The Logic of Wall Street “Securitization:” The transaction that never existed

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The logic of Wall Street schemes is simple: Create the trusts but don’t use them. Lie to everyone and assure everyone that Trusts were used to “securitize” loans. The strategy is so successful and the lie is so big and has been going on for so long, that most people believe it.

You see it in the decisions of the appellate courts who render opinions like the recent 3rd district in California which expresses the premise that the borrower was loaned money by the originator. Once you start with THAT premise, the outcome is no surprise. But start with reverse premise — that the borrower was NOT loaned money BY THE ORIGINATOR and you end up with a very different result.

We could assume that Wall Street is reckless in lending money. They can afford to be reckless because they are using investor money. And, so the story goes, the boys on Wall Street got a little wild with loans that they would never have approved for themselves.

Without risk of any loss, Wall Street investment banks make money regardless of whether the loan succeeds or goes into default.

But Wall Street is not content with earning fees. The basic credo is a question: “How can we make YOUR money OUR money.” And they have successfully devised and followed that goal for many years. As one insider told me in an interview that must remain anonymous, “It is like a magic trick. You create a trust and everyone is looking at the trust and everyone is looking at transactions affecting the trust, when in fact all the action is occurring off record, off the books and away from scrutiny by investors, trustees, rating agencies, insurers, borrowers, and of course, the courts.” 

So the question becomes “what happens to investor money after it is received by the investment bank?” If the money passes from the bank account of the managed fund (pension) fund to the bank account of the investment bank that sold bonds issued by a Trust then the Trust would receive the money. It didn’t.

The Trust would then issue funds for the origination or acquisition of loans. In return it would get the loan documents and they would be placed with the Depositor or Depository — pretty much the way ordinary loans are done. It didn’t. Instead we had millions of loan documents lost or destroyed and then re-created for litigation purposes. Why would an entire industry have engaged in that behavior? Was it really a “volume” problem where there was too much paper or was it something more sinister?

The problem is that the investment bank that acts as broker in selling the bonds is in control of the loans and investments of the Trusts. Since the fees of the investment bank are based on the existence of transactions in which the Trust issues money in exchange for investment certificates, the Wall Street bank is incentivized to make that Trust money move regardless of the quality of the investment. And since the Trust has no say in the actual underwriting decision to originate or acquire the loan, the investment bank is the only one in charge. That leaves the fox guarding the hen house.

But that doesn’t satisfy Wall Street either. They realized that they can create “proprietary profits” for the investment banks by creating a yield spread premium. A yield spread premium is the difference in value between two different loans to the same party for the same transaction — one is the honest one and the other is fictitious.

At closing the borrower is steered into the fictitious one which is far more risky and expensive than the one the borrower is actually qualified to receive.

At the investor level the “trust” is ordered to take loans that are far less valuable than they appear. This means that the Trust buys the investment bonds or shares that the investment bank has created with nobody checking the quality or ownership of the investment. The Pooling and Servicing Agreement contains provisions that effectively bars the Trustee or the investors from knowing or even inquiring about these transactions. Look at any PSA and you will see it.

The bottom line is that the worse the loan terms for the borrower and the more likely it is that the loan will fail, the lower the value of the loan. But if it is sold as though it was an ordinary conventional loan at 5%, then the price, charged for a crappy loan is much higher than its true value. Same scenario as the inflated appraisals of real property and homes. 

So the investment bank inserts itself as the Seller of the loan to the trust. At their proprietary trading desk the investment bank sells its ownership interest in the loan to the trust for the higher “value” because the investment bank is making the decisions on what loans the trust will buy. Meanwhile they have created loans that are worth far less and even have principal due on the “notes” that is far less than what the trust is forced to “pay.”

Checking with informed sources, it is evident that those proprietary transactions were fictitious and allowed the investment banks to report huge “profits” while everyone else was losing their shirts trading bonds, equities and anything else. The transaction at the proprietary trading desk of the investment bank was fictitious because the trust did not issue any payment to the investment bank, who never formally owned the loan in the first place.

You don’t see investment banks anywhere in the chain of title whether you review public records or even MERS. So you have the investment bank selling a loan they don’t own to a trust that never paid for it. The entire transaction is recorded but does not exist.

In the case of a 15% $300,000 loan to a “borrower”, it is “SOLD” as a 5% conventional loan giving the investment bank a reason to declare that it made a profit on a “proprietary trade.” How much profit? Figure it out — on the back of a napkin you can see how the investment banks “sold” the $300,000 loan but “received” $900,000 from the Trust leaving the investors with an instant $600,000 loss and the probability of losing the rest of the $300,000 as well. This is exactly opposite to the provisions of the Prospectus and PSA.

Upon examination, my sources tell me, the money to cover that declared “trading” profit does exist at the investment bank. That is because the investment bank took the money from investors, never funded the trust, and pocketed the $600,000 in advance of the “proprietary trade, which they could cause to be recorded and reported at any time, since the investment bank was in total control.

Enter moral hazard.

The only incentive that the investment bank to stay honest is to report good results so the managed funds buy more bonds. But that does not protect investors. The investment bank creates a classic PONZI scheme in which it uses investor money to make the monthly payments on the bonds or shares and reports that “all is well.” The report disclaims reliability, credibility and authenticity. Wells Fargo has an especially strong disclaimer on the distribution report to investors. The disclaimers were ignored as “boiler plate” by fund managers who made the investment on behalf of the their pensioners or mutual fund shareholders.

All the fund managers needed to know was that they were getting paid — but they did not realize that a significant part of the payment came from their own investment dollars advanced to the investment bank, as broker for the purchase of trust bonds or shares.

So the investment bank makes much less money on good investments for the trust than on really bad investments. In fact they have the  incentive to make certain the loan fails. Not only do they get the yield spread premium described above, the investment bank, is trading on inside information in which only the investment bank knows the truth. It places bets against the viability of the loan and bets further against the value of the mortgage bonds, and buys contracts for insurance, betting that the value of the bond will fall in a “credit event” without the necessity of an actual default.

SO IF THE INVESTMENT BANK DID NOT GIVE THE TRUST THE MONEY FROM INVESTORS, WHERE DID THE INVESTORS’ MONEY GO?

That is the trillion dollar question. And THIS is where the Courts have it completely wrong. Either we are a nation of laws or a nation governed by the financial industry. The banks bet on themselves, and so far, they were right to do so.

The money given to the investment banks was spread out over a long list of intermediaries owned or controlled by the investment bank. AND then SOME of it was spread out funding loans to borrowers. But the investment bank obviously could not name itself on the note and mortgage. That would have revealed that the tax advantages of a REMIC trust were nonexistent because the trust was not involved in the transaction.

So an elaborate, complicated, circuitous route was chosen for the “approval” of loans for origination or acquisition. First you have a nominee, which is often MERS plus a “lender” who was also a nominee even though they were called lender. The “lender” was subject to an assignment and assumption agreement that prohibited the “lender” from exercising any control over the closing on the loan that was being “originated.” In short, they were being paid to pretend to be a lender — hence the term pretender lender. 

The closing agent, whose fee depends upon actually closing, and the mortgage broker, whose fee depends upon actually closing, and the title company, whose fee depends upon the actual closing, have no interest in protecting the borrower from what is about to transpire.

The closing agent gets money from any one of a variety of sources OTHER THAN THE “LENDER.” The closing agent applies those funds to the closing as though the “Lender” made the loan. As stated by one mortgage document specialist for a large “originator”, “We knew that table funded loans were predatory and illegal, but we didn’t take that seriously. And the borrowers didn’t know who the lender was — that was the point. We used table funded loans to conceal the actual lender.”

Those funds came from the investors, although the money did not come through the trust. It came from the investment bank which was acting in the capacity, as they tell it, as a depository bank — which is why the Federal government allowed them to become commercial banks able to act as depositories. And every effort was made to prevent any evidence as to whose money was actually involved in the loan. Since it was the investor money that was used to originate or acquire the loan, it should have been the investors who were named as owner of the loan and recorded as such in the public records.

If you look at the PSA, it requires funding of the trust, of course. But it also requires that its acquisition of loans contain all the elements of a holder in due course, thus barring any claims from borrowers about irregularities at the closing, violations of state and federal law, etc. In summary the only defenses a borrower could raise against a holder in due course is that they paid or that they never signed the note. So a person who pays money in good faith without knowledge of the borrower’s defenses is pretty well protected. In litigation with borrowers, borrowers would be told they must sue the intermediaries that caused the problems with their loans.

The fact that no foreclosure of a loan subject to “claims of securitization” alleges HDC (holder in due course) status is very substantial corroboration that the Trust did not pay for the loan in good faith without knowledge of the borrower’s defenses.

The banks have been betting on a lot of things and winning every bet. In court they are betting that they will be treated as holders in due course and not as simply holders either with or without any right to enforce where they might be required to prove the actual loan of money from the originator, or the payment of money for an assignment and endorsement. And THAT is why the appellate court is assuming that the loan actually occurred — you, know, the loan that is underlying the execution of the note and mortgage, because the borrower didn’t know the truth.

