rate President Barack Obama has said he seeks.

    In the fine print of the form homeowners fill out to apply for Obama’s program, which lowers monthly payments for three months while the lender decides whether to provide permanent relief, borrowers must waive important notification rights.

    This clause allows banks to reject borrowers without any written notification and move straight to auctioning off their homes without any warning.

    That’s what happened to Evangelina Flores, the owner of a modest 902 square-foot home in Fontana, Calif. She completed a three-month trial modification, and made the last of the agreed upon monthly payments of $1,134.60 on Nov. 1. Her lawyer said that in late November, Central Mortgage Company told her that it would void her adjustable-rate mortgage, which had risen to a monthly sum above $2,000, and replace it with a fixed-rate mortgage.

    “The information they had given us is that she had qualified and that she would be getting her notice of modification in the first week of December,” said George Bosch, the legal administrator for the Law Firm of Edward Lopez  and Rick Gaxiola, which is handling Flores’ case for free.

    Flores, 58, a self-employed child care worker, wired her December payment to Central Mortgage Company on Nov. 30, thinking that her prayers had been answered. A day later, there was a loud, aggressive knock on her door.

    Thinking a relative was playing a prank, she opened her front door to find two strangers handing her an eviction notice.

    “They arrived real demanding, saying that they were the owners,” recalled Flores. “I have high blood pressure, and I felt awful.”

    Court documents show that her house had been sold that very morning to a recently created company, Shark Investments. The men told Flores she had to be out within three days. The eviction notice had a scribbled signature, and under the signature was the name of attorney John Bouzane.

    A representative in his office denied that Bouzane’s law firm was involved in Flores’ eviction, and said the eviction notice was obtained from Bouzane’s Web site,

    Why would a lawyer provide for free a document that gives the impression that his law firm is behind an eviction?

    “We hope to get the eviction business,” said the woman, who didn’t identify herself.

    Flores bought her home in 2006 for $352,000. Records show that it has a current fair-market value of $99,000. The new owner bought it for $78,000 at an auction Flores didn’t even know about.

    “I had my dream, but now I feel awful,” said Flores, who remains in the house while her lawyers fight her eviction. “I still can’t believe it.”

    How could Flores go so quickly from getting government help to having her home owned by Shark Investment? The answer is in the fine print of standard HAMP documents.

    The Aug. 25 cover letter from Central Mortgage Company, the servicer that collects Flores’ mortgage payments, offered Flores a trial modification with this comforting language:

    “If you do not qualify for a loan modification, we will work with you to explore other options available to help you keep your home or ease your transition into a new home.”

    CMC is owned by Arkansas regional Arvest Bank, itself controlled by Jim Walton, the youngest son of Wal-Mart founder Sam Walton.

    A glance past CMC’s hopeful promise finds a different story in the fine print of HAMP document, which contains standardized language drafted by the Obama Treasury Department and is used uniformly by lenders.

    The document warns that foreclosure “may be immediately resumed from the point at which it was suspended if this plan terminates, and no new notice of default, notice of intent to accelerate, notice of acceleration, or similar notice will be necessary to continue the foreclosure action, all rights to such notices being hereby waived to the extent permitted by applicable law.”

    This means that even when a borrower makes all the trial payments, a lender can put the house up for auction if it decides that the homeowner doesn’t qualify — assuming that foreclosure proceedings had been started before the trial period — without telling the homeowner.

    Until now, lenders haven’t even had to notify borrowers in writing that they’d been rejected for permanent modifications.

    In January, 11 months after Obama’s plan was announced, homeowners will begin receiving written rejection notices, and the Treasury Department finally will begin receiving data on rejection rates and reasons for rejections.

    The controversial clause notwithstanding, the handling of Flores’ loan raises questions.

    “Foreclosure actions may not be initiated or restarted until the borrower has failed the trial period and the borrower has been considered and found ineligible for other available foreclosure prevention options,” said Meg Reilly, a Treasury spokeswoman. “Servicers who continue with foreclosure sales are considered non-compliant.”

    CMC officials declined to comment and hung up when they learned that a reporter was listening in with permission from Flores’ legal team. Arvest officials also declined comment.

    McClatchy did hear from Freddie Mac, the mortgage finance agency seized by the Bush administration in September 2008. Freddie owns Flores’ loan, and spokesman Brad German insisted that Flores was reviewed three times for loan modification.

    “In each instance, there was a lack of documentation verifying that she had the income required for a permanent modification,” German said.

    That response is ironic, said Michael Calhoun, the president of the Center for Responsible Lending, a nonpartisan group in Durham, N.C., that works on behalf of borrowers.

    “These lenders gave loans with no documentation and charged them a penalty interest rate for doing so. And now when the people ask for help, they are using extravagant demands for documentation to give them the back of their hand and continue to foreclosure,” Calhoun said.

    German said that Flores was sent a letter on Nov. 24, which would have arrived several days later, given the Thanksgiving holiday, informing her that she’d been rejected for a permanent modification. Flores and her attorney said she never got a letter, and neither Freddie Mac nor CMC provided proof of that letter.

    Exactly one week after the letter supposedly was sent, Flores’ home was sold to Shark Investments. That company was formed on Aug. 19, according to records on the California Secretary of State’s Web site. Shark Investments, apparently an unsuspecting beneficiary of Flores’ woes, has no phone listing. The Riverside, Calif., address on the company’s filing as a limited liability company traces to a five-bedroom, four-bath house with a swimming pool.

    German didn’t comment on whether Flores received sufficient notice under Freddie Mac rules, or how the home could move to sale so quickly.

    Flores’ legal team, which specializes in foreclosure prevention, thinks that lenders and servicers are gaming Obama’s housing effort.

    “It seems servicers are giving people false hopes by sending them a plan, and they are using the program as a collection method, getting people to pay them with no intention of modifying the loan,” said Bosch. “I believe they are using this as a tool to suck people dry.”

    Dashed hopes aren’t exclusive to the working poor such as Flores.

    David Smith owns a beautiful home in San Clemente, Calif., the location of the Richard Nixon Presidential Library. Smith purchased his five bedroom home four years ago for $1.3 million. Today, the real estate Web site estimates the value of Smith’s home at $981,000, slightly below the $1 million he still owes on it.

    Smith said he went from “making a lot of money to making hardly any” as the national and California economies plunged into deep recession. He’s a salesman serving the hard-hit residential and commercial construction sector. On top of his hardship, Smith’s mortgage exceeds the limits for the HAMP plan.

    In late August, Smith signed and returned paperwork in a prepaid FedEx envelope to Bank of America that said it had received the contract needed to modify the adjustable-rate mortgage he originally took out with the disgraced lender Countrywide Financial, which Bank of America bought last year.

    The modification agreement shows that Bank of America agreed to give Smith a 3.375 percent mortgage rate through September 2014, and everything Smith paid between now and through 2019 would count as paying off interest. He’d begin paying principal and interest in October 2019, with the loan maturing in 2037.

    The deal favors the lender, but Smith, 55, jumped on it because it kept him in the home.

    Armed with what he thought was “a permanent modification,” Smith returned a notarized copy of the agreement and made subsequent payments on time.

    In return, he got a surprising notice from Bank of America saying that his house would be auctioned off on Dec. 18.

    “It looks like they’re trying to sell this out from underneath me,” Smith said. “My wife cries all the time.”

    After a Dec. 16 call from McClatchy asking why Bank of America wasn’t honoring its own modification, the lender backed off.

    “The case has been returned to a workout status and a Home Retention Division associate will be contacting Mr. Smith for further discussions,” said Rick Simon, a Bank of America spokesman. “The scheduled foreclosure sale will be postponed for at least 30 days to allow for review of the account in hope of completing a home retention solution for Mr. Smith.”

    The Center for Responsible Lending says such problems are common.

    “Everyone acknowledges that the system is not working well,” Calhoun said.


    As the following article demonstrates, the model currently used in this country and dozens of other countries  is “pay to play” — and if there is a crash it is the fees the banks paid over the years that bails them out instead of the taxpayers.
    For reasons that I don’t think are very good, the economic team is marginalizing Volcker and headed down the same brainless path we were on when Bush was in office, which was only an expansion of what happened when Clinton was in office, which was a “me too” based upon Bush #1 and Reagan. The end result is no longer subject to conjecture — endless crashes, each worse than the one before.
    The intransigence of Wall Street and the economic team toward any meaningful financial reform adds salt to the wound we created in the first palce. We were fortunate that the rest of the world did not view the economic meltdown as an act of war by the United States. They are inviting us to be part of the solution and we insist on being part of the problem.
    Sooner or later, the world’s patience is going to wear thin. Has anyone actually digested the fact that there is buyer’s run on gold now? Does anyone care that the value of the dollar is going down which means that those countries, companies and individuals who keep their wealth in dollars are dumping those dollars in favor of diversifying into other units of storage?
    The short-term “advantage” will be more than offset by the continuing joblessness and homelessness unless we take these things seriously. Culturally, we are looking increasingly barbaric to dozens of countries that take their role of protecting the common welfare seriously.

    Bottom Line on these pages is that it shouldn’t be so hard to get a judge to realize that just because the would-be forecloser has a big expensive brand name doesn’t mean they are anything better than common thieves. But like all theft in this country, the bigger you are the more wiggle room you get when you rob the homeless or a bank or the government or the taxpayers. Marcy Kaptur is right. She calls for a change of “generals”  (likening Obama’s situation to Lincoln),  since their skills were perhaps valuable when Obama first tackled the economic crisis — but now are counterproductive. We need new generals on the economic team that will steer us clear from the NEXT crisis not the LAST crisis.

    November 8, 2009

    Britain and U.S. Clash at G-20 on Tax to Insure Against Crises

    ST. ANDREWS, Scotland — The United States and Britain voiced disagreement Saturday over a proposal that would impose a new tax on financial transactions to support future bank rescues.

    Prime Minister Gordon Brown of Britain, leading a meeting here of finance ministers from the Group of 20 rich and developing countries, said such a tax on banks should be considered as a way to take the burden off taxpayers during periods of financial crisis. His comments pre-empted the International Monetary Fund, which is set to present a range of options next spring to ensure financial stability.

    But the proposal was met with little enthusiasm by the United States Treasury secretary, Timothy F. Geithner, who told Sky News in an interview that he would not support a tax on everyday financial transactions. Later he seemed to soften his position, saying it would be up to the I.M.F. to present a range of possible measures.

    “We want to make sure that we don’t put the taxpayer in a position of having to absorb the costs of a crisis in the future,” Mr. Geithner said after the Sky News interview. “I’m sure the I.M.F. will come up with some proposals.”

    The Russian finance minister, Alexei Kudrin, also said he was skeptical of such a tax. Similar fees had been proposed by Germany and France but rejected by Mr. Brown’s government in the past as too difficult to manage. But Mr. Brown is now suggesting “an insurance fee to reflect systemic risk or a resolution fund or contingent capital arrangements or a global financial transaction levy.”

    Supporters of a tax had argued that it would reduce the volatility of markets; opponents said it would be too complex to enact across borders and could create huge imbalances. Mr. Brown said any such tax would have to be applied universally.

    “It cannot be acceptable that the benefits of success in this sector are reaped by the few but the costs of its failure are borne by all of us,” Mr. Brown said at the summit. “There must be a better economic and social contract between financial institutions and the public based on trust and a just distribution of risks and rewards.”

    At the meeting at the Scottish golf resort, the last to be hosted by Britain during its turn leading the group, the ministers agreed on a detailed timetable to achieve balanced economic growth and reiterated a pledge not to withdraw any economic stimulus until a recovery was certain.

    They also committed to enact limits on bonuses and force banks to hold more cash reserves. But they failed to reach an agreement on how to finance a new climate change deal ahead of a crucial meeting in Copenhagen next month.

    The finance ministers agreed that economic and financial conditions had improved but that the recovery was “uneven and remains dependent on policy support,” according to a statement released by the group. The weak condition of the economy was illustrated Friday by new data showing the unemployment rate in the United States rising to 10.2 percent in October, the highest level in 26 years.

    The finance ministers also acknowledged that withdrawing stimulus packages required a balancing act to avoid stifling the economic recovery that has just begun.

    “If we put the brakes on too quickly, we will weaken the economy and the financial system, unemployment will rise, more businesses will fail, budget deficits will rise, and the ultimate cost of the crisis will be greater,” Mr. Geithner said. “It is too early to start to lean against recovery.”

    As part of the group’s global recovery plan, the United States would aim to increase its savings rate and reduce its trade deficit while countries like China and Germany would reduce their dependence on exports. Economic imbalances were widely faulted as helping to bring about the global economic downturn.

    Mr. Geithner acknowledged on Saturday that the changes would take time but that “what we are seeing so far has been encouraging.”

    Banks Ready to File Suit Against Short-Sellers

    editor’s note: This is part of what we have been talking about. years down the road these bankers are looking to sue borrowers for deficiencies after people recover from the disaster the bankers caused. Also set to explode in a few years are title defects that are incurable resulting from the securitization of loans and incorrect parties bringing foreclosure actions and taking title while the Lender sits blithely unaware that his rights are being twittered away.

    Banks Threaten Lawsuits Against Short Sales

    Updated: Oct 05, 2009 4:25 PM

    Banks Threaten Lawsuits Against Short Sales

    There’s a new warning out for struggling homeowners who think a short sale is their way out of a foreclosure. Big name banks like Bank of America, Citibank, and Wells Fargo are threatening to come after those who sell their homes through short sales years later once their credit is restored.

    Realtors say banks threatening to do this are causing some fear, but homeowners have no other options but to turn to short sales over foreclosure. Remember that bail out money these banks were given? Realtors say if banks do go after people, that bail out money should be given back to the government.

    Realtor Tammy Truong started in the short sale market two years ago when she noticed home owners were desperate and didn’t consider foreclosure as an option. “They’re confused and don’t know what to do. They want to do the right thing and they don’t want to walk away and foreclose,” she said.

    But short sales are now being threatened by banks. “They are pushing out the short sale process for as long as possible and looking for new avenues to try and sue people after a short sale is completed,” said Realtor Justin Chang.

    Chang says at a recent realtors meeting, big name banks were on hand and made it clear they had no problem with going after homeowners who short sell years from now as they attempt to improve their credit. “In a meeting with a lot of bank officials who came out here, they came out here and said we are able to track for up to six years peoples credit, so if they do get back on track and are able to purchase again and employment comes back, that’s when they’ll try to tag them and sue them for the difference,” he said.

    Both Truong and Chang say banks were given millions in bailout money to help them survive and help the crippling housing market. Going after owners who complete short sales was not part of the plan. “If they go back after all these people, I feel they should give back all the bailout money,” said Truong.

    Realtors are turning to Nevada’s Congressional Delegations, hoping to get them involved in this and stop these banks before anyone is sued years from now.

    Ex Freddie Mac Exec Says “Securitize No More”

    In order to revive securitization, taxpayers would have to absorb large risk. The social gains would be small, or perhaps even nonexistent. The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage.

    See Also Securitized Mortgages Are Illegal: Securitization Is ILLEGAL

    Should Mortgages be Securitized?

    Arnold Kling
    28 September, 2009
    arnold kling 77x77.jpg

    Like Humpty-Dumpty, mortgage securitization has taken a big fall. There is a widespread presumption that government policy, if not all the king’s horses and all the king’s men, should be aimed at putting securitization together again. The purpose of this essay is to question that presumption.

    The first section of this paper will describe how securitization worked at Freddie Mac in the late 1980s, when I worked there. This will allow me to introduce and explain the concepts of interest rate risk and credit risk in mortgage finance.

