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Wednesday, January 6, 2016

Definitive Story on Subprime Fraud Ignored 11 Years Ago

The Stuff Happens school of economic thought likes to whitewash the magnitude of fraud by invoking the standard cliches--excess liquidity, tail risk, Black Swan scenario, irrational exuberance, we all drank the Kool Aid, remember the tulip craze--to dismiss any empirical review of culpability.

The antidote to this doublespeak remains the seminal reporting done by Mike Hudson and Scott Rekard in The Los Angeles Times on the boiler rooms at Ameriquest Mortgage Company.

Ameriquest became the leader in subprime lending, specializing in cashout refinancings with two-year teaser rates, and led the race to the bottom in credit standards. Others followed Ameriquest's lead. At the time, the legion of stories about the company's dishonest business practices were ignored by government officials because the company and its owner, Roland Arnall, were the largest donors to the campaigns of George W. Bush and Arnold Schwarzenegger. (Ameriquest was overseen by regulators in its home state, California.)

The essence of the mortgage crisis was simple. People broke the law because they knew they could get away with it. High ranking government officials thwarted efforts to police against fraud. And when interest rates started rising, Arnall saw the writing on the wall and began to shut down and sell off his operation. And then he got Bush to appoint him Ambassador to the Netherlands.

As I wrote five years ago, the article exposes the wilfull blindness at the heart of the crisis:

Past is prologue, and everything you need to know about the financial meltdown can be gleaned from a single article published more than five years ago in The Los Angeles Times. The 3,200-word piece tells you nothing about credit default swaps or CDOs or hedge funds or AIG. There’s no need to carefully pore over the reported details. A quick skim will give you the overall gist.

The story explains how fraud had gone viral at the nation’s largest subprime lender, Ameriquest Mortgage Company. “In court documents and interviews, 32 former employees across the country say they witnessed or participated in improper practices, mostly in 2003 and 2004. This behavior was said to have included deceiving borrowers about the terms of their loans, forging documents, falsifying appraisals and fabricating borrowers’ income to qualify them for loans they couldn’t afford.”

The most important part, the part that explains everything, is not contained within the text. It’s the reaction that ensued thereafter. Nobody cared. Nobody who mattered, anyway. Sure, the article was picked up by the Associated Press and some other papers piggybacked off of the initial reporting by Mike Hudson and E. Scott Rekard. But the gatekeepers of the financial system ignored the story and its broader implications.

Goldman Sachs, Merrill Lynch, Bear Stearns, Lehman and Citigroup were all too happy to continue buying and selling Ameriquest mortgages. Rating agencies continued rating the company’s mortgage bonds, while Standard & Poor’s continued to assign its highest rating to Ameriquest’s mortgage servicing unit. The ultimate vote of confidence came from the bond markets, which demanded no increase in pricing for Ameriquest bonds.

The financial media didn’t really care either. Neither The Wall Street Journal, nor CNBC, nor Forbes, nor Fortune, nor BusinessWeek gave the story much if any play in the year following the story’s release on February 5, 2005.

Most importantly, the heavy hitters in the government didn’t give a damn. Neither the Federal Trade Commission, nor the FBI, nor the Federal Reserve, which was tasked by federal statute to regulate mortgage lending, did anything in response to the story. State regulators in California, where Ameriquest was headquartered, turned a blind eye. Ameriquest was only one company, but its widespread pattern of deceit was emblematic of what was going on throughout the subprime mortgage industry.

The fraud was easy to find if you were willing to look for it. But the gatekeepers were, with very few exceptions,  unwilling to look for it. Remember, 40% of all subprime originations were “low documentation” loans, otherwise known as liar loans.

All this fraud–the forged signatures, the falsified W-2s, the inflated appraisals–spread like a flu virus throughout the different exotic financial instruments, which had triple-A ratings. When the real estate bubble started collapsing, financiers realized that they hadn’t known what was going on all along.

At the end of the day, the cause of the financial crisis was rooted in the government’s refusal to go after crooks, large and small. Fraud was never legal, even when the markets were deregulated. But if the police show no interest in enforcing the law, lawlessness prevails. When the law is aggressively enforced, crime goes down. The murder rate in New York City did not decline because the City Council passed new laws against murder; it went down in large part because of smarter, more proactive police enforcement.

The new legislation on financial reform can have a positive impact, but only to the extent that the government is serious about enforcing the law. Remember, in the aftermath of the savings & loan crisis, Congress enacted the Home Ownership Equity Protection Act of 1994, designed to protect all homeowners from the types of tactics and transactions described in the Ameriquest story. The legislation gave the Federal Reserve authority to modify and update all consumer protections in light of changing circumstances, but Alan Greenspan adamantly refused to take any action whatsoever.

Monday, January 4, 2016

False Equivalency of the Week: GSE Risk Sharing Like Synthetic CDOs

"Taxpayers have borne the bulk of mortgage credit risk ever since Fannie Mae and Freddie Mac were put into conservatorship more than seven years ago,” writes John Carney in The Wall Street Journal's Heard On The Street column. "In an ironic twist, a plan to ease this burden relies on a version of one of the instruments most demonized in the financial crisis—the synthetic collateralized debt obligation."

