Ok tinfoilers, this is not what you think it is; I'm sure many of you came here and started to read because you thought I was going to rant about fractional reserves or the lack of "sound money."
Sorry, no dice.
No, I'm going to talk about the inherent fraud over the last five or so years in the housing (and other lending) markets, and it is NOT where you think it is.
It is, in fact, in both the accounting treatment and assumptions that were in fact made by both borrowers and lenders - simply put, they are nowhere near the same.
Let's start with a proposition: A "mortgage" is a loan made against real property with the original intent that the borrower will pay as agreed under an amortization schedule to maturity, interrupted only by significant life events such as relocation, unemployment leading to bankruptcy, divorce or serious medical illness.
With that assumption we can model the performance of a mortgage under all economic conditions, since we can draw upon history to get a fairly good idea of what unemployment rates might be, we know what relocation rates tend to look like, serious uninsured medical illnesses have an actuarial component and the like.
With that modeling in the bag we can then configure up a securitized structure that provides whatever level of protection is desired against these events, and from there yields will flow (more for the riskier sides, of course.)
Now let's add, however, what was actually sold to people during the last four or five years.
The premise that the "homeowner" was sold had nothing to do with the above concepts. Instead, that "homeowner" was sold the following by both bank and non-bank mortgage companies:
- You do not need to have "skin" in the game; we will loan you 100% of the "current market value" of the house.
- You are not presumed to be interested in paying this original note to maturity. In fact, we fully expect you to come back here in two years or so and refinance the note - at or before when the payments reset.
- We know (2) will happen because we're giving you a "teaser rate" and/or we have negative amortization features in the loan which are subject to caps; both of these events, when (not if) they expire, will cause an immediate and dramatic rise in your required payments.
- To make (3) worse, we're qualifying you on the initial payment amount, not the fully-amortized reset/recast schedule.
- And to make (4) even worse, we're not verifying that you can even make the initial payment; we're going to take your word for it.
Now dice and slice up loans made under those five principles and try to model the outcome.
Good luck.
See a loan made to someone on the premise that it will be refinanced and for which there is no equity cushion provided by a significant down payment is entirely Dependant on one thing - the market price of the underlying asset must continually increase at a rate that exceeds the negative amortization, if any, plus all costs of the refinance.
The problem isn't so much the making of these loans - it is the misrepresentation of what they are. Balloon mortgages, which in fact is what these constitute, have been a part of the lending landscape forever. They were, in fact, what blew up in the 1930s - they were the "preferred" mortgage in the "Roaring 20s".
But everyone knows that those loans blew up in the 1930s, and they were prevalent in the Roaring 20s. That is, anyone with a brain. Thus, you couldn't have sold mortgage-backed securities packaged up out of balloon notes without a significant extra yield premium.
So most lenders quite simply lied.
But not all.
Look at Berkshire's 2008 Letter (just issued, recapping the 2008 performance of Berkshire Hathaway). There is a very interesting piece in there about the financing performance of Clayton Homes, a Berkshire company that makes "manufactured housing":
Clayton’s 198,888 borrowers, however, have continued to pay normally throughout the housing crash, handing us no unexpected losses. This is not because these borrowers are unusually creditworthy, a point proved by FICO scores (a standard measure of credit risk). Their median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated “sub-prime.” Many disastrous pools of mortgages on conventional homes are populated by borrowers with far better credit, as measured by FICO scores.
Yet at yearend, our delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. (In addition to our originated loans, we’ve also bought bulk portfolios of various types from other financial institutions.) Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.
Why?
Quite simple, really. Even though Clayton's customers have crappy credit on average, they were forced to put down a meaningful amount of money from savings, and cannot borrow it somewhere else. They bought with an amortized payment, not one that will turn into a hydra in a couple of years and choke you - just before consuming you whole. They did not assume they could refinance and Clayton refused to lend to people on that basis; rather, they assumed that they would pay as agreed, from start to finish, based on current income, not based on some pie-in-the-sky future wish.
As a consequence Clayton's securitized mortgages have performed reasonably well. The reason is simple - the company actually promised to its securitized buyers the same thing they sold to its borrowers and was able to model the actual credit risk involved from "life events" - statistical models that actually are valid.
It appears that The Huffington Post has picked up on some of "The Bezzle"; in this article from the 23rd which I had previously missed:
"Whatever happened to the law (Title 12, Sec. 1831o) mandating that banking regulators take "prompt corrective action" to resolve any troubled bank? The law mandates that the administration place troubled banks, well before they become insolvent, in receivership, appoint competent managers, and restrain senior executive compensation (i.e., no bonuses and no raises may be paid to them). The law does not provide that the taxpayers are to bail out troubled banks. Treasury Secretary Paulson and other senior Bush financial regulators flouted the law. (The Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) are both bureaus within Treasury.) The Bush administration wanted to cover up the depth of the financial crisis that its policies had caused."
Yep, but it is not policies that were in play here, it was willful inaction that then "compelled" the disaster-capitalism nonsense.
