IN THE "I TOLD YOU SO" DEPARTMENT

In the "I Told You So Department" ...

It turns out that when Fannie Mae was in private hands, back in 2003, that they knew about foreclosure fraud but did absolutely nothing about it. Nice. One of the reasons for not doing anything about it was that people along the financial train were getting rich off the process ... going all the way back to the last years of the Clinton administration! Yeah, that's about 15 years ago, and almost 10 years before the 2008 market collapse.

This is what I wrote in the opening pages of chapter 12 in my book, The Myth of the Free Market ...

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

One year before the Financial Services Modernization Act (1999) was passed into law the Federal Deposit Insurance Corporation issued a set of guidelines for member banks managing transactions that involved bundled loans that were sold as collateralized securities. Concerned that deposit-taking institutions had not exercised sufficient risk management when handling these loan contracts the F.D.I.C distributed a “Statements of Policy” at the beginning of 1998 making it clear collateralized security transactions were on their radar screen. While it set out to reacquaint institutions with basic due diligence procedures, it also listed ways private firms could defraud F.D.I.C-backed institutions. More bluntly, the Statements of Policy (SOP) guidelines said private financial institutions weren’t always playing fair with F.D.I.C. backed institutions, especially when it came to complex financial instruments.

Among the embarrassingly basic rules of caution covered included “know your counterparty,” credit analysis, and credit limit reviews. The guidelines were so simple it was difficult to tell whether they were issued for the new finance guy at the local car dealership, or were really geared for seasoned F.D.I.C. affiliated banking institutions. Still, one thing stood out – in the wake of the 2008 market collapse – the 1998 SOP offered a Crow’s Nest view of what went wrong. Pointing to the tactics of subsidiaries belonging to “financially stronger and better-known firms” the SOP warns that larger corporations “may not be legally obligated to stand behind the transactions of related companies,” so the subsidiary may not be credit worthy. The F.D.I.C.’s advice? Don’t trust the other guys “character” or “integrity” until you get “the stronger firms” signature. That this needed to be said should have raised red flags back in 1998. Incredibly, the guidelines get even more basic.

We all know when we purchase a new car we have to deal with the sales staff. We’re then shuffled off into cubicles where we have to deal with the finance and credit team, who also want to sell us stuff. There’s a reason why the dealerships keep these two positions apart. Sales staff, anxious to sell a car, will either lower credit standards or overlook red flags on a customer’s credit report. Not so in the F.D.I.C. institutions. Apparently burned by too many conflict of interest transactions involving sales and finance pulling double duty, the F.D.I.C. found it necessary to remind banking institutions that credit evaluations for CDO transactions, for example, should be done by “individuals who routinely make credit decisions” and not those involved in sales. The F.D.I.C institutions were then provided with the incredibly sage advice that they should be on the look out for buyers who were already “overextended.”

Perhaps the greatest words of caution are saved for institutions inclined to believe CDO instruments could be used as market collateral. F.D.I.C. guidelines make it clear that simply because an institution has a CDO-affiliated instrument doesn’t mean it’s sitting on an asset whose book value is equal to its market value. The 1998 guidelines suggests, for example, that if a $100 million CDO transaction has occurred that “experience has shown” the underlying product or contract “will not serve as protection” if the subsidiary fails, or if the firm does not have control over the security. Put more simply, the tone of the 1998 SOP guidelines tell us market players and the federal government knew that U.S. financial institutions were sitting on a financial powder keg long before the 2008 market melt down began.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 

I know, I know ... What I wrote about is a level removed from simple mortgages. The complexity contributes to why America is baffled by the bailout language. But it's all connected. Trust me.

So, yes, people knew that the CDO markets were a mess long before 2008. The market collapse was not an aberration. Very specific activities made it happen.

And, yes, I told you so.

- Mark

MORTGAGE SETTLEMENT = PAYOUT AND THE CHANCE TO DO IT AGAIN

OK, it looks like a settlement on the mortgage mess has been reached. Rather than go into the details, or discuss how "wonderful" the $26 billion penalty is, the good people at nakedcapitalism.com have put together a wonderful list of 12 Reasons to Hate the Mortgage Settlement.

It's pretty much what I've been writing about our real estate and banking mess for years now, but it's nice to see it synopsized.

Because the article at nakedcapitalism may be a bit long, I've synopsized the first seven points here:

1. FORGERY HAS A PRICE: The price of forgery and fabricating documents is now officially $2000 per loan. Not only is this amount a fraction of the cost of the legal expenses when foreclosures are challenged, but no one goes to jail for forgery. Take that, 300 years of real estate law.

2. TAXPAYER PAYS (again): The $26 billion sticker price penalty actually involves only $5 billion of bank money. The rest is your money. Mortgages that have been securitized will be written down, which means CDO investors will get Fannie and Freddie (who are now backed by the American taxpayer) to pick up the tab for their losses. Unfortunately, the size of your pension funds, 401 (k)s, etc. will take a hit too, which means reduced assets and income for your portfolio and retirement account(s). So you actually pay twice. Nice.

3. BANKS GET OFF: $5 billion divided among the big banks means nothing. Freddie and Fannie putbacks to the major banks have been running at that level each quarter.

4. BANK BAILOUT (again): $20 billion makes bank second liens sounder. This deal is a stealth bailout that strengthens bank balance sheets at the expense of the broader public.

