The Mortgage Fraud Investigation – Shouldn't It Be Regarded As A Really Big Deal?
Last week, president Obama mumbled something about a mortgage fraud task force during his State of the Union ramble. Later on in the week, US Attorney General Holder provided more details, which was followed by the issue of subpoenas to 11 financial institutions. The focus is on residential MBS (mortgage backed securities, ed). This is one version of the news:
Housing Wire: (this link leads to the Google cache version, as apparently the original article has been removed for reasons unknown)
The market, especially the stocks of the banks involved, took the news in stride. However, shouldn't this be a really big deal?
We know to the extent to which the robo-signing error has thrown the entire foreclosure process into a state of mass confusion. While it may be technically labeled as fraud, it is in reality basically very sloppy processing by servicers who were (and are) overwhelmed by the volume of defaults. No one was intentionally trying to foreclose on widows and orphans to cheat them out of their homes.
The State Attorney Generals have been trying to extort obscene amounts from the banks for this error. Personally I think the big bad banks are evil and should be punished, but in this case they are being punished for the wrong deed.
This newest investigation into the RMBS market should open a Pandora's box.
The whole chain started with the so-called "liar loans". There is no way around the fact that thousands, probably hundreds of thousands, applicants falsified income and asset information on the loan application in order to defraud a lender into giving them a loan. Instead of rejecting these loans, the big bad banks funded the loans, packaged them and sold them to lazy investors who relied on rating agencies paid by the issuers instead of doing their own due diligence.
In my opinion, the only way that the banks are not on the hook for this is if they included a disclosure statement in their representations and warranties that said something like this:
The issuer did not check for the accuracy of the loan applications. The issuer did not verify income, asset or any other financial information provided by applicants. In fact, the issuer simply made some of these numbers up for the applicants. Buyers of these securities should be aware that they are buying pure garbage and must rely upon their own stupidity in making this purchase….
There are numerous ongoing lawsuits filed by investors against MBS issuers. If the attorneys general are able to prove fraud, could the banks be liable for a lot more than what is currently deemed to be at stake?
Furthermore, what happens to all the derivatives such as the CDS written on MBS? Can the AIG's of this world ask for the claims to be paid back since the losses were ultimately due to fraud and not a normal credit default?
There have been talks about a settlement for the robo-signing scandal in the immediate future. I wonder how can the banks accept any deals that are only limited to the robo-signing issue.
I do not have the answer and have not yet seen a good legal opinion, but this new investigation looks like a potentially explosive issue.
Addendum by Pater Tenebrarum:
A Potential Game Changer and The Socionomic View
It should be added to the above that US banks still have mortgage related assets amounting to nearly $ 3 trillion on their books. The value of these assets is a perennial moving target (we have therefore dubbed this the 'moving target problem'). At any given point in time, a bank balance sheet is merely a snapshot of the particular period it depicts. In the meantime, collateral values continue to decline and due to the vast 'shadow inventory' pipeline this seems set to continue for some time.
The potential liabilities banks will face from investors trying to get restitution for various types of MBS the banks have sold to them during the bubble have long been known to represent a large, but difficult to quantify additional headache for the banks. The collapse of Bank of America's stock price last year was largely tied to the fact that stock market investors were unable to gauge how big this liability would become.
The one thing the banks always had going in their favor on this issue was that the great bulk of MBS investors were themselves 'sophisticated' professional investors. They should have been capable of doing a modicum of due diligence of their own.
Instead they relied on dubious credit ratings and the 'insurance' provided by CDS written by credit insurance firms (of which AIG tuned out to be the most egregiously exposed). However, anyone in possession of an abacus and an ounce of common sense could have worked out on the back of an envelope that this insurance wasn't going to be worth anything if it should ever come to be called in. The writers of such CDS simply couldn't survive a general downturn in the market. They could perhaps deal with the occasional blow-up, but not a widespread one that engulfed a large percentage of mortgage loans.
Alas, if the mortgage fraud task force manages to prove that many of these MBS were in fact fraudulent deals, then we are looking at a game changer with regards to the liabilities the banks could face.
Once it has been determined that certain deals were fraudulent, the civil suits will presumably breeze through with great ease. Investors suing for restitution will be able to point at the criminal judgments and say that it has already been proven that they were in fact defrauded. The potential liabilities of the banks would undoubtedly balloon as a result.
Note that the outcome of the investigation and any law suits that might flow from it, as well as the outcome of civil litigation, are highly dependent on the state of the social mood. It is in fact the souring social mood that is the driving force behind the launching of such investigations. No-one worried about potential fraud during the bubble, although the facts were not different then from what they are today. The only difference was that no-one had as of yet suffered losses, but if the MBS deals were fraudulent, they were just as fraudulent when they were still making money.
Bubbles always create numerous opportunities for fraud. As a rule, the longer a bubble expands, the more fraudulent activity there will be. However, it usually only comes to light after the bubble has burst. Only then comes society's urge to exact retribution for the perceived crimes to the fore.
Should the social mood improve, then the banks will probably get away with out-of-court settlements. They are likely to involve large amounts, but not as large as to create an existential problem for the banks involved.
However, in the event of a further deterioration of the social mood – which will be reflected in the stock market's primary trend – the outcome could in fact turn out to be life-threatening for some banks.
As an aside, the SEC is now also probing Deutsche Bank's 'Crap Subprime CDO's'. The context is familiar from a similar investigation Goldman Sachs faced a while ago:
“The Securities and Exchange Commission investigates a Wall Street behemoth over claims that it assembled and sold a package of subprime mortgage-backed securities at the behest of hedge fund king John Paulson without telling other investors that Paulson planned to short it.”
John Paulson's highly successful short trade of mortgage-backed securities continues to haunt the banks that helped him put together the baskets of securities he wanted to short. As they didn't want to be the counterparties to his shorts, they sold the underlying securities to other investors – and of course had to present the securities concerned in the best possible light to such investors, in spite of the fact that they knew that Paulson had picked them for the great likelihood of eventual default. In our opinion these investors didn't do the due diligence they should have done, but once again, the investigation is symptomatic for the deterioration in social mood. The fact that Paulson profited greatly from correctly anticipating the collapse is of course anathema to many people as well.
US attorney general Eric Holder – going after the MBS deals sold during the housing bubble
(Photo via: the Web/unknown source)
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