The factual problem is that the presumptions and assumptions relied upon by the courts are in direct conflict with the real facts. The legal problem is that starting with the original loan, many cases, and always with the assignment of loan, is that somewhere in the chain (and probably at more than one point in the “chain”) there is no underlying transaction for the paper upon which the bankers rely in foreclosure.

Some OTHER transaction occurred, which is why the note is evidence of a loan that does not exist between the “lender” and the “borrower” and why the assignment is evidence of a transaction that does not exist between the assignor and assignee. The mistake being made is basic law: the courts are confusing “evidence” of a transaction with the transaction itself. In so doing they are escalating the status of the forecloser from a mere holder to a holder in due course without any actual claim or allegation of HDC status. Once that is done, the borrower is doomed.

The doom should fall on the investment bank and all the intermediaries that participated in this scheme. They left the investors with no coverage — the investors money was used in ways that were expressly prohibited by the offering, the PSA, and even the rules governing investments by stable managed funds whose risk is required to be extremely low in any investment. The investors are the involuntary lenders with no note and no mortgage.

The good news is that nearly all borrowers would be happy to execute a note and mortgage to investors who actually funded their loan or even a trust that was identified by the investors to represent them. The terms would be based upon current economic reality and would thus mitigate the damages to both the investor lenders and the borrowers. The balance, as we have already seen, lies in lawsuits for damages against the investment banks and their intermediaries demanding refunds, damages and even punitive damages. Those lawsuits are being brought by investors, borrowers, insurers, and guarantors and in some cases by counterparties to credit default swaps.

Without the execution of a real note and real mortgage, the foreclosures are fatally defective. So the bad news is that as long as the courts assume and then presume and then enter judgment for the foreclosing party, the Judge is inadvertently sealing a greater loss applied against the investor lender, removing the tax advantages of a REMIC trust, and creating another bar to liability and accountability of the investment bank who effectively has been lying and cheating its way through the system — using legal “presumptions” that are directly contrary to the facts.

LOCAL GOVERNMENTS UNDERWATER: TIME TO CORRECT PRINCIPAL BALANCES

COMBO Title and Securitization Search, Report, Documents, Analysis & Commentary COMBO Title and Securitization Search, Report, Documents, Analysis & Commentary

We now have a growing group of unlikely bedfellows — investors, homeowners and local governments who were all duped and whose claims are being treated as though each one was unique when in fact the entire plan was a highly organized crime. Add the Federal government to that group who has also demanded “buy-back” of fake mortgages and fake mortgage bonds, although it is highly probable that the government was complicit, certainly in the BUSH administration when the Government and the Fed started all these bailout programs whose total seems to exceed the total of ALL credit that was extended in the original transactions!?!

MY QUESTION IS WHETHER DIMON IS RIGHT: DOES HE LIVE IN A COMPLETELY RISK-FREE ENVIRONMENT OR ARE WE GOING TO APPLY THE LAW TO HIM? GOD HELP US IF HIS ASSUMPTION IS CORRECT.

THE MORE IMPORTANT QUESTION IS WHETHER WE ARE FINALLY GOING TO MAKE THE OBVIOUS CORRECTION OF AN OBVIOUS LIE ABOUT THE VALUE OF THE PROPERTIES AND THE ELABORATELY CONSTRUCTED ILLUSION OF “GROWTH” ? IT ISN’T “PRINCIPAL REDUCTION” TO CUT IT DOWN TO THE REAL FIGURE THAT SHOULD HAVE BEEN USED — IT’S PRINCIPAL CORRECTION.

STATES, COUNTIES, CITIES, TOWNS, INVESTORS AND HOMEOWNERS CAN ONLY GET OUT FROM UNDER THE ILLUSION OF DEBT BY ACKNOWLEDGING THE OBVIOUS — IT ISN’T REALLY THERE IF YOU APPLY THE LAW. IT’S ONLY THERE IF YOU APPLY UNBOUNDED POWER.

EDITOR’S COMMENT: Time for local government to start seeking debt relief and doing those securitization reports and research. Whether they received money from the banks or not, officials in local government are being forced to face the reality that they are presiding over the collapse of our social system for lack of money.

They are in debt — and the amount of debt so vastly exceeds their ability to pay or any prospect to pay that defaults are inevitable — including strategic defaults and bankruptcies where the debt is modified downward. In other words, they are in the same boat as the homeowners.

Actually they are worse off because Wall Street had the nerve to sell local governments triple-A rated mortgage bonds that were worthless, putting them both in the same boat as homeowners and the same boat as other investors.

And if you dig deeper you will connect the dots — the appraisal fraud and other misleading information led these municipalities, towns and counties into planning and for phenomenal growth in demand for services over wider geographical areas, each local government believing that their revenue stream and population would grow at a rate that was both unprecedented and unsupported by any economic fundamentals. They are now stuck with debt to pay for services, they won’t deliver, roads they won’t build, and buildings that are being abandoned or sold.

In plain language, the argument that the crisis grew from greedy homeowners must also be extended to greedy politicians who intentionally bankrupted their cities and towns in the misguided attempt to make a fast buck. Few people will argue whether people are greedy, whether they are homeowners or politicians, but the argument that they would intentionally put themselves in a position of drowning in debt is absurd. There is only one reason this all happened — Wall Street sales machine went to work selling people on “concept” and funding it with other people’s money to create a vast illusion for which we are all paying whether we  participated or not.

The astonishing reversal of fortune for virtually all Americans (except a select few who continue to lie about what they did and when they knew what they were doing) and all their societal structures, governments and government services (police, fore, medical, education etc) is in stark contrast to the massive profits and bonuses that continue to be reported and paid on Wall Street. The entire country has been tilted past the tipping point, so that everything of value went from the the nation as a whole to Wall Street.

In a NY Times Magazine article on Jamie Dimon he continues the BIG LIE strategy that Moynihan over at BofA is using: we had didn’t realize the extent of the lying on stated income loans. He’s staying on message because it is working. As a group, most of us still want to believe and do believe that our system will not break down, but it IS breaking down. The process is already underway. Dimon’s current lie is intended to distract us from considering that the lie was created by him and his officers and employees. The lie works because you must take the time away from your job-hunting and ask yourself how all those applications were filled with bad information without anyone knowing about it. “Due diligence,” a term coined on Wall Street for inspecting the chicken before you buy it, is NEVER overlooked.

Countrywide, Chase, Citi, Goldman and others lied about the quality of the loans and the values of the real property and the documentation of the loans, notes and mortgages because they could. They controlled the entire apparatus. The sheer size made it look “institutionalinstead of organized crime. Of course they knew, but they were acting in a totally risk-free environment because they were using other people’s money — investors to whom they lied with the same lies that were told to borrowers — we have reviewed the application, verified the data, verified the value of the property, and the loan meets with underwriting standards. The loan is approved. Or in the case of local government, the bond is approved, the underwriting and selling of it shall begin.

We now have a growing group of unlikely bedfellows — investors, homeowners and local governments who were all duped and whose claims are being treated as though each one was unique when in fact the entire plan was a highly organized crime. Add the Federal government to that group who has also demanded “buy-back” of fake mortgages and fake mortgage bonds, although it is highly probable that the government was complicit, certainly in the BUSH administration when the Government and the Fed started all these bailout programs whose total seems to exceed the total of ALL credit that was extended in the original transactions!?!

MY QUESTION IS WHETHER DIMON IS RIGHT: DOES HE LIVE IN A COMPLETELY RISK-FREE ENVIRONMENT OR ARE WE GOING TO APPLY THE LAW TO HIM? GOD HELP US IF HIS ASSUMPTION IS CORRECT.

THE MORE IMPORTANT QUESTION IS WHETHER WE ARE FINALLY GOING TO MAKE THE OBVIOUS CORRECTION OF AN OBVIOUS LIE ABOUT THE VALUE OF THE PROPERTIES AND THE ELABORATELY CONSTRUCTED ILLUSION OF “GROWTH” ? IT ISN’T PRINCIPAL REDUCTION TO CUT IT DOWN TO THE REAL FIGURE THAT SHOULD HAVE BEEN USED — IT’S PRINCIPAL CORRECTION.

STATES, COUNTIES, CITIES, TOWNS, INVESTORS AND HOMEOWNERS CAN ONLY GET OUT FROM UNDER THE ILLUSION OF DEBT BY ACKNOWLEDGING THE OBVIOUS — IT ISN’T REALLY THERE IF YOU APPLY THE LAW. IT’S ONLY THERE IF YOU APPLY UNBOUNDED POWER.

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Mounting State Debts Stoke Fears of a Looming Crisis

By MICHAEL COOPER and MARY WILLIAMS WALSH

The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off 13 percent of its police officers last week.

While next year could be even worse, there are bigger, longer-term risks, financial analysts say. Their fear is that even when the economy recovers, the shortfalls will not disappear, because many state and local governments have so much debt — several trillion dollars’ worth, with much of it off the books and largely hidden from view — that it could overwhelm them in the next few years.

“It seems to me that crying wolf is probably a good thing to do at this point,” said Felix Rohatyn, the financier who helped save New York City from bankruptcy in the 1970s.

Some of the same people who warned of the looming subprime crisis two years ago are ringing alarm bells again. Their message: Not just small towns or dying Rust Belt cities, but also large states like Illinois and California are increasingly at risk.