    The second section of this paper will describe developments in the mortgage industry from the mid-1980s through the 1990s, when Freddie Mac and Fannie Mae took on more interest rate risk. The third section looks at what evolved over the past ten years, when the process for allocating and managing credit risk changed, with “private-label” securitization and the growth of subprime mortgages.

    The fourth section of this paper describes various options for reviving mortgage securitization. The final section steps back and looks at interest rate risk and credit risk from a public policy standpoint. Government policy influences the allocation of credit risk and interest rate risk in capital markets. What are the social costs and benefits of various allocations? I suggest that policymakers might consider reverting to the housing finance system that preceded the emergence of securitization, in which depository institutions were responsible for managing both credit risk and interest rate risk for mortgages.

    Freddie Mac around 1989

    I joined Freddie Mac as an economist in December 1986. About eighteen months later, I was promoted to Director of Pricing/Cost Analysis, under the Vice-President for Financial Research. My job was to oversee the models used to manage interest rate risk and credit risk.

    At the time, my primary focus was credit risk. Freddie Mac bundled loans into securities, and then it sold the securities. If a mortgage loan defaulted, Freddie Mac would pay the entire unpaid balance on that loan to the security holder and then try to recover as much as it could from foreclosure proceedings on the property. Thus, Freddie Mac insulated security holders from the credit risk. This was known as the guarantee business, because Freddie Mac would guarantee that investors in its mortgage securities would not have to worry about individual mortgage defaults.

    A change in market interest rates could affect the value of the cash flows due to the investor in a mortgage. Because Freddie Mac packed nearly all of the mortgages it guaranteed into pass-through securities, Freddie Mac in the late 1980s had very little interest-rate risk. The interest-rate risk was borne by the investors who bought Freddie-Mac securities and relied on the cash flows that were passed through. Note that at that time there was a difference between Freddie Mac and Fannie Mae. Fannie Mae had traditionally financed most of its mortgage purchases with its own debt, rather than with pass-through securities. Thus, Fannie Mae had taken on interest-rate risk.

    Interest-rate risk arises because the typical mortgage in the United States is a thirty-year fixed-rate mortgage with a prepayment option. This means that the firm receiving the cash flows of the mortgage (call this the mortgage holder) faces a difficult problem in matching funding with the cash flows from the mortgage.

    Suppose that the interest rate on the mortgage is 8%, and suppose that the mortgage holder finances its position by issuing a five-year bond at 7%. If interest rates remain unchanged, then after five years the holder can issue another five-year bond at 7%. If this environment persists for thirty years, then the holder clearly makes a profit.

    However, suppose that after two years, market interest rates drop by two percentage points. The borrower takes advantage of this to obtain a new mortgage at 6%, using the proceeds from this refinance to pay off the original mortgage. The holder is still stuck with having to pay interest on the five-year bond for three more years at 7%. However, the holder cannot find investments that yield more than 6 percent, so the holder takes a loss. This is known as prepayment risk, or the cost of the prepayment option.

    On the other hand, suppose that after two years market interest rates rise by two percentage points and that this rise is permanent. Now, the mortgage borrower will try to retain the loan as long as possible, while the mortgage holder’s financing will run out after five years. At the end of the fifth year, the holder is going to have to obtain new funding, which will cost 9%, so that the holder is going to be suffering a loss. This might be called duration risk, because the cash flows from the mortgage have a longer duration (the last payment will not be received until thirty years from the date of origination) than the holder’s liability (a five-year bond in our example).

    When I joined Freddie Mac, its major competitors had recently been stung by duration risk. In the late 1960s and early 1970s, mortgage interest rates were around 6%. By the early 1980s, market interest rates had more than doubled. Fannie Mae, which at that time relied on medium-term debt to finance its mortgage holdings, was losing $1 million a day in 1982. More importantly the savings and loan industry, which financed its mortgage holdings with short-term deposits, was bankrupt.

    Thus, by the early 1980s, the approach of funding mortgages with short-term deposits was discredited. Securitization, which allowed the interest-rate risk to be transferred to institutions such as pension funds and insurance companies, seemed to be a superior financing method.

    The big challenge with securitization was managing credit risk. This required pricing policies, capital policies, and risk management policies.

    For pricing, we wanted to price mortgages according to risk. We specified a probability distribution for house prices, and we assumed that losses from mortgage defaults would take place when individual house prices fell below the outstanding mortgage balance. Because of this, the guarantee fee charged on a loan that was for 80% of the purchase price would be higher than the fee charged on a loan that was for 60% of the purchase price.

    Our capital policy was tied to something that we called “the Moody’s scenario,” since it was suggested to us by that credit rating agency, based on what happened in the Great Depression. Under this scenario, the average house price would fall by 10% per year for four years, and then remain flat thereafter. Although this was the average price path under the Moody’s scenario, we simulated a distribution of house prices, in which some fell by more and some fell by less. We then measured the total losses under this scenario, and we assumed that we would need enough capital to cover those losses. The cost of this capital was then priced into the guarantee fee. This capital charge did even more to penalize the relatively high-risk loans, such as loans backed by rental properties or loans with a high loan-to-value ratio.

    Pricing for risk is fine, assuming that the loan origination process is standardized. However, because loan origination was not under the control of Freddie Mac, we faced principal-agent problems. The incentive of the originators was to aim for volume, regardless of quality. To appreciate the challenge that we faced, consider that we might encounter a shady mortgage originator, whose intent is to create fraudulent mortgages and then abscond with the origination fees—or even the entire proceeds of the loan. Freddie Mac might revoke the eligibility of the shady operator, only to find that the operator moves to another location and does business under a different name.

    To manage this principal-agent problem, Freddie Mac had a number of devices (and Fannie Mae had very similar measures):

    –a qualification system for sellers. To sell loans to Freddie Mac, you had to prove that your staff had experience and you had to show sufficient capital that you could buy back loans that had been improperly originated.

    –a seller-servicer guide. This spelled out exactly the procedures and rules that we wanted originators to follow when approving or rejecting loan applications.

    –contractual obligations. Sellers were providing contractual representations and warranties to us that they were following our guide.

    –quality control. We inspected the loan files of a sample of loans from each originator. Loans that were found to violate the “reps and warrants” were put back to the seller to be repurchased.

    All of these risk management processes were costly, and all were imperfect. The principal-agent problems in securitization were difficult, and we were constantly tinkering with our systems to try to improve them.

    Freddie Mac and Fannie Mae Achieve Domination

    In the mid-1980s, inflation and interest rates began trending down. This made it profitable to finance mortgages with medium-term debt. Indeed, the downward movements in interest rates served to highlight prepayment risk. Mortgage holders had difficulty protecting themselves against sharp declines in interest rates, which caused borrowers to refinance while the holders were still paying interest on medium-term debt.

    Fannie Mae found a solution to the prepayment problem by issuing callable debt. For example, it might issue a ten-year bond that it could extinguish at par after five years, if interest rates had fallen. This effectively transferred prepayment risk from Fannie Mae to its debt investors, in return for which Fannie paid a slightly higher interest rate.

    The innovation of callable debt ultimately produced a dramatic change in the mortgage market. It undermined the Freddie Mac model of issuing pass-through securities. Investors were more comfortable with the relative simplicity and transparency of callable debt. In the 1990s, Freddie Mac jointed Fannie Mae as a “portfolio lender,” meaning that it held its own mortgage securities and funded them with callable debt.

    Funding mortgages with callable debt was so efficient that by 2003 Freddie Mac and Fannie Mae together held half of the mortgage debt outstanding in the United States. This dominant position was undermined by other innovations, discussed below.

    Securitization Goes Private-Label

    The benefits of securitization come from the fact that investors do not have to go to the trouble and expense of examining the underlying mortgages. Investors know the types of mortgages and the interest rates on the mortgages in the pool, which is the information that they need to manage interest-rate risk. However, investors assume that they are entirely insulated from credit risk, because of the guarantee provided by Freddie Mac or Fannie Mae.

    The guarantees from Freddie Mac and Fannie Mae were credible because of the capital and historical record of those firms. Most of all, however, the guarantees were credible because of the perception that it would be politically unacceptable to allow those firms to fail.

    There are mortgages that Freddie and Fannie could not guarantee, because of legislated limits on the size of loan eligible for those agencies. Moreover, ten years ago there were loans that the agencies would not guarantee, because low downpayments or weak borrower credit history made the loans high risk for default.

    About ten years ago, a number of innovations emerged that substituted for an agency guarantee, allowing “private-label” securities to compete with those of the agencies. Borrower credit scores provided a simple, quantitative measure of the borrower’s credit. Structured securities allowed credit risk to be reallocated, with subordinated holders taking most of the risk and senior holders only taking what was left over. The various tranches were evaluated by credit rating agencies, so that investors could treat AAA private-label securities as equivalent to agency securities (a practice which was formally ratified by bank regulators in a policy that took effect on January 1, 2002). For extra comfort, the holder of a security could purchase a credit default swap, which would pay off in the event that the security’s principal repayment was jeopardized.

    With all of these layers or protection, holders did not have to examine the underlying mortgages. In fact, it is not clear where that responsibility lay. With agency securitization, it was clearly the responsibility of Freddie Mac and Fannie Mae for managing, measuring, and bearing credit risk. However, with private-label securitization, those functions were diffused. The Wall Street firms that packaged securities had no experience with the risk management functions needed to ensure quality standards in mortgage origination. The credit rating agencies had most of the responsibility for credit risk measurement, but they bore none of the risk. In retrospect, the incentive to be overly generous in rating securities was far too high.

    Toward the latter part of the housing boom, the risk management process also broke down at Freddie Mac and Fannie Mae. Private-label securitization and the growth of subprime mortgages were leading to a sharp fall in the market share at the two agencies. In retrospect, the agencies should simply have held on to their capital standards and risk-management controls. However, at the time, they suffered from doubts about whether their traditional approach was still valid. They began to loosen standards for mortgage quality, to maintain insufficient capital relative to credit risk, and to purchase subprime mortgage securities based on agency ratings rather than on an assessment of the risks of the underlying loans. As a result, when the crisis hit, the agencies were not in a position to survive the losses that they incurred.

    Fix Securitization?

    On April 30, 2009, Gillian Tett lectured at the London School of Economics.[1] Tett, the author of perhaps the best book published so far on the origins of the financial crisis,[2] was asked a question about the impact of the failure of Lehman Brothers. In her response, she said that having the securities market break down was the equivalent of waking up one morning and finding that the Internet and cell phones had broken down.

    The consensus in the financial community is that securitization simply must be fixed. The question is how this can be done.

    Securitization worked because the holders of securities assumed that they were not bearing any credit risk. Securitization broke down when mortgage defaults reached a level where holders of securities were no longer confident that they were insulated from credit risk. For mortgage securitization to work again, the credit risk will have to be absorbed in a credible way by someone other than the holder of the securities.

    Mortgage credit risk includes both systemic risk and idiosyncratic risk. Systemic risk is the risk that conditions in the overall housing market will take a sharp turn for the worse. Idiosyncratic risk is the risk that mortgage originators will deliver faulty or fraudulent loans into the securitization process.

    The private-label securities operations did not seem to have strong mechanisms for dealing with idiosyncratic risk. Recently, the U.S. Treasury published recommendations for financial reform that included requiring mortgage originators to retain a 5% interest in the mortgage loans that they deliver for securitization. This strikes me as a crude approach. Five percent is too high for an honest but capital-strapped mortgage broker. At the same time, it is too low to deter serious fraud: retaining a 5% interest is no penalty at all if your intent all along is to abscond with 100% of the funds.

    A basic problem in private-label securitization is that the functions for managing idiosyncratic risk (procedures for qualifying sellers, establishing and enforcing guidelines, and so forth) are no one’s responsibility. Some party must take on those functions in order to address idiosyncratic risk.

    Another problem with all forms of mortgage securitization is that of systemic risk. At this point, there is no private-sector firm that can credibly insulate security holders from systemic risk. If Freddie Mac, Fannie Mae, and AIG all are unable to proceed without government backing, then there is no way that securitization can come back without the government acting as a guarantor of last resort.

    One suggestion that I have heard is that government should provide support along the lines of “the GNMA model.” This strikes me as nonsense. GNMA packages loans that are guaranteed by FHA and VA. GNMA is not taking any credit risk. Instead, losses are absorbed by the agencies from which it obtains the loans.

    The only way that the “GNMA model” could be used for the entire mortgage market would be if the FHA were to guarantee every mortgage. However, the FHA is not even capable of properly pricing the credit risk within its own niche. The FHA currently is suffering significant losses, creating large liabilities for taxpayers.

    Another proposal is what I refer to as “Wall Street’s Wet Dream.”[3] The idea is that a government agency would behave like a late-1980s Freddie Mac. This agency would take all of the credit risk in the securitization process, but it would not hold any securities in portfolio. This would be ideal from Wall Street’s point of view, because it would maximize the circulation of mortgage securities, rather than keep them stuck inside Freddie Mac or Fannie Mae in their own portfolios. The result would be an agency that bears no interest rate risk (which Freddie and Fannie were able to manage successfully), but which bears all of the credit risk (which brought them down).

    The “Wall Street Wet Dream” model would ensure that mortgage securities can be traded safely and profitably. The government agency would be responsible for managing the idiosyncratic risk of dealing with mortgage originators. It also would have to price for the systemic risk that arises from fluctuations in regional and national housing markets. Ultimately, this systematic risk would be borne by the taxpayers. Thus, the profits of the securities business would be fully privatized, and the credit risk would be fully socialized. Given the way Washington and Wall Street relate to one another in our society, it is a good bet that this is the model that will gain the most political support.

    Returning to the Savings and Loan Model

    Policymakers should consider returning to the mortgage finance system that we had forty years ago. Mortgages were originated and held by firms that financed their mortgage holdings with deposits. These were the savings and loans.

    The savings and loans did not suffer from the principal-agent problems that plague securitization. The loan originator is controlled by the institution that is going to hold the mortgage. The management of idiosyncratic risk is internalized.

    To manage systemic risk, regulators could subject depository institutions to capital regulations and stress tests. Mortgage holders that benefit from deposit insurance would have to hold enough capital to withstand a severe drop in house prices.

    The biggest flaw with the savings and loan model was that the savings and loans could not manage interest rate risk. When inflation and interest rates leaped higher in the 1970s, the savings and loans were stuck holding mortgages with interest rates that were well below the new prevailing market rates.

    There are various ways to make the S&L model work better than it did in the past. One is to conduct monetary policy in a way that stabilizes the inflation rate. In fact, since the early 1980s the Fed has been able to do that.

    Another approach would be to encourage variable-rate mortgages. These do not have to be the sort of high-risk, “teaser” loans that became notorious in recent years. Instead, they could work more like Canadian rollover mortgages, in which the interest rate is renegotiated every five years. The loans would be on a thirty-year amortization schedule, and they would start out at a market interest rate, rather than an artificially low rate. If interest rates were to rise sharply over any given five-year period, we would expect that the borrower’s income would have risen as well, so that the burden of the loan would not be significantly larger.

    Defenders of securitization will argue that it is more efficient to fund mortgages in the capital market. I would make two counter-arguments. The first counter-argument I would make[AN1] is that the alleged efficiency of securitization has not been demonstrated in the market. Mortgage securities are the artificial creation of government, starting with GNMA and Freddie Mac. The second-counter-argument is that adding efficiency to mortgage securitization serves to divert capital from other uses, and it is not necessarily the case that this capital diversion is best for society. More recently, bank capital regulations severely distorted the cost of holding mortgages relative to holding securities, strongly favoring the latter. In a completely free market, it is doubtful that securitization would emerge, particularly in light of recent experience.

