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Generational Dynamics Web Log for 28-Jan-08
Noose tightens on banks and rating agencies, as mortgage evaluator provides evidence of fraud

Web Log - January, 2008

Noose tightens on banks and rating agencies, as mortgage evaluator provides evidence of fraud

Clayton Holdings, a company that analyzed thousands of mortgage loans for investment banks, said in a statement on Saturday, that it had "entered into a cooperation agreement" with the office of Attorney General Andrew Cuomo and would tell what it knows about how Wall Street sold mortgage investments despite warnings from Clayton that the underlying home loans did not meet quality standards.

There is widespread belief (by me and many other people) that "financial engineers" and others in investments banks did not defraud the public "by accident," but knew that they were performing fraudulent acts -- maybe not in 2002 or 2003, but certainly by 2005-2007. These fraudulent acts were designed and perpetrated by Generation-Xers, under the noses of senior management Boomers who chose to close their eyes to the fraud for their own gain.

What we've been hearing for over a year was that "Duh, we're victims too. We didn't know that there was anything wrong with CDOs of CDOs of CDOs."

The evidence is mounting that, as early as 2005, investment banks took pro-active steps to deceive the public and to hide their fraudulent activities from the public.

One of the keys to exposing that fraud will be organizations that were supposed to be "watching over" and auditing these kinds of financial transactions in one way or another. We've discussed several kinds of these agencies on this web site in the past:

Ratings agencies -- the major ones are Standard & Poor's, Moody's Investors Service and Fitch Ratings -- are responsible for providing investments ratings of new securities, such as mortgage-backed CDOs, in return for fat fees from the banks. In my recent article, "A primer on financial engineering and structured finance" I explained how these securities are created, how the ratings are assigned, and how the assumptions going into those ratings turn out to be wrong. It's possible that the assigned ratings were "honest mistakes" in 2002-2005, but it's unlikely that they were in 2006. It's absolutely impossible that these ratings agencies didn't know by 2007 that their computer models were wrong, and yet the fraudulent ratings continued through August, 2007. It was only after June 30, when Bloomberg news accused the ratings agencies of purposing "masking losses," that the ratings agencies even began to talk about providing more realistic ratings.

Bond insurance agencies -- the major ones are ACA Capital Holdings Inc., MBIA Inc and Ambac Financial Group -- are responsible for providing "insurance" to low-rated securities in order give them an AAA rating, in return for fat fees from the banks. In my recent article, "A primer on financial engineering and structured finance" how these insurers provide AAA ratings, and what went wrong. Like the ratings agencies, these companies continued to overlook problems well into 2007, much longer than they should have.

Now we're looking at a third kind of "watchdog" firm. Clayton Holdings is a due-diligence firm that reviewed thousands of mortgage loans for compliance to lending standards. According to company president Keith Johnson, their reports of non-compliance were ignored by investment banks. "In some cases we felt that we were potted plants."

The new agreement with the Attorney General grants criminal immunity to Clayton, though there is no evidence so far that Clayton did anything wrong.

But an an analysis by the NY Times indicates that the noose is tightening around the necks of both banks and ratings agencies:

"As part of the deal, Clayton has told the prosecutors that starting in 2005, it saw a significant deterioration of lending standards and a parallel jump in lending exceptions. In an another sign that the industry was becoming less careful, some investment banks directed Clayton to halve the sample of loans it evaluated in each portfolio, a person familiar with the investigation said.

The mortgage business boomed from 2002 to 2006, generating lucrative fees for mortgage brokers, lenders, credit rating firms, investment banks and many investors. Investment banks began buying billions of dollars of more risky loans made to borrowers with blemished, or subprime, credit histories and packaging them into securities [CDOs] that paid high interest. ...

It is unclear how many lending exceptions are contained in the $1 trillion subprime mortgage market, but industry participants cite figures ranging from about 50 percent to 80 percent for some loan portfolios they examined."

These figures are absolutely staggering. They indicate that non-compliance in mortgage loans was THE RULE rather than the exception in 2005-2007. Furthermore, Clayton's claims indicate that investment banks were taking pro-active steps to IGNORE non-compliance.

That's why these mortgage-based securities are almost worthless. If only 5-10% of the underlying mortgage loans had been non-complying, then there would probably be no problem. But when 50-80% of the loans are non-complying, then it's almost impossible that CDOs backed by these mortgages will have any value. (To understand this better, take a look at the section "How the 'cascade rule' works" in my article on article on financial engineering.)

Furthermore, did you follow this point about "halving the sample of loans?" This is incredible. Each non-complying loan that Clayton found had to be reclassified as risky. Therefore, Clayton was instructed to evaluate only half as many loans in each portfolio, so that only half as many loans would have to be reclassified as risky:

"Investment banks hired companies like Clayton to evaluate a sample, say 20 percent, of the loans. The review was supposed to determine whether the loans complied with the law and met the lending standards that the mortgage companies said they were using. Loans that did not were classified as exceptions.

As demand for the loans surged, mortgage companies were in a strong enough position to stipulate that investment banks have Clayton and other consultants look at fewer loans. The lenders wanted the due diligence to find fewer exceptions, which were sold at a discount, the person familiar with the investigation said."