Let's look at what's in Title 12 Ch16-Sec1831:
"(3) Critical capital
(A) Agency to specify level
(i) Leverage limit Each appropriate Federal banking agency shall, by regulation, in consultation with the Corporation, specify the ratio of tangible equity to total assets at which an insured depository institution is critically undercapitalized.
(ii) Other relevant capital measures The agency may, by regulation, specify for 1 or more other relevant capital measures, the level at which an insured depository institution is critically undercapitalized.
The level specified under subparagraph (A)(i) shall require tangible equity in an amount—
(i) not less than 2 percent of total assets; and
(ii) except as provided in clause (i), not more than 65 percent of the required minimum level of capital under the leverage limit.
(C) FDIC’s concurrence required
The appropriate Federal banking agency shall not, without the concurrence of the Corporation, specify a level under subparagraph (A)(i) lower than that specified by the Corporation for State nonmember insured banks.
And later on in the same law....
(1) Capital distributions restricted
An insured depository institution shall make no capital distribution if, after making the distribution, the institution would be undercapitalized.
(2) Management fees restricted
An insured depository institution shall pay no management fee to any person having control of that institution if, after making the payment, the institution would be undercapitalized.
Got it?
This is really pretty simple - there must be a leverage limit and the OTS, OCC and FDIC must enforce that limit to insure that banks do not fall into being undercapitalized.
Further, no bank may make a capital distribution (pay a dividend) or pay a management bonus if before or after doing so it would be undercapitalized.
Where has this supervision been?
Note that Geithner and President Obama have continued this nonsense, and Geithner is one of the people personally culpable for ignoring the law in the first place.
What will stop this blatant lawlessness?
Certainly not Congress. Ben Bernanke was before Congress this last week and guess what: Not one question about the law compelling him (and the other regulators) to act before banks become insolvent.
Now President Obama has released his budget which provides for even more bailouts - a potential $750 billion "second round."
Yet the law under which we are supposed to operate in this country makes clear that this sort of policy decision is directly contrary to statute; instead, the law by its black letter requires banks to be taken into receivership before they become insolvent.
And oh by the way, the regulators are not allowed (by that law) to ignore off-balance sheet obligations either. Uh uh - they are required to take action before the insolvency occurs irrespective of how - and they did not.
In fact the banks have self-declared their non-compliance with that statute as noted in The Ticker right here ("Our Tier 1 Ratio Is Strong!") once again last night!
This "self-declaration of insolvency" in fact goes back to Washington Mutual's original 1Q 2007 report that set me off and started me writing Tickers back in April of 2007!
We are in fact talking about what amounts to nearly two years of this nonsense to date, and through the fall of 07 into the early part of 08 the MLEC garbage (and friends after it went down in flames) makes clear that regulators, including Treasury and The Fed knew exactly what the state of these firms was and willfully ignored it.
There is not a policy "decision" allowed here guys and dolls - this is black letter statutory language that compels a certain set of actions - statutory language put in place after the last time we were here (the S&L crisis) that was intended to prevent the damage ($150 billion) that was done to our nation the last time!
This time around we're at $750 billion with another $750 in "placeholders" in the budget - that is, fully ten times as much damage, and yet the black letter law of the land says that this approach is directly contrary to the statute.
This goes back to my speech Thursday night - the underlying reason we have seen a market collapse is not due to economic recession.
Recessions are not "abnormal"; they come about due to the human condition - people are both too ebullient and too fearful. "Animal spirits" include both reaching for a brass ring and cowering in the corner, contrary to the Wall Street myth that such is only a "positive" thing.
No, we have seen this collapse because "The Bezzle" has reached into literally every corner of our financial system and government and nobody has been held to account.
When the S&L crisis happened only a few people went to jail, even though thousands committed felonies. When the Internet Bubble blew up only a few went to jail even though it is trivially easy to identify thousands who flatly lied about growth metrics - and that's just one place they were lying in their annual and quarterly reports.
As we have continued to tolerate "The Bezzle" it has become clear to people in all financial areas that they can lie and get away with it. That the odds of being caught, say much less prosecuted, are so trivial that it's definitely worth the risk.
Would you risk going to a cushy federal prison for five years if you could make $100 million dollars and the odds of getting caught were 1 in 10,000? How about if the odds are the same but the profit is only $100,000? In both cases many people would and did; home "buyers" overstating incomes are the second case, and sellers of money who intentionally misrepresented what they were selling (up and down the line) fall into the first. Indeed, the FBI's own statements on this matter is that if you were engaged in "fraud for housing" (that is, you robbed a bank in order to live in a house) they aren't interested in coming after you. It is only the serial fraudsters who were engaged in fraud for pure monetary profit across many transactions that they're arresting - and then, only if you're the borrower.
Now contrast that with robbing a bank the "old fashioned" way (with a gun.) You might get away with $100,000. But the odds of getting caught are much higher than 1 in 10,000 - in fact, they're probably at least 1 in 4, and maybe worse. If you do get caught you're going to do 20 years in a nasty place where prison rape is considered a sport and what's worse, if you're in a state like Florida, you will get a mandatory, no-early-release extra 10 on your sentence if a firearm is involved.
