I guess by now our leaders have done a decent job explaining to us why the bailout package is a "necessary evil". It's not just a blank check to Wall Street at the expense of Main Street. For better or worse, we're like symbiotic organisms; our fates are tied and Wall Street credit is the lifeblood that sustains Main Street activity. Though many times (including now), it seems that Wall Street calls the shots and we are just along for the ride. They tell us it's all about credit availability. Small businesses and local governments need loans to buy raw materials or even pay their workers, not to mention the private citizens that seek car/college/home loans. But is credit the answer for everything, and does it have to play such a crucial role in modern economies? Must we do "whatever it takes" to insure a free flow of credit forever, or face worldwide panic and recession like we see now?
Despite the uproar from some GOP leaders and talk radio of all stripes, America is not "dead set" against this bill, and I bet the House will approve version 2 today (oh, I just now see on BBC that they did), especially with time running out in this Congressional session. All 535 of their asses are up for re-election on November 4 (but only a few incumbents are ever really challenged), and voters/investors are running out of patience for political posturing as the Dow sinks to 10,000. I guess the new bill is 90% similar to the previous version, except for the FDIC insurance limit is increased from $100k to $250k (that's really great news, since most of us have like $240k in our savings accounts and were getting nervous), and about $100B in new tax breaks were included to persuade the holdout Republicans, with no mention how debt-laden Washington will recover that revenue of course. Clearly Main Street, Wall Street, and Washington have problems with borrowing responsibly.
Some of the included tax breaks are pure pork and quite laughable: http://www.taxpayer.net/resources.php?category=&type=Project&proj_id=1429&action=Headlines%20By%20TCS.
Many gripes about the bailout are justified and it won't be a panacea, but unfortunately there's not much room left for further debate. If asked, "Would you risk half a trillion in tax dollars to help Wall Street recover from its mistakes?", most people would instinctively answer "no" without the benefit of additional context. So one can understand why our initial reaction to Bush's plan was skeptical at best. But recent Pew Research poll suggests America is now split roughly 50-50 over the plan, though few Americans are well versed in macroeconomics and fiscal policy to really understand the repercussions either way. If geniuses like Bernanke and Greenspan are grasping at straws, that doesn't bode well for the rest of us. People might not want to throw their tax billions at Wall Street, but they also don't want to see their investments evaporate and commerce dry up around them (and in many cases it already has). When push comes to shove, we'll go to bed with the devil to save ourselves.
That's what really frustrates me about this crisis - it demonstrates how easily Wall Street can manipulate us like a puppeteer. Big firms and private citizens alike made big bucks during the loose credit housing boom, but some got in too deep and hung around too long until they got burned. And all along, the Fed tried to prolong the binge instead of trying to cool off an obviously oversupplied and overvalued housing market. Many huge banks have seen their holdings lose over 50% of their value since 2007, causing financial panic or ruin to millions. So at every mention of a government rescue (despite many economists' concerns), the Dow surged, and when the House balked on the first bailout proposal, the tempermental Dow responded with a record point drop. Was that due to millions of Average Joes going on E*Trade in unison to cut their losses and sell their 50 shares of blue chips, or rather the high-rollers and big fund managers dumping their vast numbers of shares in favor of safer commodities like gold? It may not be deliberately punitive, but it's still blackmail.
Banks might be drowning in debt, scared to invest and lend to each other and us, but they are still sitting on billions of good, liquid assets. They could try to reverse the slide if they wanted, and some have, like the European Central Bank injecting billions into the credit market and Warren Buffet looking for some bargains. But instead they tighten up even further, because why should they risk their money when Washington might do it for them? It's like the "welfare mom with 6 kids" that Newt Gingrich types loved to villify. Why should she make an effort to get a job when Uncle Sam will cut her a check every month? Wall Street said, "OK Washington, if you don't give us the money, we're going to execute hostages until you do." Economic terrorism, right? Ordinary citizens saw the unlucky 777 point drop, and feared even more for their 401(k)'s and other investments. Maybe some who were previously opposed to the bailout changed their minds and started to lobby the bickering Congress to act. Anything to protect our money, right? Maybe I'm just full of crap and don't understand how the market works, but it sure seems like a scam to a simpleton like me.
The selective rescues or facilitated purchasing of some troubled GSEs and financial institutions by our government was huge economic news already. Maybe some people were already musing about a government repository for toxic securities as a potential next step, but the Bush-Paulson plan must have still taken America by surprise, as well as their demand for immediate implementation (hence the huge Dow swings in the last 2 weeks). I guess Congress and citizens had a right to be skeptical of a back-of-the-envelope plan crafted by Treasury, that gives Treasury god-like powers, and promoted by an administration with an unprecedented track record of augmenting executive powers (sometimes in defiance of the Constitution and common sense).
I am tired of hearing Harry Reid-type blowhards stressing the need to work together and pass this bill now, yet blame colleagues like John McCain for "interference", and proclaim that all 100 senators could have written a better bill. Then why didn't they? Don't give us a turd decorated with fancy wrapping paper and a $700B price tag, then expect us to congratulate you. I hate the fact that we have left the disease unchecked for so long that our best course of action left is to cut off our arm before the infection spreads. We've cornered ourselves. Many people in Washington and Wall Street seem very eager to get us to do a bad thing quickly, because the alternative is worse. I suppose that constitutes leadership these days. At least Lyndon Johnson had the dignity to not seek re-election after failing to deliver victory in Vietnam. If the Fed, Treasury, SEC, and Congress had an ounce of self-respect left, half of them should have resigned by now in shame. After Bush's speech to sell the plan to America, PBS had a couple chaps from the House Financial Services Committee on for analysis. At times they were actually smiling and joking about the situation to each other! Millions of Americans are in trouble and getting ulcers from worry, and they, who are in the eye of this storm and maybe contributed to the crisis, are hamming it up. Talk about out of touch; this is why revolutions happen.
A lot of people blame this credit crisis/housing bust on unbridaled personal and corporate greed and irresponsibility coupled with poor government oversight. While that may be partially true, greed and poor oversight have been and will always be a part of human civilization. There's no way around it unless we all become monks and peasants. But maybe the trick is to reduce the opportunities for reckless, greedy bastards to be reckless and greedy, and reduce the policing duties of the government to give them less chances to drop the ball. Yes, less regulation is fine as long as the credit markets and other financial systems are organized in ways where excess and fraud are not just illegal, but impossible. Maybe I'm just dreaming, but what are we paying all those PhD's for? Can commerce be free, but also with failsafe mechanisms? Can we create more ideal markets where human nature is less able to make a negative impact, without sacrificing productivity and efficiency too much? We all operate out of self-interest, and our behavior is affected by external carrots and sticks. Obviously the sticks weren't big enough to prevent even smart people from taking stupid risks in pursuit of very juicy carrots. But incentives and punishments only go so far, especially to powerful entities that think they can dodge accountability/consequences, and often they're right.
Maybe a good first step is reducing our dependence on credit. I know borrowing is necessary for some up-front costs of large investments like businesses and homes. But why can we not spend what we don't have? And do we have to exploit every last dime by loaning it out or investing in others? Can we reinvent economics with less emphasis on credit, because clearly the status quo has some pitfalls. I'm not saying we should bury our cash in the backyard, but there has to be some restraint and moderation. Otherwise, we'll keep getting market panics and crises like this one, except maybe worse and worse as financial institutions become "too big and interconnected to fail". It has gotten so complicated that we don't even know where the money in our savings account really goes, nor the true value of our investments. We are so dependent on large, predatory credit entities - it's too dangerous and unfair. They are the "landlords" and we are the "tennants". They dictate terms to us and only exist to take a piece of our labor and creativity. Microfinance has helped millions out of poverty in the Third World, even if it has its share of criticisms, such as very high interest rates to justify the investment risk. Maybe instead of relying on corporate America to keep our local economies going (where their interests may be quite different than ours), we can form more credit unions and municipal cooperatives. Share and spread the accountability and prosperity, with the goal being collective stability and security, not individual profit. People pay into and withdraw from a general fund based on their economic situations and financial preferences. Members vote on who gets loans and the conditions of those loans in a transparent, democratic fashion. But maybe that's just crazy socialist talk?
