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The Great Gambling Goof and Your Government

The recent foreclosure news has led to an interesting divide between the federal government and the states. The Obama administration (which I generally favor) has come out against the “mortgage moratorium” while all 50 states are investigating mortgage fraud and most favor some type of freeze on foreclosure processing. Even several major banks have voluntarily suspended foreclosure processing pending internal investigations. To understand why the federal government (and a President who favors middle-class America) would oppose a foreclosure freeze, we must see the bigger picture.

For the very few who are really paying attention and grasp the size of the numbers involved, there’s a HUGE unresolved issue at the center of the collapse of our financial system – the great gambling goof. In simple terms, our major financial institutions invented a new type of gambling in hopes of making BIG bucks – known formally as derivatives[1] and informally as financial WMDs or weapons of mass [financial] destruction[2]. The banks decided to become insurers and sold insurance policies to investors to protect them against faulty investment products. Meanwhile, they were creating a new type of securitized[3] financial product known as Structured Investment Vehicles (SIVs) – a pool (or cesspool) of loans, bonds, mortgages, or other “assets” grouped such that riskier transactions (such as “zero-down” mortgages) were hidden behind “safer” transactions[4] (such as “mortgage backed securities” or MBSs).

For years, the market gobbled these SIVs up and banks were able to make large profits by using short-term funds to buy long-term assets, re-bundling these long-term assets as SIVs, and then selling both the investment vehicle AND insurance to protect the investor against faulty SIVs. This was gambling at its highest level in two forms: if the banks “over-leveraged” and bought too many long-term investments, they used up their liquid resources and if the products failed (defaulted), they had to pay out as the insurer.

Because this gambling was sufficiently lucrative (as in addictive), banks used funds that would have been loaned to businesses and used to service their increasing debt load to buy up more and more “toxic assets” for bundling into SIVs (profiting in the difference between the cost of the short-term money and the returns earned on the long-term assets). In this process, they were aided by the loan rating agencies who would take a cut in exchange for offering undeserved high ratings on risky products.

Then, in 2007, the market changed: the zero-down home buyers couldn’t make their payments as rates changed or reality prevailed over financial fakery (unemployed people were basically given free homes for a couple of years with the only risk being a hit to their already low credit score). The traditional buyers for the SIVs either refused to buy or wanted better insurance to protect their investment. Increasingly desperate banks continued to insure SIVs that they should have known were likely to default. When major banks like Bank of America, Citibank, Bear Stearns, and Morgan Stanley began to reveal the dangerously large amount of these SIVs they couldn’t sell, the market began its collapse.

By 2008, Lehman Brothers, AIG and other massive financial companies knew they couldn’t survive the pending collapse as investors began to make claims on their insurance policies (the CDSs). By that time, credit default swaps were the lion’s share of a derivatives market worth over $500 trillion[5] or about 10 times the value of the entire world's wealth. In other words, the financial institutions had underwritten insurance policies on defective financial products (that they often created) at a value 2000-4000 times greater than they could possibly cover.

There is no parallel in human history – the level of fraud, the failure of regulation, and the foolishness of these gamblers surpasses every similar event by several orders of magnitude. Enron was child’s play by comparison; the dot-com fiasco was an “honest mistake” in relation to this; and Bernie Madoff was an “up-front guy” compared to these “peers” of his.

So, the downward spiral continued and continues:  the credit crunch deepened as lenders and investors began to balk at providing the short-term money that funded the SIVs; banks had their rude awakening as it became clear that their SIVs were worthless assets and no one would buy them even if insured; and they were over-leveraged. Without funding, the banks would be forced into bankruptcy. Many saw that as being the first domino in the collapse of our entire financial system. The only sources for rescue funds were governmental.

While most politicians are gamblers by nature, they don’t like being forced to bet on a long-shot - and yet, they have. They are gambling because they have weighed the other options as being even more risky. They are gambling on ignorance and hanging upon a slender thread of hope. They chose this because the alternative is to risk the greatest economic disaster in world history. Since I despise the fear-mongers that permeate our media, I say this with reservation and good reason.

First, we need to understand that our financial “security” is built upon a belief in the stability and soundness of our institutions. “Capitalism” only works when people invest effort and funds in their belief that doing such will offer some future reward. Both governmental and financial institutions exist largely to securitize our investments at all levels – we expect these institutions to prevent theft, destruction, foul play, and corruption so that our property, work, savings, and investments are protected. The American “success story” is largely one of good institutions and world-wide confidence in the stability and effectiveness of them. The actions of a few greedy gamblers have stretched their “rubber band of trustworthiness” beyond its limits. It might break or it might snap back (the slender thread of hope is still holding). For now, the doubt about the system’s ability to snap back is part of the stress that weakens it.

This brings us back to the newest mess in the greatest financial mess ever – the foreclosure fiasco. The power to foreclose on a mortgage helps make it a secure investment and banks have been behind legislation that makes foreclosure law their law. And since the typical foreclosure of the past was uncontestable (at least legally), the courts have generally “rubber stamped” the ex parte (one sided) proceedings. But the invention of SIVs created a legal problem that surfaced in 2007[6] and has just recently (Oct. 2010) reached broad attention. When the financial industry started treating mortgages like other investments (bundling them into “collateralized debt obligations” or CDOs) and re-sold them as securitized bonds, they lost the special status accorded mortgages under foreclosure law.