    At its best, securitization appeared to lower mortgage rates about about one quarter of one percentage point relative to loans that could not be placed into securities. Suppose that government-backed securitization could be put in place to achieve a comparable reduction in mortgage interest rates. Is that an outcome for which we should aim?

    Compared with the risks that the government must assume in order to make securitization work, it seems to me that lowering mortgage interest rates by one quarter of one percent is not a commensurate benefit. This is particularly so given the alternative uses of capital. If mortgage rates are a bit higher than they could be under the most efficient system, then some capital will go toward other uses—interest rates charged to businesses or to consumers for other loans will be slightly lower. It is not clear that mortgage loans are better for society than other uses of capital. If it turns out that the “originate and hold” model is not as efficient as securitization for delivering low mortgage interest rates, that would not be a tragedy.

    In order to revive securitization, taxpayers would have to absorb large risk. The social gains would be small, or perhaps even nonexistent. The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage.


    Arnold Kling is an economist and member of the Financial Markets Working Group of the Mercatus Center at George Mason University. In the 1980’s and 1990’s he was an economist with the Federal Reserve Board and then with Freddie Mac. He blogs at

    [1] A recording of the lecture is available at or…

    [2] Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press, 2009).

    [3] For an example of the type of proposal I am describing, see Harley S. Bassman, “GSE’s: The Denouement,” available at….

    AIG Letter on CDS Shows Transfer and Subrogation

    In November of 2008, AIG answered a request from the SEC that requird them to explain the inner workings of Credit Default Swaps. While they appear to have finessed certain issues, this is the clearest glimpse of how it worked.

    There are several classes of transactions but each of them involves some “delivery” of the underlying “performance obligation.” Thus any claim from, for example, US bank as Trustee for MBS series XXXX, would be a nullity if they received payment under a CDS contract (in addition to the fact that the “Trustee” never owned the “underlying” loans in the first place). And it is quite apparent that performing loans were also paid off if they were part of an over-collateralized scheme, which was prevalent. So even mortgages that are current in their payments may have been paid off by AIG, and probably AMBAC and other insurers. And of course the money for these payoffs came from the US Taxpayers who now own around 80% of AIG. The following is an excerpt from that letter. See the whole letter at AIG CDS SEC CORRESP 1 filename1

    Triggers and Settlement Alternatives
    CDS transactions entered into by counterparties for regulatory capital purposes, together with a number of arbitrage transactions (comprising approximately $47 billion or 38.6 percent of the net notional amount for the arbitrage portfolio at September 30, 2008), have cash-settled structures (see Cash Settlement below) in respect of a basket of reference obligations, where AIGFP’s payment obligations may be triggered by payment shortfalls, bankruptcy and certain other events such as write-downs of the value of underlying assets as further described below. By contrast, under the large majority of CDS transactions in respect of multi-sector CDOs (comprising approximately $57 billion or 46.5 percent of the net notional amount for the arbitrage portfolio at September 30, 2008) AIGFP’s payment obligations are triggered by the occurrence of a non-payment event under a single reference CDO security, and performance is limited to a single payment by AIGFP in return for physical delivery by the counterparty of the reference security. See Physical Settlement below. A number of CDS transactions in respect of CLOs have similar settlement mechanisms. In addition, the arbitrage portfolio includes transactions with a net notional amount of $4.9 billion that allow holders to put securities to AIGFP at par in the event of a failed remarketing of the referenced security. AIGFP cannot currently determine if and when it may be required to perform its obligations in the future including the timing of any future triggering events or the amount of any additional purchases, individually or in the aggregate, that might be required.
    Physical Settlement. For CDS transactions requiring physical settlement, AIGFP is required to pay unpaid principal and accrued interest for the relevant reference obligation in return for physical delivery of such reference obligation by the CDS buyer [Editor’s Note: Who is the Buyer and do they have possession, custody, control or ownership of the “performance obligation?} upon the occurrence of a credit event. After purchasing the reference obligation, AIGFP may sell the security and recover all or a portion of the purchase price paid under the CDS, or hold such security and be entitled to receive subsequent collections of principal and interest. There can be no assurance that the satisfaction of these obligations by AIGFP will not have a material effect on AIG’s liquidity. AIGFP generally is required to settle such a transaction only if the following conditions are satisfied:
    A “Credit Event” (as defined in the relevant CDS transaction confirmation) must have occurred. In all CDS transactions subject to physical settlement, “Failure to Pay” is specified as a Credit Event and is generally triggered if there is a failure by the issuer under the related CDO to make a payment under the reference obligation (after the expiration of any applicable grace period and, in certain transactions, subject to a nominal non-payment threshold having been met).
    In addition, certain of the AIGFP CDSs, with an aggregate net notional amount totaling $7.7 billion, provide credit protection in respect of CDOs that require minimum amounts of collateral to be maintained to support the CDO debt, where the value of such collateral is affected by among other things the ratings of the securities and other obligations comprising such collateral. In the event that the issuer of such a CDO fails to maintain the minimum levels of collateral, an event of default would occur, triggering a right by a specified controlling class of CDO note holders to accelerate the payment of principal and interest on the protected reference obligations. Under certain of the CDSs, upon acceleration of the reference obligations underlying a CDS, AIGFP may be required to purchase such reference obligations for a purchase price equal to unpaid principal and accrued interest of the CDO in settlement of the CDS. As a result of this over-collaterization feature of these CDOs, AIGFP potentially may be required to purchase such CDO securities in settlement of the related CDS sooner than it would be required to if such CDOs did not have an over-collaterization feature. As of November 5, 2008, eight CDOs for which AIGFP had written credit protection on the super senior layer had experienced over-collaterization related events of default. One of these CDOs was accelerated in the second quarter of 2008, and AIGFP extinguished a portion of its CDS obligations by purchasing the protected CDO security for $103 million, which equaled the principal amount outstanding related to this CDS. AIGFP extinguished the remainder of its CDS obligations related to this CDO on November 6, 2008 by purchasing the protected CDO security for $59 million, which equaled the remaining principal amount of this CDO security subject to CDS protection. AIGFP’s remaining CDS net notional exposure with respect to CDOs that have experienced over-collateralization events of default was $2.4 billion at November 5, 2008. While AIGFP believes that these defaulted transactions are most likely to result in a payment by 
    AIGFP, AIG cannot estimate the timing of any required payments since the timing of a Credit Event may be outside of AIGFP’s control.
    In addition, certain of AIGFP’s CDSs provide credit protection in respect of CDOs that provide if the CDO issuer fails to pay amounts due on classes of CDO securities that rank pari passu with or subordinate to such referenced obligations, an event of default would occur, triggering a right by a specified controlling class of CDO noteholders to accelerate the payment of principal and interest on the protected reference obligations. As in the case of CDOs with the over-collateralization feature, the existence of such an acceleration feature potentially may result in AIGFP being required to purchase the super senior reference obligation in settlement of the related CDS sooner than would be required if such CDO did not have such acceleration feature.
        The CDS buyer must deliver the reference obligation within a specified period, generally within 30 days. There is no payment obligation if delivery is not made within this period.
        Upon completion of the physical delivery and payment by AIGFP, AIGFP would be the holder of the relevant reference obligation and have all rights associated with a holder of such securities.
          Cash Settlement. Transactions requiring cash settlement (also known as “pay as you go”) are in respect of protected baskets of reference credits (which may also include single name CDSs in addition to securities and loans) rather than a single reference obligation as in the case of the physically-settled transactions described above. Under these credit default swaps:
        Each time a “triggering event” occurs a “loss amount” is calculated. A triggering event is generally a failure by the relevant obligor to pay principal of or, in some cases, interest on one of the reference credits in the underlying protected basket. Triggering events may also include bankruptcy of reference credits, write-downs or postponements with respect to interest or to the principal amount of a reference credit payable at maturity. The determination of the loss amount is specific to each triggering event. It can represent the amount of a shortfall in ordinary course interest payments on the reference credit, a write-down in the interest on or principal of such reference credit or any amount postponed in respect thereof. It can also represent the difference between the notional or par amount of such reference credit and its market value, as determined by reference to market quotations.
        Triggering events can occur multiple times, either as a result of continuing shortfalls in interest or write-downs or postponements on a single reference credit, or as a result of triggering events in respect of different reference credits included in a protected basket. In connection with each triggering event, AIGFP is required to make a cash payment to the buyer of protection under the related CDS only if the aggregate loss amounts calculated in respect of such triggering event and all prior triggering events exceed a specified threshold amount (reflecting AIGFP’s attachment point). In addition, AIGFP is typically entitled to receive amounts recovered, or deemed recovered, in respect of loss amounts resulting from triggering events caused by interest shortfalls, postponements or write-downs on reference credits.
        To the extent that there are reimbursements received (actual or deemed) by the CDS buyer in respect of prior triggering events, AIGFP will be entitled to receive equivalent amounts from the counterparty to the extent AIGFP has previously made a related payment.

    Don’t Get “HAMP”ED Out Of Your Home!

    By Walter Hackett, Esq.
    The federal government has trumpeted its Home Affordable Modification Program or “HAMP” solution as THE solution to runaway foreclosures – few things could be further from the truth.  Under HAMP a homeowner will be offered a “workout” that can result in the homeowner being “worked out” of his or her home.  Here’s how it works.  A participating lender or servicer will send a distressed homeowner a HAMP workout agreement.  The agreement consists of an “offer” pursuant to which the homeowner is permitted to remit partial or half of their regular monthly payments for 3 or more months.  The required payments are NOT reduced, instead the partial payments are placed into a suspense account.  In many cases once enough is gathered to pay the oldest payment due the funds are removed from the suspense account and applied to the mortgage loan.  At the end of the trial period the homeowner will be further behind than when they started the “workout” plan.   

    In California, the agreements clearly specify the acceptance of partial payments by the lender or servicer does NOT cure any default.  Further, the fact a homeowner is in the workout program does NOT require the lender or servicer to suspend or postpone any non-judicial foreclosure activity with the possible exception of an actual trustee’s sale.  A homeowner could complete the workout plan and be faced with an imminent trustee’s sale.  Worse, if a homeowner performs EXACTLY as required by the workout agreement, they are NOT assured a loan modification.  Instead the agreement will include vague statements that the homeowner MAY receive an offer to modify his or her loan however there is NO duty on the part of the servicer or lender to modify a loan regardless of the homeowner’s compliance with the agreement. 
    A homeowner who fully performs under a HAMP workout is all but guaranteed to have given away thousands of dollars with NO assurance of keeping his or her home or ever seeing anything resembling an offer to modify a mortgage loan. 
    While it may well be the case the government was making an honest effort to help, the reality is the HAMP program is only guaranteed to help those who need help least – lenders and servicers.  If you receive ANY written offer to modify your loan meet with a REAL licensed attorney and ask them to review the agreement to determine what you are REALLY agreeing to, the home you save might be your own.




    The Elephant in the Room – Well One of Many…

    By Brad Keiser

    For those of you who have been to our seminars, (coming to Southern California next month) You have heard me ask about Hank Paulson and Ben Bernanke…”Are they stupid or were they lying when they said everything was OK through out all of 2007 and most of 2008?” You have seen and heard why Neil and I declare we are of the belief that there is simply “not enough money in the world to solve this problem.”

    Fannie Mae’s (FNM) 8k has an interesting slide of their questionable assets in the supplement. It can be found below along with the complete 2009 Second Quarter filing. The report describes FNM’s exposure to problematic classes of mortgages on their book. That total comes to almost $1 Trillion. (that’s with a “T”) The total book of business is about $2.7 Trillion, at least 30% and more likely as high as 50% of their book is troubled. The report muddles with the actual holdings, as there are overlaps in the descriptions. The actual numbers they provide include:

    • Negative Amortization Loans: $15B
    • Interest Only: $196B
    • Low Fico: $357B
    •  LTV>90%: $265B
    • Low Fico AND > 90% LTV: $25B
    • Alt-A: $269B
    • Sub Prime: $8B

    Those numbers add up to $1.13 trillion. They are troubled for multiple reasons. For example, $25 billion are loans that have BOTH  high LTV and a FICO score less than 620. While there are varying degrees of toxicity when it comes to “toxic” assets these would be considered highly toxic.

     What might all this mean? Some trends are emerging. Based on historical private sector experience with these types of troubled loans, particulary those 30 % of Alt A/No doc and Negative Am loans that are non-owner occupied properties, one could expect that 50% of these borrowers will go into default. On the defaulted loans the losses will be conservatively about 50% of the outstanding loan balances. In other words, losses of 25% on the troubled book are reasonable assumptions. That would imply a loss over time on these loans of $275-$300B. And that does not include losses on Prime loans. And that is JUST Fannie. The Obama Administration has an estimate of $250B over four years for the full cost of cleaning up the ALL the GSE Agencies. These numbers suggest it could be double that, triple that or more.


    This is ONLY Fannie…not Freddie or Ginnie or Sallie, not Citi, not BoA, not Wells Fargo, not numerous community banks who owned preferred shares in Fannie or Freddie that had their capital severly eroded when those preferred shares were wiped out last fall. How about the dwindling balance of FDIC reserves? Ladies and Gents we have a veritable herd of these elephants lingering in the room.

    Gee no wonder Mr. Lockhart decided now would be a good time to step down from running Fannie, Hank Paulson is getting a tan somewhere now that he has saved Goldman Sachs(for the moment)and something tells me Uncle Ben Bernanke would not be heartbroken if he was replaced by Summers or whomever this fall and could simply go back to pontificating at Princeton.

    In the interest of full disclosure I hold no position in Fannie or any of the stocks mentioned….I am long 1200 shares of Smith & Wesson.

    Fannie 8k August 2009

    Double click chart below to enlarge

    Fannie Mae 8k Sup August 09

    OHIO SLAM DUNK by Judge Morgenstern-Clarren: US BANK TRUSTEE and OCWEN Crash and Burn

    Pretender Lenders — read and weep. Game Over. Over the next 6-12 months the entire foreclosure mess is going to be turned on its head as it becomes apparent to even the most skeptical that the mortgage mess is just that —  a mess. From the time the deed was recorded to the time the assignments, powers of attorneys, notarizations and other documents were fabricated and executed there is an 18 minute Nixonian gap in the record that cannot be cured. Just because you produce documents, however real they appear, does not mean you can shift the burden of proof onto the borrower.

    If you say you have a claim, you must prove it. If you say you are the lender, you must prove it.

    Bottom Line: Every acquisition of residential real property that was allegedly subject to a securitized mortgage is subject to nullification whether it was by non-judicial foreclosure, judicial foreclosure, short-sale, modification or just a regular sale. Every foreclosure, short-sale or modification is subject to the same fatal flaw. Pension funds are not going to file foreclosure suits even though they are the ones who allegedly own the loans.

