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Wednesday, October 13, 2010

One huge pile of steaming shit

It seems everywhere you look in the mortgage mess there's a new pile of shit and evidence, not just of abysmal stupidity but outright fraud.

It started with "liars loans" where mortgages were knowingly written despite a complete lack of due diligence. Banks did that because they knew the mortgage was going to sold within weeks and bundled up by an investment bank who would then sell it off to the next person.

We already know that the rating agencies gave them all AAA ratings without bothering to do their due diligence We know that the investment banks bet against their mortgage derivatives while they were still selling them. We're now finding out that foreclosures were processed by the thousands without following proper procedures, more often than not, without possession of the original mortgage or with proper notarization. The banks are calling this a mere 'technical' issue, althoough the correct word is fraud.

Now a new wrinkle has emerged which will undoubtedly create a slew of huge lawsuits against the banks. This excellent article by Felix Salmon is devastating.

You thought the foreclosure mess was bad? You’re right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren’t properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it’s looking very much as though none of the notes were properly transferred.

But that’s not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there’s a pretty strong case that they lied to the investors in many if not most of these deals.

Banks would put in bids for a pool of mortgages. The bank with the winning bid would them submit a sample of the mortgages in the pool to a third party to examine the quality of the mortgages in that sample. Most were done by Clayton, a company that controls 70% of that market. The article cites 1,280 mortgages owned by Citibank. Of those, 582 or 45% were rejected as not meeting underwriting standards. Citibank could then send all or most of those mortgages back to the originator.

Bear in mind the pool still contained a significant amount of bad mortgages that weren't examined by Clayton. In normal times any sane bank would walk away from a sample that bad but not in those times. The bank would then renegotiate a lower rice for rhe pool of mortgages. The bank, in this case Citibank, didn't mind the fact that the pool contained a huge pe4rcentage of bad loans because they were ging to sell the pool anyway, and armed with a triple A rating the buyer would be none the wiser.

In fact, the nanks were more than happy to do this vecause they could make more money at the renegotiated lower price.

The article goes on to explaion the end game.

In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That’s a lie of omission, and if I was one of the investors in one of these pools, I’d be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can’t imagine they’ll like what they find.

The bank I talked to didn’t even attempt to excuse its behavior. It just said that Clayton’s taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That’s the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn’t have that crucial information.

These mortgage bonds were then sold to pension funds, to city and state governments both domestic and foreign among others. The big question is will the investment banks ever be made to pay for these fraudulent transactions. Most of us are paying for this in one way or another but the banks seem to b e doing just fine.

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