The financial industry didn’t want to deal with the paperwork hassles of keeping track of mortgage “pieces” in the chopped up CDOs, so they created a “nominee company” called MERS (Mortgage Electronic Registration Systems). MERS supposedly kept track of mortgage ownership changes on its computers, registering and recording mortgage loans under its name. MERS not only served its primary purpose of facilitating the easy turnover and transfer of mortgages and mortgage-backed securities, it also served as a “corporate shield” to protect investors from claims of predatory lending practices. If foreclosure was necessary, it was filed by MERS instead of the original mortgage holder.

But there’s a legal problem in this process that escaped attention for years – under the laws of most states, the privilege of foreclosure (as opposed to regular loan default proceedings) is restricted to the  “holder of the note” or the party of interest (whoever holds the “original note” or mortgage document – the legal sine qua non of foreclosure). Under common contract law a person (plaintiff) claiming breach of contract must produce a signed contract proving they are entitled to relief under said contract. When the original mortgage holders separated the deed of trust from the promissory note (to create the SIV), the mortgage loan became legally ineffectual (unless the holder of the deed of trust has an “agency relationship” to the holder of the note). A person holding only the note lacks the power (“legal standing”) to foreclose in the event of default and the securities (SIV) holders have no standing to foreclose because they were not signatories to the original agreement. Both MERS and the original lender lost standing to foreclose because title had to pass to the secured parties for the arrangement to legally qualify as a “security.” The lender has legally been paid in full and has no further legal interest in the claim[7]. (Geez, Louise!)[8]

Thus, there are some 60 million mortgages out there where standard foreclosure proceedings are legally impossible. The recent related scandal is based upon the use of affidavits to prove legal standing where someone (under penalty of law) claimed to either hold the proper privileges (standing), documents or claims when they actually didn’t. These perjurious officials are subject to criminal sanctions and their attorneys are subject to disciplinary sanctions.  It will be interesting to see if these persons escape accountability for their attempt to “steal” using the courts.

There is going to be little sympathy for the financial institutions that participated in this egregious gambling and are now caught between the courts and their “loan shark” investors and “bookies”[9]. And, since we’re largely dealing with unethical and unscrupulous characters, we may assume that they will expect us to bail them out (again) when the next round of repercussions arise – the claims upon their derivative bets. But we can’t (and hopefully won’t try).

There is an interesting parallel between the government’s position and that of many “underwater” mortgage holders. These homeowners may have the resources to continue paying a mortgage where the mortgage value exceeds the worth of the property, but they face a dilemma: continuing to pay seems like the right (ethical) thing to do (and avoids a “hit” on their credit rating) while doing so makes little economic sense. When these folks see how the banks act unethically and treat their customers with disdain, they find it easier to simply let the bank “eat the loss”.

The government may have the ability to protect the financial industry from “disaster” (while rewarding them for their bad behavior) and seeks to avoid the loss of trust and reputation that would come with letting them “fail”. And, the government has some obligation to protect unknowing investors from the significant losses that would result. But the decision should be based upon greater obligations and more fundamental principles: the government’s obligation of fairness and responsibility to citizens combined with the “free market concept” expressed under the principle of laissez-faire.

Admittedly, there is a difficult balancing in these obligations and principles: the government creates a “moral hazard” if it rewards mortgage takers who fail to honor their loan agreements and mortgage companies who gouged the market. Allowing financial institutions to fail will hurt a variety of ancillary folks who have done nothing wrong. But the alternative is to steal money from all Americans (our taxes) and give it to gamblers and shysters so that they are immunized from their own stupidity and greed.

The path of lesser harm and better result is for the government to negate the entire derivative market. For sure, such an action will also deprive some investors of legitimate “insurance” against bad investment. But for the most part the people adversely affected are those who have gambled with other people’s money or gambled upon failure that THEY contributed to. This solution best distributes the losses to those who deserve it. (And either they will have to remain silent about it or they will have to reveal who they are). Without the weight of all these “gambling debts”, the financial marketplace can begin to breathe again, the financial institutions can start to perform their essential functions again, and the American people can be relieved of the burden wrongly imposed upon them.

The alternatives simply don’t make sense. Putting off a solution in the hope that the economy can recover sufficiently to reduce the number of defaults is hopeless. Delay is making the economy worse and spending more borrowed money in an attempt to restore economic growth isn’t going to work. The government is powerless to fix the defective products sold by the financial industry and further efforts to put off an accounting for these destructive actions is only going to make matters worse. Using tax dollars to buy an interest in these companies is the greatest gambling goof in the history of governments. The only way the government will ever recover from this mistake is to nationalize these companies and make them immune from liability. That would have many of the undesirable effects associated with nullifying the derivative market while offering few of its benefits.