    Legislators take notice: Just because bankers give you money doesn’t mean they can change 1000 years of common law, statutory law and constitutional law. It just won’t fly. And if you are a legislator looking to get elected or re-elected, your failure to act on what is now an obvious need to clear title and restore the wealth of your citizens who were cheated and defrauded, will be punished by the votes of your constituents.


    memo_20090212_Motions for Relief From Stay Update – Endorsement of Note by Alleged Attorney-in-Fact_pmc-2

    memo_20080709_Additional Guidance on Motions for Relief From Stay_pmc-1

    memo_20080212_Tips for How a Motion for Relief From Stay Can Proceed Smoothly Through the Court _pmc-1

    memo_19980824_Motions for Relief From Stay_pmc-1

    FDCPA — Fair Debt Collection Practices Act

    Don’t get misled by titles. The wording of the statute clearly uses “verification” not validation. Verification generally means some sworn document or affidavit. This means when you contest the debt under FDCPA (in addition to sending a QWR) the party who is supposedly collecting or enforcing the debt has a duty to “obtain verification”. And that means they can’t verify it themselves unless they are the actual lender. And the statutes says pretty clearly that they must give the lenders name and contact information — past and present. STRATEGY: IF THEY SUPPLY SUCH A DOCUMENT, PICK UP THE PHONE AND SPEAK WITH THE PERSON WHO SIGNED IT.I CAN PRACTICALLY GUARANTEE THEY WILL DISCLAIM EVERYTHING THAT WAS IN IT AND POSSIBLY EVEN THAT THEY SIGNED IT.

    15 U.S.C. 1692 ———–


    Salient provisions affecting foreclosures:

    § 1692. Congressional findings and declaration of purpose

    Abusive practices

    There is abundant evidence of the use of abusive, deceptive, and unfair debt collection practices by many debt collectors. Abusive debt collection practices contribute to the number of personal bankruptcies, to marital instability, to the loss of jobs, and to invasions of individual privacy.
    (b) Inadequacy of laws
    Existing laws and procedures for redressing these injuries are inadequate to protect consumers.

    (4) The term “creditor” means any person who offers or extends credit creating a debt or to whom a debt is owed, but such term does not include any person to the extent that he receives an assignment or transfer of a debt in default solely for the purpose of facilitating collection of such debt for another.
    (5) The term “debt” means any obligation or alleged obligation of a consumer to pay money arising out of a transaction in which the money, property, insurance, or services which are the subject of the transaction are primarily for personal, family, or household purposes, whether or not such obligation has been reduced to judgment.
    The term “debt collector” means any person who uses any instrumentality of interstate commerce or the mails in any business the principal purpose of which is the collection of any debts, or who regularly collects or attempts to collect, directly or indirectly, debts owed or due or asserted to be owed or due another. Notwithstanding the exclusion provided by clause (F) of the last sentence of this paragraph, the term includes any creditor who, in the process of collecting his own debts, uses any name other than his own which would indicate that a third person is collecting or attempting to collect such debts.

    § 1692g. Validation of debts

    (a) Notice of debt; contents
    Within five days after the initial communication with a consumer in connection with the collection of any debt, a debt collector shall, unless the following information is contained in the initial communication or the consumer has paid the debt, send the consumer a written notice containing—
    (1) the amount of the debt;
    (2) the name of the creditor to whom the debt is owed;
    (3) a statement that unless the consumer, within thirty days after receipt of the notice, disputes the validity of the debt, or any portion thereof, the debt will be assumed to be valid by the debt collector;
    (4) a statement that if the consumer notifies the debt collector in writing within the thirty-day period that the debt, or any portion thereof, is disputed, the debt collector will obtain verification of the debt or a copy of a judgment against the consumer and a copy of such verification or judgment will be mailed to the consumer by the debt collector; and
    (5) a statement that, upon the consumer’s written request within the thirty-day period, the debt collector will provide the consumer with the name and address of the original creditor, if different from the current creditor.
    (b) Disputed debts
    If the consumer notifies the debt collector in writing within the thirty-day period described in subsection (a) of this section that the debt, or any portion thereof, is disputed, or that the consumer requests the name and address of the original creditor, the debt collector shall cease collection of the debt, or any disputed portion thereof, until the debt collector obtains verification of the debt or a copy of a judgment, or the name and address of the original creditor, and a copy of such verification or judgment, or name and address of the original creditor, is mailed to the consumer by the debt collector. Collection activities and communications that do not otherwise violate this subchapter may continue during the 30-day period referred to in subsection (a) unless the consumer has notified the debt collector in writing that the debt, or any portion of the debt, is disputed or that the consumer requests the name and address of the original creditor. Any collection activities and communication during the 30-day period may not overshadow or be inconsistent with the disclosure of the consumer’s right to dispute the debt or request the name and address of the original creditor.
    (c) Admission of liability
    The failure of a consumer to dispute the validity of a debt under this section may not be construed by any court as an admission of liability by the consumer.
    (d) Legal pleadings
    A communication in the form of a formal pleading in a civil action shall not be treated as an initial communication for purposes of subsection (a).
    § 1692j. Furnishing certain deceptive forms

    (a) It is unlawful to design, compile, and furnish any form knowing that such form would be used to create the false belief in a consumer that a person other than the creditor of such consumer is participating in the collection of or in an attempt to collect a debt such consumer allegedly owes such creditor, when in fact such person is not so participating.
    Any person who violates this section shall be liable to the same extent and in the same manner as a debt collector is liable under section 1692k of this title for failure to comply with a provision of this subchapter.

    § 1692k. Civil liability

    (a) Amount of damages
    Except as otherwise provided by this section, any debt collector who fails to comply with any provision of this subchapter with respect to any person is liable to such person in an amount equal to the sum of—
    (1) any actual damage sustained by such person as a result of such failure;
    (A) in the case of any action by an individual, such additional damages as the court may allow, but not exceeding $1,000; or
    (B) in the case of a class action, (i) such amount for each named plaintiff as could be recovered under subparagraph (A), and (ii) such amount as the court may allow for all other class members, without regard to a minimum individual recovery, not to exceed the lesser of $500,000 or 1 per centum of the net worth of the debt collector; and
    (3) in the case of any successful action to enforce the foregoing liability, the costs of the action, together with a reasonable attorney’s fee as determined by the court. On a finding by the court that an action under this section was brought in bad faith and for the purpose of harassment, the court may award to the defendant attorney’s fees reasonable in relation to the work expended and costs.
    (b) Factors considered by court
    In determining the amount of liability in any action under subsection (a) of this section, the court shall consider, among other relevant factors—
    (1) in any individual action under subsection (a)(2)(A) of this section, the frequency and persistence of noncompliance by the debt collector, the nature of such noncompliance, and the extent to which such noncompliance was intentional; or
    (2) in any class action under subsection (a)(2)(B) of this section, the frequency and persistence of noncompliance by the debt collector, the nature of such noncompliance, the resources of the debt collector, the number of persons adversely affected, and the extent to which the debt collector’s noncompliance was intentional.
    (c) Intent
    A debt collector may not be held liable in any action brought under this subchapter if the debt collector shows by a preponderance of evidence that the violation was not intentional and resulted from a bona fide error notwithstanding the maintenance of procedures reasonably adapted to avoid any such error.
    (d) Jurisdiction
    An action to enforce any liability created by this subchapter may be brought in any appropriate United States district court without regard to the amount in controversy, or in any other court of competent jurisdiction, within one year from the date on which the violation occurs.
    (e) Advisory opinions of Commission
    No provision of this section imposing any liability shall apply to any act done or omitted in good faith in conformity with any advisory opinion of the Commission, notwithstanding that after such act or omission has occurred, such opinion is amended, rescinded, or determined by judicial or other authority to be invalid for any reason.

    § 1692n. Relation to State laws

    This subchapter does not annul, alter, or affect, or exempt any person subject to the provisions of this subchapter from complying with the laws of any State with respect to debt collection practices, except to the extent that those laws are inconsistent with any provision of this subchapter, and then only to the extent of the inconsistency. For purposes of this section, a State law is not inconsistent with this subchapter if the protection such law affords any consumer is greater than the protection provided by this subchapter.

    § 1692o. Exemption for State regulation

    The Commission shall by regulation exempt from the requirements of this subchapter any class of debt collection practices within any State if the Commission determines that under the law of that State that class of debt collection practices is subject to requirements substantially similar to those imposed by this subchapter, and that there is adequate provision for enforcement.

    NY Times: Why Creditors Should Suffer, Too

    Editor’s Note: This article is on the right track. Using the guidelines of resolution trust, a fair and equitable distribution of risk and loss could be achieved while at the same time demonstrating to the world that the United States accepts the responsibility for what our “masters of the universe” on Wall Street and Main Street did to world commerce, government operating funds, pension funds and the rest. My faith in the Federal government coming up with a real solution to the financial crisis is diminishing daily. They talk to the talk about helping homeowners and states and the game still goes on. Impostors are stepping in to grab trillions in assets that don’t belong to them through the process of foreclosures. These proceedings are fraudulent in most cases, from one end to the other and dismissive of the offsets borrowers are entitled to for predatory lending, inflated appraisals and a complete abrogation of the underwriting duties.

    The ultimate risk here is going to fall on the citizens of every state whether they have a mortgage or not. The inconvenient truth here is that title is becoming increasing cloudy on virtually all property in every state as these foreclosures proceed. There is a solution. It has been done many times and it is time to do it again — without concern to the repercussions on Wall Street. Since the Federal government seems to preoccupied with Wall Street Banks, leave that problem to them.

    States need to look after their own affairs and one of those is property law and title to real property. A fair redistribution through agency authority under enabling legislation would give everyone a chance to prove up their title claims, and provide each state with the revenue they were cheated out of when this scheme of “off-record” assignments and hidden profits and fees were not reported because the entities were not even registered much less regulated by each state. Counties, cities and state treasuries could and should be filled back up as local banks take up the vacuum left behind by the monster mash left by Wall Street. Local banks (perhaps with state guarantee) could by state mandate be empowered to participate in the new loans under clear title providing the state with the revenue they lost and the homeowner with a fair transaction restoring some of the equity they thought they were getting but which was diverted to unknown players receiving undisclosed fees.

    And certain states that have a potentially good tax base, along with underlying land or mineral assets could issue proprietary currency to avoid the repercussions of the wholesale printing of money going on in Washington. We’ve seen the result of that too. My opinion is that this is ONLY going to get solved at the state level. We can strengthen our state governments, strengthen the wealth of our citizens, strengthen the banks that did not play with the funny money derivatives and played fair, and regenerate the industries that drive each state economy. It doesn’t take money to do this. It takes commitment and resolve. If the Republicans want to take charge of this issue, let them do it where they can — in the state houses they still control. Success in this venture will change the trajectory of the GOP from being a marginalized party of NO to a party of fiscal responsibility that says YES and has the ideas to back it up.


    April 6, 2009, 7:00 am <!– — Updated: 8:30 am –>

    Why Creditors Should Suffer, Too

    The Obama administration’s proposals to reform financial regulation sound ambitious enough as they aim to bring companies like A.I.G. under a broader umbrella of government rule-making and scrutiny.

    But there is a big hole in these proposals, as there has already been in the government’s approach to bailing out failing financial companies, Tyler Cowen writes in The New York Times’s latest Economic View column. Even as they focus on firms deemed too big to fail, the new proposals immunize the creditors and counterparties of such firms by protecting them from their own lending and trading mistakes.

    This pattern has been evident for months, with the government aiding creditors and counterparties every step of the way. Yet this has not been explained openly to the American public.

    In truth, it’s not the shareholders of the American International Group who benefited most from its bailout; they were mostly wiped out. The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.

    These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner, the Treasury secretary, would give firms like these every incentive to make similar deals down the road.

    If we are going to prevent an A.I.G.-like debacle from happening again, institutions like these need incentives to be more wary of their trading partners. Any new regulatory plan needs to deal with them in a sophisticated way.

    That’s because even smart and honest regulators can monitor a financial firm only so well. A firm’s balance sheet doesn’t always reflect its true health, and regulators do not have an inside perspective on the firms they are supposed to secure. We do need more effective regulation, but calls for regulators to “get tough” are likely to prove effective only as long as a crisis lasts.

    What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

    But in both the bailouts and in the new proposals, the government is effectively neutralizing creditors as a force for financial safety. This suggests a scary possibility — that the next regulatory regime could end up even worse than the last.

    The more closely a financial institution is regulated, the more it will be assumed that its creditors enjoy federal protection. We may be creating a class of institutions whose borrowing is, in effect, guaranteed by the government.

    It doesn’t need to be this way.

    A simple but unworkable alternative is to let major creditors make their claims in the bankruptcy courts, as was done with Lehman Brothers. But that is costly for the economy and, after the fallout from the Lehman failure, politically impossible now. Instead, the key to effective regulatory reform is to find a credible means of imposing some pain on creditors.

    Here is one possibility. The government has restricted executive pay at A.I.G. and banks receiving government funds, but this move fails to recognize that the richest bailout benefits go to creditors. Restricting compensation at these creditor firms would have more force — if it is done transparently, in advance and in accordance with the rule of law. A simple rule would be that some percentage of bailout funds should be extracted from the bonuses of executives on the credit or counterparty side of transactions.

    Such a rule would make lenders more conservative, which would generally be a good thing. To make sure that this measure doesn’t choke off economic recovery, a workable plan would impose compensation restrictions only after the economy improves and banks are recapitalized.

    Here is another option: Even in good times, when there is no threat of insolvency on the horizon, credit agreements should provide for the possibility of a future, prepackaged bankruptcy. Those agreements should require that the creditors themselves would suffer some of the damage — even if the government stepped in to bail out the afflicted firm.

    There is a risk that these sacrifices will not be extracted when the time comes, but the prospect might still check the worst excesses of leverage.

    Right now, people cannot understand why A.I.G. received bailout money, so they feel deceived. A single insurance company, even a very large one, just does not seem that essential to the American economy, which makes the company all the more a scapegoat. Much went awry at A.I.G., but in the context of a bailout, the company should be thought of as the conduit for helping an entire market that went bust.

    This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

    Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns, the Fed and Mr. Geithner receive bad publicity over the bailouts, and we are all laying the groundwork for a future financial crisis.

    The challenge isn’t easy, and we can’t start on it today, but one way or another a new regulatory plan has to move some risk back to creditors.

    The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

    The Mortgage Forgiveness Debt Relief Act and Debt Cancellation

    If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable.

    The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

    This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

    More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.

    The following are the most commonly asked questions and answers about The Mortgage Forgiveness Debt Relief Act and debt cancellation:

    What is Cancellation of Debt?
    If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

    Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.

    Is Cancellation of Debt income always taxable?
    Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

    • Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
    • Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
    • Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
    • Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
    • Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

    These exceptions are discussed in detail in Publication 4681.

    What is the Mortgage Forgiveness Debt Relief Act of 2007?
    The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.

    What does exclusion of income mean?
    Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

    Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?
    No. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing

    Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?
    Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.

    How long is this special relief in effect?
    It applies to qualified principal residence indebtedness forgiven in calendar years 2007 through 2012.

    Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
    There is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982 and the detailed example in Publication 4681.

    If the forgiven debt is excluded from income, do I have to report it on my tax return?
    Yes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return.

    Do I have to complete the entire Form 982?
    No. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach the Form 982 to your tax return.

    Where can I get this form?
    If you use a computer to fill out your return, check your tax-preparation software. You can also download the form at, or call 1-800-829-3676. If you call to order, please allow 7-10 days for delivery.

    How do I know or find out how much debt was forgiven?
    Your lender should send a Form 1099-C, Cancellation of Debt, by February 2, 2009. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.

    Can I exclude debt forgiven on my second home, credit card or car loans?
    Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion. See Publication 4681 for further details.

    If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
    Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent.  You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.

    I lost money on the foreclosure of my home. Can I claim a loss on my tax return?
    No.  Losses from the sale or foreclosure of personal property are not deductible.

    If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?
    Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case.  An exclusion is also available for the cancellation of certain nonbusiness debts of a qualified individual as a result of a disaster in a Midwestern disaster area.  See Form 982 for details.