5. ENFORCEMENT IS A JOKE: The first layer of supervision is the banks reporting on themselves. Seriously.

6. SERVICERS WON'T COMPLY WITH THE AGREEMENT: The history of servicer consent decrees is clear. Even though the banks said they wouldn't engage in criminal acts again (like forgery for paperwork they couldn't locate) in exchange for not being prosecuted, the banks and the servicers have failed to comply. Robo signings, among other activities, continue because the industry wants to bury the bodies.

7. CONSENT DECREE RENDERED TOOTHLESS: When Nevada and Arizona caved on the Countrywide settlement suit Bank of America rejoiced. It proved that failing to comply with a consent degree has no consequences 

You should read the entire article, and the follow up pieces too. Long story short? No penalties, another backdoor bailout, and another market collapse in the future. Only the next one will be worse than in 2008 because the banks haven't learned any lessons.

Oh, and they're going to try and do the same thing on a global level with the emerging markets. 

- Mark

WALL STREET'S DOING IT AGAIN (PART II): Our Daisy Chain of Debt

Last week I wrote in a post that Wall Street was "doing it again." Specifically, in the post I discussed how broker-dealers in the 1960s had "borrowed" assets from client accounts and used them as collateral to secure loans from banks (i.e. repo borrowing). They then used the money to make investments elsewhere, which they (or the firm) pocketed when the gambles paid off. Problems developed, however, because numerous broker-dealer deals failed, which led to over $100 million in losses for their clients.

As you can imagine, investors were furious. Congress acted and we ended up with new regulations through Rule 15c 3-3. To be sure, broker-dealers in the United States still retained the authority to borrow against client accounts. But they would not be able to operate as loosely as they did in the late 1960s (securities accounts were segregated, new net capital rules were implemented, reserve requirements were imposed, etc.). This is precisely why this article by Money Morning's Keith Fitz-Gerald is an eye opener.

In "How Banks Are Using Your Money to Create the Next Crash" Fitz-Gerald makes it clear that market players are not only using client accounts to borrow money and make trades elsewhere, but they're now borrowing and gambling at record levels.

How is this happening, you ask? Check it out.

Let's say you have a portfolio valued at $5,000. Most of what you have is invested in stocks, securities and other market instruments. Suddenly, you find yourself in need of cash (for whatever reason) and dip into your investment fund. You borrow $2,000 against your $5,000 portfolio. Legally you have to pay the $2,000 back or suffer serious early withdrawal tax penalties. But you're fine with this because you're actually paying yourself back.

Good so far? Great. This is where it starts to get good.

According to SEC Rule 15c3-3, the broker-dealers who run your portfolio can take what you owe to yourself - in this case $2,000 - and use that amount as a source of credit for their own use. Loosely speaking, your broker-dealer can use your promise to repay yourself as if it were a promise to pay the firm. The idea is that since you're going to return the $2,000 to your fund, you're actually paying your broker-dealer because they're the ones who manage the account.

It makes perfect sense, doesn't it? I mean, since you owe your account money, it's actually a credit for the broker-dealers who manage your funds, right?

But wait. It gets better ... for the broker-dealers that is.

According to the rules broker-dealers can add 40% of what you owe to "their" credit accounts. So, for example, if you borrow $2,000 from your account your $2,000 debt magically turns into a $2,800 credit (or borrowing limit) for the broker-dealers. Once your broker-dealer borrows $2,800 and then deposits it in a bank the $2,800 (less reserve requirements) can then be invested or lent out elsewhere. This money can then be deposited, and then used again (again, less reserve requirements), then deposited and lent again, then ... well, you get the point.

This daisy chain of debt is one of the primary reasons that the size and volume traded in our financial markets has exploded (computers, deregulation, etc. have also contributed to its growth).

In effect, your debt contract enables broker-dealers to borrow and gamble in other areas that they might never had done, were it not for your account. And while it's been going on since the 1960s, it really exploded with computers, deregulation, and the creation of new security products (repo borrowing surged past $1 trillion before the 2008 market collapse).

The explosion in financial trading has been phenomenal. Consider the following.

While our national economy produced approximately $14 trillion in goods and services in 2011, the total value (i.e. "notional value") that our financial market players have gambled on various market instruments, or now claim some kind of control over, has grown to well over $300 trillion (commercial banks contribute about $120 trillion to this amount).

To put this in perspective, this is akin to your debt-laden neighbor making $60,000 a year and your bank allowing him borrow $1.2 million to invest gamble as they want.Try asking your bank if they'll let you borrow 20 times the value of your assets & income.

But wait. It gets even better. On a global level, if we throw in what market players in the G-10 nations are doing, the total value (i.e. notional value) that our market players now control or claim some kind of authority over now hovers around $600 trillion, or 40 times what America produces in a year. Nice.

At the end of the day, this financial daisy chain is built on your hard work. It derives it's entire value from your financial accounts (and your debt). But here's the kicker. Whatever paper trail of wealth that's created won't be shared with you (have you ever seen a note in your monthly portfolio statement that reads "Here's an extra $20,000, which represents a small part that I earned from using your account to make bets elsewhere"? Neither have I).

According to Larry Fitz-Gerald, not only is this wealth extracting daisy chain legal, but "it's common practice specified in the fine print of most brokerage agreements." And it's called rehypothecation.

I think I'll leave it that for now.

- Mark

ADDENDUM: All of this is only the beginning. The legal use of your account (i.e. rehypothecation) has created a murky world where activities derived from your account (i.e. pledged collateral rights tied to rehypothecated instruments) can be used by several entities at once (p. 9). This is one of the reasons that the size of our shadow banking system (which is largely unregulated) now reaches into the multiples of trillions (p. 9), while the size of our real economy pales in comparison to our symbolic economy by a ratio of at least 20: 1. 