In closing, I find myself thinking about my few months as a student in Europe in 2000 (when the dollar was kicking the Euro's butt, so it was great timing). Obviously Paris is a modern metropolis with its share of problems too, but people from many walks of life were not obsessed with money, advancement, and acquisition, as we are. Of course there was plenty of greed and evil, though life was so different. It was a fast-paced, turbulent city, but somehow life seemed saner and more people-centric also. Maybe nostalgia is a rose-colored lens, but the differences were too large to be imagined. Every little neighborhood had several bakeries, convenience stores, and boutiques. Sometimes they would have no customers all day, yet they were still in business, paying the bills and providing for their familes. In America, it seems that all but the best small businesses are hanging on by a thread, while the rest of us whores have to attach ourselves to corporations for career development and financial survival. It is hard to get fired, and even harder to work more than 50 hours a week, yet unemployment was at 10% (though no one was starving to death). Companies weren't merging or going under left and right. Workers left their work at the office and could actually relax at home, often having two-hour long dinners together with the whole family. Maybe they didn't have a big home with a white picket fence, big screen, and station wagon, but they seemed quite happy and comfortable.
No one worried about saving up for tuition, child care, or retirement, because the state assumes most of those burdens. In America, we get nickel and dimed into poverty with "maintenance fees" on our retirement investments and college loan scams. Same goes for medical insurance, obviously, as France's system perennially ranks in the top 5, while ours is about #30-40 near Estonia. Middle-class people went on month-long vacations and could afford it. My uncle was on unemployment insurance for years and no one accused him of being a deadbeat. Taxes run about 50%, but many consider it a patriotic duty in order to maintain their society and quality of life. Maybe that welfare state lifestyle is going the way of the dinosaurs, with an aging populace and rising costs of basic goods and services. There is plenty of evidence for that, with conservatives like Sarkozy coming to power. However, other socialist nations have rejected their Bush-allied conservative leaders in favor of leftists, like Australia, Spain, and Japan. Maybe there is a chance. There has to be an alternative to this insane, and I mean literally insane, American way of life and commerce. Oh yeah, and mainland Europe isn't saddled with war expenses and the accompanying political blowback either.
Some interesting links:
http://www.iht.com/articles/2008/10/01/opinion/edbuchanan.php (using computational models to better understand/predict economic activity)
http://news.bbc.co.uk/2/hi/business/7646863.stm (have banks share more information and maintain accountability for their lending)
http://www.newsweek.com/id/161199 (the menace of the booming 'credit default swap' market and how it could be regulated)
http://baltimorechronicle.com/2008/092908Lendman.shtml (a big economics rant that I haven't even finished reading yet)
This section in italics is pretty lame, so please skip it over unless you want to ridicule my ignorance:
[The market and the past decisions of financiers have left us little alternative. We need to restore confidence and flowing credit in the markets, or the whole machine grinds to a halt. Credit is the "lubricant" of our economy, but does it have to be so? Liberal capitalism is roughly defined as private ownership and exchange of products/services/investments/etc., with prices determined by a free market. Credit is not inherently essential to market economies, but of course in our current industrialized, globalized economy, it is. We already know the dangers of relying on or abusing available credit. Our government is in record debt to foreigners, which contributes to our weak dollar and makes some struggling companies ripe for the taking by offshore competitors. Hyper-consumers with little self control keep taking out new credit cards to cover spending beyond their means, as well as their previous accumulating debt. Yet some of those people were offered huge mortgages without having to provide evidence that they were able to afford them. And sadly, many vendors almost rely on and tailor their business models in expectation of customers over-spending. We know all this already.
But why does our economy need to revolve around credit? I know borrowing and lending are as old as the pyramids, but it's probably no coincidence that usury is a sin in most religions. Micro-finance aside (a relatively recent invention), very few of us possess the vast capital and/or means of production necessary to provide substantial credit to would-be borrowers. So instead, investments and assets are pooled into vast multinational corporate financial entities that become umbrella lending hubs. Millions of people entrust their savings to them, hoping it will grow, and millions others depend on loans from them for various large purchases. Heck, even non-finance related companies make a good portion of their revenues through lending (GE and insurance companies like State Farm to name a few). GE makes jet engines and toasters - why venture into financial services? I think it's because the money is easier. They have all this surplus cash lying around - why not lend it out for a higher return, even if it gets them in hot water at times? It's hard to provide a tangible, desirable product or service to the marketplace, such as a new software application, home appliance, medical therapy, or even a cup of coffee. You have huge development and production costs, may need to file for patents (which could take years), conduct extensive safety and reliability testing, study consumer tastes, and comply with government regulations. And if things go wrong, you had better have deep pockets and some good lawyers/lobbyists. With lending, all you need are a few PCs and MBAs. I know I'm being simplistic, but you can't deny that the infrastructure needs of a company like Citi are much less than ExxonMobil or Toyota.
I know economics is all about maximizing efficiency, so in a sense it rewards "easy money". I guess that is why we may never totally expunge financial "gimmicks" from our society, and it seems that regulators are always playing catch-up as new scams emerge just as the old ones are finally contained. I guess this is the price we pay for freedom and democratic capitalism. ExxonMobil has to search for new oil fields, build wells, pay royalties, and find ways to get the product to buyers in a safe, legal, and cost-effective manner. Investment banks just move numbers on a board, albeit through very ballsy, high-stakes, and heavily-researched transactions. Easy money? There must be a reason why the median salary at places like Goldman Sachs is higher than even highly respected, productive companies like Google or Amazon. A neurosurgeon or Silicon Valley engineer might make good money, but it pales in comparison to the next innovative investment vehicle or shady tax shelter conceived by Wall Street. Maybe that's why the financial sector is the most powerful in our economy, even though it doesn't really do anything tangible. Everyone wants more money, and to grow the money they have. Surely there is a large demand for their services, which is why they exist, but I don't know how we can justify the power they wield. No other industry can bring global commerce to a halt and billions of people to their knees with a simple error.]
Showing posts with label credit. Show all posts
Showing posts with label credit. Show all posts
Friday, October 3, 2008
Saturday, September 20, 2008
Newsweek comments about bailouts
WHEN DOES A COMPANY QUALIFY FOR A BAILOUT?
http://www.newsweek.com/id/158615
Wall Street is consumed with the subject of bailouts. As analysts chewed over the implications of the government's decision to assume the debt of ailing mortgage giants Fannie Mae and Freddie Mac, traders (and their real-estate brokers) wondered whether erstwhile titans Lehman Brothers and Washington Mutual would be next in line for government assistance. Meanwhile, lobbyists for the big three automakers were refining their pitches for $25 billion in loan guarantees. It is sure to be another long weekend for Treasury Secretary Henry Paulson.
Bailouts—the government's stepping in and providing financial assistance or credit guarantees to private-sector companies—are a highly confusing subject. As policymakers hasten to save some companies from the ravages of creative destruction, they leave others to fail. Some 5,644 businesses went bankrupt in July, up 80 percent from July 2007. So are there some objective criteria we can use to determine whether the government will toss a lifeline to a particular company?
It's a truism that the bigger you are, and the more you owe, the more forbearance you're likely to get. In 1984, when Continential Illinois, whose reckless lending practices had catapulted it into the ranks of the nation's 10 largest banks, ran into trouble, the government bought some of its loans and provided extraordinary compensation to depositors. "We have a new kind of bank," complained Fernand St. Germain, a congressman from Rhode Island, "It is called too big to fail." (St. Germain, who shepherded the bill that deregulated the savings-and-loan industry, would be blamed in part for the record-setting bailout of S&Ls later that decade).