    If the remaining balance owed on my mortgage loan that I was personally liable for was canceled after my foreclosure, may I still exclude the canceled debt from income under the qualified principal residence exclusion, even though I no longer own my residence?
    Yes, as long as the canceled debt was qualified principal residence indebtedness. See Example 2 on page 13 of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

    Will I receive notification of cancellation of debt from my lender?
    Yes. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form.

    What if I disagree with the amount in box 2?
    Contact your lender to work out any discrepancies and have the lender issue a corrected Form 1099-C.

    How do I report the forgiveness of debt that is excluded from gross income?
    (1) Check the appropriate box under line 1 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2.  Any remaining canceled debt must be included as income on your tax return.

    (2) File Form 982 with your tax return.

    My student loan was cancelled; will this result in taxable income?
    In some cases, yes. Your student loan cancellation will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation.

    Are there other conditions I should know about to exclude the cancellation of student debt?
    Yes, your student loan must have been made by:

    (a) the federal government, or a state or local government or subdivision;

    (b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or

    (c) a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.

    Can I exclude cancellation of credit card debt?
    In some cases, yes. Nonbusiness credit card debt cancellation can be excluded from income if the cancellation occurred in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See the examples in Publication 4681.

    How do I know if I was insolvent?
    You are insolvent when your total debts exceed the total fair market value of all of your assets.  Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.

    How should I report the information and items needed to prove insolvency?
    Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to exclude canceled debt from income to the extent you were insolvent immediately before the cancellation.  You were insolvent to the extent that your liabilities exceeded the fair market value of your assets immediately before the cancellation.

    To claim this exclusion, you must attach Form 982 to your federal income tax return.  Check box 1b on Form 982, and, on line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately prior to the cancellation.  You must also reduce your tax attributes in Part II of Form 982.

    My car was repossessed and I received a 1099-C; can I exclude this amount on my tax return?
    Only if the cancellation happened in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See Publication 4681 for examples.

    Are there any publications I can read for more information?
    (1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) is new and addresses in a single document the tax consequences of cancellation of debt issues.

    (2) See the IRS news release IR-2008-17 with additional questions and answers on

    Closed: Utah’s MagnetBank, Florida’s Ocala National Bank, Maryland’s Suburban Federal Savings Bank — 6 so far in 2009

    Utah’s MagnetBank closed without an acquirer

    FDIC shuts down three banks in one day amid ongoing credit crisis

    By John Letzing, MarketWatch
    Last update: 6:42 p.m. EST Jan. 30, 2009
    SAN FRANCISCO (MarketWatch) — Federal regulators closed three banks in a single day Friday, as the ongoing credit crisis showed no signs of abating.
    Utah’s MagnetBank became the fourth bank failure of the year, and the Federal Deposit Insurance Corp. was forced to directly refund depositors after being unable to find another institution willing to take over its operations.
    That marked the first time the FDIC has been unable to find an acquirer for a failed bank in nearly five years, according to FDIC spokesman David Barr. “This bank did not have an attractive franchise value, and not many retail deposits or core deposits,” Barr said. The FDIC had conducted an extensive marketing process for the bank’s assets, he said.
    Salt Lake City-based MagnetBank had total assets of $292.9 million as of Dec. 2, and $282.8 million in total deposits. “It is estimated that the bank did not have any uninsured funds,” the FDIC said in a statement.
    The FDIC later said it has also closed Maryland-based Suburban Federal Savings Bank, and Florida’s Ocala National Bank.
    Suburban Federal had total assets of roughly $360 million as of Sep. 30, and total deposits of $302 million, the FDIC said in a statement. Tappahannock, Va.-based Bank of Essex agreed to assume all of the failed bank’s deposits, the FDIC said.
    Ocala National had $223.5 million in total assets as of Dec. 31, and $205.2 million in total deposits, the FDIC said. Winter Haven, Fla.-based CenterState Bank has agreed to assume all of the failed bank’s deposits.
    The closures mark the fourth, fifth and sixth bank failures of 2009, bringing the total to 31 since the start of the credit crisis. End of Story




    Red Flags

    Critical loan processing activities, such as  verification of

    income, employment, or deposit, is delegated to brokers.

    Delegated underwriting allowed for correspondents that are new or

    lack an established track record with the FI.

    A growing number of loans is being repurchased due to

    misrepresentations by the FI under purchase and sale agreements

    with secondary market investors.  The originating FI may suffer

    significant financial losses in the event of a large and

    unforeseen fraud.

    Third party mortgage loan fraud is not covered in standard

    fidelity bond insurance.

    Tax returns show RE taxes paid but no property is identified as


    Alimony is paid but not disclosed.

    Evidence of white out or other document alterations is observed.

    Type or handwriting varies from other loan file documents or

    handwriting is the same on documents that should have been

    prepared by different people or entities.

    Internal Controls/Best Practices

    Review purchase and sales agreements with brokers, correspondents,
    and secondary market investors to determine if general
    representations and warranties contain appropriate fraud and
    misrepresentation provisions.

    Determine the FI’s responsibility for repurchasing and putting
    back loans that were funded based on misrepresentations.

    Check whether an endorsement or rider exists to the fidelity bond
    that provides coverage of third party mortgage fraud.

    Regularly document the FI’s review of insurance coverage.

    Establish procedures to ensure the bonding company is notified of
    a possible claim within the policy’s specified period.

    Adopt detailed policies and procedures to ensure effective
    controls are in place to set, validate, and clear conditions prior
    to final approval processes.

    Base underwriter compensation on loans reviewed and not loans

    Establish effective pre-funding and post QC programs that include
    sampling, portfolio analysis, appraisal, and income/down payment
    verification practices.

    As a part of the pre-funding QC process, use AVMs to corroborate
    appraised values.

    Employ internally developed or vendor-provided fraud detection

    Institute corporate wide fraud awareness training.

    Perform due diligence of brokers and correspondents.  Understand
    the risks in their policies, procedures, and practices before
    transacting business.

    Determine how and when the FI reserves for fraud and ensure
    compliance with FAS 5.

    Review the FI’s litigation roster for existing and potential class
    actions, and threatened litigation that may highlight a problem
    with a particular broker, correspondent, or internal practices.

    Review whistleblower and hot line reports, which may indicate
    fraudulent activities.

    Mortgage Brokers

    A mortgage broker is an individual who, for a fee, originates and

    places loans with an FI or an investor but does not service the


    o Review the broker’s financial information as stringently
    as for other RE borrowers.
    o Ensure the FI’s broker agreements require brokers to act
    as the FI’s representative/agent.
    o Independently verify the broker’s background information
    by checking business history outside of given references.
    o Obtain a new credit report for the broker and check for
    recent debt at other FIs.
    o Obtain resumes of principal officers, primary loan
    processors, and key employees.
    o Conduct state license verification.
    o Conduct criminal background checks and adverse data base
    searches, i.e., MARI (fraud repository).

    Conduct an annual re-certification of brokers.

    Conduct pre-funding reviews on all new production utilizing a pre-
    funding checklist.

    Conduct QC underwriting reviews.

    Base broker compensation incentives on something other than loan
    volume, i.e., credit quality, documentation completeness,
    prepayments, fraud, and compliance.

    Establish measurable criteria that trigger recourse to the broker,
    such as misrepresentation, fraud, early payment defaults, failure
    to promptly deliver documents, and prepayments (loan churning).

    Hold brokers and third party contract underwriters responsible for
    gross negligence, willful misconduct, and errors/omissions that
    materially restrict salability or reduce loan value.

    Establish a broker scorecard to monitor volume, prepayments,
    credit quality, fallout, FICO scores, LTVs, DTIs, delinquencies,
    early payment defaults, foreclosures, fraud, documentation
    deficiencies, repurchases, uninsured government loans, timely loan
    package delivery, concentrations, and QC findings.

    Perform detailed vintage analysis, and track delinquencies and
    prepayments by number and dollar volume.

    Closely monitor the total number of loans and products from a
    single broker.

    Establish an employee training program that provides instruction
    on understanding common mortgage fraud schemes and the roles of a
    mortgage broker, as well as recognizing red flags.

    Establish a periodic audit of the brokered mortgage loan
    operations with specific focus on the approval process.

    Perform social security number validation procedures to validate
    borrower identity.

    Red Flags

    No attempt is made to determine the financial condition of the

    broker or obtain references and background information.

    A close relationship exists between the broker, appraiser, and

    lender, raising independence questions.

    The broker acts as an advocate for the borrower instead of serving

    as the FI’s representative/agent.

    High “yield spread premiums” are paid by the FI.

    Original documents are not provided to the funding FI within a

    reasonable time.

    An unusually high volume of loans with maximum loan to value

    limits have been originated by one broker.

    An uncommonly large number of foreclosures, delinquencies, early

    payment defaults, prepayments, missing documents, fraud, high-risk

    characteristics, QC findings, or compliance problems exist on

    loans purchased from any broker.

    A large volume of loans from one broker arrives using the same


    High repurchase volume exists for a specific broker.

    Numerous applications from a particular broker are provided

    possessing unique similarities.

    A high volume of loans exist in the name of trustees, holding

    companies, or offshore companies.

    An unusually large increase is noted in overall volume of loans

    during a short time period.

    Internal Controls/Best Practices5

    Conduct an initial acceptance review and obtain documentation to

    support broker approval.  Examples of actions to be taken include:


    The mortgage application is the initial document completed by the
    borrower that provides the FI with comprehensive information
    concerning the borrower’s identity, financial position and
    employment history.

    Red Flags

    The application is unsigned or undated.

    Power of attorney is used.  Investigate why the borrower cannot
    execute documents and if formal supporting documentation exists.

    Signatures on credit documents are illegible and no supporting
    identification exists.

    Price and date of purchase is not indicated.

    Borrower is selling his current residence, but does not provide
    documents to support a sale.

    Down payment is not in cash, i.e., source of deposit is a
    promissory note or repayment of a personal loan.

    Borrower has high income with little or no personal property.

    Borrower’s age is not consistent with the number of years of

    Borrower has an unreasonable accumulation of assets compared to
    income or has a large amount of unsubstantiated assets.

    Borrower claims to have no debt.

    Borrower owns an excessive amount of RE.

    New housing expense exceeds 150% of current housing expense.

    A post office box is the only indicated address for the borrower’s

    The same telephone number is used for the borrower’s home and

    Application date and verification form dates are not consistent.

    Patterns or similarities are apparent from applications received
    from a specific seller or broker.

    Certain brokers are unusually active in a soft RE market.

    Concentration of loans to individuals related to a specific
    project is noted.

    Borrower does not guarantee the loan or will not sign in an
    individual capacity.

    Borrower’s income is not consistent with job type.

    Employer is an unrealistic commuting distance from property.

    Years of education is not consistent with borrower’s profession.

    Borrower is buying investment properties with no primary

    Transaction resulted in a large cash-out refi as a percent of the
    loan amount.

    Internal Controls/Best Practices

    Establish an employee training program that provides instruction
    on understanding common mortgage fraud schemes and recognizing red

    Conduct pre-funding reviews on new production.

    Closely monitor new brokers, correspondents, and products.
    Scorecard criteria can be used to track performance.  Typical
    tracking data includes:  default rates, pre-purchase cycle times,
    loan quality indicators such as underwriting exceptions, and key
    data changes prior to approval.

    Verify the source of down payment funds by directly contacting the
    FI where funds are shown deposited.

    Closely analyze the borrower’s financial information for unusual
    items or trends.

    Independently verify employment by researching the location and
    phone number of the business.

    Employ pre-funding and post-closing reviews to detect any
    inconsistencies within the transaction.

    Conduct risk based QC audits prior to funding.

    Ensure that prior liens are immediately paid from new loan

    Assess the volume of critical post-closing missing documents,
    determine the potential for repurchase recourse, and evaluate
    reserve adequacy.

    Monitor RE markets from the locale in which the FI’s mortgage
    loans originated.

    Establish a periodic independent audit of mortgage loan

    Provide fraud updates/alerts to employees.

    Review patterns on declined loans, i.e., individual social
    security number, appraiser, RE agent, loan officer, broker, etc.

    Establish a fraud hotline for anonymous fraud tips.

    Increase the use of original supporting documentation on third
    party transactions, i.e., wholesale and correspondent


    An appraisal is a written report, independently and impartially
    prepared by a qualified individual, stating an opinion of market
    value of a property as of a specific date.

    Red Flags

    The appraiser is a frequent or large volume borrower at the FI.

    The appraiser owns property in the project being appraised.  This
    is a violation of the appraisal regulation and raises concerns
    about appraiser independence and bias.

    The most recent assessed tax value does not correlate with the
    appraisal’s market value.

    An appraiser is used who is not on the institution’s designated
    list of approved appraisers.

    The appraiser is from outside the area and may not be familiar
    with local property values.  Understanding of local market nuances
    is critical to an accurate property valuation.

    An appraisal is ordered by a party to the transaction other than
    the FI, such as the buyer, seller, or broker.

    An appraisal is ordered before the sales contract is written.

    Certain information is left blank such as the borrower, client, or

    The appraised value is contingent upon curing some property
    defects, i.e., drainage problems or a zoning change.

    Comparables are not verified as recorded or are submitted by a
    potentially biased party, such as the seller or broker.

    Old comparables (9-12 months old) are used in a “hot” market.

    Comparables are an excessive distance from the subject property or
    are not in the subject property’s general area.

    Comparables all contain similar value adjustments or are all
    adjusted in the same direction.

    All comparables are on properties appraised by the same appraiser.

    Unusual or too few comparables are used.

    Similar comparables are used across multiple transactions.

    Comparables and valuations are stretched to attain desired loan-
    to-value parameters.

    Excessive adjustments are made in an urban or suburban area when
    the marketing time is less than six months.

    Appreciation is noted in a stable or declining areas.

    Large unjustified valuation adjustments are shown.

    The land constitutes a large percentage of the value.

    The market approach greatly exceeds the replacement cost approach.

    Overall adjustments are in excess of 25%.

    Photos do not match the description of the property.

    Photos of comparables look familiar.

    Photos reveal items not disclosed in the appraisal, such as a
    commercial property next door, railroad tracks, etc.

    Items with the potential for negative valuation adjustments, i.e.,
    power lines, railroad tracks, landfill, etc., are avoided in
    appraisal photos.

    Loan amounts are disclosed to the appraiser.

    File documentation is inadequate to determine whether appraisals
    were properly scrutinized or supported by additional appraisal

    The appraisal fee is based on a percentage of the appraised value.

    Independent reviews of external fee appraisals are never

    One or more sales of the same property has occurred within a
    specified period (6-12 months) and exceeds certain value increases
    (10% or more value increase).

    A fax of the appraisal is used in lieu of the original containing
    signature and certification of appraiser.

    Internal Controls/Best Practices

    Establish an employee training program that provides a good
    overview of common mortgage fraud schemes, the appraisal
    regulation, the RE lending standards regulation, appraisal
    techniques, and red flag recognition.

    Implement a strong appraisal and evaluation compliance review
    process that is incorporated into the pre-funding quality
    assurance program.

    Ensure reviewers identify violations of regulations and
    noncompliance with RE lending standards and other interagency

    Establish an approved appraiser list for use by retail, broker,
    and correspondent origination channels.  This list should be
    generated and controlled by a unit independent of production.

    Obtain a current copy of each appraiser’s license or certificate.

    Implement “watch” list and monitoring systems for appraisers who
    exhibit suspect practices, issues, and values.  Include a post-
    closing review to detect any transaction inconsistencies.