WEALTH EXTRACTION 101

Remember this? (full view here; thanks Seven)

This chart explains who owns the title to one home in America. It was put together by a securities analyst who wanted to know who held the title to his home. It took him one year to figure this out. Here's the incredible part. It's the day job of this analyst to figure this stuff out on a daily basis.

Yeah, I know. Property rights in America shouldn't be this difficult. What a mess.

Anyways, I wrote about this and the legal maze that makes our financial and real estate markets such a mess earlier (here and here). Specifically I wrote that the very notion of property rights in America may be in trouble because of how Wall Street wanted access to income streams (to create securities), but didn't want to actually produce anything for the money. So they found a way to dump the actual title (plus the administrative and legal responsibility) of a home on to an obscure mega corporate entity called Mortgage Electronic Registration Systems (MERs). Then - in a demonstration of wealth extraction at its finest - they siphoned off the house payments into another legal maze (of securities) that benefited a few Wall Street market players.

And just like that, a small group of market players were able to make claims on millions of mortgage payments (through various "security" instruments) without having any responsibility for filing, registering, and tracking who owned the note on the house. (If you're looking for a metaphor it's kind of like handing the car keys, your wallet, and a keg of beer to your unemployed cousin and telling him to have fun.)

This is where it gets real good.

Rather than deal with homeowners after the mortgage bubble collapsed - and after their mortgage payment-security scheme went bust - Wall Street and other big market players said: "We can't negotiate with homeowners because we don't have the title to the home (MERs does). And besides, the loans have already been sold several times over ... oops."

Then, while threatening that system collapse was imminent if they didn't get bailed out, Wall Street and America's biggest financial players got the federal government to provide them with trillions in taxpayer backed guarantees. Why should big banks and Wall Street have to negotiate with homeowners (and learn from market justice) when Uncle Sam can foot the bill for their greed and arrogance?

Trillions of dollars in bailout money are now being used to purify and prop up an entire industry, while filling financial holes created when the income stream (i.e. mortgage payments) behind Wall Street's (pyramid) security schemes dried up.

Again, wealth extraction at its finest (if you're wondering why Wall Street isn't in jail, me too).

Anyways, I'm writing about all of this (again) because of how this Harper's Magazine article on MERs (hat tip to Barry Ritholtz) explains how Wall Street can make claims on money without actually producing anything of value. It also helps us all understand how our nation's biggest market players have undermined our nation's market integrity, while making a mockery of property rights in America.

If you care about the Constitution (hello, Tea Party) and the future of our nation this is one of the areas where you should be directing your attention.

- Mark

DEUSTCHE BANK ... THE TRUE FACE OF BIG BANKS IN AMERICA?

Most of you have heard of Deustche Bank. Some of you might even bank with them. A regional Deustche branch in Atlanta requested the eviction of Vita Lee, a 103-year-old Atlanta woman, and her 83-year-old daughter. They have lived in the home for 53 years. The good news is that when the movers and county sheriff arrived they took one look at the bed ridden 103-year-old and had a change of heart.


No doubt - in spite of the movers and sheriff being the good guys here - Deustche Bank will try to spin the event so that they look like they're merciful bankers. Then they'll probably try the eviction again, when no one's looking. But, in reality, whatever reprieve is granted to Vita Lee, the merciful banking face we're looking at resembles the one in this scene ...

For those of you who aren't familiar with Deutsche Bank know this: Deutsche Bank was a big trader bettor in the toxic market instruments that Wall Street gambled on during the U.S. mortgage bubble.

Indeed, a Senate report about Wall Street and the financial crisis found that Deutsche Bank even continued to churn out toxic crap even as the market was collapsing, with one top trader betting that home mortgages (which were inside the larger toxic instruments, or CDOs) would fail. Put more simply, Deutsche Bank set themselves up to make money when they foreclosed on certain mortgages. This helps explain why selling faulty mortgages and then kicking a 103-year-old out of her house makes good business sense for Deutsche Bank. They make money off the process.

And, yes, apart from lying to customers in the U.S. and Germany about the investments, Deustche Bank received over $12 billion in bailout funds, and was poised to take a hit of hundreds of billions if the U.S. government didn't bailout A.I.G. (kind of like the House in Vegas covering your losses into the hundreds of thousands, but allowing you to keep your winning bets).

Oh, and for good measure, the former chief economist at the International Monetary Fund called the CEO of Deustche Banks, Josef Ackermann, “one of the most dangerous bankers in the world” because of his reckless business practices.

- Mark

WHY THE MARKET CRASHED IN 2008 (in 10 easy to understand steps)

Arrgh ... If I hear one more GOP presidential hopeful blame our current market mess on President Obama again I think I'm going to have a brain aneurysm. To be sure, I understand the political part of what the candidates are doing. What gets me is how so many Americans buy into the ignorance and stupidity, and it's starting to burn through the electorate like wildfire ...

I bring this up because people speak as if President Obama could have somehow waved a magic wand and fixed the economy in just three years. Apart from having to deal with a "just say no" GOP, what they forget is that it took the better part of 6 years for the Bush administration and a GOP-led Congress to blow through budget surpluses and set the stage for burning down our economic house.

Destroying the peace and prosperity that was left to President Bush took some real effort and incompetence, and can't easily be undone.

So, in an effort to dispel any notion that President Obama is to blame for our current mess (though, I agree, he screwed up on bailing out the banks), I'm going to present what I hope is an easy ten point overview of why the market collapsed in 2008. What you'll see is that our current economic mess didn't happen over night, and won't be turned back over night either. I'm drawing the information straight out of my book. So if you want more information go out and buy my book (I know, shameless plug).