But these days, size alone doesn't matter. Earlier this decade, Enron, WorldCom, and Global Crossing, three gargantuan companies, went bust while the government looked the other way. Of course, when the aforementioned companies filed for Chapter 11, nobody lost electricity or was unable to make a phone call. "But if the government envisions that a failure will have a serious adverse consequence on the economy, it's going to step in," said Benton Gup, a professor of banking at the University of Alabama and editor of the collection Too Big To Fail: Policies and Practices in Government Bailouts.
For that reason, certain types of financial institutions are much more likely to be helped than others. A bank that lends to people with dodgy credit in California doesn't pose much of a threat to the Davos crowd. But financial intermediaries like Bear Stearns and the FM twins function like the heart of the global financial system. If they go into cardiac arrest, the whole body is in danger. Since Bear Stearns was a counterparty to (and guarantor of) trades and financial arrangements with the world's major financial players, its failure would have triggered a cascade of losses. In the same vein, huge quantities of the $5.4 trillion in debt issued and insured by Fannie Mae and Freddie Mac sit on the balance sheets of central banks and financial institutions around the globe. For the U.S. government simply to let this debt—which it had been implicitly backing for decades—go bad would have meant inflicting severe damage on America's most significant diplomatic and trading partners. Fannie Mae wasn't too big to fail, one Wall Street wag told me this week. It was too Chinese to fail.
To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients' cash. It got a bailout. Lehman Brothers, which has taken painful measures to reduce its risk, is perversely less likely to get direct government help. "The worst Lehman can do is destroy the firm," said Barry Ritholtz, CEO of Wall Street research firm FusionIQ and author of the forthcoming Bailout Nation. "Bear Stearns, on the other hand, set up the firm so that if they screwed up, they could threaten the entire financial system." That may explain why Treasury Secretary Paulson has thus far resisted providing federal succor to Lehman.
Finally, companies seeking the tender mercies of the taxpayer must have good timing. Nearly all the great corporate bailouts of modern times have come in election years. Congress enacted loan guarantees for Chrysler in January 1980, ensuring that a company that employed about 130,000 people, many of them in the swing state of Michigan, would not go bust on the eve of primary season. So, if your company is in trouble, what should you do? Double down. Establish links to other firms. Export your products with abandon. And hustle. There are only seven more weeks until the election.
PERSONAL NARRATIVES AND EMOTIONS IN ELECTION PSYCHOLOGY
http://www.newsweek.com/id/158749
Narratives have been used to attract voters at least since Lincoln's campaign managers cast him as the rugged rail-splitter from the country's frontier, not the prosperous railroad lawyer and sophisticated writer he was, notes historian Michael Beschloss: voters are drawn to someone they can relate to, and the way to make that happen is by offering them stories. (The human brain is wired so that we can follow a chain of events that have people doing things in chronological order more easily than we can follow abstractions.) But the power of the narrative has grown as party identification has weakened—putting more voters in play—and as the culture has changed. Television has made voters expect to, and think they can, "see into people's souls to take their measure," says Beschloss. To do that, "they need clues," and there are few clues so potent as the challenges a person has faced and how he or she has met them. "The feeling that we need to know who these people are has become so enormous that a good part of Sarah Palin's appeal is her life history, the choices she made, things that let voters form a bond with her," says Beschloss.
The outsized power of the personal narrative today compared with even a generation ago (in 1980, Ronald Reagan ran not on personal narrative, but on hope and the promise of change) reflects something that has become almost a cliché in political analysis—namely, that emotions, more than a dispassionate and rational analysis of candidates' records and positions, determine many voters' choice on election day. The emotion can be hope or fear, pride or disgust. And don't be too quick to pat yourself on the back for thinking you cast your vote based on a logical parsing of a candidate's positions. For all but the most wonkish wonks, what matters is how the prospect of pulling out of Iraq or expanding oil drilling or any other policy makes you feel, and not a pro-and-con analysis of its pluses and minuses, which few people can figure out.
All of this has been true for decades. What's new is that the circumstances of this election have conspired to push people away from the reason- and knowledge-based system of decision-making and more down the competing emotion-based one. The latter is more ancient and has, throughout the course of human evolution, "assured our survival and brought us to where we are," says neuroscientist Antonio Damasio of the University of Southern California, a pioneer in the study of human emotions and decision-making. ...One of the most salient circumstances of this campaign is the sheer amount of information voters are bombarded with, says Damasio. You can barely pass a screen (TV or computer) or overhear a radio without being pummeled with the latest brouhaha over lipstick-wearing pigs or which candidate was cozier with lobbyists for the failed mortgage giants. When FDR was making radio addresses, "people had the time needed for reflection, to mix emotion with facts and reason," says Damasio. "But now, with 24-hour cable news and the Web, you have a climate in which you don't have time to reflect. The amount and speed of information, combined with less time to analyze every new development, pushes us toward the emotion-based decision pathway." And not even emotions such as hope. Voters are being driven "by pure like and dislike, comfort or discomfort with a personality," says Damasio. "And voters judge that by a candidate's narrative."
Friday, May 30, 2008
More causes to the subprime crisis, but why do we always find out too late?
http://www.npr.org/templates/story/story.php?storyId=90840958
Auditor: Supervisors Covered Up Risky Loans
by Chris Arnold
Morning Edition, May 27, 2008 · Now that millions of people are facing foreclosure because they got into loans that never should have been approved, everybody's looking for someone to blame. Borrowers, or their brokers, lied on loan applications. Others got high interest rates they couldn't afford.
A big unanswered question is whether the Wall Street investment banks that were packaging these mortgages knew they were selling garbage loans to investors. A wave of litigation is starting against these firms. One former worker whose job was to catch bad loans says her supervisors covered them up.
Mortgage Quality Control
Tracy Warren is not surprised by the foreclosure crisis. She saw the roots of it firsthand every day. She worked for a quality-control contractor that reviewed subprime loans for investment banks before they were sold off on Wall Street.
It was her job to dig into the loans and ferret out problems. By 2006, they were easy to find.
"I'd see people who were hotel workers saying that they made, in California, making $15,000 a month so that they could qualify for a $500,000 home," Warren says. "If a hotel worker is making $15,000 a month changing sheets at the Days Inn, everybody would want to do it. It just really made no sense."
Warren has worked in the mortgage business for 25 years, the past five in quality control. Most recently, she was a contract worker for a company called Watterson-Prime, which did loan audits for investment banks. She says their biggest client was Bear Stearns, which recently all but collapsed because of its exposure to bad loans.
Putting Bad Apples Back in the Barrel
Warren thinks her supervisors didn't want her to do her job. She says that when she would reject, or kick out, a loan, they usually would overrule her and approve it.
"The QC reviewer who reviewed our kicks would say, 'Well, I thought it had merit.' And it was like 'What?' Their credit score was below 580. And if it was an income verification, a lot of times they weren't making the income. And it was like, 'What kind of merit could you have determined?' And they were like, 'Oh, it's fine. Don't worry about it.' "
After a while, Warren says, her supervisors stopped telling her when she had been overruled. She figured it out by going back later and pulling the loans up on her computer.
"I would look every couple of days, and just see, if it was a loan that I thought was a bad loan, I'd go back and see if it was pulled."
About 75 percent of the time, loans that should have been rejected were still put into the pool and sold, she says.
'A Smoking Gun'
Some legal experts say it's a pretty big deal that people like Warren are willing to talk.
"This is a smoking gun," says Christopher Peterson, a law professor at the University of Utah who has been studying the subprime mess and meeting with regulators. "It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud."
Bear Stearns had no comment.