    Establish a “suspended” or “terminated” list of appraisers who
    have provided unreliable valuations or improper practices.

    Implement controls to ensure that “terminated” appraisers are
    prohibited from engaging in future transactions with the FI, and
    its brokers and correspondents.

    Implement third party appraisal controls to ensure compliance with
    regulatory guidance, specifically as it applies to appraisals and
    evaluations ordered by loan brokers, correspondents, or other FIs.

    Develop appraisal requirements based on transaction risks.

    Statistically test the appropriateness of appraisals obtained by
    brokers and correspondents by obtaining independent AVMs and

    Establish an independent appraisal review/collateral valuation
    unit to research valuation discrepancies and provide technical

    Review the appraisal’s three-year sales history to determine if
    land flips are occurring.

    Perform detailed research on each appraiser’s business history and
    financial condition.

    Physically verify the location and condition of selected subject
    properties and comparables.

    Monitor RE market values in areas that generate a high volume of
    mortgage loans and where concentrations exist.

    Employ pre- and post-closing QC reviews to detect inconsistencies
    within the transaction and hold production units financially
    accountable for proper documentation and quality.

    Conduct periodic independent audits of mortgage loan operations.

    Credit Report

    A credit report is an evaluation of an individual’s debt repayment

    Red Flags

    The absence of a credit history can indicate the use of an alias
    and/or multiple social security numbers.

    A borrower recently paying all accounts in full can indicate an
    undisclosed consolidation loan.

    Indebtedness disclosed on the application differs from the credit

    The length of time items are on file is inconsistent with the
    buyer’s age.

    The borrower claims substantial income but only has credit
    experience with finance companies.

    All trade lines were opened at the same time with no explanation.

    A pattern of delinquencies exists that is inconsistent with the
    letter of explanation.

    Recent inquiries from other mortgage lenders are noted.

    AKA (also known as) or DBA (doing business as) are indicated.

    The borrower cannot be reached at his place of business.

    FI cannot confirm the borrower’s employment.

    DTI ratios are right at maximum approval limits.

    Employment information/history on the loan application is not
    consistent with the verification of employment form.

    Credit Bureau alerts exist for Social Security number
    discrepancies, address mismatches, or fraud victim alerts.

    Internal Controls/Best Practices

    Establish an employee training program that provides instruction
    on understanding common mortgage fraud schemes, analyzing credit
    reports, and recognizing red flags.

    Include an analysis of the credit report in the pre-funding
    quality assurance program.

    Make direct inquiries to the borrower and creditors to get an
    explanation of unusual or inconsistent information.

    Obtain an updated credit report if the one received is older than
    six months.

    Independently verify employment by researching the location and
    phone number of business.

    Implement a post-closing review to detect any inconsistencies
    within the transaction.

    Establish a periodic independent audit of mortgage loan

    Define DTI calculation criteria and conduct training to ensure
    consistency and data integrity.

    Clarify non-borrower spouse issues, such as community property
    issues and the impact of bankruptcy and debts on the borrower’s
    repayment capacity.

    Ensure lease obligations are reflected in borrower debts and
    repayment capacity.

    Conduct re-verification of credit to ensure accuracy of
    broker/correspondent provided credit reports.

    Obtain more than one report from multiple repositories available
    to corroborate the initial credit report if data appears


    A closing or settlement is the act of transferring ownership of a
    property from seller to buyer in accordance with the sales contract.

    Escrow is an agreement between two or more parties that requires
    certain instruments or property be placed with a third party for
    safekeeping, pending the fulfillment or performance of a specific
    act or condition.

    Red Flags

    Related parties are involved in the transaction.

    The business entity acting as the seller may be controlled by or
    is related to the borrower.

    Right of assignment is included which may hide the borrower’s
    actual identity.

    Power of attorney is used and there is no documented explanation
    about why the borrower cannot execute documents.

    The buyer is required to use a specific broker or lender.

    The sale is subject to the seller acquiring title.

    The sales price is changed to “fit” the appraisal.

    No amendments are made to escrow.

    A house is purchased that is not subject to inspection.

    Unusual amendments are made to the original transaction.

    Cash is paid to the seller outside of an escrow arrangement.

    Cash proceeds are paid to the borrower in a purchase transaction.

    Zero funds are due from the buyer.

    Funds are paid to undisclosed third parties indicating that there
    may be potential obligations by these parties.

    Odd amounts are paid as escrow deposits or down payment.

    Multiple mortgages are paid off.

    The terms of the closed mortgage differ from terms approved by the

    Unusual credits or disbursements are shown on settlement

    Discrepancies exist between the HUD-1 and escrow instructions.

    A difference exists between sales price on the HUD-1 and sales

    Internal Controls/Best Practices

    Establish an employee training program that provides an
    understanding of common mortgage fraud schemes, proper closing
    procedures, and recognizing red flags.

    Provide the closing agent with instructions specific to each
    mortgage transaction.

    Instruct the closing agent to accept certified funds only from the
    FI that is the verified depository.

    Require the closing agent to notify the FI if the agent has
    knowledge of a previous, concurrent, or subsequent transaction
    involving the borrower or the subject property.

    Obtain a specific transaction closing protection letter from the
    closing agent.

    Implement controls to ensure loan proceeds fully discharge all
    debts and prior liens as required.

    Employ pre- and post-closing reviews to detect any inconsistencies
    within the transaction.

    Conduct periodic independent audits of mortgage loan operations.

    Use IRS form 4506 on all loans to facilitate full investigation of
    future fraud allegations.

    Industry studies indicate that a significant portion of the loss
    associated with residential RE loans can be attributed to fraud.
    Industry experts estimate that up to 10% of all residential loan
    applications, representing several hundred billion dollars of the
    annual U.S. residential RE market, have some form of material
    misrepresentation, both inadvertent and malicious.  An in-depth
    review by The Prieston Group of Santa Rosa, California of early
    payment defaults, an indicator of problem loans, revealed that 45-
    50% of these loans have some form of misrepresentation.
    Additionally, this study showed that approximately 25% of all
    foreclosed loans have at least some element of misrepresentation,
    and losses on floan balance.

    The second motive, fraud for profit, is a major concern for the
    mortgage lending industry.  It often results in larger losses per
    transaction and usually involves multiple transactions.  The schemes
    are frequently well planned and organized.  There may also be intent
    to default on the loan when the profit from the scheme has been
    realized.  Multiple loans and people may be involved and
    participants, who are often paid for their involvement, do not
    necessarily have knowledge of the whole scheme.

    Fraud for profit can take many forms including, but not limited to:

    Receipt of an undisclosed or unusually high commission or fee,

    Representation of investment property as owner-occupied since
    FIs usually offer more favorable terms on owner-occupied RE, •
    Sale of an otherwise unsalable piece of property by concealing
    undesirable traits, such as environmental contamination,
    easements, building restrictions, etc.,

    Attainment of a new loan to redeem a property from foreclosure
    to relieve a burdensome debt,

    Rapid buildup of a RE portfolio with an inflated value to
    perpetrate a land flip scheme,

    Mortgage of rental RE with the intention of collecting rents
    and not making payments to the lender, retaining funds for
    personal use,

    The advance of loan approvals for customers to benefit from the
    commission payments, and/or

    Misrepresentation of personal identity, i.e., use of illegally
    acquired social security numbers, to illegally obtain a loan,
    or to sell/take cash out of equity on a property with no
    intention of repaying the debt.

    The third motive, which involves additional criminal purposes beyond
    fraud, is becoming more of a concern for law enforcement and FIs.
    This involves taking the profit motive one step further by applying
    the illegally obtained funds or assets to other crimes, such as:

    Money laundering through purchase of RE, most likely with cash,
    at inflated prices,

    Terrorist activities such as the purchase of terrorist safe
    houses and,

    Other illegal activities like prostitution, drug sales or use,
    counterfeiting, smuggling, false document production and
    resale, auto chop shops, etc.


    It is important to be aware of the different participants and
    transaction flows to understand the fraud schemes described in this
    paper.  This section provides background information on various
    participants and their roles in typical mortgage transactions.


    Common participants in a mortgage transaction include, but are not
    limited to:

    Buyer – a person acquiring the property,

    Seller – a person desiring to convert RE to cash or another
    type of asset,

    Real Estate Agent – an individual or firm that receives a
    commission for representing the buyer or seller, •
    Originator – a person or entity, such as a loan officer,
    broker, or correspondent, who assists a borrower with the loan

    Processor – an individual who orders and/or prepares items
    which will be included in the loan package,

    Appraiser – a person who prepares a written valuation of the

    Underwriter – an individual who reviews the loan package and
    makes the credit decision,

    Warehouse Lender – a short term lender for mortgage bankers
    that provides interim financing using the note as collateral
    until the mortgage is sold to a permanent investor, and

    Closing/Settlement Agent – a person who oversees the
    consummation of a mortgage transaction at which the note and
    other legal documents are signed and the loan proceeds are

    Refer to Appendix A – Glossary for additional and expanded
    definitions for participants and other terms used throughout this

    Mortgage Loan Purchased from a Correspondent – In this transaction,
    the borrower applies for and closes his loan with a correspondent of
    the FI, which can be a mortgage company, small depository
    institution, or finance company.  The correspondent closes the loan
    with internally generated funds in its own name or with funds
    borrowed from a warehouse lender.  Without the capacity or desire to
    hold the loan in its own portfolio, the correspondent sells the loan
    to an FI.  The purchasing FI is frequently not involved in the
    origination aspects of the transaction, and relies on the
    correspondent to perform these activities in compliance with the
    FI’s approved underwriting, documentation, and loan delivery
    standards.  The purchasing FI reviews the loan for quality prior to
    purchase.  The purchasing FI must also review the appraisal or AVM
    report and determine that it conforms to the appraisal regulation
    and is otherwise acceptable.  The loan can be booked in the FI’s own
    portfolio or sold.

    In “delegated underwriting” relationships, the FI grants approval to
    the correspondent to process, underwrite, and close loans according
    to the FI’s processing and underwriting requirements.  The FI is
    then committed to purchase those loans.  Obviously, proper due
    diligence, controls, approvals, QC audits, and ongoing monitoring
    are warranted for these higher risk relationships.

    Financial institutions that generate mortgage loans through
    correspondents should have adequate policies, procedures, and
    controls to address:  initial approval and annual re-certification,
    underwriting, pre-funding and QC reviews, repurchases, early
    prepayments, appraisals, quality and documentation monitoring,
    fraud, scorecards, timely delivery of loan packages, and utilization
    of contract underwriters.  In addition, FIs should have contractual
    agreements to demand and enforce repurchase proceedings and other
    disciplinary actions with correspondents delivering loans outside of
    product and other contractual agreements.

    There are a variety of mechanisms by which third party mortgage loan
    fraud can take place.  Various combinations of these mechanisms may be implemented in a single fraud.  Some of these mechanisms and
    their uses are described in this section.


    Collusion involves two or more individuals working in unison to
    implement a fraud.  Various third parties may conspire to perpetrate
    a fraud against an FI with each generally contributing to the plan.
    Each person performs his respective role and receives a portion of
    the illicit proceeds.  Often, but not always, third parties recruit
    or bribe FI employees to take part in the scheme.  The scheme may
    also include additional parties not involved in the planning or
    aware of all participants, but who are still part of the plan’s

    Documentation Misrepresentation

    Mortgage fraud is generally achieved using fictitious, forged, or
    altered documents needed to complete a transaction.  Pertinent
    information may also be omitted from documents.  The following
    describes some key documents and ways they can be altered to
    perpetrate fraud.

    Loan Application – The application captures information needed
    for an FI to make a credit decision based on the borrower’s
    qualifications such as financial capacity.  It may include
    false information regarding the identity of the buyer or
    seller, income, employment history, debts, or current occupancy
    of the property.  The information on the final application may
    have been altered and be materially different than that
    provided on the initial application.

    Appraisal – An appraisal is a written statement that should be
    independently and impartially prepared by a qualified
    practitioner setting forth an opinion of the market value of a
    specific property as of a certain date, supported by the
    presentation and analysis of relevant market information.  It
    is an integral component of the collateral evaluation portion
    of the credit underwriting process.

    An appraisal is fraudulent if the appraiser knowingly intends
    to defraud the lender and/or profits from the deception by
    receiving more than a normal appraisal fee.  This includes
    accepting a fee contingent on a foregone conclusion of value,
    or a guarantee for future business in response to the inflated
    value.  The appraiser may inflate comparable values or falsify
    the true condition of the property, which can allow the
    defrauder to obtain a larger loan than the property legitimately supports.  An appraisal that does not include
    negative factors affecting the property value can influence the
    FI to enter into a transaction that it normally would not
    approve.  The defrauder may use comparables that are outdated,
    fictitious, an unreasonable distance from the subject property,
    or materially different from the subject property.  Photos
    represented to be of the subject property may be of another
    property.  Inflated appraisal values create high loss potential
    and contribute to an FI’s losses at the time of foreclosure or

    Credit Report – This document contains an individual’s credit
    history which is used to analyze an individual’s repayment
    patterns and capacity.  Credit histories can be forged or
    altered through various methods to repair bad credit or create
    new credit histories.  Fraudsters can also use the credit
    report of an unknowing individual who has a good credit record.
    Perpetrators have been known to scan and alter illegally
    obtained legitimate credit reports that are then printed and
    used as originals.  Copiers can be similarly used to produce
    fictitious or altered credit reports.  Fraudsters have used
    computers to hack into credit bureau files and have purchased
    credit bureau computer access codes from persons who work for
    legitimate businesses.

    Alternate credit reference letters are often used for
    applicants with limited or no traditional credit history.  They
    are usually in the form of a letter directly from a business
    such as a utility, small appliance store, etc., to which the
    applicant is making regular payments.  These letters can be
    easily altered or completely fabricated using the business’s
    letterhead.  As lenders expand to provide loans to more diverse
    income levels, alternate credit references are becoming more

    Deed – A deed identifies the owner(s) of the property.  It can
    be altered to disguise the true property owner or the
    legitimate owner’s signature can be forged to execute a
    mortgage transaction.  Alteration or forgery of this document
    allows the fraudster to use a false identity to complete the

    Financial Information – This includes financial statements, tax
    returns, FI statements, and income information provided during
    the application process.  Any of this data can be falsified to
    enable the applicant to qualify for a mortgage loan.
    Inadequate income and employment verification procedures may
    allow mortgage loan fraudsters to deceive the FI regarding this information.  Some perpetrators have been known to set up phone
    banks to receive verification calls from FIs.

    HUD-1 Settlement Statement – The HUD-1 accompanies all
    residential RE transactions.  This is a statement of actual
    charges, adjustments, and cash due to the various parties in
    connection with the settlement.  Working alone or with
    accomplices this document can be altered to defraud the parties
    to the transaction.  Information on the original HUD-1 may show
    entities or persons not noted as lien holders but who still
    receive payoffs from seller’s funds.  These individuals may be
    deleted from the final HUD-1 that is available for review prior
    to loan closing.  This enables individuals involved in the
    fraudulent scheme to receive funds from the loan disbursement
    without the FI being aware of such payments.  The document may
    show a down payment when none was made.  The document may also
    include the borrower’s forged signature.

    Mortgage – A mortgage is a legal agreement that uses real
    property as collateral to secure payment of a debt.  In some
    locales a deed of trust is used instead.  A mortgage can be
    altered to disguise the true property owner, the legitimate
    lien holder, and/or the amount of the mortgage.  Alteration or
    forgery of this document allows the fraudster to obtain loan
    proceeds meant for another party or in an amount that exceeds
    the legitimate value of the property.