Municipal bankruptcies or defaults have been extremely rare — no state has defaulted since the Great Depression, and only a handful of cities have declared bankruptcy or are considering doing so.

But the finances of some state and local governments are so distressed that some analysts say they are reminded of the run-up to the subprime mortgage meltdown or of the debt crisis hitting nations in Europe.

Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country.

Mr. Rohatyn warned that while municipal bankruptcies were rare, they appeared increasingly possible. And the imbalances are so large in some places that the federal government will probably have to step in at some point, he said, even if that seems unlikely in the current political climate.

“I don’t like to play the scared rabbit, but I just don’t see where the end of this is,” he added.

Resorting to Fiscal Tricks

As the downturn has ground on, some of the worst-hit cities and states have resorted to fiscal sleight of hand to stay afloat, helping them close yawning budget gaps each year, but often at great future cost.

Few workers with neglected 401(k) retirement accounts would risk taking out second mortgages to invest in stocks, gambling that the investment gains would be enough to build bigger nest eggs and repay the loans.

But that is just what Illinois, which has been failing to make the required annual payments to its pension funds for years, is doing. It borrowed $10 billion in 2003 and used the money to invest in its pension funds. The recession sent their investment returns below their target, but the state must repay the bonds, with interest. The solution? Illinois sold an additional $3.5 billion worth of pension bonds this year and is planning to borrow $3.7 billion more for its pension funds.

It is the long-term problems of a handful of states, including California, Illinois, New Jersey and New York, that financial analysts worry about most, fearing that their problems might precipitate a crisis that could hurt other states by driving up their borrowing costs.

But it is the short-term budget woes that nearly all states are facing that are preoccupying elected officials.

Illinois is not the only state behind on its bills. Many states, including New York, have delayed payments to vendors and local governments because they had too little cash on hand to make them. California paid vendors with i.o.u.’s last year. A handful of other states, worried about their cash flow, delayed paying tax refunds last spring.

Now, just as the downturn has driven up demand for state assistance, many states are cutting back.

The demand for food stamps has been rising significantly in Idaho, but tight budgets led the state to close nearly a third of the field offices of the state’s Department of Health and Welfare, which take applications for them. As states have cut aid to cities, many have resorted to previously unthinkable cuts, laying off police officers and closing firehouses.

Those cuts in aid to cities and counties, which are expected to continue, are one reason some analysts say cities are at greater risk of bankruptcy or are being placed under outside oversight.

Next year is unlikely to bring better news. States and cities typically face their biggest deficits after recessions officially end, as rainy-day funds are depleted and easy measures are exhausted.

This time is expected to be no different. The federal stimulus money increased the federal share of state budgets to over a third last year, from just over a quarter in 2008, according to a report issued last week by the National Governors Association and the National Association of State Budget Officers. That money is set to run out next summer. Tax collections, meanwhile, are not expected to return to their pre-recession levels for another year or two, given that the housing market and broader economy remain weak and that unemployment remains high.

Scott D. Pattison, the budget association’s director, said that for states, next year could be “the worst year of this four- or five-year downturn period.”

And few expect the federal government to offer more direct aid to states, at least in the short term. Many members of the new Republican majority in the House campaigned against the stimulus, and Washington is debating the recommendations of a debt-reduction commission.

So some states are essentially borrowing to pay their operating costs, adding new debts that are not always clearly disclosed.

Arizona, hobbled by the bursting housing bubble, turned to a real estate deal for relief, essentially selling off several state buildings — including the tower where the governor has her office — for a $735 million upfront payment. But leasing back the buildings over the next 20 years will ultimately cost taxpayers an extra $400 million in interest.

Many governments are delaying payments to their pension funds, which will eventually need to be made, along with the high interest — usually around 8 percent — that the funds are expected to earn each year.

New York balanced its budget this year by shortchanging its pension fund. And in New Jersey, Gov. Chris Christie deferred paying the $3.1 billion that was due to the pension funds this year.

It is these growing hidden debts that make many analysts nervous. States and municipalities currently have around $2.8 trillion worth of outstanding bonds, but that number is dwarfed by the debts that many are carrying off their books.

State and local pensions — another form of promised debt, guaranteed in some states by their constitutions — face hidden shortfalls of as much as $3.5 trillion by some calculations. And the health benefits that state and large local governments have promised their retirees going forward could cost more than $530 billion, according to the Government Accountability Office.

“Most financial crises happen in unpredictable ways, and they hit you when you’re not looking,” said Jerome H. Powell, a visiting scholar at the Bipartisan Policy Center who was an under secretary of the Treasury for finance during the bailout of the savings and loan industry in the early 1990s. “This one isn’t like that. You can see it coming. It would be sinful not to do something about this while there’s a chance.”

So far, investors have bought states’ bonds eagerly, on the widespread understanding that states and cities almost never default. But in recent weeks the demand has diminished sharply. Last month, mutual funds that invest in municipal bonds reported a big sell-off — a bigger one-week sell-off, in fact, than they had when the financial markets melted down in 2008. And hedge funds are already seeking out ways to place bets against the debts of some states, with the help of their investment banks.

Of course, not all states are in as dire straits as Illinois or California. And the credit-rating agencies say that the risk of default is small. States and cities typically make a priority of repaying their bond holders, even before paying for essential services. Standard & Poor’s issued a report this month saying that the crises that states and municipalities were facing were “more about tough decisions than potential defaults.”

Change in Ratings

The credit ratings of a number of local governments have improved this year, not because their finances have strengthened somewhat, but because the ratings agencies have changed the way they analyze governments.

The new higher ratings, which lower the cost of borrowing, emphasize the fact that municipal defaults have been much rarer than corporate defaults.

This October, Moody’s issued a report explaining why it now rates all 50 states, even Illinois, as better credit risks than a vast majority of American non-financial companies.

One reason: the belief that the federal government is more likely to bail out a teetering state than a bankrupt company.

“The federal government has broadly channeled cash to all state governments during recent recessions and provided support to individual states following natural disasters,” Moody’s explained, adding that there was no way of being sure how Washington would respond to a bond default by a state, since it had not happened since the 1930s.

But some analysts fear the ratings are too sanguine, recalling that the ratings agencies also dismissed the possibility that a subprime crisis was brewing. While most agree that defaults are unlikely, they fear that as states struggle with their growing debts, investors could decide not to buy the debt of the weakest state or local governments.

That would force a crisis, since states cannot operate if they cannot borrow. Such a crisis could then spread to healthier states, making it more expensive for them to borrow, if Europe is an example.

Meredith Whitney, a bank analyst who was among the first to warn of the impact the subprime mortgage meltdown would have on banks, is warning that she sees similar problems with state and local government finances.

“The state situation reminded me so much of the banks, pre-crisis,” she said this fall on CNBC.

There are eerie similarities between the subprime debt crisis and the looming municipal debt woes. Among them:

¶Just as housing was once considered a sure bet — prices would never fall all across the country at the same time, conventional wisdom suggested — municipal bonds have long been considered an investment safe enough for grandmothers, because states could always raise taxes to pay their bondholders. Now that proposition is being tested. Harrisburg, the capital of Pennsylvania, considered bankruptcy this year because it faced $68 million in debt payments related to a failed incinerator, which is more than the city’s entire annual budget. But officials there have resisted raising taxes.

¶Much of the debt of states and cities is hidden, since it is off the books, just as the amount of mortgage-related debt turned out to be underestimated. States and municipalities often understate their pension liabilities, in part by using accounting methods that would not be allowed in the private sector. Joshua D. Rauh, an associate professor of finance at Northwestern University, and Robert Novy-Marx, an assistant professor of finance at the University of Rochester, calculated that the true unfunded liability for state and local pension plans is roughly $3.5 trillion.

¶The states and many cities still carry good ratings, and those issuing warnings are dismissed as alarmists, reminding some analysts of the lead up to the subprime crisis.

Now states are bracing for more painful cuts, more layoffs, more tax increases, more battles with public employee unions, more requests to bail out cities. And in the long term, as cities and states try to keep up on their debts, the very nature of government could change as they have less money left over to pay for the services they have long provided.

Richard Ravitch, the lieutenant governor of New York, is among those warning that states are on an unsustainable path, and that their disclosures of pension and health care obligations are often misleading. And he worries how long it can last.

“They didn’t do it with bad motives,” he said. “Ninety-five percent of them didn’t understand what they were doing. They did it because it was easier than taxing people or cutting benefits. We’re getting closer and closer to the point where we can’t do that anymore. I don’t know where that is, but I know we’re close.”

FRAUD IS THE CENTRAL PROBLEM

It is hard to state this strongly enough. The entire mortgage backed securitization structure was based upon FRAUD. An intentional misstatement of a material fact known to be untrue and which the receiving party reasonably relies to his detriment is fraud. BOTH ends of this deal required fraud for completion. The investors had to believe the securities were worth more and carried less risk than reality. The borrowers had to believe that their property was worth more and carried less risk than reality. Exactly the same. Using ratings/appraisals and distorting their contractual and statutory duties, the sellers of this crap defrauded the investors, who supplied the money and the borrowers were accepted PART of the benefit.