As you'll see, there's enough bi-partisan stupidity to go around, though one party definitely deserves more blame than the other for our current mess. You can quibble with the 10 points (I might even emphasize one point over another in the future), but the general outline of our market collapse, and what ails our markets today, are here.

Anyways, here goes. Our market collapse, in ten easy steps ...

______________________________________

THE BEGINNING

1. A Naive Belief in "Free Market" Ideology (blinds policymakers)
... Ronald Reagan enters the White House after Maggie Thatcher becomes Britain's Prime Minister. Trickle Down economics is born. Deregulation, tax cuts for the rich, and globalization are embraced.
... After dumping trillions in borrowed money into the economy Reagan almost triples the national debt, raises taxes on the middle class (FICA), and lifts the debt-limit ceiling 17 times. Yet he's hailed as a fiscal conservative.
... In an effort to concentrate on  "free markets" in the 1980s, U.S. leaders effectively ignore economic costs associated with (1) paying for the defense of the west, (2) America's rude introduction to unbridled globalization (caused, in part, by the success of Bretton Woods), (3) the structural changes in the economy caused by the rise of financial services sector (i.e. the "symbolic" economy), (4) Nixon's price controls, and (4) OPEC's inflation inducing price hikes.
... Instead of dealing with costs of U.S. militarism, competition from abroad, the financialization of the economy, Nixon's price controls and OPEC price hikes, America's leadership blames sluggish U.S. economy on "the state" (regulations, domestic programs, and taxes), while calling for "a good 'ol shot of capitalism" in 1980.

BUILD UP: 1970s-1980s

2. Deregulation / Financialization  of Economy (regulator vacation)
... 1971 the dollar is de-linked from gold and becomes a commodity. Futures markets develop for money, interest rates, and other novel investment tools of the trade.
... OPEC price hikes wreak havoc on markets and prices. Pundits and foreign policy experts alike (see especially Henry Kissinger) are caught flat footed.
... new policies and deregulation pushed by financial services sector make the Savings & Loan debacle possible (1970s/1980s), and help to set the stage for the deregulation stupidity that eventually leads to the dismantling of the Glass-Steagall Act and the passage of the Financial Services Modernization Act (1999)
... financial services sectors consolidates as symbolic economy grows in importance. SEC begins its disappearing act.

3. Interest Rate Manipulation (what free market?)
... Interest rates are used first to stabilize markets, and then as a tool to stimulate them. Bailouts and money dumps begin in earnest under Alan Greenspan's leadership at the Federal Reserve. The Greenspan Put (dumping cheap money into the system when Wall Street gets in trouble) begins in 1987.
... Federal Reserve becomes Wall Street's support system, and then it's puppet.
... Market recklessness surges as financial services (and gambling) grows.

4. Yield Hunts / Secondary Markets (casino economy begins)
... Inflation + low interest rates in 1980s lead bond traders to start looking for higher yield investments.
... Non-traditional investment products become more attractive, but market players are (initially)reluctant because of low bond ratings.
... Globalization (largely unregulated) allows financial firms to seek higher investments abroad through loans, secondary markets, arbitrage, etc.

5. Bailout City (what, accountability?)
... Beginning with Mexico in 1982 (actually it begins earlier, but this is where I'm starting), Wall Street's stupidity is bailed out time and time again. The Greenspan Put begins in earnest in 1987 with LTCM.
... Accountability and free market ideology are undermined with bailouts, but no one cares. Wall Street/investment bankers continue to believe in the wonders of the market.

MANIA: 1990s / Aughts ...

6. Securitization / Derivative Markets Explode (hello Rumpelstiltskin)
... Market players become Rumpelstiltskin, and turn crap into gold. CDOs, SIVs, CDSs, and other novel investment products become popular, especially after ratings agencies get into bed with Wall Street's biggest investment banks. Interconnected market players game the system.
... Wealth extraction becomes more important than wealth creation. What would have been criminal or fraudulent before becomes modus operandi with favorable legislation.
... Security markets begin demanding more products (i.e. debt) to securitize, as rating companies begin to hand out AAA ratings on virtually anything that can be chopped up and modeled.
... Symbolic economy grows 30-40 times the real economy.

7. Toxic Market "Innovations" Applauded (herd mentality for rugged individualists)
... Wall Street (Goldman Sachs then-CEO, Hank Paulson) goes to SEC for permission in 2004 to carry 40:1 debt to equity ratios (Imagine going to a bank and asking to borrow $2 million on a $50,000 a year income). It's granted.
... With demand for securities growing, hedge funds, shadow banks, and Wall Street press Washington regulators to allow "non-conventional" lender packages into the housing market.
... Non-bank, or shadow banks, become critical cogs in financial machine. Subprime mortgage underwriters ignore all lending standards.
... With brokers dumping newly created loans 30-60 days after they're written, NINJA loans, No Doc loans, Liar loans, and other type of teaser programs become the norm.
... Caution thrown to the wind as competent regulators like Brooksley Born are buried politically (after she called attention to disastrous derivative markets), and Sarbanes-Oxley legislation allows Washington/Wall Street to say "See, we fixed it" after Enron. Free market praised as fraud & lack of oversight become the norm.
... Consumers borrow and use homes as ATMs, which give the illusion of prosperity.
... Personal debt climbs; Bush doubles the national debt. Bubbles and record profits grow.

