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: Federal Mortgage Fraud Task Force Subpoeanas 11 Banks (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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6 Responses to “A Really Big Deal”

  • emaij:

    As Bill Black makes clear, the “lie” was overwhelmingly put into the liar loan by the lender: http://www.capitalismwithoutfailure.com/2012/02/bill-black-how-fraud-leads-to-recurrent.html

    I’m not saying borrowers should be absolved… But the BIG fraud was on the lender side.

  • Andyc:

    Pater

    Don’t get me wrong, I agree with what you and MC are saying about responsibility and that everyone that participated in this mess should have to take losses but I think that should start from the top down not the bottom up.

    From Greenspan and Bernanke on down……

    Instead it starts from the very bottom up, taxpayers and savers who never participated are taking the brunt, then the people that bought homes and then…. nothing…….the people that wrote the loans are sailing right through TOTALLY without consequence.

    I also feel that this whole mess was an elaborate fraud, the banks were not concerned even in the slightest about the risks loaning this money because they felt they could slough off all the risk via packaging the loans into MBS and selling them to widow and orphan fund managers and the like…..and they felt that their CDS purchases would cover them although it should have been obvious that those CDS could never pay off….they expected to be bailed out and they were.

    Control fraud, top to bottom.

    In the meantime they are running out the clock on the statute of limitations and by 2016 it will be all over without a single consequence

    I’m in favor of real old fashioned capitalism myself and think that not only should these homebuyers, house flippers be out on their asses but the Jamie Dimons and Lloyd Blankfeins of the world should be too……driving cabs in fact or shining shoes better still!!

    : )

  • Andyc:

    MC

    “The blame goes to all parties, and no one should escape for lack or bounty of sophistication. Persons taking out bad loans should lose money, banks that made bad loans should lose money, investors not doing their due diligence should lose money, and ideally in hindsight we will all learn a valuable lesson.”

    Agree, but the message in this article is that it was the borrowers who were the most culpable in this mess.

    This housing boom was a control fraud from the get go and blaming the borrowers for lying is to put the cart before the horse.

    If the bankers were on the hook for these loans themselves how many of these loans would have went through?

    I’d say none, the bankers were eager to hear these lies so they could make the loans and then package the crap into MBS and pawn it off on the suckers, pension funds, charitable endowments, widow and orphan funds……

    If you lie to someone and they accept your lies as truth even though they know you are lying….who’s doing the lying?

    Putting the borrowers at the forefront for the blame is just banker apologia.

    The blame should flow from the central bankers and fed on down with the borrowers being the LEAST culpable, not the other way around.

    This author is way too banker friendly as far as I’m concerned and as confirmed by this next statement in this piece.

    “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.”

    Technically?…as in a mere technicality, eh?

    Uh no, they committed OUTRIGHT fraud upon the court.

    Outright fraud

  • Andyc:

    “No one was intentionally trying to foreclose on widows and orphans to cheat them out of their homes.”

    Says who? I would not put it past them

    “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.’

    You are blaming the egg for the chicken that laid it.

    The banks were tripping over themselves to make these loans and lying FOR these applicants seeking them, sometimes even without the applicants knowledge.

    I’d like to meet the hairdresser that could BS a banker.

    The banks made the loans on the premise that housing rises every year, so who can blame the borrower for thinking they were onto a sure thing in trying to flip houses and the like?

    They were using the bankers own rationale for making the loans as justification for taking on the loans and all agreed upon as a good deal at even the highest levels of finance.

    Who can say the house flippers, the people that took on too much house and the would be real estate kings were acting irrationally or in bad faith when the word from on high was that these dealings would be profitable?

    The blame goes to the sophisticated party in all these cases in my opinion and that is the banks.

    The banks blaming the borrowers is just another example of the banks wanting to have their cake, eat it too and not pay for it……and they succeeded, they made a fortune personally on these fraudulent loans which was the whole point in the first place.

    “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.”

    This trade was a total fraud because as Pater states here……..

    “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. ”

    You cant make a trade when you know at the outset that the trade should not pay off.

    That trade should have been analyzed as a bustout from its inception but they knew one thing most did not and that was that Timmy would pay off on it all.

    I laugh when I see it described as The Greatest Trade Ever!!

    What BS

    Cheers!

    : )

    • mc:

      “They were using the bankers own rationale for making the loans as justification for taking on the loans and all agreed upon as a good deal at even the highest levels of finance.”

      This article specifically mentions those in high finance (Paulson among others) that believed that the housing boom was a false boom. It was not close to “all agreed”, just the most foolish believed the market only went up. Try this one in foreclosure court: “I tried to guess what bankers were thinking, was wrong, but it isn’t my fault.”

      “Who can say the house flippers, the people that took on too much house and the would be real estate kings were acting irrationally or in bad faith when the word from on high was that these dealings would be profitable?”

      I will. They were certainly borrowers who acted in bad faith, not disclosing their entire financial situation to lenders. Many other persons borrowed money and defaulted on the loan when the home value went underwater, regardless of their ability to pay. Any one who made an investment decision based on “the word from on high” is not acting rationally and deserves any loss that they have brought upon themselves. It is no one else’s responsibility to ensure that your speculative investments are profitable.

      The blame goes to all parties, and no one should escape for lack or bounty of sophistication. Persons taking out bad loans should lose money, banks that made bad loans should lose money, investors not doing their due diligence should lose money, and ideally in hindsight we will all learn a valuable lesson.
      The effects on the broad economy due to these mistakes will be bad enough without expecting that there will be bailouts of those who made these decisions which are open to criticism both post and ex ante.

    • Ultimately the bubble can be traced back the the Fed’s decision to leave interest rates too low for too long. This without a doubt falsified economic calculation and seduced all concerned – buyers, lenders, developers, investors – to make economic decisions that later turned out to be huge mistakes.
      However, we can not absolve any of the parties to this drama from their responsibility.
      If you do that, then what about the many individuals that did NOT take out a ‘liar loan’, but are now forced as tax payers to help pay for various bailouts? Is there no difference in terms of personal responsibility between those who DID knowingly lie about their financial situation in mortgage applications in order to buy houses they could not afford and that those that did not do so?
      Moreover, given the fact that the banks almost went under when the bubble blew up, we can probably state that their actions were primarily a result of stupidity and greed. Surely they would have refrained from pushing these dubious loans if they had correctly appraised the future and foreseen that the mortgage bubble’s eventual bursting would almost put them out of business (in fact, several banks WERE put out of business, and many of those that were not were rescued by the Fed and tax payers).
      The financial sector has become ‘dead money’ for many years. I’m sure that was not the intention. Similarly, individuals who played along mainly proved how stupid they were. An adult should be able to recognize when he takes on a liability that will prove too much for him. We can not simply excuse the actions of all these people on the grounds that the bankers were similarly stupid and paved the way. This is not meant to excuse the bankers, mind – I merely want to point out that no party to the debacle was innocent.

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