See this article posted by our friend Anonymous:

Posts by Aaron Task
“A Gigantic Ponzi Scheme, Lies and Fraud”: Howard Davidowitz on Wall Street
Jul 01, 2010 08:00am EDT by Aaron Task in Newsmakers, Banking
Related: XLF, AIG, GS, JPM, BAC, C, FNM
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Day one of the Financial Crisis Inquiry Commission’s two-day hearing on AIG derivatives contracts featured testimony from Joseph Cassano, the former head of AIG’s financial products unit. Goldman Sachs president Gary Cohn was also on the Hill.
Meanwhile, the Democrats are still trying to salvage the regulatory reform bill, with critical support from Senator Scott Brown (R-Mass.) reportedly still uncertain.
According to Howard Davidowitz of Davidowitz & Associates, what connects the hearings and the Reg reform debate is the lack of focus on the real underlying cause of the financial crisis: Fraud.
“It was a massive fraud… a gigantic Ponzi Scheme, a lie and a fraud,” Davidowitz says of Wall Street circa 2007. “The whole thing was a fraud and it gets back to the accountants valuing the assets incorrectly.”
Because accountants and auditors allowed Wall Street firms to carry assets at “completely fraudulent” valuations, he says the industry looked hugely profitable and was able to use borrowed funds to make leveraged bets on all sorts of esoteric instruments. “Their bonuses were based on profits they never made and the leverage they never could have gotten if the numbers were right – no one would’ve given them the money in their right mind,” Davidowitz says.

To date, the accounting and audit firms have escaped any serious repercussions from the credit crisis, a stark difference to the corporate “death sentence” that befell Arthur Anderson for its alleged role in the Enron scandal.
To Davidowitz, that’s perhaps the greatest outrage of all: “Where were the accountants?,” he asks. “They did nothing, checked nothing, agreed to everything” and collected millions in fees while “shaking hands with the CEO.”

Magnetar Echoes Livinglies call for Alignment of Investors, Servicers and Borrowers

see Magnetar%20Mortage%20Recovery%20Backstop%20Whitepaper%20Jun09.pdf

Magnetar Mortage Recovery Backstop Whitepaper Jun09

Two things jump out at me with this paper from June, 2009.

First it is obvious that the “real money” investors are defined as those seeking low risk and willing to take lower yield. The fact that they are called “Real Money Investors” underscores my point about the identity of the creditor. Those “traditional” investors are no longer available to buy the mortgage backed securities or any other resecuritized derivative package based upon mortgage backed securities. Legal restrictions requiring the securities to be investment grade would prevent them from jumping back in even if they wanted to do so, which they obviously don’t.

Thus the inevitable conclusion drawn almost a year ago and borne out by history, is that the fair market value of the securities, trading as pennies on the dollar, is reflective of a lack of demand for mortgage backed securities no matter how high the yield (i.e., no matter how low the price).

Second there is a growing realization that the interests of the investor and the borrowers are actually aligned in many ways and that the solution to mortgage modification, principal reduction, and other aspects of the mortgage mess and the foreclosure crisis lies in recognizing certain realities and then dealing with them in an equitable manner. The properties were never worth the amount of the appraisal in most instances and now they are worth even less than they were when the loan deals were closed. The securities were also “appraised” far too high thus creating a giant yield spread premium for the investment bank-created seller of mortgage backed securities.

In my opinion, based upon a sampling of the data available, it is entirely possible that the “true” fair market value of those securities in the best of circumstances is probably less than 40% of the initial offering price. It is this well-hidden analysis that is not getting the attention of the Obama administration and which completely explains why servicers are obstructing modifications under instruction from investment banking intermediaries like the “Trustee”.

Leaving the servicers and other parties as the middlemen “in the middle” to sort this out is another license to steal creating another mark-up applied against both borrowers and investors as the “real money” parties. The status quo is what is causing the stagnation in lieu of recovery. Until everyone accepts basic notions of “real party in interest” and eliminates those who don’t fit that description, the moral hazards will remain and escalate.

As concluded in this paper, either judicial or executive intervention is required to kick the middlemen out of the way and let the light in. When investors and borrowers are able to compare notes and work with each other the figures for both will be enhanced, foreclosures will decline, losses will be taken, and yes it is highly probable that the number of investor lawsuits will proliferate against those who defrauded them.

The lender is identified as the investor in this paper (indirectly) and the party who defrauded them is not some greedy borrower with stars in his eyes, it was the usual suspect — a financial wizard making a sales pitch that was so complex, the buyer basically was forced to rely upon the integrity of the investment banking house for appropriate pricing. That is where the system fell apart. Moral hazard escalated to moral mess.

Ghost Towns: 25 million more suburban homes by 2030 than are needed.

Editor’s Note: Put simply this crisis will still be ongoing in 20 years. When you add the student loans that were securitized and which were “non-dischargable” in bankruptcy because of the government guarantee of the “risk” (which never existed because the risk was sold before the loan was ever funded, hence the guarantee should not flow with sale of loans into securitized pools and should therefore be capable of discharge), auto loans, credit card loans etc., it is not just a career to help people ensnared by the derivative trap it is generational.

More than that, this report shows, corroborates and confirms a central thesis to this blog: APPRAISAL FRAUD, KNOWINGLY IMPLEMENTED AT ALL LEVELS OF THE SECURITIZATION CHAIN FROM THE INVESTOR DOWN TO THE BORROWER.

Think about it. 30 million EXTRA homes. It didn’t come from population growth. It didn’t come from rising incomes and people expanding their families. Where did the demand for these houses come from? The conventional wisdom is that the demand came from the people who bought the houses, never mind that they left vacant property to move in and now have moved out leaving vacant property, leaving themselves with less wealth or more debt than they had before.

Look to the result to determine intent. It’s a basic proposition in law, psychology and criminology. Sure accidents happen but this was no accident — everyone can see that. The negative result here is that the investors got bilked out of trillions, the homeowners lost their homes, down payments, monthly payments (which were higher than rental) leaving them with no savings, higher debt, more owed on their credit cards, either no job or less of a job, rising expenses and less money at the end of each month.

And remember we are not talking about a few people who were living high on the hog because they were con artists. We are talking about 30 MILLION nuns, priests, police chiefs, cops, fireman, soldiers who served in our wars, and every day people who worked 9-5 scratching out a living. So the idea that 30 million people somehow connected into a mob and decided to wreck the financial system and their own lives is not very compelling or credible.

No, the all the positive results went to Wall Street. They got the money from the investors, the homeowners, the taxpayers and now the investors again as they “re-securitize” the old toxic crap. So the inescapable conclusion is that the demand came from Wall Street. It was Wall Street that needed new homes and developers who got higher and higher prices for unneeded homes. without the homes they could not sell mortgage backed derivative securities. Yes it IS that simple.

Wall Street needed the homes because they had this new financial toy they were taking out for a spin — but it couldn’t work without more homes at ever higher prices. Since they had amassed trillions of dollars and they were taking about 1/3 of it in their pockets off-shore, it was easy to spread around the gelt and get the securitization and mortgage origination players to pretend these were legitimate transactions when everyone other than the ivnestors and the homeowners knew the transactions were doomed.

It was Wall Street that created the demand and it was Wall Street that bet against the result, knowing that they had artificially pumped up the demand for housing, artificially inflated the value of the property, improperly inflated the appraisal from the rating agencies, and fraudulently sold securities, bought insurance, and abused the taxpayers with their influence in Washington.

NOW we have ghost towns on the rise — rising areas of crime, slums, drug manufacture, gangs and all that a dysfunctional society can offer. Like Harry Truman said, “How many times do you have to get hit in the head before you look to see who’s hitting you?”

It is Wall Street that should bear the brunt of the loss and Wall Street who should pay the taxes they owe on income they never reported and “protected” off-shore, it is Wall Street that owes billions in taxes, fees, fines and penalties to state and local government for the transactions they created involving property within the borders of each state and county.

Housing crisis turns some suburban neighborhoods into ghost towns

March 30, 2010 |  3:01 pm

There are hundreds of stories about how the housing crisis has affected people who have lost their homes — but what about the people left behind?  Eddie and Maria Lopez can tell you that the flight of families who have walked away or been foreclosed on has completely changed their small gated community in Hemet.

When they moved in, they were enticed by the ducks walking around the development, the lakes, the pool and clubhouse. Families held parties during the holidays; kids would play together on the street. But homes in the gated community of Willowalk plummeted in value — the Lopezes’ home went from $440,000  to $169,000 — and families began leaving in droves.

Now, the Lopezes say just about every house on their block is either empty or rented, and the behavior of some of the tenants makes the family feel uncomfortable. The house next door, for instance, is rented out to a handful of men, each of whom live in a separate room.

Some observers say that these suburban communities could become the new slums of America. As baby boomers age, they won’t need McMansions and will want to live closer to urban centers. And Generation X and Y already prefer walkable residences, according to Arthur C. Nelson, a University of Utah professor who projects there could be 25 million more of these suburban homes by 2030 than are needed.

For more on Willowalk and how cities across the state are coping with gated ghost towns, check out the story.

— Alana Semuels

From bucolic bliss to ‘gated ghetto’

Hemet’s Willowalk tract was family-friendly. Then the recession hit.

