We have long known that lender fraud was rampant during the real estate boom. The FBI began warning of an “epidemic” of mortgage fraud as early as 2004. We know that mortgage originators invented “low doc” and “no doc” loans, encouraged borrowers to take out “liar loans”, and promoted “NINJA loans” (no income, no job, no assets, no problem!). All of these schemes were fraudulent from the get-go. Property appraisers were involved, paid to overvalue real estate. That is fraud. The securitizers packaged trash into bundles that ratings agencies blessed with the triple A seal of approval. By their own admission, raters worked with securitizers to provide the rating desired, never looking at the loan tapes to see what they were rating. Fraud. Venerable investment banks like Goldman Sachs packaged the trashiest securities into collateralized debt obligations at the behest of hedge fund managers--who were allowed to choose the most toxic of the toxic waste—then sold the CDOs on to their own customers and allowed the hedge funds to bet against them. More fraud.
Indeed, the largest financial institutions were run by their management as what my colleague Bill Black calls “control frauds”. That is, the banks used accounting fraud to manufacture fake profits so that they could pay huge bonuses to top management. The latest data out on Wall Street bonuses show that these institutions are still run as control frauds, with another record year of bonuses paid by cooking the books. The fraud continues unabated.
This is the biggest scandal in human history. Indeed, all previous scandals from around the globe combined cannot even touch this one in terms of scale and scope and stench. This is the mother of all frauds and it will be etched into the history books for all time.
Many have called for a national moratorium on foreclosures. Even some of the banks that have been run as control frauds have voluntarily stopped foreclosing. And yet President Obama, ever the centrist, has taken sides with the Securities Industry and Financial Markets Association, which warns that “it would be catastrophic to impose a system-wide moratorium on all foreclosures and such actions could do damage to the housing market and the economy”.
No, it would expose the securities industry, itself, as the chief architect of the biggest scandal in human history.
Now we know that it was not just the mortgage brokers, and the appraisers, and the ratings agencies, and the accountants, and the investment banks that were behind the fraud. It was the securitization process itself that was fraudulent. Indeed, the securities themselves are fraudulent. Many, perhaps most, maybe all of them.
Some are trying to argue that this is just a matter of some missing paperwork. A moratorium would allow the banks to get all their ducks in a row so that they can supply all the documents needed to foreclose.
However, as reported by Ellen Brown (at Web of Debt) and by Yves Smith (at Naked Capitalism), the paperwork does not exist. Worse, as Yves has discovered, the banks are furiously working to manufacture documents, aided and abetted by companies like DocX that specialize in “document recovery solutions”—for a fee they will create fraudulent documents that banks can use in court.
The banks would like us to believe that in the speculative frenzy of the real estate boom they “forgot” to do some of the required paperwork. That is not likely. The absence of the documents was required to run the scam.
Recall that the banks invented “no doc” mortgages. This was not at the behest of no-account borrowers, high school dropouts with bad credit histories who were duping investment bankers into making mortgage loans they could not repay. No, these mortgages were created and endorsed by originators and securitizers and credit raters to create a patina of “plausible deniability” to be used later in court when they were sued for fraud by investors who bought the securities and by the borrowers who could not possibly service the mortgages. Because if the originators had ever requested the documentation from borrowers it would have demonstrated that the mortgages and the securities were frauds.
Similarly, the paperwork required for the securities was never done because the securities were fraudulent. Yves helps to explains why. The trust that purportedly underlies a mortgage backed security must hold the “note”—the borrower's IOU (in 45 US states the mortgage that is a lien on the property is an “accessory” to the note, and is not sufficient to do a foreclosure). If the note is not conveyed to the trustee (usually before closing but sometimes up to 90 days after signing) the securities are no good.
This is not just some pesky little rule imposed by a pin-headed regulator. This is IRS code. As reported by Brown, MBSs are typically pooled through a Real Estate Mortgage Investment Conduit (REMIC) that must according to the Internal Revenue Code hold all the paperwork demonstrating a complete chain of title. Done properly, taxes are avoided. Since a number of intermediaries are usually involved from the mortgage originator through to the trustee of the REMIC, there must be endorsements all along the line. However, it now appears that most of the original notes are still held in the loan originator warehouses. There are no endorsements. The trustees do not have the notes. Can anyone say “tax fraud”?
So why weren't the notes conveyed to the REMICs? There seem to be two possibilities—probably both of them correct. Karl Denninger at MarketTicker believes it was because the REMIC trustees feared an audit by investors in the securities. If the documentation existed, it would show that the mortgage loans were fraudulent. Far better to “lose” the docs, then later manufacture new ones for the foreclosure.
