Corruption

I'm sure you all remember how clearly I have stated that I believe that mortgage origination, securities packaging and dealing was fraudulent during the housing bubble, right?

I've been saying it now for three years - that credit quality was flatly ignored, appraisals were intentionally rigged and borrower lies were intentionally ignored.

Well now FHLB San Francisco has gone and done what no criminal prosecutor has had the balls to do - it has sued nine securities dealers.  Among them are Credit Suisse, Deutsche Bank, JP Morgan and Bank of America.  What is FHLB San Francisco alleging in its suit?

“The bank’s complaints allege that the dealers made untrue or misleading statements about the characteristics of the mortgage loans underlying the securities,” according to the statement.

The dealers made false statements or omitted important information about the loans that backed the securities they sold, the bank alleged in its complaints. The bank claims the dealers failed to disclose that appraisals were biased upward on properties that secured mortgage loans, that underwriting guidelines were ignored by originators and that loan to property value ratios were exaggerated.

Yep.  Exactly what I have said for the last three years, and what should, in my opinion, had long since led to criminal charges for alleged fraudulent conduct.

This is the second such suit - as I reported earlier the same bank and the FHLB Pittsburgh bank sued Goldman, JP Morgan and Morgan Stanley last year.

The economic mess we are in will not be resolved until these securities are recognized on bank balance sheets at their true underlying value and, where appropriate, those who falsified credit quality and other information about these securities during their packaging and sale are held to account for what they have done.

Now exactly where are all these securities and at what marks are they being held in the banks across our land?

That's a question we all deserve an answer to.

Now we're cooking:

March 17 (Bloomberg) -- Deutsche Bank AG, JPMorgan Chase & Co., UBS AG and Hypo Real Estate Holding AG’s Depfa Bank Plc unit were charged with fraud linked to the sale of derivatives to the city of Milan. Bloomberg's Elisa Martinuzzi reports. (Source: Bloomberg)

Oh wait - that's over in Italy, where the government isn't sufficiently bribed, er, bought off.

Now, let's see, where have we seen swaps written here in the US?  Oh yeah, I remember - places like Jefferson County Alabama, where there have already been some guilty pleas on bribery related to those swaps!

I wonder if some State AGs could be persuaded to grow some brass between their legs and start bringing these institutions up on criminal charges?

(Yes, they should, and yes, I'd cheer.)

Is this just words?  A glimmer of light flickers on in the dark halls of 535 fools....

Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm and which included riveting detail on the firm’s accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis.

Exactly.  I've been writing about this for three years; indeed, it was recognition of fraud in large financial firms that led me to begin writing The Market Ticker.

Lehman structured its repo agreements so that the collateral was worth 105 percent of the cash it received – hence, the name “Repo 105.” As explained by the New York Times' DealBook, “That meant that for a few days – and by the fourth quarter of 2007 that meant end-of-quarter – Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.”

It was a little more than that.  Lehman accounted for these transactions as a sale, when in fact they were a loan.  There's a hell of a difference between the two - in one case you remove an asset from your balance sheet and replace it with cash (and that change is permanent) and in the other you exchange an asset for a liability, and the net impact on your balance sheet is in fact negative, not positive (since you must pay interest on a loan.)

First, we must undo the damage done by decades of deregulation. That damage includes financial institutions that are “too big to manage and too big to regulate” (as former FDIC Chairman Bill Isaac has called them), a “wild west” attitude on Wall Street, and colossal failures by accountants and lawyers who misunderstand or disregard their role as gatekeepers. The rule of law depends in part on manageably-sized institutions, participants interested in following the law, and gatekeepers motivated by more than a paycheck from their clients.

Second, we must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street. We must treat financial crimes with the same gravity as other crimes, because the price of inaction and a failure to deter future misconduct is enormous.

Third, we must help regulators and other gatekeepers not only by demanding transparency but also by providing clear, enforceable “rules of the road” wherever possible. That includes studying conduct that may not be illegal now, but that we should nonetheless consider banning or curtailing because it provides too ready a cover for financial wrongdoing.

Everything that went on leading up to the crisis, and most of what went on in "managing" it, was unlawful under already-established black-letter laws.  Some examples should make this clear:

• AIG sold credit-default swaps (a form of insurance, even though we don't call it that) with no capital behind them - that is, no ability to pay.  Entering into a contract with full knowledge that you have no ability to perform is a fraudulent act - you are representing to someone that you have capacity to pay under the loss scenario, when you do not.
  
  
• Purchasing "protection" of this sort at below the market rate of risk as determined by the spread is an uneconomic act.  That is, the essential purpose of such a purchase is not to buy protection against the adverse event, but rather to intentionally misrepresent to regulators that your assets are "covered" and thus of better quality than they are, for the explicit purpose of not having to hold reserves against them.  I argue that this is an act of fraud.  The essential point is that nobody works for free - it is therefore impossible to buy a Bond that has a risk spread over Treasuries (of equivalent duration) of 3% plus a credit-default swap to cover it for less than the same spread.  A seller of protection who does not charge at least the risk-adjusted spread will not have sufficient capital to pay, and a seller who does charge at least the risk-adjusted spread (and thus can pay) leaves you with a trade, in total, that yields less than the Treasury!   If you desire a risk-free trade it makes no sense to purchase the more-risky bond and credit-default swap, as your total return will be lower than just buying the Treasuries!
  