8. The Federal Reserve / Congress Become Cheerleaders (casino economy goes Vegas) 
... Cheerleaders (who should be regulators) applaud innovative instruments and massive (unregulated) lending as evidence of the power of unrestrained markets.
... Home equity loans explode, consumption increases. Debt is the name of the game as it provides source for new securities and credit default swaps (insurance).
... Alan Greenspan cheers "new paradigm of active credit management" as interconnected institutions and the shadow banking system sign off on new securities, mortgage back contracts, and other debt instruments/loans.
... Wall Street and financial services sector pay and bonuses shoot through the roof.
... Notional value of contracts surge past $285 trillion (when annual GDP is only $14 trillion).

PAYING THE PIPER: The Mother of All Bailouts

9. Boom / Bust / Credit Freeze (back to reality)
... What do you know? Strawberry pickers making minimum wage really can't afford $700,000 home loans.

10. Blame Game Begins (continues today)
... Government Secured Enterprises (Fannie Mae), FHA loans, and Community Reinvestment Act (the poor) originally blamed for market collapse. Former Treasury Secretary Hank Paulson joins the game.
... George W. Bush (wrongly) claims he inherited a recession, and left with a recession. Nothing to see here. What a loser.
... Much anticipated bi-partisan FCIC report is blind-sided by GOP primer that deliberately excludes any mention of Wall Street, the shadow banks, interconnected cronyism, and deregulation (all the stuff I highlighted in red above).

______________________________________

The incredible thing is that we have now come full circle. Today, Republican presidential candidates are full fledged free market ideologues, pushing for more of the same policies that got us into our current mess. Don't believe me? Start at #1 above. Begin reading, again.

Only this time the banks and Wall Street are the only ones who have access to, and are profiting from, unlimited cheap money and our propped up casino economy. Think about it. Today the house of cards (yes, it's still a house of cards) is propped up by cheap money for Wall Street, deregulation for Wall Street, favorable legislation for Wall Street, and adherence to a failed ideology in Washington that keeps the trillion dollar bailout and QE money flowing, for Wall Street.

At the end of the day it took almost a full generation to reach our current level of market stupidity. It's not going to end under President Obama in one term. Especially with the GOP acting like a political boat anchor.

- Mark

WALL STREET... "SCREW THE CAR FAX"

One of the reasons the market collapsed in 2008 is because market players either ignored or didn't have enough information about derivative market exposure. Then they ignored the casino economy this ill-informed derivative market helped create. This is important because when market players learn new things about co-signers, collateral, job status, price, or market valuations they might be more (or less) willing to consummate the deal.

Think about an esteemed uncle who promises to co-sign a house note for you, and then learning that he is going to declare bankruptcy. But his books still look good, so he's willing to hold off until you get the house. Is withholding this information a good idea, for anyone? Now imagine this market wide.

Not securing and sharing critical information proved devastating in 2008. Even though Wall Street and other market players were backed up by rosy market models (that few understood), the money people on Wall Street started to panic when they learned that big financial houses (like Lehman Bros.) didn't actually have the money to back up their over sized market bets.

Well, hold on to your hats. Because of Wall Street's muscle in Washington, it looks like much hasn't changed after all. Wall Street's lobbyists have fixed things so that we're poised to party like it's 2008. Cue to Prince ...

Seriously, International Finance Review is reporting that the trading centers ("trade repositories") that are supposed to document and house information crucial for derivative markets may not be collecting the information that they should. According to a recent report on Over The Counter (OTC) derivative data, the regulatory scope of derivative trade centers appears to exclude,

"... information contained in derivatives master agreements and credit support annexes, as well as data relating to collateral or payment transfers, or valuation data coming from external sources."

Translated this means that critical due diligence - like collateral and market valuation, among others - that could help assess risk, isn't always documented or presented. You know, kind of like before the market collapsed in 2008.

So, in spite of Dodd-Frank (as I pointed out here), Wall Street can enter into a derivative agreement and they don't necessarily have to reveal previous prices (how much the last customer paid) or demonstrate proper collateral. It's kind of like going car shopping and asking for the Car Fax and being told, "Our market doesn't really require this."

Why is this important? Because as of January 2010 the notional value of the OTC derivative market has apparently grown to about $300 trillion dollars in the U.S., and over $600 trillion between the G-10 countries. This is about 20-40 times the size of the American economy.

So, yeah, we're doing it all over again.

- Mark

FORGET THE DEFICITS, THIS IS (STILL) OUR REAL THREAT

While it's no longer big news, this story from the state of Washington is yet another example why our mortgage and housing mess is far from over. The key points about this specific house (which could be any foreclosed house in America) include:

* After the homeowners were evicted the house became both an eye sore and part time hotel for local vagrants and drug dealers.

* The mortgage contract that was foreclosed on had been bundled up with other mortgages and sold to investors as part of a security, so ...

* The market "owners" of the mortgage (American Home Mortgage Servicing, Inc.) may have the title but claim they "don’t have legal possession.”

Huh?

In plain language - and as I pointed out in November - what all of this means is that because financiers, brokers, and investors have created a legal maze that only they understand (and benefit from), we're screwed.

Because private property lies at the heart of the American experience, if we can't figure out something as simple as home ownership, fixating on deficits won't mean a thing. Simply put, we're going to have much bigger legal and financial problems down the road if we don't deal with this Wall Street-banker induced mess.

Seriously, check out this trail of home ownership that took one market securities expert one year to put together ... (and it was his home!).

Now, ask yourself, Is this the way private property rights should be organized in America?