The loan-auditing firm Watterson-Prime's parent company, Fidelity National Information Services, provided a statement. It says the company has no incentive to give loans a passing review if they fail to meet underwriting criteria and that it uses additional quality-control measures to further check up on loan reviews.
But Peterson says such breakdowns in quality control must have happened at a lot of companies. How else did millions of people wind up in loans that they can't pay?
"People have a tendency to think about economic trends as though they're an uncontrollable force that no one understands. This isn't the weather. These are people who are individually making decisions to approve and pass on fraudulent loans," he says.
Accountability on Wall Street
Peterson said auditors like Warren basically were hired to find the bad apples in the barrel and pull them out: borrowers with payments they couldn't afford, houses with inflated appraisals, people lying about their income.
But Warren says her bosses were taking a lot of those bad apples and putting them back in. And Peterson says he thinks the investment banks had a strong financial incentive to do that.
"They put the bad apples back in the barrel because they knew that they could sell the bad apples along with the good apples and, at least in the short term, nobody would know the difference. That's why they put them back in — because they made more money that way," Peterson says.
"There's a name for this — it's called 'passing the trash,' " says David Grais, an attorney getting ready to sue Wall Street firms on behalf of investors — big pension funds and others — who bought the bad loans.
"These were immensely profitable deals. One study showed that the investment banks were making a 40 percent return on equity every two months on these securitizations, which is an eye-popping number," he says.
Grais says many people on Wall Street make huge bonuses when their business unit is making big money. So the faster they could package up loans — good, bad or ugly ones — and sell them to investors, the more money that they made, he says.
Warren thinks her managers got bonuses for how quickly they reviewed loans, not for how many bad loans they caught.
Watterson-Prime disputes that. It says its managers, staff and contractors are compensated on an hourly or salary basis and never by the number of loans reviewed.
Report: Banks Agreed to Limit Loan Rejections
Other evidence is emerging.
A bankruptcy examiner in the case of the collapsed subprime lender New Century recently released a 500-page report, and buried inside it is a pretty interesting detail. According to the report, some investment banks agreed to reject only 2.5 percent of the loans that New Century sent them to package up and sell to investors.
If that's true, it would be like saying no matter how many bad apples are in the barrel, only a tiny fraction of them will be rejected.
"It's amazing if any investment bank agreed to a maximum number of loans they would kick back for defects. That means that they were willing to accept junk. There's no other way to put it," says Kurt Eggert, a law professor at Chapman University.
Meanwhile, the attorney general in New York and other prosecutors are taking a look at all of this. They, too, want to know whether Wall Street firms were covering up bad loans and selling them to investors.
Analysis: Lenders, Investors, Buyers Fed Loan Crisis
by Robert Smith and Adam Davidson
Morning Edition, May 27, 2008 · Co-host Robert Smith talks to NPR's Adam Davidson about how lenders, investors and buyers all contributed to the subprime mortgage crisis.
Davidson says everyone at every step of the chain acted irresponsibly, "taking on way more risk than was appropriate." He says he has interviewed dozens of homeowners, subprime home buyers who bought way more house than they could afford, who said they knew they were taking on more risk than was reasonable. And the mortgage brokers and mortgage banks knew, too.
Brokers didn't mind the extreme risk because they were passing on loans quickly to the banks; banks didn't mind because they were passing on the loans to Wall Street. Wall Street knew about the extreme risk but was passing it on to global investors, many of whom said they weren't paying enough attention because they trusted the credit rating agencies — but now those agencies admit that their models were flawed and faulty, Davidson says.
Many thought the reward would outweigh the risk, he says. Everyone "was making massive amounts of money — you're talking about 25-year-old kids who don't have a college degree making over a million a year."
Shady Practices Led to New Century Financial's Fall
by Carrie Kahn
Morning Edition, March 27, 2008 · Two years ago, New Century Financial was the country's second largest subprime mortgage lender. Now, it's in bankruptcy, and a new report mandated by the bankruptcy court shines light on the company's shady practices.
Business
New Century's Risky Lending Practices Detailed
by Chris Arnold
All Things Considered, March 26, 2008 · Before the mortgage company New Century went bankrupt last year, it was the second-largest sub-prime lender in the country. A court-appointed examiner released a new report Wednesday that finds widespread wrongdoing at the company and also alleges negligence by the company's auditor KPMG.
The report says New Century had a brazen obsession with selling more loans without due regard to the risks.
Michael J. Missal, the examiner appointed to dig into New Century's collapse as part of the bankruptcy process, says, "What we found was it really shows the embryo of the credit crisis and how easy it was to originate very risky loans and put them into the financial system."
In its quest for new customers, New Century made increasingly unwise loans, according to the report. Borrowers incomes weren't documented. Loans were offered for the full value of a house. Missal adds, "They took risky products — made them that much riskier — and essentially created a ticking time bomb that exploded in 2007 as the market was changing."
Missal was also charged with finding causes for lawsuits that creditors might pursue. He named New Century's accounting firm, KPMG:
"Their independent auditors, KPMG, were supposed to be there to test and be skeptical of the way New Century was doing business. I found that KPMG failed to do so and a cause of action may exist."
A spokesman for KPMG says the report needs to be reviewed.
Missal says executives at New Century also failed in their oversight responsibilities and engaged in improper accounting. He says top executives were paid millions of dollars in bonuses that were calculated based on inaccurate financial statements.
The SEC and Department of Justice are both investigating New Century.
A Lot of Blame to Share in Subprime Sinkhole
http://www.npr.org/templates/story/story.php?storyId=12847198
All Things Considered, August 16, 2007 · Robert Siegel talks with Financial Times reporter Saskia Scholtes about the article "As Subprime Bites, U.S. Investigators Look for Culprits."
Scholtes, and colleague Brooke Masters, found fraud at myriad levels of the market, from borrowers who overstate their incomes, to fraudulent companies that offer help to lie about income, to lenders who don't bother to check.
As subprime bites, US investigators look for culprits
By Brooke Masters and Saskia Scholtes
Wednesday Aug 8 2007 14:05
http://us.ft.com/ftgateway/superpage.ft?news_id=fto080820071539268198
At the height of the US subprime lending boom, taking out a mortgage could not have been easier. Low credit score and history of bankruptcy? No problem. Income too low to qualify for a mortgage? Inflate what you earn on a "stated income" loan. Nervous that your lender might check up on your "stated income"? Visit www.verifyemployment.net.
For a $55 fee, the operators of this small California company will help you get a loan by employing you as an "independent contractor". They provide payslips as "proof" of income and, for an additional $25, they also man the telephones to give you a glowing reference should your lender need it.
But perhaps the most absurd aspect of the US subprime mortgage market in recent years is that lenders became so generous with credit provision for out-of-pocket borrowers that very few checks were ever made.
That left the system extraordinarily vulnerable to widespread fraud, a possibility that federal and state prosecutors across the US have begun to look into. With the subprime crisis expected to cost investors between $50bn (£24bn, €36bn) and $100bn, according to the US Federal Reserve, these investigations could transform it from a market correction to a full-blown national scandal.
At the root of the subprime problem was easy credit: lenders and their brokers were often rewarded for generating new mortgages on the basis of volume, without being directly exposed to the consequences of borrowers defaulting. During several years of strong capital markets and strong investor appetite for high-yielding securities, lenders became accustomed to easily selling the risky home loans they made to Wall Street banks. The banks in turn packaged them into securities and sold them to investors around the globe.
Such ease of mortgage funding allowed thousands of borrowers to get away with fraudulently mis-stating their incomes, often with the encouragement of their brokers. More ambitious fraudsters appear to have taken out multiple mortgages and walked away with the cash.
Karen Gelernt, a partner at law firm Cadwalader, Wickersham & Taft, says: "The difficulty is getting a handle on the size of the problem, because there is no real mechanism for reporting fraud for most originators in this market. In fact, they had every incentive not to report."
Fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the value of the properties involved.