Willowalk's decline“We loved how everything was family-oriented,” said Willowalk resident Eddie Lopez, left, with wife Maria and six of their children. They bought their 5,000-square-foot house for $440,000 in 2006. It’s probably worth about $170,000 now. (Gina Ferazzi / Los Angeles Times / March 17, 2010)
By Alana SemuelsMarch 30, 2010

Reporting from Hemet – The gated community in Hemet doesn’t seem like the best place for Eddie and Maria Lopez to raise their family anymore.

Vandals knocked out the streetlight in front of the Lopezes’ five-bedroom home and then took advantage of the darkness to try to steal a van. Cars are parked four deep in the driveway next door, where a handful of men rent rooms. And up and down their block of handsome single-family homes are padlocked doors, orange “no trespassing signs” and broken front windows.

It wasn’t what the Lopezes pictured when they agreed to pay $440,000 for their 5,000-square-foot house in 2006.

The 427-home Willowalk tract, built by developer D.R. Horton, featured eight distinct “villages” within its block walls. Along with spacious homes, Willowalk boasted four lakes, a community pool and clubhouse. Fanciful street names such as Pink Savory Way and Bee Balm Road added to the bucolic image.

Young families seemed to occupy every house, throwing block parties and holiday get-togethers, and distributing a newsletter about the neighborhood, Eddie Lopez recalled.

“We loved how everything was family-oriented — all our kids would run around together,” said Lopez, a 41-year-old construction supervisor and father of seven. “Now everybody’s gone.”

Home foreclosures have devastated neighborhoods throughout the country, but the transformation from suburban paradise to blighted community has been especially stark in places like Willowalk — isolated developments on the far fringes of metropolitan areas that found ready buyers when home prices were soaring but then saw an exodus as values crashed.

Vacant homes are sprinkled throughout Willowalk, betrayed by foot-high grass. Others are rented, including some to families that use government Section 8 vouchers to live in homes with granite countertops and vaulted ceilings.

When the development opened in 2006, buyers were drawn to the area by advertising describing it as a “gated lakeshore community.” Now, many in Hemet call Willowalk the “gated ghetto,” said John Occhi, a local real estate agent.

There are dozens of places like Willowalk, and they are turning into America’s newest slums, says Christopher Leinberger, a visiting fellow at the Brookings Institution. With home values at a fraction of their peak, he said, it no longer makes sense to live so far from the commercial centers where jobs are concentrated.

“We built too much of the wrong product in the wrong locations,” Leinberger said.

Thanks to overbuilding, demographic changes and shifts in preferences, by 2030 there could be 25 million more suburban homes on large lots than are needed, said Arthur C. Nelson of the University of Utah. Nelson believes that as baby boomers age and as younger generations buy real estate, the population will abandon remote McMansions for smaller homes closer to shops, jobs and the other necessities of life.

Whatever their number, the presence of unwanted or abandoned homes stands to be a burden on local governments for years to come, as cash-strapped cities and counties have to spend precious resources to patrol the neighborhoods and clean unkempt yards and abandoned houses.

“There are cities saying to us, ‘I used to have eight code enforcement officers, and now I have one,’ ” said Bill Higgins, a staff attorney for the League of California Cities.

About 80 California municipalities are striking back, enforcing ordinances that fine lenders up to $1,000 a day for not maintaining properties that have been foreclosed, Higgins said. But most cities don’t have the resources to force absentee owners or renters to keep up their properties.

In Hemet, city officials have simply boarded up homes in some troubled neighborhoods. Plywood covers the windows of dozens of apartments on Valley View Drive; resident David Hall says it keeps prostitutes and drug dealers out.

Willowalk presents a different challenge. The development promised a Tiffany neighborhood for what was then something closer to a Target price.

“Leave the world behind as you unwind by our picturesque lakes,” cooed one advertisement, which touted “intimate botanical gardens and walking trails, tranquil lakes” and other attractions.

At first, the reality matched the come-ons.

Maria Lopez, a stay-at-home mother, recalls gazing at the mountains in the distance as her children played with groups of neighbors their own age. The community pool was just a few blocks away, and she says she used to let her older children, ages 13 and 14, go there by themselves.

Now she accompanies her children to the pool — though it has been closed of late — because the people who now hang out there “have no class,” she said, and she sits out front with her children if they play in the yard.

“My next-door neighbors — there are so many people living there, I don’t know who they are,” she said.

Walking through the development, there is not much evidence of the well-kept yards and friendly families Maria Lopez fondly recalls.

Many of the people answering a knock say they are renters, and won’t open their doors more than a crack to see who is on their doorstep. Red-and-white “for sale” signs dot the neighborhood, clashing with the golds and browns of the homes. The contrast between occupied and empty houses is evident on one block, where high grass in weedy clumps gives way to a neatly mowed lawn with handwritten signs pleading “Please do not let your dog poop on our yard.”

Homeowner Norma Hernandez, one of the few people outside on a recent sunny afternoon, can point out which families are permanent on her block.

“Rented, owned, rented, rented, rented,” she said, gesturing at the gargantuan houses across the street, one after another. “It’s bad,” she said, shaking her head.

Nacho Gomez is paid by absentee owners to look after their rental properties. Currently, he’s taking care of 17.

Doing a check of the homes on a recent Thursday, he left his van’s engine running as he inspected a shattered window in one property.

“A lot of them can’t pay the rent, and they leave the house a mess,” Gomez said, referring to tenants.

He has had to fix holes punched in walls and replace refrigerators, dishwashers and other appliances — even ovens — stolen by renters on their way out.

Those tenants appear to be the exception, and the renters provide at least one benefit: Without them, there would be even more vacant homes. Even so, their presence has fundamentally changed the character of what was once sold as an exclusive community.

The Willowalk Homeowners Assn. is trying to recapture some of the community’s lost spirit. In recent months, it launched a trash committee — members pick up rubbish in the park — and started a neighborhood watch group to keep an eye on residents’ homes.

But it wasn’t enough for Angelica Stewart and her family, who are leaving the $318,000 home they bought in 2006. To Stewart, living in a gated community is absurd when drug busts are a regular occurrence.

“It’s not worth it for us to live in this neighborhood,” she said.

The Lopez family plans to stick it out, knowing they can’t sell their house for anywhere near the $440,000 they paid for it. Based on comparable prices in the neighborhood, the place is probably worth about $170,000 now, and maybe less. They’re petitioning their bank for a loan modification.

Despite the financial loss and the fact that Eddie Lopez’s hours at work were cut because of the construction slowdown, the family holds out for a brighter future.

They’re hoping that Willowalk will someday become the idyllic neighborhood they once knew, nearly as perfect as advertisements had promised.

“When we moved in, everybody was homeowners, now everybody’s renting them out,” Eddie Lopez said. “But I have to stay. There’s nothing I can do.”

alana.semuels@latimes.com //

Taking Aim at Bonuses based on $23.7 Trillion in Taxpayer Gifts

see bully-bonus-11-7-billion-jpm

If they earned it, what business is it of ours or the government? On the other hand, if they stole it, why are they not in jail?

If there is money for bonuses it is because of illusory (fake) profits from an illegal scheme that I would call fraudulent. If that is profit then so are the proceeds of purse snatching. So the bonuses, the “profits” and the “capital of the perpetrators belongs to the taxpayers, the homeowners and the investors — the only real victims in this mess.

The REAL tally of taxpayer aid is coming out from members of the media and oversight committees and it isn’t $700 billion the way they have said, and it isn’t $7 trillion the way some pundits have calculated it. It is $23.7 trillion, which is roughly TWICE the U.S. gross domestic product. That’s right folks, so far, as the tally is rising, Wall Street sucked out of our economy the amount we measure as all goods and services traded in the entire United States for two years.

Just think about it. If it were really about $600 billion in defaults or even $2 trillion in defaults, why would the entire economy have taken a nose dive? Why would the world have have been paralyzed? We’ve taken hits before and it didn’t bring us to the brink of ruin. This one did, because the percentage was more than 3% or even 15% of GDP, it was around 200%, so far and it is growing.

It isn’t the bailout or the stimulus that is putting us behind the 8-ball. It’s the money siphoned off by Wall Street who have successfully disseminated two myths through the lazy media: (1) the banks had losses caused by excessive risk taking and (2) government bailout is TARP. The truth is they never had any losses from mortgage defaults or defaults on SWAPS  (how could they with $23.7 trillion covering them?) and TARP is barely 2% of the taxpayer aid through entities created, preserved or promoted with the blessing of the U.S. Treasury and the Federal Reserve.

It shouldn’t surprise me, but it always does — somehow the people with the most money get closest to the microphone and the lazy press lets them take over the narrative. My personal choice is that if they committed fraud knowing of the huge catastrophic consequences and if that fraud and associated acts constitute a crime, then they belong in jail.

If you are serious about getting the past corrected as much as it is possible to do so, and serious about sending referees back onto the playing field so this really doesn’t happen again then start writing to your congressmen, legislators, governors, the White House and DON’T STOP. Make it a weekly ritual.

Those people in the tea parties might seem extreme and some of them might be racist, but their underlying theme is getting traction simply because the people are way out in front of their government this time and the political consequences will be very painful for those who think their jobs are secure. Their theme is that government has been stolen from the people and they are right. The only people to take it back are citizens who vote and people who are willing to serve in public office.