So, if you want to understand why homeowners are adrift, while the big banks are sitting on a pile of money after their bailouts, take a deeper look at our housing mess. Then take a look at how Wall Street both contributed and is largely to blame for the mess. It will leave you wondering why Wall Street isn't in jail.

When conservatives and their Tea Party overlords take a serious look at this stuff, and start fixing this banking-mortgage-Wall Street mess, then maybe I'll take them seriously. Otherwise, we're setting ourselves up for a trip down Bailout Memory Lane, again. What then? More deregulation and tax breaks for our Wall Street and banking gargoyles?

Until then, the GOP and their Tea Party noise machine need to take a seat, and quit yappin' about things they don't really understand.

- Mark

P.S. I'll have a post on the deficits next week.

THE AMERICAN SISYPHUS ...

Remember the story of Sisyphus? He was the king in Greek mythology who was punished by being forced to roll a boulder up a hill, only to watch it roll back down. He was to repeat this activity throughout eternity.

If you recall this story then you'll understand why this piece from Mother Jones makes the U.S. taxpayer out to be little more than an American Sisyphus ...

First you bailed out Fannie and Freddie. Now you're paying their legal bills.

Taxpayers have covered $434 million in legal fees for Fannie Mae, Freddie Mac, and their highly-paid executives since the federal government took over the wounded housing giants in September 2008, according to data (PDF) provided to Mother Jones by a congressional source.

In case you forgot, Fannie Mae and Freddie Mac were privately managed, government backed, institutions who were used to absorb corporate America's toxic mortgage loans. They then bundled them up and dumped these contracts (CDOs) on gullible market players (like union and state pension funds), who ended up taking huge hits when the market collapsed in 2008.

After the American taxpayer bailed out Fannie and Freddie, and backstopped all the toxic loans for Wall Street's wage and bonus bonanza in 2008 and 2009, we're now paying to defend their incompetence too. Great.

I don't know about anyone else, but I'm beginning to feel like the American Sisyphus ... condemned to bailout out Wall Street and corporate America's incompetence into eternity.

- Mark

BAILOUT NATION ... HOW IT REALLY WORKS (South Park Style)

One of the best ways to get someone to understand a concept is to tell a story. The story doesn't necessarily have to be true to convey what you're trying to explain. It just has to have a moral, a lesson, or a logical set of consequences (most often associated with fables). For example, if you you want to teach kids about the importance of hard work and paying attention to the details you tell the story of The Three Little Pigs.

I always liked this story.

But if you want to teach America how Wall Street manipulated sheep-like consumers, and then built an economy dependent on debt and financial gimmicks to extract wealth you really should watch this South Park episode. Here's a snippet (click here for the entire episode, with a 15 second commercial intro) ...





The episode ("Margaritaville") helps convey the criminal stupidity that has overtaken our financial system, and pokes fun at all the finger pointing, the conspiracy theories, and the feigned spiritual concern over the excesses and consumerism that dominate our national debate on the topic. It really does a good job of mocking our current reality by explaining how we've been sold a bill of goods by con men financiers for the better part of a generation.

Ultimately the episode (which has nothing to do with The Three Little Pigs) reminds us all how getting Americans into debt was always the goal of Wall Street's financiers, and how bailouts have become the magic potion behind our Wall Street created Ponzi scheme.

Kudos to Rafa for sending it to me.

- Mark

P.S.: If you're insulted by the language in the South Park episode, but not upset by the reality we're currently living, your indignation is misplaced. No apologies.

P.S. to my P.S.: I should point out that in Chapter 2 of my book (p. 39) makes it clear that since the 1980s the business plan for Wall Street's biggest financial companies has been to "produce" debt that can be bundled and sold as securities (Collateralized Debt Obligations). It's what got us into this mess, and continues today.

THIS HELPS TO EXPLAIN WHY WE'RE SCREWED

If you've ever wondered why congress is so clueless when it comes to understanding how to unwind and fix our financial mess take a look at this from Zero Hedge.

It appears that Dan Edstrom, who performs securitization audits (Reverse Engineering and Failure Analysis) for his company, wanted to find out who actually owns his home and how his home fit into the securitization process (ABS, CDO, CDS, etc.) that was created by the geniuses on Wall Street. After a year, this is what he came up with ...

Zero Hedges Williambanzi7 put it best when he commented: "Take a look at this chart and then decide how long you think it will take for Barney Frank and Eric Holder to sort everything out."

Put another way, this chart shows why we're screwed.

Worse, unlike the students in my "Myth of the Free Market" class, most members of Congress don't understand the basics behind how we got into our current predicament and, consequently, don't know how to clean up this mess. For our members of Congress it's a lot easier to hide behind blind ideology, shrug, and say "let the market work ... let's deregulate."

Throw in a few campaign contributions and ... well, you get the picture.

At the legal seminar Mr. Edstrom is organizing for December, topics to be discussed include "control fraud" (see William K. Black), the securitization process, and the legal loopholes behind the engineering of complex financial instruments by Neil Garfield.

- Mark

P.S. Here's the link for an expandable version of the chart.

WHY WALL STREET IS TO BLAME

So I'm sitting in the barber's chair and getting my hair cut this morning. The talk turns to what's happening in the markets, and who's to blame. The standard Fox News meme emerged: "It's the fault of everyone who couldn't afford to buy a home."

My, my, where to begin ...

Why Wall Street Is At Fault ...
Let's start with this. The money had to come from somewhere. Fox News and their Republican friends may get political mileage pointing at irresponsible borrowers and Fannie Mae as the problem. But the real issue lies with people in the private sector who were creating and insuring shady mortgage contracts, as I've posted on here and here.