"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers. With mortgage rates rising and house prices falling, subprime borrowers have been defaulting at record rates.
The fallout is working its way up from the retail level – forcing people out of their homes and lenders into bankruptcy. Investment banks have lost revenue as investors back away from mortgage securities and a handful of high-profile hedge funds have collapsed – most notably two highly leveraged funds managed by
Bear Stearns (NYSE:BSC) . The crisis has contributed to turmoil in financial markets in recent weeks and could threaten the health of the US economy as lenders tighten access to credit, putting a drag on consumer spending.
For some, this rapid and dramatic unravelling of the subprime lending industry has echoes of the costly savings and loans crisis of the early 1980s – a meltdown that also had its origins in financial market innovation and inadequate oversight, and which many cite as a contributing factor in the 1990-91 economic recession. That crisis ended with a federal bail-out of $150bn and a handful of high-profile convictions for fraud.
This time around, the major losers have been hedge funds, which in theory are limited to wealthy investors. But some analysts believe the pain could spread – many pension funds and college endowments have turned to hedge funds to heat up their returns and some, including Harvard University, are starting to get their fingers burned. Harvard is estimated to have lost $350m of the $550m it invested in a hedge fund run by Jeffrey Larson, a former Harvard money manager, that collapsed recently as a result of positions related to the subprime market.
If the losses trickle down and end up hurting small investors, pressure may grow for a public bail-out. Rumours swept the market earlier this week that Fannie Mae (NYSE:FNM) and Freddie Mac, the government-backed mortgage agencies, might get the authority to make sweeping purchases of underpriced mortgage securities.
"The US mortgage landscape has become a top-of-mind political talking point, and we would not be surprised to see the usual 'flow like mud' legislative process fast-tracked with respect to items offering relief to the troubled mortgage market," says Louise Purtle, strategist at CreditSights, a research firm.
Most fraud in subprime lending appears to have been so-called "fraud for purchase" – lying about income so as to win a mortgage approval. In reviewing a sample of "no doc" loans that relied on borrowers' statements, the Mortgage Asset Research Institute recently found that almost all would-be home owners had exaggerated their income, with almost 60 per cent inflating it by more than 50 per cent.
These fraudulent borrowers are often difficult to uncover, says Ms Gelernt, because they often stretch to meet their minimum payments for some time before they eventually default. The time lag between initial fraud and default also makes a conviction hard to obtain, she adds, while mortgage investors also have little chance of recovering their losses from individual borrowers in these circumstances.
Many of the originators to blame for poor quality control standards may not be held to account either – with several such lenders already in bankruptcy. "There's a real problem in finding fraud after the fact because the money is already out the door and you won't get the recovery," says Ms Gelernt.
Loose lending standards also facilitated fraud for profit. US prosecutors around the country have broken up at least a dozen mortgage fraud rings and more cases are expected.
In one New York case, the FBI charged 26 people who used stolen identities, invented purchasers and inflated appraisals to obtain subprime loans on more than $200m of property. In an Ohio case, 49 per cent of the mortgages processed by a single broker never made even a first payment.
The fate of a series of North Carolina neighbourhoods built by Beazer Homes (NYSE:BZH) may offer a foretaste of the looming problem. Low income home-buyers around Charlotte have sued the builder alleging that its lending arm steered them into mortgages they could not afford, leading to widespread foreclosures.
The homeowners allege that sales agents misrepresented their personal data, including assets and income, to help them qualify for government-insured mortgages starting in 2002. By the beginning of this year, 10 Beazer subdivisions in Charlotte had foreclosure rates of 20 per cent or higher, compared with 3 per cent state-wide, according to a local newspaper analysis.
The FBI is probing Beazer for possible fraud and the US Housing and Urban Development is examining whether its sales practices violated government-insured mortgage rules. Beazer has defended its sales practices and says it has a "commitment to managing and conducting business in an honest, ethical and lawful manner". In June it announced that it had fired its chief accounting officer for allegedly attempting to destroy documents. The company's shares have lost 75 per cent of their value since the probes began.
Several state attorneys-general are also on the trail. Andrew Cuomo of New York state made headlines this spring with a series of subpoenas to property appraisal companies and has said publicly that he is probing the entire industry. Sources familiar with the office's work say the investigation is still at a relatively early stage.
Marc Dann, the Ohio attorney- general, is looking further up the funding chain. He has been outspoken in his criticism of the role the financial services industry may have played in the large numbers of foreclosures in his state. "There's a whole series of people that knew or should have known that there was fraud in the acquisition of these mortgages," Mr Dann told the Financial Times. "We're looking at ways to hold everybody who aided and abetted that fraud."
Mr Dann's office is looking at brokers, appraisers, rating agencies and securitisers and plans to use several legal methods to hold bad actors accountable. The Ohio attorney-general not only has criminal enforcement powers, but also represents the third-largest set of public pensions in the country and can thus file civil lawsuits on behalf of investors.
"But for the mechanism of packaging these loans, the fraud never would have existed," Mr Dann says. "We're following this trail from homeowner to bondholder." He says his investigation could take six months to a year to bear fruit.
The Securities and , for its part, is investigating whether Bear Stearns and other hedge fund managers were forthright about disclosing the rapidly declining value of their holdings.
Many of the mortgage-related securities bought by the hedge funds are rarely traded and difficult to value accurately. They are often valued in portfolios according to complex mathematical models because real market prices are not available, making it possible to disguise underperformance if models are not updated.
The SEC has not brought a case in the area so far, but current and former regulators note that it has previously won settlements from several mutual funds and banks that failed to revise the prices of illiquid assets during a falling market.
Private securities lawyers are also starting to file securities fraud lawsuits on behalf of investors who have lost out because of the subprime meltdown.
Jake Zamansky, a lawyer who negotiated an early settlement from Merrill Lynch in the scandal over skewed investment bank research, has filed an arbitration claim against Bear Stearns alleging the firm misled investors about its exposure to the mortgage-backed securities market.
The class action law firm of Bernstein Litowitz is also preparing a claim against Bear Stearns, alleging the firm made material mis-statements in the offering documents for its now defunct hedge funds.
"This was simply about a hedge fund strategy that failed," said a Bear Stearns spokesman. "We plan on defending ourselves vigorously against the allegations in these complaints."
Other hedge funds may also come under political or legal pressure over their role in the loan crisis.
Richard Carnell, a professor at Fordham law school, says it may be possible to hold the investment banks that securitised the mortgages at least partially responsible in the case of a major collapse of the market. "There are two things you can object to in the securitisers' conduct: failing to disclose material facts about the credit quality of the mortgages; and you can also criticise them for acting as an enabler for someone they know is a bad actor," he says.
But putting together a case will not be easy because the hedge funds and other investors who bought such securities are presumed to be sophisticated about financial matters. This means it will be harder for them to prove they were not properly warned about the risks involved.
In the case of the Bear Stearns funds, investors may face new hurdles to recovering any money through US lawsuits. Though the funds operated mostly in New York, they were incorporated in the Cayman Islands and that is where they have filed for bankruptcy. In what could be a test case for international bankruptcy laws, the liquidators have applied to the US courts asking them to block US lawsuits during the liquidation process.
Bear Stearns said in a statement: "Because the two funds are incorporated in the Cayman Islands, the funds' boards filed for liquidation there . . . The return to creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing."
Even if the US lawsuits do go forward, a case pending before the Supreme Court could also prove crucial to investors who hope to make a case that hedge funds and rating agencies enabled widespread fraud.
In Stoneridge Investment Partners v Scientific Atlanta, the court is considering whether investors can recover from firms – including accountants, lawyers and bankers – that help a public company commit fraud by participating in a "scheme to defraud". If the high court rules against "scheme liability", investors who lost money in the subprime market will have very few places to turn to try to get some of it back.