    Quitclaim Deed – This is a document used to transfer the named
    party’s interest in a property.  The transferring party does
    not guarantee that he has an ownership interest, only that he
    is conveying the interest to which he represents he is
    entitled.  Fraud perpetrators may use this document to quickly
    transfer property to straw or nominee borrowers without a
    proper title search.  Straw borrowers are discussed on page 17
    under Third Party Mortgage Fraud Schemes.  This technique can
    disguise the true property owner and allow the mortgage
    transaction to be completed quickly.

    Title Insurance/Opinion – Either of these documents confirms
    that the stated owner of the property has title to the property
    and has the right to transfer ownership of that property.  They
    identify gaps in the chain of title, liens, problems with the
    legal description of the property, judgments against the owner,
    etc.  Title insurance schedules or opinions can be altered to
    change the insured FI or omit prior liens.  This can be part of
    the falsification that occurs when a perpetrator attempts to
    obtain multiple loans from different FIs for one mortgage transaction.  Alteration of title insurance or opinions occurs
    in other fraud scenarios, as well.

    Identity Theft

    Identity theft means the theft of an individual’s personal
    identification and credit information, which is used to gain access
    to the victim’s credit facilities and FI accounts to take over the
    victim’s credit identity.  Perpetrators may commit identity theft to
    execute schemes using fake documents and false information to obtain
    mortgage loans.  These individuals obtain someone’s legitimate
    personal information through various means, i.e., obituaries, mail
    theft, pretext calling, employment or credit applications, computer
    hacking, and trash retrieval.  With this information, they are able
    to impersonate homebuyers and sellers using actual, verifiable
    identities that give the mortgage transactions the appearance of

    Mortgage Warehousing

    Mortgage warehousing lines of credit are used to temporarily
    “warehouse” individual mortgages until the mortgage banker, who may
    be acting as a broker, can sell a group of them to an FI.  If a
    dishonest mortgage banker has warehousing lines with two FIs, he can
    attempt to warehouse the same mortgage loan on each line.  The
    individual FIs may not be aware of the other’s line.  One FI may be
    presented with the original documents, while the delivery of the
    documents to the other FI is indefinitely delayed.  The second FI
    may fund the line without the documents if previous dealings with
    the mortgage banker have been satisfactory.  It is only after
    transferring funds that the second lender realizes it has been
    defrauded.  The Mortgage Electronic Registry System (MERS) can also
    be used as a valuable control tool.

    The mortgage warehouse lender often relies on the mortgage banker’s
    internal loan data regarding FICO, loan-to-value (LTV), debt-to-
    income (DTI), appraised value, credit grade and aging, making them
    vulnerable to fraud if the provided data is not accurate.  The
    mortgage warehouse lender should have proper procedures and controls
    to provide ongoing monitoring, verification, and audits of the loans
    under this line of credit.  It may also want to consider scorecards,
    due diligence, and customer identification policies and procedures.


    Negligence occurs when people who handle mortgage transactions are
    careless or inattentive to the accuracy and details of the documents
    or disregard established processing procedures.  This often happens
    when an FI is experiencing fast growth and uses temporary and part-time employees to process a large volume of mortgages without proper
    controls or oversight.  Inattention to detail provides perpetrators
    with the opportunity to submit documents containing fraudulent
    information with the probability that the fraud will not be
    detected.  Fraudsters may target FIs once they identify these


    The purpose of this section is to describe some of the most
    prevalent types of mortgage fraud that have resulted in significant
    losses to FIs.  Fraud schemes using one or more of the mechanisms
    described earlier are limited only by the imagination of the
    individuals who initiate them.  The following scenarios are not
    intended to be an all-inclusive list.  Specific examples for most of
    these schemes are detailed in Appendix C.

    Appraiser Fraud

    A person falsely represents himself as a State-licensed or State-
    certified appraiser.  Appraiser fraud also can occur when an
    appraiser falsifies information on an appraisal or falsely provides
    an inaccurate valuation on the appraisal with the intent to mislead
    a third party or FI.  Appraiser fraud is often an integral part of
    some fraud schemes.

    Double Selling

    Double selling is a scheme wherein a mortgage loan broker accepts a
    legitimate application, obtains legitimate documents from a buyer,
    and induces two FIs to each fully fund the loan.  In this scenario,
    the originator leads each FI to believe that the broker internally
    funded the loan for a short period.  Since there is only one set of
    documents, one of the funding FIs is led to believe that the proper
    documentation will arrive any day.  Double selling is self-
    perpetuating because different loans must be substituted for the
    ones on which documents cannot be provided to keep the scheme going.
    Essentially, the broker uses a lapping scheme to avoid detection.

    Another variation of double selling entails a mortgage loan broker
    accepting a legitimate application and proper documentation, who
    then copies the loan file, and presents both sets of documents to
    two investors for funding.  Under this scheme, the broker has to
    make payments to the investor who received the copied documents or
    first payment default occurs.

    False Down Payment

    Another third party mortgage fraud involves false down payments.  In
    this scenario, a borrower colludes with a third party, such as a
    broker, closing agent, etc., to reflect an artificial down payment.
    When this scheme is carried out with collusion by an appraiser, the
    true loan-to-value greatly exceeds 100% and has the potential to
    cause substantial loss to the FI.

    Fictitious Mortgage Loan

    A fictitious mortgage loan scheme is perpetrated primarily by
    mortgage brokers, closing agents, and/or appraisers.  In one version
    of this scheme, the identity of an unsuspecting person is assumed in order to acquire property from a legitimate seller.  The broker
    persuades a friend or relative to allow the broker to use the
    friend’s or relative’s personal credit information to obtain a loan.
    The FI is left with a property on which it must foreclose and the
    third parties pocket substantial fees from both the FI and buyer.
    Straw Borrower

    The straw borrower scheme involves the intentional disguising of the
    true beneficiary of the loan proceeds.  The “straw”, sometimes known
    as a nominee, may be used to:

    conceal a questionable transaction,

    replace a legitimate borrower who may not qualify for the
    mortgage or intend to occupy the property, or

    circumvent applicable lending limit regulations by applying for
    and receiving credit on behalf of a third party who may not
    qualify or want to be contractually obligated for the debt.

    The straw borrower scheme is accomplished by enticing an individual,
    sometimes a friend or relative, to apply for credit in his own name
    and immediately remit the proceeds to the true beneficiary.  The
    straw borrower may feel there is nothing wrong with this and fully
    believes that he is helping the third party.  He expects the
    recipient of the loan proceeds to make the loan payments, either
    directly or indirectly.  The recipient may be unable to or may never
    intend to make the payment.  Over time, default would occur with the
    FI initiating foreclosure proceedings.  This scheme can involve FI
    personnel, as well as other third party participants.  The straw
    borrower may or may not be paid a fee for his involvement or know
    the full extent of the scheme.

    In summary, millions of dollars have been lost because of the
    mortgage fraud schemes described above.  These schemes produce many
    indicators that are apparent to an educated observer.  The next
    section identifies these red flags and provides best practices that
    FIs can use to mitigate risk of loss.


    Prudent risk management practices for third-party originated loans
    are critical.  Strong detective and preventive controls are an
    integral part of a sound oversight framework, including adequate
    knowledge of the FI’s customers.  Knowledgeable, trained employees,
    coupled with disciplined underwriting and proactive prevention
    controls, are an FI’s best deterrent to fraud.  Implementation of
    strong controls does not prevent human errors or oversight failures,
    but documentary evidence of QC measures taken by the FI can be a
    useful defense against a repurchase request from an investor.

    As a part of the exam process, examiners should assess actions taken
    by the FI to document its controls over internal fraud, relative to
    safe and sound FI practices and individual agency regulatory requirements.  Examiners should also include Patriot Act and SAR
    requirements in their evaluations.

    The following list of red flags3, which is not intended to be all-
    inclusive, may be used to identify and deter misrepresentations or
    fraud.  Other automated systems for fraud detection, if used in
    conjunction with this list, are dependent on the quality of the
    input and analysis of the output.  The presence of any of these red
    flags DOES NOT necessarily indicate that a misrepresentation or
    fraud has occurred, only that further research may be necessary.


    Congress enacted Title XI of the Financial Institutions, Reform,
    Recovery and Enforcement Act of 1989 (FIRREA) requiring member
    agencies of Federal Financial Institutions Examination Council
    (FFIEC) to issue RE appraisal regulations to address problems
    involving faulty and fraudulent appraisals.  One of the cornerstones
    of the regulation was a requirement that a regulated financial
    institution or its representative select, order, and engage
    appraisers for federally related transactions to ensure
    independence.  The agencies’ expectations on this subject are stated
    in an interagency statement dated October 27, 2003 entitled
    Interagency Appraisal and Evaluation Functions.  This statement
    provides clarification of the various agencies’ appraisal and RE
    lending regulations and should be reviewed in conjunction with them.

    Specifically, the October 2003 statement primarily addresses the
    need for appraiser independence.  A regulated institution is
    expected to have board approved policies and procedures that provide
    for an effective, independent RE appraisal and evaluation program.
    Basic elements of independence are discussed such as separation of
    the function from loan production and engagement of the appraiser by
    the institution, not the borrower.  A written engagement letter is
    encouraged.  An effective internal control structure is also
    necessary to ensure compliance with the agencies’ regulations and
    guidelines.  This includes a review process provided by qualified,
    trained individuals not involved with loan production.  The depth of
    review should be based on the size, complexity, and other risk
    factors attributable to the transactions under review.  For the full
    text of the October 27, 2003 statement please refer to Appendix G.

    KISS – Keep It Simple Stupid: Why Brad Conducts Part of the Workshops

    See also provident-bank-v-silverman-super-duper-explanation-of-ucc-transferres-holders-and-holders-in-due-course-and-perfecting-title-to-note-or-mortgage

     KISS – Keep It Simple Stupid

    Totaled Cars and Totaled Mortgages – Credit Default Swaps – CDS – 101

    By Brad Keiser

    OK this article is for those newer readers and tenured Livinglies devotees as well as those who have attended Al Pacino’s(oops I mean Neil Garfield’s ) workshops and are not quite yet fluent in Garfieldeese or Wall Street Pig Latin. You have  heard him rant about derivative securities, credit default swaps, insurance products and co-obligors, etc….and why/how they come into play with the securitization process with respect to the argument that the party bringing the foreclosure action against you has already been paid.  Trial lawyers who use expert witness testimony realize that the success of expert testimony often hinges less on impressing the jury with degrees or credentials of the expert witness than on the ability of the expert witness to effectively communicate with a jury or judge and often simplify complex subject matter and put them into the context of the case at hand. The same is true for lawyers or Pro Se litigants. Allow me to break down the credit default swap elephant into bite size pieces

    First, a credit default swap(CDS) can be defined in layman’s terms as “an insurance policy.” The objective of my car insurance policy is to protect a physical asset I own or replace the vehicle if it is totaled without having to take the cash out of my pocket. In the case of my life insurance policy, the benefit is a lump sum of money that theoretically would replace the “income stream” my family depends on if I die. The rationale for insurance is that it is easier for me to budget $500 every six months for car insurance than suddenly have to come up with $30,000 at once to replace my wife’s totaled minivan. In both instances beside the financial benefit I also derive the additional benefit of peace of mind.

    In the securitization process, typically the Special Purpose Entity (SPE) or Trust that issued the mortgage backed securities (MBS) purchased an insurance policy (CDS) on the assets they were holding for the same reasons. In the event the mortgage was “totaled” the insurance carrier (we’ll call them AIG in this instance) paid out on the policy and made the SPE or Trust whole so they could continue to pay the investors they sold the securities to their periodic return on investment(ROI). As with the car and life insurance above, there was a similar “non-financial benefit” called peace of mind. The presence of this “insurance” gave the investors in the securities peace of mind and no doubt contributed to the peace of mind of the ratings agencies (Moody’s, Fitch, S&P) who gave these securities AAA ratings. The triggering events in each of the above examples are respectively an accident, a death or a default.


    Totaled Car, Totaled Mortgage Pretty Simple Judge

    So when my wife totaled the minivan, a vehicle I might add that had a properly RECORDED lien noted on my vehicle title, the insurance carrier issued a check to the bank that held the lien and paid off the note on the car OR put another way satisfied the obligation. The check did not come from me, it came from the insurance company, the bank obviously did not care where the money came from, the obligation was satisfied and the lien on the minivan was released. So did the bank, after getting paid by the insurance company, get to keep the damaged minivan ALSO and take it to an auto auction (READ: foreclosure sale) and keep the proceeds of auctioning off the wrecked minivan?  Noooo… Did I, the owner, of the minivan get to keep the wrecked minivan and sell it for additional $$$ beyond the benefit of the proceeds of the insurance policy paying off the loan at the bank? Noooo…

    Based on the terms of the typical auto insurance policy who ends up with the title on the totaled minivan? It sure isn’t the bank that got paid off by the insurance company. The point is that absent someone’s sworn testimony, who can attest to personal knowledge about your specific loan and/or irrefutable evidence that your mortgage was a) not sold or securitized or b) not subject to an “insurance policy” we cannot be sure that the parties in court today have any authority.

    KISS – Just win the argument of the day. Judge we are not saying this closing never occurred, we are not saying that a note was never signed; we are not saying the note wasn’t funded. We are saying the  material dispute before the court today is whether or not the parties here today bringing this action have already been paid and/or whether or not they are even the right parties with authority to bring this action against my client… We simply want the case to be heard on the merits.

    By the way my wife now drives a monster, gas guzzling Chevy Suburban ,not that I am anti-environment or anything, just protecting the most valuable cargo I have in this world …the Keiser kids.

    Credit Card Issuers See the Writing on the Wall: Forgiveness of Debt — they also got paid in full through securitization, so there is no obligation owed to them

    Credit Card Companies Willing to Deal Over Debt

    Bank of America says it eased off on more than 700,000 credit card holders in 2008, lowering interest rates and some balances.
    Published: January 2, 2009
    Hard times are usually good times for debt collectors, who make their money morning and night with the incessant ring of a phone.

    Behind Changing Tactics, Mounting Losses
    Times Topics: Credit Crisis — The Essentials

    But in this recession, perhaps the deepest in decades, the unthinkable is happening: collectors, who usually do the squeezing, are getting squeezed a bit themselves.

    After helping to foster the explosive growth of consumer debt in recent years, credit card companies are realizing that some hard-pressed Americans will not be able to pay their bills as the economy deteriorates.

    So lenders and their collectors are rushing to round up what money they can before things get worse, even if that means forgiving part of some borrowers’ debts.

    Increasingly, they are stretching out payments and accepting dimes, if not pennies, on the dollar as payment in full.

    “You can’t squeeze blood out of a turnip,” said Don Siler, the chief marketing officer at MRS Associates, a big collection company that works with seven of the 10 largest credit card companies. “The big settlements just aren’t there anymore.”

    Lenders are not being charitable. They are simply trying to protect themselves.

    Banks and card companies are bracing for a wave of defaults on credit card debt in early 2009, and they are vying with each other to get paid first. Besides, the sooner people get their financial houses in order, the sooner they can start borrowing again.

    So even as many banks cut consumers’ credit lines, raise card fees and generally pull back on lending, some lenders are trying to give customers a little wiggle room. Bank of America, for instance, says it has waived late fees, lowered interest charges and, in some cases, reduced loan balances for more than 700,000 credit card holders in 2008.