This should not be taken as an endorsement of the tea party — just their message. Wall Street stole our gross domestic product for two years and we want it back. If we get it back or any significant portion of it, state budget deficits will disappear or at least become manageable. Foreclosures will stop or be reduced to a  lower rate than before this mess started. Wealth will be returned at least in part to the middle class so the the economy can function without government stimulus and without that ridiculous cycle of debt.

We have to get over the myth that the banks took the losses from mortgage defaults. They didn’t. They always had the securities sold before committing the funds and used investor money to fund the mortgages. That is why it is incorrect to say that they took excessive risks. They took no risk at all. They schemed like the movie “The Producers”: to open a show that was sure to fail and bet on that. Where is the risk. None to Wall Street.

Of course that’s just my opinion. Maybe the ideologues are right. Maybe we should focus on personal responsibility, selectively enforce it against the middle  and lower class, and let the country go to hell.

So about those bonuses. In the law we have a doctrine called a constructive trust where a thief or other person who is not authorized takes title to property or money that is clearly the property or money of another. Under the doctrine of a constructive trust the current holder of the property, despite his pleas to the contrary is actually holding the property “constructively” for the real owner(s).

If there is money for bonuses it is because of illusory (fake) profits from an illegal scheme that I would call fraudulent. So the bonuses, the “profits” and the “capital of the perpetrators belongs to the taxpayers, the homeowners and the investors — the only real victims in this mess.

Mortgage Meltdown: Fed Knew 4-5 years Ago — and Told Lenders

If you dig deep enough you will find that it wasn’t hard for regulators to figure out that we were heading for a “shock.” It wasn’t hard to figure out that there were abuses traveling downline to borrowers and upline to investors. And it wasn’t hard to figure out that the securities issued at both ends of the mortgage meltdown — the notes issues by borrowers and the bonds issued by SPV’s were over-rated and over-priced just as the underlying real property was over-appraised.

CDO managers were inventing derivatives on derivatives using “embedded leverage” to create new CDOs (CDO2, CDO3 etc) for the riskiest part of portfolios to make them look safer than they were and to get higher ratings than what they were worth. This pattern of dark matter being infused into the financial system created inevitable pressure on all facilitators including “lenders” to produce “product. And it was widely known that the argument being used was specious: first, they were spreading the risk they were mulltiplying it when these instruments came under pressure and second, the default rates used for ratings were average default rates when the CDO’s were composed of tranches heavily weighted with subprime loans. The real default rate was accordingly much higher than the projected default rate, giving the CDO managers room to wiggle on the value of the securities they were issuing. THE SIGNIFICANCE OF THIS IS THAT FED REGULATORS WERE BRINGING HEDGE FUND MANAGERS AND CDO MANAGERS IN FOR MEETINGS IN WHICH THEY WERE “ENCOURAGED” TO REIN IN THEIR ENTHUSIASM. ALL PARTIES KNEW THAT THE LOANS TO THE BORROWERS WERE HIGH RISK SECURITIES, AND ALL PARTIES KNEW THAT THE ABS INVESTMENTS AND THE DERIVATIVES OF THOSE ABS INSTRUMENTS WERE GOING TO FAIL. EVERYONE KNEW EXCEPT THE BUYERS OF THE ABS INSTRUMENTS AND THE BUYERS OF REAL ESTATE THAT WAS HYPER-INFLATED IN ORDER TO MOVE THE HUGE INVENTORY OF CASH THAT WAS CASCADING THROUGH WALL STREET.

The “lenders’ were being advised by regulators to hold back on these increasingly risky loans, to return to normal loan underwriting standards. But the “lenders” were encouraged, compensated and they thought protected by the securitization process. Thus their perception of risk (zero) coupled with their greed for fees, kept the process going and they in turn passed on the pressure to mortgage brokers and appraisers. THUS THE ARGUMENT THAT THE LENDER DID NOT KNOW FOR SURE, THAT THE LENDER CAN HIDE BEHIND PLAUSIBLE DENIABILITY IS A SHAM. 

Witness this article written in January, 2007 reflecting more than 3 years of Fed concern over the direction the financial markets were taking and showing that financial institutions were well aware of the Fed’s displeasure with what they were doing. 

FRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFRFR

 

Central banks can’t determine how much leverage is out there

 Section:    

After the Flood:
How Central Banks Fret
About Failures
Once Liquidity Dries Up

By John Plender
Financial Times, London
Tuesday, January 30, 2007

http://www.ft.com/cms/s/539c92d0-b006-11db-94ab-0000779e2340.html

In September 1998 Bill McDonough, the then president of the Federal Reserve Bank of New York, corralled representatives of 14 leading banks into the Fed’s offices at 33 Liberty Street in Manhattan’s financial district and urged them to bail out the ailing Long-Term Capital Management hedge fund. It was a classic central banker’s response to a potential systemic crisis.

“Gentle pressure” is the euphemism often employed to describe such central bank bullying to persuade competing banks to collaborate in the common interest. The interesting question, in the light of huge structural upheavals in financial markets since 1998, is whether the nature of systemic risk has changed and whether a central bank could pull off the same trick today.

In the period between the break-up of the Bretton Woods semi-fixed exchange rate system in the early 1970s and the near-collapse of LTCM in 1998, financial crises were frequent. Yet for the best part of a decade an eerie stability has prevailed. Big financial institutions have collapsed, notably Refco, the derivatives dealer, and the Amaranth hedge fund. Yet neither initiated a systemic shock, even though Amaranth’s $6bn losses were greater than those of LTCM.

Many private sector bankers believe that the newer markets in credit default swaps, which investors use as insurance against corporate default, and collateralised debt obligations, packages of debt instruments used to back the issue of new securities, are inherently stabilising. That is because they spread risk more widely around the system. At the same time technology, which facilitates trading in complex new financial instruments, serves to make markets more efficient.

This, together with a big surge in global liquidity, has contributed to a dramatic decline in financial institutions’ concern about risk to the point where some companies are issuing securities at a zero or negative risk premium. The risk premium is the additional return over the return on risk-free government bonds that investors normally require as a reward for taking risk.

The credit euphoria in the markets, which has caused the yields of riskier bonds to move closer to the risk-free bond yield, is partly driven by the prime brokerage divisions of investment banks competing ferociously for hedge fund business. They have loosened lending standards and margin requirements relating to the amount of collateral they require to support a given amount of hedge fund debt.

Even central bankers, traditionally cautious about the consequences of financial innovation, see some advantages in the new world of high-octane derivatives trading. Tim Geithner, president of the New York Fed, points out that past crises would cause less damage today if they were to recur because of the greater dispersion of credit risk, the improvements in risk management, the size of the capital cushions maintained by banks and the improvements in many parts of the payment and settlements infrastructure.

That said, neither he nor any other leading central banker believes that we are witnessing the end of volatility or the demise of the credit cycle, though some youthful bankers in the private sector are prepared to argue that case.

According to Gerald Corrigan, a former president of the New York Fed who is now a partner in Goldman Sachs, there is a virtual consensus among leading practitioners and central bankers that “the statistical probability of a major financial shock with systemic features has got lower over time”. But there is also agreement that another major shock is likely and that the potential damage could be greater. Mr Corrigan gives three reasons for this increased toxicity: speed, complexity and tighter linkages across institutions and markets, as the system has become more integrated thanks to financial innovation.

“The trouble,” he adds, “is that we do not have the capacity to anticipate the timing and triggers of such a shock — every now and then stuff happens. And if we could anticipate the timing and triggers, the shocks wouldn’t happen.”

There is no shortage of potential accidents, ranging from an over-abrupt unwinding of global financial imbalances to a dollar collapse. A particular concern, raised at the World Economic Forum at Davos by Jean-Claude Trichet, president of the European Central Bank, is the likelihood that credit spreads – the gap between the yield on risky bonds and the risk-free rate – could widen sharply if perceptions of risk change, inflicting large losses on traders. The collapse of a hedge fund or bank might then cause widespread disruption in the markets.

In the euphoria that has accompanied the explosive growth of credit derivatives and collateralised debt instruments, there is not just a possibility that risk is being seriously underpriced. Much trading in credit derivatives assumes that liquidity — the ready availability of funds — will remain when any adjustment in credit markets takes place. Liquidity permits traders to close positions rapidly when risks and potential losses are escalating.

Christopher Whalen of Institutional Risk Analytics, a consultancy, argues that, given the lower risk premiums in credit markets, it may no longer be prudent to assume credit default swap contracts will be liquid when the adjustment comes. In other words, traders may be unable to escape from positions where losses are ballooning because nobody will be willing to deal. He notes that a hedge fund that sells insurance protection against default may depend indirectly upon another under-regulated hedge fund having the resources to meet that guarantee.

Maintaining confidence in counterparties, adds Mr. Whalen, is absolutely required for the game to continue; and the stability of the entire credit derivatives market rests on the notion that hedge funds will somehow have access to sufficient liquidity to meet their obligations. For some, that looks a dangerously optimistic assumption.

Jim O’Neill, head of global economic research at Goldman Sachs, recently remarked that “liquidity is there until it is not — that is the reality of modern markets.” The liquidity glut, he thinks, could reverse at any time. So much for what some claim is a secular increase in liquidity.