William Poole of the Federal Reserve Bank of St. Louis thinks that this may be what investors who lose money on subprime mortgage-linked securities deserve for not looking at them closely enough.
Criticising Wall Street underwriting standards recently, he said: "The punishment has been meted out to those who have done misdeeds and made bad judgments. We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.''
RISING PRICES OFFSET A BRITISH SUBPRIME SNIFFLE
Last month some of the most senior figures in the UK mortgage industry gathered at London's Royal Albert Hall for a glittering awards dinner, writes Jane Croft.
Entertainment was provided by British comedian Al Murray and a colourful troupe of can-can dancers. But in spite of the celebratory mood, the chatter soon turned to recent findings by the UK's Financial Services Authority on problems with subprime mortgages. The regulator had said it was "very concerned" about "the high level of subprime arrears in a benign market" and had uncovered "weaknesses" in lending practices.
The level of defaults has been much lower than across the Atlantic – partly because the UK subprime market is much smaller, accounting for around 8 per cent of mortgages compared with 20 per cent in the US.
However, a recent report by Standard & Poor's showed overall arrears and repossession rates in the British subprime sector rising. The rating agency's non-conforming Residential Mortgage Backed Securities (RMBS) index tracks the performance of subprime mortgages securitised into capital markets. It found 10.5 per cent of loans in the first quarter of 2007 were more than 90 days in arrears – up from 7 per cent in 2004.
This is still far below the US, where research by the Centre for predicts that one in five subprime mortgages made in the past two years will end in foreclosure.
A big concern raised by the FSA is whether UK mortgage brokers and lenders are properly assessing how much borrowers can afford to pay back each month. While he acknowledges there are key differences between the US and UK, Clive Briault, managing director of retail markets at the FSA, admitted recently that "we cannot completely ignore the parallels with our own market".
The FSA is also concerned that rising house prices are encouraging some over-indebted borrowers to increase their levels of debt by borrowing against their property.
In its review, the FSA examined 11 lenders and 485 case files at 34 mortgage brokers. It found that in a third of the files, brokers had made an "inadequate assessment" of the customers' ability to afford the loan. It also found failings amongst lenders that resulted in "the approval of potentially unaffordable mortgages".
Figures from the Council of last week showed that home repossessions jumped 30 per cent year-on-year, rising to 14,000 in the first half of 2007. The industry body said some of the increase was due to rising defaults on subprime mortgages. Indeed, a third of the possession hearings in one local study by the Citizens Advice Bureau last year were brought by subprime mortgage lenders.
The buoyancy of the UK market, at least, means there is still an escape route. "House prices have not been impacted as they have in the US," says Andrew South, an analyst at S&P. "That gives borrowers more refinancing options if they get into difficulties."
Auditor: Supervisors Covered Up Risky Loans
by Chris Arnold
Morning Edition, May 27, 2008 · Now that millions of people are facing foreclosure because they got into loans that never should have been approved, everybody's looking for someone to blame. Borrowers, or their brokers, lied on loan applications. Others got high interest rates they couldn't afford.
A big unanswered question is whether the Wall Street investment banks that were packaging these mortgages knew they were selling garbage loans to investors. A wave of litigation is starting against these firms. One former worker whose job was to catch bad loans says her supervisors covered them up.
Mortgage Quality Control
Tracy Warren is not surprised by the foreclosure crisis. She saw the roots of it firsthand every day. She worked for a quality-control contractor that reviewed subprime loans for investment banks before they were sold off on Wall Street.
It was her job to dig into the loans and ferret out problems. By 2006, they were easy to find.
"I'd see people who were hotel workers saying that they made, in California, making $15,000 a month so that they could qualify for a $500,000 home," Warren says. "If a hotel worker is making $15,000 a month changing sheets at the Days Inn, everybody would want to do it. It just really made no sense."
Warren has worked in the mortgage business for 25 years, the past five in quality control. Most recently, she was a contract worker for a company called Watterson-Prime, which did loan audits for investment banks. She says their biggest client was Bear Stearns, which recently all but collapsed because of its exposure to bad loans.
Putting Bad Apples Back in the Barrel
Warren thinks her supervisors didn't want her to do her job. She says that when she would reject, or kick out, a loan, they usually would overrule her and approve it.
"The QC reviewer who reviewed our kicks would say, 'Well, I thought it had merit.' And it was like 'What?' Their credit score was below 580. And if it was an income verification, a lot of times they weren't making the income. And it was like, 'What kind of merit could you have determined?' And they were like, 'Oh, it's fine. Don't worry about it.' "
After a while, Warren says, her supervisors stopped telling her when she had been overruled. She figured it out by going back later and pulling the loans up on her computer.
"I would look every couple of days, and just see, if it was a loan that I thought was a bad loan, I'd go back and see if it was pulled."
About 75 percent of the time, loans that should have been rejected were still put into the pool and sold, she says.
'A Smoking Gun'
Some legal experts say it's a pretty big deal that people like Warren are willing to talk.
"This is a smoking gun," says Christopher Peterson, a law professor at the University of Utah who has been studying the subprime mess and meeting with regulators. "It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud."
Bear Stearns had no comment.
The loan-auditing firm Watterson-Prime's parent company, Fidelity National Information Services, provided a statement. It says the company has no incentive to give loans a passing review if they fail to meet underwriting criteria and that it uses additional quality-control measures to further check up on loan reviews.
But Peterson says such breakdowns in quality control must have happened at a lot of companies. How else did millions of people wind up in loans that they can't pay?
"People have a tendency to think about economic trends as though they're an uncontrollable force that no one understands. This isn't the weather. These are people who are individually making decisions to approve and pass on fraudulent loans," he says.
Accountability on Wall Street
Peterson said auditors like Warren basically were hired to find the bad apples in the barrel and pull them out: borrowers with payments they couldn't afford, houses with inflated appraisals, people lying about their income.
But Warren says her bosses were taking a lot of those bad apples and putting them back in. And Peterson says he thinks the investment banks had a strong financial incentive to do that.
"They put the bad apples back in the barrel because they knew that they could sell the bad apples along with the good apples and, at least in the short term, nobody would know the difference. That's why they put them back in — because they made more money that way," Peterson says.
"There's a name for this — it's called 'passing the trash,' " says David Grais, an attorney getting ready to sue Wall Street firms on behalf of investors — big pension funds and others — who bought the bad loans.
"These were immensely profitable deals. One study showed that the investment banks were making a 40 percent return on equity every two months on these securitizations, which is an eye-popping number," he says.
Grais says many people on Wall Street make huge bonuses when their business unit is making big money. So the faster they could package up loans — good, bad or ugly ones — and sell them to investors, the more money that they made, he says.
Warren thinks her managers got bonuses for how quickly they reviewed loans, not for how many bad loans they caught.
Watterson-Prime disputes that. It says its managers, staff and contractors are compensated on an hourly or salary basis and never by the number of loans reviewed.
Report: Banks Agreed to Limit Loan Rejections
Other evidence is emerging.
A bankruptcy examiner in the case of the collapsed subprime lender New Century recently released a 500-page report, and buried inside it is a pretty interesting detail. According to the report, some investment banks agreed to reject only 2.5 percent of the loans that New Century sent them to package up and sell to investors.
If that's true, it would be like saying no matter how many bad apples are in the barrel, only a tiny fraction of them will be rejected.
"It's amazing if any investment bank agreed to a maximum number of loans they would kick back for defects. That means that they were willing to accept junk. There's no other way to put it," says Kurt Eggert, a law professor at Chapman University.
Meanwhile, the attorney general in New York and other prosecutors are taking a look at all of this. They, too, want to know whether Wall Street firms were covering up bad loans and selling them to investors.
Analysis: Lenders, Investors, Buyers Fed Loan Crisis
by Robert Smith and Adam Davidson
Morning Edition, May 27, 2008 · Co-host Robert Smith talks to NPR's Adam Davidson about how lenders, investors and buyers all contributed to the subprime mortgage crisis.