On this front, Wall Street knew what they were doing. Their models told them they would make money on their activities, so they pushed for more mortgages. Ability to pay wasn't really an issue. Creating marketable securities that they could bet on was.

Irresponsible borrowers? No doubt there was a problem. But we have to ask ourselves, Why was Wall Street and their financial mandarins so eager to lend to "irresponsible" borrowers?

The simple answer is that Wall Street's market players were becoming irresponsible lenders. They became irresponsible lenders because they had created a sweet ponzi mortgage scheme, built around a fraudulent insurance system.

In the first part of the scheme, as Nomi Prins outlined, between 2002 and 2008 about $1.4 trillion in subprime mortgages were issued. Out of these mortgages Wall Street created ("derived") about $14 trillion in securitized bets. In part because the underlying contracts were subprime mortgages, Wall Street needed insurance for their bets.

I'm over simplifying, but the second part of the scheme worked something like this.

* I tell you I will provide insurance for your mortgage backed securities.
* You must pay me premiums for my insurance.
* If the market collapses, "tough goat cookies ... we won't pay" (this wasn't actually said).

An illusory sense of security (insurance) plus record profits (for Wall Street) made for a euphoric market mood. So more mortgage contracts were sought, written up, and sold off to security slavery. Wall Street created it's own demand. It didn't matter who the mortgage holders were. As long as they could fog a mirror they were going to get a mortgage contract, which was going to be insured (wink, wink) somewhere down the line.

(At the time no one really knew or cared whether the insurer had the money to pay out claims. There were three reasons for this. First, Wall Street's market models said everything was OK. Second, the insured mortgage contracts were labeled as "derivative" contracts which, at the time, were largely unregulated. Finally, everyone was making lots of money).

Ben Bernanke Feeds the Fire
It was like handing the car keys to a teenager, and then being assured that everything will be fine by their loser friends, who are all carrying bottles of booze out the door as they wave good bye.

And why not? Ben Bernanke (the trusty father of the "loser friends" in this scenario) was confident that "market fundamentals were strong" and that bank regulators were doing the right thing. And, besides, national housing prices don't fall, right? Here's Bernanke making these claims before the market collapsed ...




A Ponzi Insurance Scheme + the sage (albeit, wrong) words of Fed Chair Ben Bernanke  =  a sense of market security.

This market chemistry was so soothing that Wall Street and the financial titans of America actively went out and looked for more home mortgages to issue, bundle up (CDOs), and then insure (CDSs) right up to when the market collapsed. Bonuses, sweet fees, and juicy commissions made this a win-win for everyone involved, but especially Wall Street.

"Don't Blame Me ..." Wall Street's Lack of Accountability
At the end of the day, as I pointed out here, when people stopped paying their debts and mortgages - which once gave value to the market securities that Wall Street created - what should have happened is that those who insured the securities should have paid up. Instead, they blamed irresponsible borrowers for ruining their ponzi-scheme.

Let me be clear here. When people stopped paying the debts and mortgages that made security contracts worth something, the people and institutions who provided the insurance for these contracts should have paid up.

But they didn't have to. The American taxpayer did, and will continue to do so long into the future.

MORAL OF THE STORY: Don't count your chickens before they hatch.

MORAL OF THE STORY, II: But especially don't blame Main Street for your own stupidity and greed when you create and feed a mortgage and insurance ponzi-scheme that produces profits for you but undermines the integrity of the market.

- Mark

Addendum: Congress held hearings on Fannie Mae and Freddie Mac today. It was covered by C-SPAN. As expected there were Republicans who wanted to direct blame away from Wall Street. So they tried to blame Fannie Mae and Freddie Mac for the market collapse because of how they backed reckless borrowers. Fortunately, Congressman Brad Miller (D-NC) was there to set the record straight.

He reminded Republican committee members that they once praised subprime lending as the type of innovative lending that comes from deregulated or "unfettered" markets, and because of how it contributed to a spike in home ownership. Among the points Congressman Miller brought up included:

1. When Republicans criticized Fannie Mae and Freddie Mac after 2003, they were essentially using the talking points of Fannie and Freddie's unregulated private insurer competitors (AIG, Goldman Sachs, Lehman Bros., Merrill Lynch, etc), who had financial axes to grind.

2. The private insurers were "running rings" around Fannie and Freddie in lending to and insuring affordable - or "subprime" - housing mortgages (which the data makes clear).

3. The Bush administration pressured Fannie and Freddie to purchase and insure the toxic assets of the private insurers (which constitutes a market subsidy).

There's more, but you get the point. While Wall Street is to blame, Congress had a helping hand in making the mess worse than it should have been. Miller's comments, and the complaining that led to Miller's comments, begin at 1:42 and 15 seconds here.

WHY WE'RE SCREWED, III: POST-REFORM VERSION ...

Last December I wrote about Structured Investment Vehicles (SIVs). While there may be legitimate reasons for SIVs, in practical terms SIVs have become a neat accounting tool for conducting what more and more looks like white-collar crime. Here's why ...

In a few words SIVs are "investment tools" - approved by the Financial Accounting Standards Board (FASB) - that give our largest financial institutions the legal means to transfer billions of dollars worth of toxic crap off their books. As a result of this neat "deregulation" gift companies like Merrill Lynch, Citigroup, etc. looked much better right before the market crash.

If you're having trouble understanding the concept think of this: It would be the same as if you were able to legally take your credit card debts, your car payments, and other annoying debts off of your financial statements. You could then get additional lines of credit, and continue doing business as usual ... like buying more toxic crap.