Optimists downplay the risk to the system of the potentially problematic credit derivatives, which are still only 7 percent of estimated total notional over-the-counter (that is, unquoted) derivatives contracts. Yet the New York Fed’s Tim Geithner emphasises that despite this underwhelming percentage, credit risk in the OTC derivatives market is large relative to more traditional forms of credit and is also quite large relative to the capital cushions and earnings of the major banks and investment banks.

He adds that these exposures are harder to measure because investments in credit derivatives contain “embedded leverage” where one’s exposure to profit or loss is multiplied many times compared to the same investment in the underlying conventional security.

The problem for central bankers is that “embedded leverage” has expanded phenomenally and does not appear on balance sheets, so it is impossible to quantify embedded leverage across the financial system.

In other words, no one can be sure how much capital to set aside as insurance against these leveraged bets going wrong. While risk management techniques have improved, they remain flawed in fundamental respects.

It is widely acknowledged, for example, that mathematical models of risk, which are used to stress-test derivatives, give too much weight to the low volatility of recent times. In other words, they use the recent past as a guide to predicting the future. In financial markets this is the one sense in which history is bunk, since financial shocks have a habit of coming from unexpected quarters.

These risk models can ignore the potential occurrence of very low-probability scenarios with potentially extreme outcomes, in which one big loss can wipe out several years of positive returns. Statistically driven models and risk metrics are poor at capturing these low-probability financial blow-outs. If stress-testing does throw up an outcome that looks scary, people in financial institutions tend to declare the result “unrealistic” because a conservative assessment of risk would put them at a competitive disadvantage to more “realistic” competitors.

Academics such as Harry Kat of the Cass Business School at the City University in London have produced evidence that many hedge funds are, in fact, pursuing trading strategies that can be relied on to produce positive returns most of the time as compensation for a very rare negative return. They are encouraged to do this by a fee structure that does not require the fund managers to pay back their earlier profit share to investors if an extreme event strikes and wipes out the fund.

At the same time, big financial institutions have no incentive to incorporate the potential costs and risks to the system of their own collapse in their market pricing. They prefer others to incur the costs of providing the “public good” of financial stability, while under-insuring against the risk of failure and under-investing in systems to enhance financial stability. So central banks and governments pick up the tab in the event of a systemic collapse.

Considerable work has been done by banking authorities and private sector institutions to address these problems, notably through the work of the Counterparty Risk Management Policy Group II headed by Gerald Corrigan. He characterises the objective as being to strengthen the shock-absorbers of the global financial system. The group’s recommendations were aimed primarily at the private sector, ranging from strengthening corporate governance to improvements in transaction processing.

Meantime, US and European financial watchdogs launched a probe before Christmas into lending to hedge funds and margin practices. This involves looking at risk-management in individual firms and telling them where they stand in relation to best practice, but without necessarily being prescriptive.

In essence, the goal of the authorities in dealing with potential shocks is damage-control and containment. As far as the co-ordination of bailouts is concerned, persuading bankers that they have a collective interest in rescuing competing financial institutions has never been easy, since most central banks have no legal powers to enforce such action. In a very different environment from that of 1998, it is a moot point whether a rescue would work when an institution deemed too big to fail finds itself in trouble.

Sir John Gieve, deputy governor of the Bank of England, has publicly questioned whether it would now be possible to put a failing firm’s bankers into a room and persuade them to do their stuff. He points out that firms nowadays often do not know who holds their shares and debt, and many investors are looking to take the hit and get out as quickly as possible. Others add that some banks’ proprietary trading desks might have short positions in a failing firm as well as outstanding loans, which could dilute their interest in joining a rescue.

Yet this is not something on which all central bankers agree. Tim Geithner acknowledges the difficulties of putting the lending banks in a room, but points out that we are now several decades into the securitisation of bank loans and dispersion of credit risk and there is no general increase in bankruptcies or decline in average recovery rates, though he adds that there are many other factors that may help explain this.

As for the conflicting interests within banks in relation to a failing firm, he adds that structurally, the banks have long positions in credit overall. It is worth noting too, that the New York Fed also has a big advantage in lender-of-last-resort operations relative to many European countries, including the UK, in that monetary policy decision-making and banking supervision are in the same institution, which minimises problems of communication and co-ordination.

Whoever is right, the one certainty is that lightning will eventually strike. The systemic crisis could arise in a conventional corner of the markets. But given the novelty, opacity and complexity of derivatives trading, and challenges that central banks face in trying to understand the risks involved, there is a high chance that the lightning will go there.

Foreclosure Defense: Countrywide Ruling Can be Cited as Persuasive Support for Bad Lending Practices

COUNTRYWIDE SUED FOR IMPROPER LENDING PRACTICES BY ITS SHAREHOLDERS: GOOD MATERIAL HERE FOR BORROWERS TO ALLEGE IN THEIR LAWSUITS AND DEFENSIVE ACTIONS

In these posts I am trying to keep pace with the events unfolding on the investor side of the Mortgage Meltdown. That is because these lawsuits are more sophisticated than the usual fair you find with lawyers representing individual borrowers in foreclosure defense, bankruptcy or non-judicial sales.

Our theme is simply this: lender practices went astray because of lack of supervision, failure of regulation, improper oversight by stockholders and congress, and direct collusion with the even more sophisticated Wall Street firms offering “securitization” of risk products that removed the risk element from the loan underwriting process. The result was predictable — lending standards not only fell, they were smashed under a cloud of plausiable deniability. 

countrywide_class_action_defense_stay_ord

Note the article below and in particular, the bold sections which this editor has added.

May 15, 2008

Judge Says Countrywide Officers Must Face Suit by Shareholders

Directors and officers of Countrywide Financial, the beleaguered mortgage lender, must answer shareholder accusations of insider trading and an overall failure to monitor lending practices that led to the company’s collapse, a federal judge in California has ruled.

Rejecting the arguments of Countrywide executives and directors that they were unaware of lax loan operations that led to ballooning defaults, Judge Mariana R. Pfaelzer of Federal District Court in Los Angeles ruled Tuesday that she found confidential witness accounts in the shareholder complaint to be credible and that they suggested “a widespread company culture that encouraged employees to push mortgages through without regard to underwriting standards.”

Plaintiffs also identified “numerous red flags” that would have warned directors of increasingly risky loans made by Countrywide, according to the judge, who rejected a motion to dismiss the suit. “It defies reason, given the entirety of the allegations,” Judge Pfaelzer wrote, “that these committee members could be blind to widespread deviations from the underwriting policies and standards being committed by employees at all levels. At the same time, it does not appear that the committees took corrective action.”

Hundreds of mortgage companies have failed in the last year or so, but few executives or directors have taken responsibility. That makes the ruling significant, said Blair A. Nicholas, one of two lawyers at Bernstein Litowitz Berger & Grossmann representing the plaintiffs.

“It is a critical step enabling Countrywide and its shareholders to hold accountable the officers and directors who looted the company and were responsible for its devastating collapse,” Mr. Nicholas said.

Countrywide shareholders have lost billions of dollars since 2007 when its shares hit a high of $45.03. They closed on Wednesday at $4.85.

“As institutional investors, it is our duty to seek recourse when a company’s directors engage in practices that are not in the best interests of shareholders,” said Christa S. Clark, chief legal counsel of the Arkansas Teacher Retirement System, the lead plaintiff in the case. “We are pleased with the court’s ruling as it enables the shareholders to move forward with our case and remedy this wrong.”

A Countrywide spokesman declined to comment on the ruling.

The plaintiffs in the case said they hoped to recover money for shareholders from Countrywide officials named in the case who sold $850 million in stock from 2004 to 2007. The plaintiffs contend that the directors and officers dumped shares even as the company spent $2.4 billion to repurchase its own stock in late 2006 and early 2007.

The chief executive of Countrywide, Angelo R. Mozilo, has argued that his $474 million in stock sales during the three-year period complied with securities laws under a planned selling program. But he revised the program, known as a 10b5-1 plan, several times, each time increasing the shares to be sold.

As a result, the judge wrote: “Mozilo’s actions appear to defeat the very purpose of 10b5-1 plans,” created to allow corporate insiders to sell stock regularly and without direct involvement.

Gerald H. Silk, who also represents the plaintiffs, said: “Corporate fiduciaries cannot expect to evade liability by blaming a general market downturn when there is specific and systematic misconduct taking place right beneath their noses.”

The suit names 14 current and former directors and officials as defendants; it is known as a derivative action because shareholders of Countrywide are suing its officers and directors on behalf of the company.

Lawyers for the plaintiffs said that they would ask the judge to expedite discovery so that they can get testimony before the proposed purchase of Countrywide by Bank of America takes place. The deal is expected to close in the third quarter.

Senator Charles E. Schumer, Democrat of New York, asked the Federal Trade Commission on Wednesday to investigate whether Countrywide took advantage of borrowers who filed for bankruptcy protection to try to keep their homes.

In the letter to William E. Kovacic, the F.T.C. chairman, Mr. Schumer said, “An investigation by the Federal Trade Commission would help pull the curtain back on a hidden corner of the existing foreclosure crisis, and could help stem the tide of homeowners who are now unnecessarily being forced into bankruptcy and foreclosure.”