Davidson says everyone at every step of the chain acted irresponsibly, "taking on way more risk than was appropriate." He says he has interviewed dozens of homeowners, subprime home buyers who bought way more house than they could afford, who said they knew they were taking on more risk than was reasonable. And the mortgage brokers and mortgage banks knew, too.
Brokers didn't mind the extreme risk because they were passing on loans quickly to the banks; banks didn't mind because they were passing on the loans to Wall Street. Wall Street knew about the extreme risk but was passing it on to global investors, many of whom said they weren't paying enough attention because they trusted the credit rating agencies — but now those agencies admit that their models were flawed and faulty, Davidson says.
Many thought the reward would outweigh the risk, he says. Everyone "was making massive amounts of money — you're talking about 25-year-old kids who don't have a college degree making over a million a year."
Shady Practices Led to New Century Financial's Fall
by Carrie Kahn
Morning Edition, March 27, 2008 · Two years ago, New Century Financial was the country's second largest subprime mortgage lender. Now, it's in bankruptcy, and a new report mandated by the bankruptcy court shines light on the company's shady practices.
Business
New Century's Risky Lending Practices Detailed
by Chris Arnold
All Things Considered, March 26, 2008 · Before the mortgage company New Century went bankrupt last year, it was the second-largest sub-prime lender in the country. A court-appointed examiner released a new report Wednesday that finds widespread wrongdoing at the company and also alleges negligence by the company's auditor KPMG.
The report says New Century had a brazen obsession with selling more loans without due regard to the risks.
Michael J. Missal, the examiner appointed to dig into New Century's collapse as part of the bankruptcy process, says, "What we found was it really shows the embryo of the credit crisis and how easy it was to originate very risky loans and put them into the financial system."
In its quest for new customers, New Century made increasingly unwise loans, according to the report. Borrowers incomes weren't documented. Loans were offered for the full value of a house. Missal adds, "They took risky products — made them that much riskier — and essentially created a ticking time bomb that exploded in 2007 as the market was changing."
Missal was also charged with finding causes for lawsuits that creditors might pursue. He named New Century's accounting firm, KPMG:
"Their independent auditors, KPMG, were supposed to be there to test and be skeptical of the way New Century was doing business. I found that KPMG failed to do so and a cause of action may exist."
A spokesman for KPMG says the report needs to be reviewed.
Missal says executives at New Century also failed in their oversight responsibilities and engaged in improper accounting. He says top executives were paid millions of dollars in bonuses that were calculated based on inaccurate financial statements.
The SEC and Department of Justice are both investigating New Century.
A Lot of Blame to Share in Subprime Sinkhole
http://www.npr.org/templates/story/story.php?storyId=12847198
All Things Considered, August 16, 2007 · Robert Siegel talks with Financial Times reporter Saskia Scholtes about the article "As Subprime Bites, U.S. Investigators Look for Culprits."
Scholtes, and colleague Brooke Masters, found fraud at myriad levels of the market, from borrowers who overstate their incomes, to fraudulent companies that offer help to lie about income, to lenders who don't bother to check.
As subprime bites, US investigators look for culprits
By Brooke Masters and Saskia Scholtes
Wednesday Aug 8 2007 14:05
http://us.ft.com/ftgateway/superpage.ft?news_id=fto080820071539268198
At the height of the US subprime lending boom, taking out a mortgage could not have been easier. Low credit score and history of bankruptcy? No problem. Income too low to qualify for a mortgage? Inflate what you earn on a "stated income" loan. Nervous that your lender might check up on your "stated income"? Visit www.verifyemployment.net.
For a $55 fee, the operators of this small California company will help you get a loan by employing you as an "independent contractor". They provide payslips as "proof" of income and, for an additional $25, they also man the telephones to give you a glowing reference should your lender need it.
But perhaps the most absurd aspect of the US subprime mortgage market in recent years is that lenders became so generous with credit provision for out-of-pocket borrowers that very few checks were ever made.
That left the system extraordinarily vulnerable to widespread fraud, a possibility that federal and state prosecutors across the US have begun to look into. With the subprime crisis expected to cost investors between $50bn (£24bn, €36bn) and $100bn, according to the US Federal Reserve, these investigations could transform it from a market correction to a full-blown national scandal.
At the root of the subprime problem was easy credit: lenders and their brokers were often rewarded for generating new mortgages on the basis of volume, without being directly exposed to the consequences of borrowers defaulting. During several years of strong capital markets and strong investor appetite for high-yielding securities, lenders became accustomed to easily selling the risky home loans they made to Wall Street banks. The banks in turn packaged them into securities and sold them to investors around the globe.
Such ease of mortgage funding allowed thousands of borrowers to get away with fraudulently mis-stating their incomes, often with the encouragement of their brokers. More ambitious fraudsters appear to have taken out multiple mortgages and walked away with the cash.
Karen Gelernt, a partner at law firm Cadwalader, Wickersham & Taft, says: "The difficulty is getting a handle on the size of the problem, because there is no real mechanism for reporting fraud for most originators in this market. In fact, they had every incentive not to report."
Fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the value of the properties involved.
"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers. With mortgage rates rising and house prices falling, subprime borrowers have been defaulting at record rates.
The fallout is working its way up from the retail level – forcing people out of their homes and lenders into bankruptcy. Investment banks have lost revenue as investors back away from mortgage securities and a handful of high-profile hedge funds have collapsed – most notably two highly leveraged funds managed by
Bear Stearns (NYSE:BSC) . The crisis has contributed to turmoil in financial markets in recent weeks and could threaten the health of the US economy as lenders tighten access to credit, putting a drag on consumer spending.
For some, this rapid and dramatic unravelling of the subprime lending industry has echoes of the costly savings and loans crisis of the early 1980s – a meltdown that also had its origins in financial market innovation and inadequate oversight, and which many cite as a contributing factor in the 1990-91 economic recession. That crisis ended with a federal bail-out of $150bn and a handful of high-profile convictions for fraud.
This time around, the major losers have been hedge funds, which in theory are limited to wealthy investors. But some analysts believe the pain could spread – many pension funds and college endowments have turned to hedge funds to heat up their returns and some, including Harvard University, are starting to get their fingers burned. Harvard is estimated to have lost $350m of the $550m it invested in a hedge fund run by Jeffrey Larson, a former Harvard money manager, that collapsed recently as a result of positions related to the subprime market.
If the losses trickle down and end up hurting small investors, pressure may grow for a public bail-out. Rumours swept the market earlier this week that Fannie Mae (NYSE:FNM) and Freddie Mac, the government-backed mortgage agencies, might get the authority to make sweeping purchases of underpriced mortgage securities.
"The US mortgage landscape has become a top-of-mind political talking point, and we would not be surprised to see the usual 'flow like mud' legislative process fast-tracked with respect to items offering relief to the troubled mortgage market," says Louise Purtle, strategist at CreditSights, a research firm.
Most fraud in subprime lending appears to have been so-called "fraud for purchase" – lying about income so as to win a mortgage approval. In reviewing a sample of "no doc" loans that relied on borrowers' statements, the Mortgage Asset Research Institute recently found that almost all would-be home owners had exaggerated their income, with almost 60 per cent inflating it by more than 50 per cent.
These fraudulent borrowers are often difficult to uncover, says Ms Gelernt, because they often stretch to meet their minimum payments for some time before they eventually default. The time lag between initial fraud and default also makes a conviction hard to obtain, she adds, while mortgage investors also have little chance of recovering their losses from individual borrowers in these circumstances.
Many of the originators to blame for poor quality control standards may not be held to account either – with several such lenders already in bankruptcy. "There's a real problem in finding fraud after the fact because the money is already out the door and you won't get the recovery," says Ms Gelernt.