While people do still rob banks with a gun there are far more people who "robbed the bank" using a pen and piece of paper instead during the last five years - some of them "home buyers", some of them mortgage brokers and some of them bankers both on and off Wall Street.
Now let's mark this disconnect a bit more.
There is absolutely a price on human life. Doubt that? Go visit a hospital. People with no hope can and do obtain a million dollars or more of free (to them) medical care. OJ Simpson was sued after he won acquittal for the murder of his ex-wife and ordered to pay money damages, establishing that there is a value on human life, and we can and do reduce that value to dollars in our justice system.
So why is it that we refuse to apply the same standard when it comes to sentences? Nicole Brown Simpson's children, Sydney and Justin, were awarded $12.5 million dollars after OJ Simpson lost his civil case.
So we have a "reasonable boundary" for a human life - $12.5 million dollars. Other verdicts have found larger and smaller amounts, but this makes a nice, public and well-documented figure.
Does this not provide all the evidence you need that should someone manage to steal (in aggregate) through fraud more than $12.5 million dollars that they should get, at minimum, "20 to life" in prison? That is, a sentence equal to the least stringent for homicide?
How many of these fraudsters would have committed these offenses, and how many would in the future if this was the penalty? Commit a fraud worth $12.5 million or more, bye-bye. Oh, and we'll take the $12.5 million from you (since you stole it) to pay for your imprisonment too!
This - up and down the line - from the intentional lack of prosecution to willful refusal to follow the law to utter stupidity in criminal sanction - is the essence of "The Bezzle" and it is why capital has fled.
It also, however, points out an essential truth about any future recovery in our economy and banking system - it won't happen until "The Bezzle" is muzzled to a significant degree.
It is too much to expect that we will ever get rid of "The Bezzle" entirely. That's simply not going to happen - there will always be cheats, liars and frauds.
However, until those who commit such crimes and blatantly ignore the black letter of the law are held to account on a consistent basis, thereby destroying the belief that this sort of criminal activity is "free of material risk", there can be no meaningful recovery of economy progress.
We can either demand and obtain this change in policy and attitude now as Americans, or the market will do it for us by continuing to tank and forcing these firms and examples into the open where they are destroyed. The unfortunate reality, however, is that the latter course - refusing to face this and allowing the inevitable market implosion to do that which we refuse to through law enforcement - will also take down tens of thousands of sound companies who also see their capital base removed while their obligations remain.
Bluntly put - Congress and The Administration must, right here and now, compel these regulators to follow the law or remove them from their positions of power.
This had to be done two years ago and it still needs to be done.
There is no way to stop the bleeding in our capital markets - both credit and equity - until this occurs. It will happen; we are only choosing the means and where we want to confine the risk to.
If we continue down the path we are on now we are risking the meltdown of the United States Federal Government; Fed President Plosser said the following:
An agreement with the Treasury to switch U.S. government bonds for these less-liquid non-traditional assets on the Fed's balance sheet would help the central bank focus on conducting traditional monetary policy.
"With Treasuries back on the balance sheet, the Fed will be able to drain reserves in a timely fashion with minimal concerns about disrupting particular credit allocations or the pressures from special interests," said Plosser, who is not a voting member on the Fed's policy-setting committee this year.
You got that? The Fed knows that it is holding a bunch of crap and is threatened by the "value" (or lack thereof.) If they shove that off onto Treasury then the detonation of over $1 trillion in bad debt will occur on the government's balance sheet, which will (1) cause a dramatic move upward in Treasury interest rates, (2) translate into all other forms of debt and (3) result in exactly the same collapse that happened in the 1930s - but it will be far worse in degree, since we are far more in debt now than then.
As things stand today I have no confidence whatsoever that The Obama Administration has any intention to act according to law any more than George Bush's Administration did.
As a consequence until and unless the government's position and actions change my "base case" economic forecast must remain bearish and over time continue to grow more bearish; without the 2/3rds of all capital that is private in our economy, even with supplanting of that capital from the government (to the extent it is able) I believe we are looking at a potential 30% contraction in GDP from top to bottom and unemployment reaching north of 20% on U-6 (broad form), with the very real possibility of a 20% headline number.
We are headed for an Economic Depression worse than the 1930s at Warp Speed folks, and it is not going to happen because of "fundamentals" or even because "the credit markets froze up."
No, it is going to happen because both the Bush and Obama administrations are intentionally, with malice aforethought, ignoring the black-letter law of the land for the purpose of covering up their own malfeasance and misfeasance, and neither political party or the American People will get off their fat asses and demand that it be stopped.
Your job, prosperity and wealth are on the line America - right here, right now.
This is not some abstract failure in the market - this is a series of actions that have been taken with the full intention of screwing you, by both Democrats and Republicans, so that a handful of robber barons masquerading as capitalists do not have to face the music for their acts.
How bad can it get? Have a look at these charts folks over at Calulated Risk. They're sobering - and if the lawlessness does not stop we are just getting started.
Audio Streams