Mortgage Meltdown Still in Progress and Getting Worse

 

  • Somehow, the housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

Here is a man who has “seen it all” and who doesn’t like what he sees. Echoing our continuous please for creating an atmosphere of safety or “amnesty”, Bernstein sees a long haul without much lift unless we address the etnire spectrum of risk-taking. Confidence levels are so low that it hard to imagine, each month, that they could go lower. But they they keep sinking. Bernstein’s vision is one of reality, encouraging us to “snap out of it” and hope, if we get our act together without tripping over ideological differences. 

 
The Wall Street Journal  
April 26, 2008
 
 

One Guy Who Has Seen It All 
Doesn’t Like What He Sees Now

By E.S. BROWNING
April 26, 2008; Page B1

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

[Peter Bernstein]
One of Peter Bernstein’s worries: ‘If China goes into a recession, God knows.’

Today’s trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond — longer than many people expect.

Mr. Bernstein, whose books include “Against the Gods: The Remarkable Story of Risk,” sees two culprits. One is the abuse of securitization — the trend for banks to hold fewer loans on their books and instead turn them into securities that were sold to other investors. The other is simply years of overborrowing by financial institutions and consumers alike.

Mr. Bernstein is hopeful that Federal Reserve intervention will prevent deflation and depression, but he says there is no guarantee.

Excerpts of a recent interview:

WSJ: Aside from securitization, what were the main causes of the problem?

Mr. Bernstein: You don’t get into a mess without too much borrowing. It was sparked primarily by the hedge funds, which were both unregulated by government and in many ways unregulated by their owners, who gave their managers a very broad set of marching orders. It was a real delusion. It was like [former New York Gov. Eliot] Spitzer: “I am doing something dangerous, but because of who I am, and how smart I am, it is not going to come back to haunt me.”

When you think about how all of this will work out in the long run, we are going to have an extremely risk-averse economy for a long time. The lesson has painfully been learned. That’s part of the problem going forward. You don’t have a high-growth exit from this, as you’ve had from other kinds of crises. We won’t have a powerful start, where the business cycle looks like a V. Here, the shape of the business cycle is like an L, where it goes down and doesn’t turn up. Or like a U, a flat U. The reason for that is that people aren’t going to get caught in this bind again. They will tell themselves, “I’m too smart to do that again.” And everyone else is going to be saying the same thing. It is, in fact, going to be a wonderful environment in which to take risk, because there aren’t going to be any excesses.

I’m a child of the Depression, and I am thinking about what the early years were like after World War II. It took a very long time to get the memory of the Depression out of business decisions, and certainly banking decisions. I think this is going to be the same. The Fed, too, is going to be less decisive and is going to feel that what it should do is less clear. One of the things that gave people a sense that they could afford to take risks was the sense that the central bankers more or less know what they are doing. But I don’t think we are going to feel that way going forward.

WSJ: You said that it could turn out that the smart thing to do is to take more risk, because everyone will be so risk-averse. What kinds of investments do you see as the big winners coming out of this?

Mr. Bernstein: You could say: the things that have been beaten down the most, which would be real estate. But I think real estate is going to be under a cloud for so long, and you can’t buy real estate with cash, it is too much money. I think you should go with the stock market. If things are better, the stock market will go up, and if things are awful, the stock market is going to be way down. But it is a place where, if you want to take risks, you’ve got a wide range of choices. This is why I own stocks [in addition to other investments], because I don’t know where the bottom is going to come, and I want to be exposed to every kind of possibility I can think of. And, at least, if you pick the stock market and you are wrong, you can change your mind. There is some liquidity there. Stocks never became cheap, but they didn’t become crazy, the way other assets were.

WSJ: How long do you think this whole process will take, before we get back to normal?

Mr. Bernstein: Longer than people think. The people who think we will have turned in 2009 are wrong. There has to be a respite along the way. Nothing goes in one direction forever. But it will take longer than people think. If that weren’t the case, I would be talking entirely differently. I would be saying, “What an opportunity we have got.” And I just can’t believe that the opportunity is here yet. There is too much to unwind.

WSJ: Can you explain the reason you think it will take a long time?

Mr. Bernstein: We have to go back to a moment when people have the courage to borrow and lenders have the courage to lend. Until credit is going up instead of down, you can’t have growth. Housing has got to be a very important part of that; it always has been. You have to reach a point where somebody says, “This house is cheap, I am going to buy it,” or where some businessman says, “This is a great opportunity for us to expand our business. Everything is available to us.”

If China goes into a recession, God knows. The Iraq war and the whole situation with terrorism, we really don’t know where that is going to come out. There are so many things that have got to get buttoned down before you say that the future looks good enough to take a risk.

WSJ: What kind of indications are you looking for as signs that the economy is about to get better and that the stock market and the investment world are about to turn the corner?

Mr. Bernstein: Somehow, the housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

Before, it was investment that made the V at the bottom of the business cycle. I don’t see real investment turning enough without some sign from the consumer side. Maybe the foreign countries will do it for us. That is a substitute for consumption here. Maybe. But I think that they won’t do enough for us, and maybe will be too infected by us to do it. But maybe growth in Asia will help us. The Asian thing is tremendously exciting.

Write to E.S. Browning at jim.browning@wsj.com1

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Mortgage Meltdown: Blaming the Victims – Answer to Ben

I have two answers for you on the question of fairness.

1. How fair is it, after you have saved and conducted yourself properly and with financial savvy, to see the value of your investment steeply decline as a result of some game Wall Street was playing with the banks? How fair is it that the houses in your enighborhood are going into foreclosure dminishing the value of your neighborhood and your house? The big benefit of saving these houses from going vacant is to you, not the lender, and not the borrower. The big danger is not that 10% will go into default or foreclosure — it is that 90% will suffer the consequences. So do you want to stand on principle and fairneess and watch the economy go to hell and a handbasket or do you want to forgive the borrowers, lenders and investment bankers and get back on track?

2. OK here is the other answer. You are a guy who obviously plays by the rules and reads the documents, and made it his business to gain some financial savvy and you know enough to be at least somewhat cynical of any deal. Let’s say you applied for a loan and the mortgage broker or representative of the mortgage lender “explained” why one mortgage was better than another. Let’s say he didn’t tell you that there were other options available that were better than the ones he was offering. Let’s say he didn’t disclose  that the lender was NOT taking the risk because they were selling the mortgage as soon as they closed. Let’s say the lender had a vested interest in getting you to sign ANYTHING regardless of risk or truthfulness of the appraisal or anything else. Let’s say the lender was sharing the bounty with bonuses, rebates and kickbacks to your real estate broker, mortgage broker, and anyone who would help get you to sign and that they were not disclosing that either. Let’s say you would have no way of knowing that the the lender was not taking on any risk and was just the sales agent for some Wall Street brokers. Let’s say all of those things. Would you sign that deal? I think not. And neither would anyone else.

Mortgage Meltdown: A New Perception of Risk Changes American Economics

Whether Krugman is right in today’s New York Times, predicting a massive bailout between $450 billion and $3 trillion at taxpayer expenses, or the “free marketers” have their way and let everyone collapse, or some people finally get it and move toward a consensus of policy that forgives everyone their transgressions but keeps them in the game as we have suggested repeatedly in these posts, it is clear that perception of risk, trust, confidence and integrity has been changed. This change will be reflected in world and domestic financial markets rights down to a car loan, credit card, home equity loan or business loan. 

  • The recent rise of ankle biting between home equity lenders (many of whom have frozen home equity loan accounts making the credit limit unavailable to borrowers), borrowers and fist mortgage lien holders on short and long sales and refinancing, shows what has happened: Nobody trusts anybody anymore and credit is going to decline not only because of availability of money, not only because of viability of short-term credit instruments and the auction markets that drive them, but because rising borrower distrust of all lenders for all reasons is going to lower demand for credit.
  • Just as there isn’t enough money in the world to bailout everyone in this mess, there isn’t enough equity, income or assets to cover the credit that exists, much less putting on more. But more is what we are getting in the form of inflation fueled by the Fed churning out money supply like it was candy from a machine.
  • Borrowers seem to have learned that what lenders tell them can’t be trusted. It is a valuable lesson. They are realizing that lenders have a vested interest in keeping borrowers in debt and to maximize the debt of every man, woman and child in the United States. 
  • The number of homes going upside down either because of overvaluation of the home for purposes of the purchase money mortgage or over valuation for purposes of home equity loans is increasing daily. Sorry to hit a sore point but the chickens are coming home to roost. The motivation of change lifestyle from home owner to renter has never been greater. It seems likely that people will do just that.
  • This might be a paradigm change that could forever change the landscape of the American economy. retail buying sprees of things that nobody needs, and that nobody wants after they make their purchase, are on the decline. They might be on their way out as a way of life. That accounts for 70% of the U.S. economy.
  • This new perception of risk and the new distrust, have taken on the same dynamics as the politics of division which was bound to be reflected in the marketplace eventually. Basic assumptions and formulas currently used in economics are now cast under a cloud of doubt, as are the policies based on current assumptions and current measurements of things that might not matter as much in the future as they did in the past.
  • Doubt and uncertainty create bad environments for doing business, investing and living. We might be in for some hard times, but it is probably high time for the AMerican economy to “get real.”
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