    American Express and Chase Card Services say they are taking similar actions as more customers fall behind on their bills. Every major credit card lender is giving its collection agents more leeway to make adjustments for consumers in financial distress.

    Debt collectors, who are typically paid based on the amount of money they recover, report that the number of troubled borrowers getting payment extensions has at least doubled in the last six months. In other cases, borrowers who appear to be pushed to the brink are being offered deals that forgive 20 to 70 percent of credit card debt.

    “Consumers have never been in a better position to negotiate a partial payment,” said Robert D. Manning, the author of “Credit Card Nation” and a longtime critic of the credit card industry. “It’s like that old movie ‘Rosalie Goes Shopping.’ When it’s $100,000 of debt, it’s your problem. When it’s a million dollars of debt, it’s the bank’s problem.”

    The recent wave of debt concessions is a reversal from only a few years ago, when consumers usually lost battles with their credit card companies. Now, as bad debts soar, it is the lenders who are crying mercy.

    Credit card lenders expect to write off an unprecedented $395 billion of soured loans over the next five years, according to projections from The Nilson Report, an industry newsletter. That compares with a total of about $275 billion in the last five years.

    All that bad debt is getting harder to collect. In the past, troubled borrowers might have been able to pay down card loans by tapping the equity in their homes, drawing on retirement savings, taking out a debt consolidation loan, or even calling a relative for help. But with credit tight, consumers are maxed out.

    “Knowing that the sources of funding have dried up, having someone pay the balance in full isn’t a viable strategy,” said Tim Smith, a senior executive at Firstsource, one of the biggest debt collection companies.

    Lenders are reluctant to admit they will accept less than full payment, lest they encourage good customers to stop paying what they can. Industrywide data is scarce.

    Unlike the huge mortgage loan modification programs that are taking place, which address thousands of mortgages at once, workouts for credit card customers are still being handled on a case-by-case basis.

    In addition to debt forgiveness, debt collectors are allowing many delinquent borrowers to pay down their debt over the course of a year rather than the standard six months.

    Paul Hunziker, the chairman of Capital Management Services, said that before this downturn, his firm put only about a quarter of all borrowers into longer-term repayment plans. Now, it puts about half on such plans.

    Some lenders are also reaching out to borrowers shortly after they fall behind on their payments to try to avoid having to write off the account. Others are reaching out to customers who seem likely to fall behind. Just as lenders competed for years to be the first card to be taken out of the wallet, they are now competing to be the first ones paid back.

    And realizing that millions more consumers are likely to default on their credit card bills in the coming months, the banking industry has started lobbying regulators to make it more advantageous to lenders to extend payment terms or forgive debt.

    In an unusual alliance, the Financial Services Roundtable, one of the industry’s biggest lobbyists, and the Consumer Federation of America recently proposed a credit card loan modification program, which was rejected by regulators.

    Under the plan, lenders would have forgiven about 40 percent of what was owed by individual borrowers over five years. Lenders could report the loss once whatever part of the debt was repaid, instead of shortly after default, as current accounting rules require. That would allow them to write off less later. Borrowers would have been allowed to defer any tax payments owed on the forgiven debt.

    Landmark changes to bankruptcy legislation passed in 2005, for which the industry aggressively lobbied, seem to have hurt card debt collections. Credit card industry data indicate the average debt discharged in Chapter 7 bankruptcy has nearly tripled since 2004. And in Chapter 13 bankruptcies, secured lenders like auto finance companies routinely elbow out unsecured lenders like card companies, trends that have contributed to the card lenders’ willingness to settle.

    Borrowers should not expect sweetheart deals. Card companies will offer loan modifications only to people who meet certain criteria. Most customers must be delinquent for 90 days or longer. Other considerations include the borrower’s income, existing bank relationships and a credit record that suggests missing a payment is an exception rather than the rule.

    While a deal may help avoid credit card cancellation or bankruptcy, it will also lead to a sharp drop in the borrower’s credit score for as long as seven years, making it far more difficult and expensive to obtain new loans. The average consumer’s score will fall 70 to 130 points, on a scale where the strongest borrowers register 700 or more.

    For the moment, it may be easier for troubled borrowers to start negotiating a modification by contacting the card company or collection agency directly. Credit counselors can help borrowers consolidate their debts and get card companies to lower their interest payments and other fees, but they currently cannot get the loan principal reduced.

    Another option is for a borrower to sign up a debt settlement company to negotiate on her behalf. But regulation of this business is loose, and consumer advocacy groups warn that some firms prey on troubled borrowers with aggressive marketing tactics and exorbitant upfront fees.

    More Articles in Business » A version of this article appeared in print on January 3, 2009, on page B1 of the New York edition.


    Perhaps it’s time to look at credit card debt through the prism of TILA and unfair debt collection practices, etc..


    Harvard-educated architect to lead an agency dealing with the mortgage mess

    by Philip Elliott | The Associated Press

    Saturday December 13, 2008, 3:54 PM

    CHICAGO — Promising a prominent role for his housing department, President-elect Barack Obama on Saturday named a Harvard-educated architect to lead an agency dealing with the mortgage mess that dragged the country into a recession.

    Former Clinton aide: New York Housing Preservation and Development Commissioner Shaun Donovan has a national reputation for developing affordable housing.With one in 10 U.S. homeowners delinquent on mortgage payments or in foreclosure, Obama said New York City housing commissioner Shaun Donovan will bring “fresh thinking, unencumbered by old ideology and outdated ideas” at the Housing and Urban Development Department to help resolve the housing and economic crisis.

    “We can’t keep throwing money at the problem, hoping for a different result,” Obama said during his weekly address on radio and YouTube. “We need to approach the old challenge of affordable housing with new energy, new ideas, and a new, efficient style of leadership. We need to understand that the old ways of looking at our cities just won’t do.”

    Donovan, head of the New York’s Housing Preservation and Development Department, is former Clinton administration HUD official with a national reputation for curtailing low-income foreclosures, developing affordable housing and managing the nation’s largest housing plan.

    If confirmed by the Senate, Donovan would become the nation’s top housing official in the midst of the worst recession in decades. Falling home values and stricter lending standards have ensnared millions of U.S. households. More than 259,000 homes received a foreclosure-related notice in November, up 28 percent from a year earlier. The Federal Reserve is predicting that new foreclosures this year will reach 2.25 million, more than double pre-crisis levels.

    Conrad Egan, president of the nonpartisan National Housing Conference, said Obama’s selection of Donovan signals that he recognizes HUD can play a big role in the economic recovery.

    “It really needs to be a seat at the Cabinet table that is the principle point where housing and community development issues are brought together and resolved successfully,” Egan said. “HUD has been perceived as a second-tier participant in meeting that challenge.”

    Congressional Democrats, with support from Obama, have sought to use part of the $700 billion banking bailout to help homeowners facing foreclosure. The Bush administration has resisted those efforts.

    Obama has been reluctant to dive into the details of the plans. Since winning the presidency, he has asked his advisers to develop a plan that would save or create some 2.5 million jobs in the next two years and include the largest public works program in a half century. He said Saturday he sees HUD playing an important role

    “This plan will only work with a comprehensive, coordinated federal effort to make it a reality. We need every part of our government working together,” Obama said, adding that “few will be more essential to this effort” than HUD.

    Donovan, a 42-year-old New York native, told the Senate Banking, Housing and Urban Affairs Committee in May that HUD’s programs have led to “a feast-famine cycle, in which our program grows to the allowed size and then contracts so we don’t go above our authorized level.”

    Obama said Donovan “understands that we need to move past the stale arguments that say low-income Americans shouldn’t even try to own a home or that our mortgage crisis is due solely to a few greedy lenders. He knows that we can put the dream of owning a home within reach for more families, so long as we’re making loans in the right way, and so long as those who buy a home are prepared for the responsibilities of homeownership.” said.

    As New York Mayor Michael Bloomberg’s top aide for housing, Donovan kept foreclosures to a minimum in the city’s low- and moderate-income home ownership plan, with just five of 17,000 participating homes falling. He oversaw the creation of the $200 million New York Acquisition Fund, a collaboration involving the city, foundations and financial institutions. It is intended to help small developers and nonprofit groups compete for land in the private market.

    Obama’s selection of Donovan marks the 11th post he has filled in his Cabinet, in just over a month since his election as the nation’s first African American president. Still to come are the Central Intelligence Agency, the Environmental Protection Agency, and the departments of energy, education, interior, labor, transportation and agriculture.

    The rollout of the selection — announced at 6 a.m. Saturday via e-mail and later in Obama’s Saturday radio address — also was a surprise. Obama had introduced all previous Cabinet appointments at televised news conferences, where he also took questions from reporters.

    Most speculation had centered on Miami Mayor Manny Diaz, Atlanta Mayor Shirley Franklin or Bronx borough President Adolfo Carrion Jr.

    HUD often has been led by someone who is a minority; Donovan is white. Latino groups were pushing heavily for Diaz, following in the footsteps of Clinton appointee Henry Cisneros of San Antonio. Bush picked Mel Martinez of Florida, a Hispanic, and Alphonso Jackson of Texas, an African-American.

    This HUD appointment bodes well for housing, and addressing the Mortgage Meltdown.


    Mortgage Meltdown: Credit Crisis Spreads

    McClatchy Washington Bureau

    Posted on Sun, Jun. 08, 2008

    Credit crisis expands, hitting all kinds of consumer loans

    Kevin G. Hall | McClatchy Newspapers

    last updated: June 08, 2008 08:39:12 PM

    WASHINGTON — The credit crisis triggered by bad home loans is spreading to other areas, forcing banks to tighten credit and probably extending the credit crisis that’s dragging down the economy well into next year, and perhaps beyond.

    That means consumers are going to have an increasingly difficult time getting bank loans for car purchases, credit cards, home equity credit lines, student loans and even commercial real estate, experts say.

    When financial analyst Meredith Whitney wrote in a report last October that the nation’s largest bank, Citigroup, lacked sufficient capital for the risks it had assumed, she was considered a heretic.

    However, Whitney was proved correct: Citigroup pushed out its CEO, sought foreign investors and slashed its dividend. Her comments now carry added weight on Wall Street, and she has a new warning for ordinary Americans: The crisis in credit markets is far from over, and it increasingly will affect consumers.

    “In fact, we believe that what lies ahead will be worse than what is behind us,” Whitney and colleagues at Oppenheimer & Co. wrote in a lengthy report last month about threats faced by big national banks, including Bank of America, Wachovia and others.

    The warning is scary considering what’s already behind us in the credit crisis — the resignation or firing since last August of CEOs at almost every large commercial or investment bank; the Federal Reserve lowering its benchmark lending rate by 3.25 percentage points; a Fed-brokered deal to sell investment bank Bear Stearns; and weekly auctions of short-term loans from the Fed worth billions of dollars to keep credit markets functioning.

    Whitney argues that the worst is still ahead because the financial tools that enabled credit to flow so freely to homeowners and consumers for most of this decade are likely to remain in a prolonged shutdown indefinitely.

    “After years of inherently flawed underwriting, banks face the worst yet of the credit crisis — over $170 billion in write-downs and charge-offs from consumer loans,” Whitney told McClatchy. The same kind of losses from housing may be ahead for credit extended to consumers, she said.

    At the heart of the nation’s lending boom from 1996 to 2006 was a process called securitization. In housing, this process involved pooling mortgages for sale to investors as special bonds called mortgage-backed securities. Monthly mortgage payments were also pooled and served as the return to investors.

    Securitization meant that most home loans no longer sat on a bank’s balance sheet. Instead, they were sold into a secondary market, where they were sliced and diced in a process that was supposed to spread investment risk a mile wide and an inch deep.

    For every dollar of mortgage loans that banks kept on their balance sheets since 2000, another $7 of these loans were sold to the secondary market and securitized. This led to the industry joke that “a rolling loan gathered no loss.” Risk was passed along to the next holder of the debt. Securitization added what bankers call liquidity, a fancy term for having more money on hand to lend.

    Now, the structured finance that enabled Americans to borrow cheaply has gone away, at least in the housing market.

    “With that source of liquidity removed, the sheer number of buyers who can qualify for mortgages and therefore buy homes will decline dramatically,” Whitney told McClatchy. “It stands to reason, therefore, that less demand and more supply will drive home prices down well below current expectations.”

    In addition, interest is waning in other areas of lending where securitization has also been common — car loans, credit cards, home equity lines of credit, student loans and even commercial real estate. It means that lending in those areas is growing tighter.

    “There are still many areas where people aren’t going to be able to do transactions that they were able to a year ago,” said Sean Davys, managing director of the Securities Industry and Financial Markets Association (SIFMA), the trade association for big finance. “We do expect that it will take a significant amount of time for the market to return to any sense of normalcy. What’s your reference to normalcy? It’s going back several years, not just a couple of years.”

    These other areas of lending are suffering through a buyer’s strike. Investors just don’t have much interest in buying anything whose underlying asset are pooled loans.

    Because there are no buyers, banks are taking an accounting hit as they mark down the value of the securitized mortgages they own, and Whitney believes they’ll have to do so with other types of securitized loans, such as car loans and credit card debt.

    That’s likely to result in a large pullback in bank lending. She forecasts tighter lending standards, banks with increasingly limited capital, a growing need for banks to set aside more money to offset losses and tough new federal regulations to protect borrowers, which would reduce lending further.

    If the positive side of securitization was that it let banks lend more by passing loans into a secondary market, the inverse is now true. Banks are less willing or able to lend — they collectively set aside more than $10 billion to shore up their balance sheets in the first quarter of 2008. That’s meant that consumers must pay more to borrow to buy a car or fix a home, and it’s harder to get loans.

    “There are a lot of businesses and individuals that are going to find that their access to credit is a lot more limited than it used to be and it’s a lot more expensive,” said Mark Vitner, a senior economist with Wachovia, a large national bank headquartered in Charlotte, N.C. “And the reason why is the lessened ability to securitize these loans and sell them in the secondary market. That lack of liquidity is being priced into all new loans.”

    Higher borrowing costs are on top of tighter lending. The Whitney report estimated that by 2010 credit card issuers would withdraw more than $2 trillion in credit that they’ve been extending to consumers.

    “We’re already seeing examples of people seeing their credit limits reduced,” said Joseph Ridout, a spokesman for Consumer Action, a consumer rights group based in San Francisco.

    More troubling, he said, some banks are doubling interest rates on customers who are current on payments but considered a credit risk because of changes in their credit profile. The hikes apply to credit-card debt already racked up.

    Federal Reserve Chairman Ben Bernanke worried about the state of the credit markets in a June 3 speech. Financial institutions already have taken $300 billion in write-downs and credit losses, he said, noting that “balance sheet pressures and the relatively high cost of new bank capital have reduced the willingness and ability of these institutions to make markets and extend credit.”

    Translation: Expect less credit for consumers and businesses and higher borrowing costs.

    It’s a bad omen for a sluggish economy struggling to stay out of recession.

    Still, not everyone is so downbeat.

    Bert Ely, a banking consultant who was prominent during the savings and loan crisis, thinks that once the economy rebounds, banks will look a lot stronger. That’s because the loans they’re bringing back on their balance sheets will look better over time.

    “Many of the losses financial institutions have reported will essentially reverse out (and become accounting gains) . . . that’s why large institutions have been raising capital to hang on to these securities so they don’t have to sell them at what would be unrealistically high losses,” said Ely.

    He nonetheless agreed with Whitney that “there are still some serious issues with securitization” and the credit markets are unlikely to bounce back within two or three years.


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