The stunning liability created by the great gambling goof-up of our financial institutions cannot be solved by a great governmental gambling goof-up. But then, the government is already on the line for some huge risks and payouts[10]:

                                                                                             At risk                   Likely Losses (at least)

Federal National Mortgage Association (“Fannie Mae”)      $2.3 trillion                     $350 billion

Federal Home Mortgage Corporation (“Freddie Mac”)      $1.2 trillion                      $160 billion

Federal Depositors Insurance Corporation (“FDIC”)         $7.6 trillion                       $30 billion[11]

Thus, even if the government’s plan of waiting the crisis out was to “succeed”, American taxpayers will have to absorb at least $500 billion in government “gambling losses” and that amount doesn’t include the huge governmental losses from unemployment insurance payouts, “stimulus programs”, and lower tax revenues.

Along with these governmental losses, Americans suffered from property value decline, stock losses, and retirement fund losses amounting to over $10 trillion[12]. And, as we all know, the national debt is approaching $14 trillion (growing by over $4 billion per day) as the government borrows heavily to make up the growing gap between its spending and its income.

Nullifying the entire derivatives market is the best way to “cut our losses” and restore some level of sanity to the world economy. It would send the right messages to the right people, make the financial marketplace stable, and let the banks who caused this mess assume the risks and losses. I realize that some friendly foreign investors would suffer, some filthy rich folks would lose a very small percentage of possible gambling gains, and the most corrupt banks and financial institutions would have wasted the large sums (bribes) paid to our politicians. Oh darn.

The alternatives create greater risks for the wrong people and don’t really solve the core problem – the great gambling casino is still open for business and the great gambling addiction has not been addressed.  

 

 

(By the way, one of the better Wikipedia articles deals with the financial crisis of 2007–2010…  http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932010). 

 

[1] Most specifically, we’re focused upon a derivative known as a credit-default-swap or CDS. For a full explanation of derivatives, I suggest http://www.fdic.gov/bank/analytical/fyi/2003/032603fyi.html.

[2] "We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." Warren Buffett in his 2002 Chairman's Letter for Berkshire Hathaway’s Annual Report.

[3] “In a securitization, a bank or other mortgage lender sells the future proceeds of a mortgage loan to a trust, or special purpose entity (SPE). The trust then pools them with other loans and issues bonds backed by the loan payments.” “Saving Banks: How the Mortgage Bailout Strains Accounting Efforts”, CFO magazine (December 10, 2007).

[4] Many major banks have been accused of using SIVs to keep “toxic assets” off their balance sheets so that investors couldn’t determine their risk.

[5] In 2007, the Bank for International Settlements reported derivative trades totaling $681 trillion while the World Bank estimated the combined gross domestic product of all the countries in the world at $55.117 trillion.

[6] In October 2007, U.S. District Court Judge Christopher A. Boyko (Case # 07-cv-02282-CAB, USDC, Northern District of Ohio, Eastern Division) ruled that Deutsche Bank’s “trustee affidavits” were insufficient to establish a right to foreclose. Judge Boyko stated that “The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance… Plaintiff’s argument reveals a condescending mindset and quasi-monopolistic system where financial institutions have traditionally controlled, and still control, the foreclosure process… unchallenged by underfinanced opponents, the institutions worry less about jurisdictional requirements and more about maximizing returns.”

” Then, in Landmark National Bank v. Kesler, 2009 Kan. LEXIS 834 (2009); the Kansas Supreme Court held that MERS has no right or standing to bring an action for foreclosure. Other courts have followed with similar rulings. Plaintiff’s argument reveals a condescending

mindset and quasi-monopolistic system where financial institutions have traditionally controlled, and still

control, the foreclosure process… unchallenged by underfinanced opponents, the institutions worry less about jurisdictional requirements and more about maximizing returns.

[7] To satisfy the requirements of Article III of the United States Constitution, a plaintiff must show that they have personally suffered some actual injury as a result of the illegal conduct of the defendant. See Coyne v. American Tobacco Company, 183 F. 3d 488 at 494(6th Cir. 1999); Valley Forge Christian College v. Americans United for Separation of Church & State, Inc., 454 U.S. 464 at 472 (1982).

[8] See also, “Foreclosures Hit a Snag for Lenders” by Gretchen Morgenson published in the New York Times November 15, 2007.

[9] The real purpose of the TARP bailout was to stave off the “loan-sharks” and “bookies” - owners of the failed mortgage-backed securities (SIVs & CDOs) and the policy holders who bet against them. There are two huge “ticking time bombs” in the financial system:  the ability of investors in mortgage bonds to require banks to buy back the defective products at face value if there was fraud in the origination process (an obligation equaling over 10 times the current market worth of these banks) and the power to collect outstanding “lost bets” (insured by the banks and other financial companies) in the derivative market (an obligation perhaps as much as 1000 times the current market value of the insurers).

[10] It is very difficult to accurately assess the risks because the government allows ridiculous accounting practices, market values are difficult to determine, and the circumstances are so volatile.

[11] The FDIC is funded by charges to banks and S&Ls, so this cost and risk is indirect.

 

 

 

 

 

 

 

 

Please let me know if you have comments about or corrections for this web site.

rich1vanwinkle@yahoo.com


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