  
• Mortgage origination and rating was rife with fraud up and down the line.  The breaches of representations and warranties are not accidents or oversights - they are frauds.  The most-carefully-negotiated set of terms in any offering document (for anything) is always the reps and warranties; as a seller of a business in the past I can tell you with absolute certainty that this is the case, because it is the section by which you can be hung if you make false statements.  The Securitizers represented to the buyers of these mortgage-backed securities that the credit quality was of a certain caliber in the loans that were made, when in fact post 2004 it was known that the majority of "ALT-A" loans contained some element of misrepresentation.
  
  
• Carrying second lien loans on the books of a bank that are behind a 60+ delinquent first that is underwater at any material value is, in my opinion, a fraudulent act.  By black-letter law these second-position liens are entitled to exactly nothing until the first mortgage is fully paid.  In the case where such a loan is underwater and not performing they have no economic value whatsoever.  Current statistics are that virtually all 60+ delinquent mortgages will ultimately foreclose or sell short.  80% of the dollar value of HELOCs are in the four bubble states (Nevada, Arizona, California and Florida) and the majority of these lines are behind an underwater first.  ALL of the big banks are currently holding a massive number of these loans (tens of billions individually and hundreds of billions in aggregate) on their balance sheets at or near par value, that is, 100 cents on the dollar.  I can come up with no reasonable argument for these claimed valuations, and yet they are allowed to persist.  Packages of these loans currently trade on the second market for literal pennies on the dollar.

Why is this allowed to continue?  I have, for the last three years, asked repeatedly "Where are the cops?"

I have also asked a more-serious question, and one with unpleasant implications for our society as a whole: Is the government a felon itself?

I believe these questions are fair.  You speak in your letter of FERA, The Fraud Enforcement and Recovery Act.  Well, if we're supposed to be enforcing the law against fraud, where are the cops sir?  All I've seen FERA do thus far is fatten the officers at the local donut shop.

As I said more than a year ago: "At the end of the day, this is a test of whether we have one justice system in this country or two. If we don’t treat a Wall Street firm that defrauded investors of millions of dollars the same way we treat someone who stole 500 dollars from a cash register, then how can we expect our citizens to have faith in the rule of law? For our economy to work for all Americans, investors must have confidence in the honest and open functioning of our financial markets. Our markets can only flourish when Americans again trust that they are fair, transparent, and accountable to the laws."

The American people deserve no less.

We may deserve no less, but so far we the people have received zilch, all in the name of "not disturbing the so-called recovery."

But in point of fact we've not only refused to prosecute, we've allowed these financial institutions to try to cover the holes blown in their own balance sheets as a consequence of this fraudulent activity with fees and interest charges assessed on the people!

This is akin to not only looking the other way when the robbers show up and commit their heist, but then in addition assessing the victims a tax to pay for the robber's getaway car!

Sarbanes-Oxley was supposed to prevent crap like this:

From the paper:

Lehman employed off-balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.2847

Oh yeah, that's legal?  It's not supposed to be!

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850  Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851  Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.

Isn't that special?

It gets better, as you might expect.

The Examiner concludes that colorable claims of breach of fiduciary duty exist against Richard Fuld, Chris O’Meara, Erin Callan, and Ian Lowitt, and that a colorable claim of professional malpractice exists against Arthur Anderson Ernst & Young.2915  (strikethrough mine, not in the original)

It is stated that Government Regulators (FRBNY and The SEC) had "no knowledge" of these practices.  Perhaps true.  But this calls into question why we're hearing of this just now, and whether other firms have or are at present doing the same sort of thing.

There also appears to be a colorable claim that Lehman Management was fully-aware of what was going on:

Although interview statements given to the Examiner were inconsistent at times, no reasonable dispute exists that each of Lehman’s Chief Financial Officers from late 2007 to September 2008 possessed some knowledge of and/or involvement with multiple aspects of Lehman’s Repo 105 program, including the existence of firm-wide Repo 105 limits, the volume of Repo 105 activity Lehman engaged in at quarter‐end, and Lehman’s efforts to manage its balance sheet using Repo 105 transactions.

Well that's special.

But we're just getting warmed up.

Remember, The Feral Reserve is supposed to by the "uber-regulator" and the "safety and soundness" manager for the financial system.

They did a great job, right?  Well...

Remember this Ticker from a few days ago?

I am constantly amused by those people who claim there is some vast "conspiracy" in this country when it comes to banks, balance sheets, and fraudulent lending and accounting.

There is no conspiracy.

It is, in fact, "in your face" fraud.

Well, one of the people on the forum emailed The FDIC to ask about what I had alleged.  This was their response:

That’s the value the bank had them on their books on their year-end financials, but the true value is much less. It is similar to someone in Las Vegas saying that their house is worth $300,000 because that’s what they paid for it three years ago, but the reality is, if they had to sell it in today’s market, they’d only get $250,000 for it. The FDIC has to sell assets in today’s market.

--db

Or tomorrow's market.

The simple fact of the matter is that there it is, right in front of you.

A raw admission that the banks are carrying these loans at dramatically above their actual value.

Yes, this means that essentially all balance sheets must now be considered fraudulent, and thus the valuations assigned by the market to them are also fraudulent.

Extending this to the stock market as a whole you now have a market that is intentionally overvalued as a direct and proximate consequence of fraud, permitted and endorsed by the government, of somewhere between 25-40%.

Now you know why the market rallied off the SPX 666 lows to where it is now.  1139 (where we are now) * .60 (a 40% haircut) = 683.40, or awfully close to that 666 bottom.

Of course this "valuation" expressed in the market can only be maintained for as long as the fraud is.  If the ability to maintain that fraud is lost for any reason then values will instantly collapse back to reflect reality.

Still sleeping well with your investments?