According to Brown (quoting Steve Liesman and Neil Garfield), the other possibility is that the tranching process actually prohibited assignment of the notes to the REMICs. Bundles of mortgages of varying quality would be tranched into a variety of securities, say from AAA to BBB. But no individual mortgage is actually assigned to a particular tranche—until it defaults. When one defaults, it is assigned to a lower tranche security and then the foreclosure process begins. This means that from inception of that BBB security, there was no way to assign a note to the trustee because the trustee did not know in advance which mortgage would default. The REMIC trustees tried to get around that by using a dummy conduit called MERS (Mortgage Electronic Registration System) that would “hold” the mortgages and assign them to the proper tranches later. But they do not have the paperwork either, and some courts have rejected their claims as owners.
This is a complete mess. What President Obama must understand is that fraud is endemic at every level of the home finance food chain. We were long told that securitized mortgages cannot be modified because of the complexity involved—modification of most mortgages would require consent of the holders of the securities that each have a piece of the mortgage. But actually it is impossible to tell how many—if any—of these securities holders have a legitimate claim on any of the mortgages. Simply imposing a moratorium will not be enough—it will just give the banks time to manufacture false documents, encouraging even more fraud. Meanwhile, half of all homeowners with mortgages are already underwater or are within spitting distance of being underwater. Many of these are drowning because the epidemic of fraud perpetrated by financial institutions destroyed our economy and caused housing prices to collapse.
The President needs to try a different approach, consisting of the following series of steps:
1. Declare a national bank holiday that would close the biggest financial institutions—say, the top dozen or so. Send in the supervisors to examine their books to uncover fraud. Determine which ones are insolvent and resolve them. While resolving them, net their claims on one another (including derivatives). Do not allow any insolvent institutions to reopen, and do not use the resolution process to merge institutions (we don't need even bigger “too big to fail” banks). Prosecute the crooks and jail the guilty.
2. Stop all foreclosures. Investigate and prosecute all institutions that have been selling or buying fake documents to be used in foreclosures. Prosecute the crooks and jail the guilty.
3. Announce that all homeowners who occupied their homes on October 1, 2010 will be allowed to remain in their homes indefinitely. Create a national mediation board to adjust all mortgage payments to “owner's equivalent rent”—the fair value of rent for the home. Establish a fund to provide rental assistance to keep low income homeowners in their homes.
4. Give purported mortgage holders 30 days to produce the original notes; if they cannot find them, hand the homes over to the owner-occupants—free and clear of debt.
5. Create a process to allow securities holders to sue for recovery of value. This must be national—state courts will not be able to handle the case load.
6. Direct the GSEs to refinance mortgages at a low fixed rate. Mortgages would be provided against real estate appraised at fair market value to any borrower for a primary residence. The GSEs would pay holders of existing mortgages only current fair market value. Those holding these mortgages can seek redress through the process outlined in step 5. Only in the case of borrower fraud would the homeowner be held responsible for losses attributed to the refinancing.
7. There will be fall-out from losses. It is better to deal with the collateral damage directly than to prop up the control fraud banks. For example, pension funds hold toxic waste securities as well as equities in the control fraud banks, and by all reasonable accounting the Pension Benefit Guarantee Corporation is already insolvent. But it is better to directly bail-out pensions than to maintain the charade that fraudulently created securities have value.
Bill Black likes to joke that economists are afraid to use the “F” word (fraud). The President must come to realize that there is no other word that can be applied to the US home finance system. Until we deal with the fraud we will never resolve this financial crisis.
(Go to www.nakedcapitalism.com for Yves Smith, “4ClosureFraud posts lender processing services mortgage document fabrication sheet”, October 3, 2010; and to www.webofdebt.com for Ellen Brown, “Foreclosuregate and Obama's ‘pocket veto'”, October 7, 2010.)
L. Randall Wray is a Professor of Economics, University of Missouri—Kansas City. A student of Hyman Minsky, his research focuses on monetary and fiscal policy as well as unemployment and job creation. He writes a weekly column for Benzinga every Tuesday.He also blogs at New Economic Perspectives, and is a BrainTruster at New Deal 2.0. He is a senior scholar at the Levy Economics Institute, and has been a visiting professor at the University of Rome (La Sapienza), UNAM (Mexico City), University of Paris (South), and the University of Bologna (Italy).