Loose lending standards also facilitated fraud for profit. US prosecutors around the country have broken up at least a dozen mortgage fraud rings and more cases are expected.
In one New York case, the FBI charged 26 people who used stolen identities, invented purchasers and inflated appraisals to obtain subprime loans on more than $200m of property. In an Ohio case, 49 per cent of the mortgages processed by a single broker never made even a first payment.
The fate of a series of North Carolina neighbourhoods built by Beazer Homes (NYSE:BZH) may offer a foretaste of the looming problem. Low income home-buyers around Charlotte have sued the builder alleging that its lending arm steered them into mortgages they could not afford, leading to widespread foreclosures.
The homeowners allege that sales agents misrepresented their personal data, including assets and income, to help them qualify for government-insured mortgages starting in 2002. By the beginning of this year, 10 Beazer subdivisions in Charlotte had foreclosure rates of 20 per cent or higher, compared with 3 per cent state-wide, according to a local newspaper analysis.
The FBI is probing Beazer for possible fraud and the US Housing and Urban Development is examining whether its sales practices violated government-insured mortgage rules. Beazer has defended its sales practices and says it has a "commitment to managing and conducting business in an honest, ethical and lawful manner". In June it announced that it had fired its chief accounting officer for allegedly attempting to destroy documents. The company's shares have lost 75 per cent of their value since the probes began.
Several state attorneys-general are also on the trail. Andrew Cuomo of New York state made headlines this spring with a series of subpoenas to property appraisal companies and has said publicly that he is probing the entire industry. Sources familiar with the office's work say the investigation is still at a relatively early stage.
Marc Dann, the Ohio attorney- general, is looking further up the funding chain. He has been outspoken in his criticism of the role the financial services industry may have played in the large numbers of foreclosures in his state. "There's a whole series of people that knew or should have known that there was fraud in the acquisition of these mortgages," Mr Dann told the Financial Times. "We're looking at ways to hold everybody who aided and abetted that fraud."
Mr Dann's office is looking at brokers, appraisers, rating agencies and securitisers and plans to use several legal methods to hold bad actors accountable. The Ohio attorney-general not only has criminal enforcement powers, but also represents the third-largest set of public pensions in the country and can thus file civil lawsuits on behalf of investors.
"But for the mechanism of packaging these loans, the fraud never would have existed," Mr Dann says. "We're following this trail from homeowner to bondholder." He says his investigation could take six months to a year to bear fruit.
The Securities and , for its part, is investigating whether Bear Stearns and other hedge fund managers were forthright about disclosing the rapidly declining value of their holdings.
Many of the mortgage-related securities bought by the hedge funds are rarely traded and difficult to value accurately. They are often valued in portfolios according to complex mathematical models because real market prices are not available, making it possible to disguise underperformance if models are not updated.
The SEC has not brought a case in the area so far, but current and former regulators note that it has previously won settlements from several mutual funds and banks that failed to revise the prices of illiquid assets during a falling market.
Private securities lawyers are also starting to file securities fraud lawsuits on behalf of investors who have lost out because of the subprime meltdown.
Jake Zamansky, a lawyer who negotiated an early settlement from Merrill Lynch in the scandal over skewed investment bank research, has filed an arbitration claim against Bear Stearns alleging the firm misled investors about its exposure to the mortgage-backed securities market.
The class action law firm of Bernstein Litowitz is also preparing a claim against Bear Stearns, alleging the firm made material mis-statements in the offering documents for its now defunct hedge funds.
"This was simply about a hedge fund strategy that failed," said a Bear Stearns spokesman. "We plan on defending ourselves vigorously against the allegations in these complaints."
Other hedge funds may also come under political or legal pressure over their role in the loan crisis.
Richard Carnell, a professor at Fordham law school, says it may be possible to hold the investment banks that securitised the mortgages at least partially responsible in the case of a major collapse of the market. "There are two things you can object to in the securitisers' conduct: failing to disclose material facts about the credit quality of the mortgages; and you can also criticise them for acting as an enabler for someone they know is a bad actor," he says.
But putting together a case will not be easy because the hedge funds and other investors who bought such securities are presumed to be sophisticated about financial matters. This means it will be harder for them to prove they were not properly warned about the risks involved.
In the case of the Bear Stearns funds, investors may face new hurdles to recovering any money through US lawsuits. Though the funds operated mostly in New York, they were incorporated in the Cayman Islands and that is where they have filed for bankruptcy. In what could be a test case for international bankruptcy laws, the liquidators have applied to the US courts asking them to block US lawsuits during the liquidation process.
Bear Stearns said in a statement: "Because the two funds are incorporated in the Cayman Islands, the funds' boards filed for liquidation there . . . The return to creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing."
Even if the US lawsuits do go forward, a case pending before the Supreme Court could also prove crucial to investors who hope to make a case that hedge funds and rating agencies enabled widespread fraud.
In Stoneridge Investment Partners v Scientific Atlanta, the court is considering whether investors can recover from firms – including accountants, lawyers and bankers – that help a public company commit fraud by participating in a "scheme to defraud". If the high court rules against "scheme liability", investors who lost money in the subprime market will have very few places to turn to try to get some of it back.
William Poole of the Federal Reserve Bank of St. Louis thinks that this may be what investors who lose money on subprime mortgage-linked securities deserve for not looking at them closely enough.
Criticising Wall Street underwriting standards recently, he said: "The punishment has been meted out to those who have done misdeeds and made bad judgments. We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.''
RISING PRICES OFFSET A BRITISH SUBPRIME SNIFFLE
Last month some of the most senior figures in the UK mortgage industry gathered at London's Royal Albert Hall for a glittering awards dinner, writes Jane Croft.
Entertainment was provided by British comedian Al Murray and a colourful troupe of can-can dancers. But in spite of the celebratory mood, the chatter soon turned to recent findings by the UK's Financial Services Authority on problems with subprime mortgages. The regulator had said it was "very concerned" about "the high level of subprime arrears in a benign market" and had uncovered "weaknesses" in lending practices.
The level of defaults has been much lower than across the Atlantic – partly because the UK subprime market is much smaller, accounting for around 8 per cent of mortgages compared with 20 per cent in the US.
However, a recent report by Standard & Poor's showed overall arrears and repossession rates in the British subprime sector rising. The rating agency's non-conforming Residential Mortgage Backed Securities (RMBS) index tracks the performance of subprime mortgages securitised into capital markets. It found 10.5 per cent of loans in the first quarter of 2007 were more than 90 days in arrears – up from 7 per cent in 2004.
This is still far below the US, where research by the Centre for predicts that one in five subprime mortgages made in the past two years will end in foreclosure.
A big concern raised by the FSA is whether UK mortgage brokers and lenders are properly assessing how much borrowers can afford to pay back each month. While he acknowledges there are key differences between the US and UK, Clive Briault, managing director of retail markets at the FSA, admitted recently that "we cannot completely ignore the parallels with our own market".
The FSA is also concerned that rising house prices are encouraging some over-indebted borrowers to increase their levels of debt by borrowing against their property.
In its review, the FSA examined 11 lenders and 485 case files at 34 mortgage brokers. It found that in a third of the files, brokers had made an "inadequate assessment" of the customers' ability to afford the loan. It also found failings amongst lenders that resulted in "the approval of potentially unaffordable mortgages".
Figures from the Council of last week showed that home repossessions jumped 30 per cent year-on-year, rising to 14,000 in the first half of 2007. The industry body said some of the increase was due to rising defaults on subprime mortgages. Indeed, a third of the possession hearings in one local study by the Citizens Advice Bureau last year were brought by subprime mortgage lenders.
The buoyancy of the UK market, at least, means there is still an escape route. "House prices have not been impacted as they have in the US," says Andrew South, an analyst at S&P. "That gives borrowers more refinancing options if they get into difficulties."
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