Well that's about six degrees of separation from reality. GSE risk sharing is a version of a synthetic CDO the same way that aspirin is a version of heroin, (you know, they are both painkillers that can be lethal when taken in excessive doses).  Carney wanted to make a comparison that was provocative--in The Big Short movie, Selena Gomez explains synthetic CDOs at a blackjack table--though I wasn't sure if he aimed for a false equivalency that was so ridiculously misleading.

In a nutshell, GSE risk sharing involves syndicating, or selling off pieces of, the GSE guarantee obligation that applies to every mortgage pool it securitizes.  It’s very much like the centuries-old reinsurance market. There is one tangible asset, a specific mortgage pool owned by investors in the GSE securitization, insured by the GSEs, who now share that fee income and risk with outsiders.

Synthetic CDOs were portfolios of credit derivatives—ISDA contracts that were specifically invented in 2005 to make these CDOs possible. As Greg Lippmann (played by Ryan Gosling in the The Big Short movie) explained, during the first 10 years of his career as a trader, he could only go long or less long in RMBS. Without those Pay As You Go derivatives, which he helped invent, The Big Short would have been impossible. Pay As You Go derivatives provided a method for estimating a “fair market value” for triple-B bonds that never traded because they were stuffed in CDOs; and they provided a method for payout by way of “credit event” (i.e. rating agency downgrade) which occurred long before the bond suffered a payment default.

Synthetic CDOs never insured mortgages, only structured finance bonds, triple-B subprime mortgage bonds that were certain to fail because their breakeven could not withstand slowdown in home price appreciation.

Those credit default swaps act like insurance contracts without the standard protections against insurance fraud.  Synthetic CDOs were all about people insuring bonds they did not own for amounts that far exceeded the bonds’ face value. And it was all done in secret, because everything about credit default swaps and CDOs was kept secret, away from public view or scrutiny.  

The fatal flaws of all structured finance CDOs were threefold:

  1. The rating agencies assumed that defaults by structured finance entities, which operate like dumb machines, are similar to defaults by corporations, which are run by people who continually adapt to changing circumstances;
  2. As noted before, the rating agencies ignored the impact of hyper-subordination, which can wipe out principal in a very brief timeframe; and
  3. In the face of hard evidence proving otherwise, the rating agencies assumed that the deeply subordinated residential mortgage backed securities in a CDO portfolio were uncorrelated, that there was no reason to expect that all the bonds would would face similar problems during a housing downturn.

Synthetic CDOs never financed a single home. They were created so that some insiders, who recognized that the rating agencies'  processes for rating mortgage bonds and CDOs had devolved into a sham, could take advantage of suckers--at MBIA, AMBAC, ACA and elsewhere--who placed their blind faith in the triple-A ratings of senior CDO tranches.

Which is why synthetic CDOs are nothing like GSE risk sharing.

Guess who came up with a new pretext for saying the GSEs are evil incarnate? A day later, the Journal's editorial writers doubled down, informing readers that one, "Fan and Fred to use synthetic collateralized debt obligations (CDOs) to offload some of the mortgage risk they are holding." The fig leaf pretense, of GSE risk sharing being a version of a synthetic CDO, was gone.

That verbal sleight of hand fits into an old and familiar pattern. Whenever the public is reminded of a financial disaster that occurred under the Bush Administration, the Journal's editorial writers take a piece of financial jargon, pervert its original meaning, and then make the spurious claims that Fannie and Freddie are just as bad as Enron, or predatory subprime originators, or greedy Wall Street types who bet against the housing market.  

In "Fannie Mae Enron?" Journal editorial writer Susan Lee used an assortment of propagandistic tricks like this one: "By the way, last year Fan's derivative strategy went, um, somewhat amiss and she had to write down shareholder equity by $7.4 billion."  Lee's grasp of accounting went, um, somewhat amiss. A mark-to-market loss is not "written down," because that loss can be reversed on the next trading day. But here's the critical point about hedging and derivatives. Like every balance sheet lender in America,  Fannie hedged the interest rate risk embedded mortgage loans, with interest rate swaps and other derivatives. Under accounting rules the derivatives are always marked-to-market while the loans are recorded at historical cost. There is always a disconnect that tells you nothing about the true cash flow or economic hedges that manage interest rate risk. 

Lee tried to equate Enron's energy derivative trading with Fannie's reliance on interest rate swaps, which, in terms of volatility and transparency, is like equating LSD with a glass of wine.

As noted before here and here, the ensuing Fannie Mae "accounting scandal" is one of the great Emperor's New Clothes phenomena of the 21st century. Apparently, I was the first to write about the absence of any debits-and-credits explanation.  

As for Fannie and Freddie leading the race to the bottom because Ed Pinto discovered 27 million subprime mortgages hidden in plain sight on June 30, 2008, I've lost count how many times--it's probably 2,579 by now--that somebody in the Opinion pages has repeated that famous canard.  Whereas in capitalismland people want to know which loans paid back with interest and which did not. And anyone who denies that the GSEs have the best loan performance in the industry is lying. 

And now at year-end 2015, after the movie starring Ryan Gosling and Brad Pitt reminded everyone that synthetic CDOs were inside bets that made some guys rich when the economy tanked, the Journal's editorial board wants readers to believe that Fannie and Freddie are reviving the toxic triple-A investments that crippled MBIA, AMBAC, and a few others.

As I've written before and will write many times again, corruption in finance is rooted in corruption of language.  GSE critics use the same tricks and devices used by other doublespeak artists who deny the dangers of cigarette smoke or the reality of climate change.