All of this makes it 100% clear that the investment banks were defrauding the public and investors, and that they KNEW that they were defrauding the public and investors. The "Duh, I didn't know" excuse is eliminated.

Now let's turn to the ratings agencies.

According to the article, "Investment rating firms like Moody’s and Fitch have said that they were deprived of [information on non-compliance] before they gave the securities the top rating, triple-A."

But the article continues:

"The investment banks then pooled the mortgages into securities, often by blending loans from different lenders. Information on those mixed pools was then delivered to the rating agencies, which assigned the securities a score. Pension funds and other big investors bought them because they had triple-A ratings.

But investment banks did not give the rating agencies their due diligence reports, and it appears that the agencies did not demand them, people familiar with Mr. Cuomo’s investigation said.

In January 2007, Clayton briefed at least one credit rating agency about the exception reports it was producing, the person involved in the agreement said, but the credit firm did not ask to see the reports. ...

Chris Atkins, a spokesman for Standard & Poor’s, said the firm was not responsible for verifying information provided to it by the issuers of securities. It is customary for rating agencies to accept the information they are provided by issuers of securities.

In November, Fitch Ratings published a detailed review of 45 loans in an effort to identify what went wrong as mortgages were turned into securities. It found extensive inaccuracies and fraud. The firm noted that many of the problems would have been easy to identify by looking at loan applications, appraisals and credit reports — but it appears that such review was either never done or ignored. Fitch now says that it will no longer rate subprime mortgage securities unless it is provided access to loan files."

In my recent article on Boomers and Gen-Xers, I used the phrase "Lenscap Stupidity," alluding to a Boomer government official who was briefed for half an hour while looking through binoculars with the lenscap still on. The third paragraph above is a perfect example: The ratings agencies knew that the news was bad, and they refused to hear it.

It's very convenient for S&P to say that they simply accept the information provided by the rating agencies without questioning it, and it was only in November that they learned of "extensive inaccuracies and fraud," but if the prosecutor determines that they "must have known" or "should have known" anyway, and the jury agrees, then fraud will be found.

One thing is clear: That there has been an enormous amount of crime committed, by people at many level -- ordinary people applying for mortgages, credit rating firms, housing contractors, housing inspectors, real estate appraisers, real estate brokers, mortgage brokers, mortgage lenders, savings banks, investment banks, ratings agencies, bond insurers, and we're looking at due diligence firms. (This paragraph updated on 30-Jan.)

When combined with the Société Générale fraud, you can see that there's a lot of fraud going on, and a lot of prosecution going on.

This is not unexpected, because it's all happened before. In fact, the next-to-last international generational financial crisis, the Hamburg crisis of 1857 (panic of 1857), was triggered by a small event -- an employee of the New York branch of the Ohio Life Insurance and Trust Company was found to have embezzled money.

There was a great deal of embezzlement leading up to the last generational financial crisis. I've quoted this passage before, but it's worth posting again. John Kenneth Galbraith described what happened -- and what will happen again -- in his 1954 book, The Great Crash - 1929, as follows:

"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in -- or more precisely not in -- the country's businesses and banks. This inventory -- it should perhaps be called the bezzle -- amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

The stock market boom and the ensuing crash caused a traumatic exaggeration of these normal relationships. To the normal needs for money, for home, family and dissipation, was added, during the boom, the new and overwhelming requirement for funds to play the market or to meet margin calls. Money was exceptionally plentiful. People were also exceptionally trusting. A bank president who was himself trusting Kreuger, Hopson, and Insull was obviously unlikely to suspect his lifelong friend the cashier. In the late twenties the bezzle grew apace.

Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.

After the first week or so of the crash, reports of defaulting employees were a daily occurrence. They were far more common than the suicides. On some days comparatively brief accounts occupied a column or more in the Times. The amounts were large and small, and they were reported from far and wide. ...

Each week during the autumn more such unfortunates were reveled in their misery. Most of them were small men who had taken a flier in the market and then become more deeply involved. Later they had more impressive companions. It was the crash, and the subsequent ruthless contraction of values which, in the end, exposed the speculation by Kreuger, Hopson, and Insull with the moey of other people. Should the American economy ever achieve permanent full employment and prosperity, firms should look well to their auditors. One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: "Every great crisis reveals the excessive speculations of many houses which no one before suspected." [pp. 132-35]

Galbraith's point was that there were many criminal activities going on before the 1929 crash, but nobody cared, as long as everyone was making money. But once the crash occurred, any irregularity was viewed with suspicion and led to an investigation. These investigations turned up many cases of embezzlement -- people who had "temporarily borrowed" money that wasn't theirs to invest in the stock market, and then got caught in the crash.

That's happening again. If you're one of the people who have committed embezzlement or fraud, then it's time to put your affairs in order, because you're going to get caught. (28-Jan-08) Permanent Link
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Generational Dynamics Web Log for 28-Jan-08 Noose tightens on banks and rating agencies, as mortgage evaluator provides evidence of fraud

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Generational Dynamics Web Log for 28-Jan-08
Noose tightens on banks and rating agencies, as mortgage evaluator provides evidence of fraud