I'm oversimplifying, but this is how it worked for Merrill Lynch ...

1. BAD BETS: Because they're greedy and stupid they made terrible investments in soon to be toxic mortgage-backed securities (also called collaterlitized debt obligations, or CDOs). They now had toxic crap they needed to get off their books.

2. FRAUD FRONTS: Merrill Lynch created a special company, Pyxis, which helped them borrow money. Pyxis issued  I.O.U.s saying they would pay the borrowed money back (referred to as issuing short-term debt).

3. SIV DEBT BOMBS: With borrowed money Pyxis purchased portions (tranches) of toxic crap from Merrill's CDOs. These purchases by Pyxis created our SIVs and made it look like someone else (Pyxis) was on the hook for the toxic crap Merrill Lynch had in their CDOs.

4. SMOKE & MIRRORS: To make the people at Pyxis look legit Merrill entered into a "derivatives" contract (known as a "total return swap"), which obliged Merrill to cover any losses at Pyxis. Because derivative markets are NOT controlled or regulated like the NYSE billions of dollars of these toxic contracts flew under the regulatory radar.

This is how Merrill Lynch was able to claim that it was exposed to only about $15.2 billion in toxic crap. In reality it was actually exposed to $46 billion worth of securities that would eventually collapse. As I pointed out in December, these neat little financial toilets allowed our nation's largest financial institutions to flush billions of dollars in future losses off their books, legally.

This encouraged Merrill Lynch - and other firms on Wall Street - to go out and create more CDO and derivative contracts (for which they paid themselves handsome fees and bonuses).

I ask you, is this financial innovation or financial fraud? The geniuses on Wall Street think it's financial innovation.

However you look at it (it's "control fraud" in William K. Black's book) there's little doubt that even the experts who have a reputation for understanding the nitty gritty behind these transactions find the details hard to follow, or understand. Take a look at this and this to see what I mean.

This is important because the rules were changed after the 2008 market collapse so that banks had to bring certain derivative assets back on to their balance sheets.

But - and this is a very big "but" - companies like Wells Fargo found that they would NOT have to add certain derivatives back on their books after all. Why? Because, while they believed they would have to add $46 billion back on to the books, government guarantees from the bailout programs (and other agency guarantees) allows Wells Fargo to claim that they're only exposed to $10 billion in losses from the derivatives market ... when they're actually into the derivatives market for $2 trillion (see page 31).

Throw in the trillions Bank of America, JPMorgan Chase, etc. have in derivative markets and you can imagine how much value in toxic derivatives we still have out there (to get an idea you can start here, here, and here ...)

 Sigh.

- Mark

ANOTHER SIGN THAT WE'RE SCREWED ...

Robert Smith at nakedcapitalism.com points us to a rather strange development in the rating world. They're afraid to take responsibility for doing do their job.

It turns out that the new financial regulation legislation that's about to land on President Obama's desk has a new liability clause. It says investors can sue ratings agencies "for a knowing or reckless failure to conduct a reasonable investigation" of the market instruments that they grade.

In a few words, a ratings agency does research on bonds and other market securities (like ABSs, CDOs, etc.) to determine whether they're risky or solid investments. If they're solid investments they will get a Triple A rating. Market players like AAA ratings because it makes it easier to sell their products (bonds, securities, etc.). Undeserved favorable ratings are what allowed America's financial institutions to sell securities that were backed by toxic mortgages.

Under the proposed legislation the ratings agencies who blew it big time before the 2008 market collapse -  because they handed out AAA ratings on virtually anything the financial institutions threw out there - are now subject to “expert liability” claims if they jump into bed with their Wall Street patrons, again. They don't like it.

Here's my question. At what point does the concept of taking responsibility for doing your job return to the Wall Street? Diligence, integrity, and honesty should not be a one way street, traveled on only by the American taxpayer.

Seriously, the proposed legislation only mandates that companies in the ratings world - who make millions of dollars for being "experts" - not "knowingly" or "recklessly" do a poor job. It doesn't prevent them from doing a poor job. It just says don't do a poor job on purpose ... no more regulatory subsidies. Pretty simple if you ask me.

At the end of the day, if Wall Street's ratings agency can't find a degree of security, or a loophole, in a weak performance bar that says don't let us catch you becoming incompetent, or negligent, on purpose we're screwed.

- Mark

OUR EVOLVING THIRD DEPRESSION

Economist and NY Times' op-ed writer Paul Krugman sees the beginning of "the Third Depression" in America and around the world. Pointing to the Long Depression of the 19th century (beginning in 1873) and the Great Depression of the 20th century (1929), Krugman argues that what we saw both times was "an era of nonstop decline." This is what we face today.

Arguing that the Third Depression is really just getting under way, Krugman writes that "this third depression will be primarily a failure of policy" and points to "last weekend’s deeply discouraging G-20 meeting" where governments obsessed about inflation "when the real threat is deflation." For Krugman "preaching the need for belt-tightening when the real problem is inadequate spending" is a policy prescription destined for disaster because of the millions who remain unemployed.

The primary culprit here is "the victory of an orthodoxy that has little to do with rational analysis," with policymakers slavishly adhering to the idea that we need to assuage markets by holding back on spending. The outcome is a stunningly shallow belief globally "that imposing suffering on other people is how you show leadership in tough times."

When we throw in the fact that Republicans derailed legislation last week that would have extended unemployment benefits and sent billions to states in an effort to avoid layoffs it's easy to understand Krugman's pessimism. Over 1 million people will be affect by this decision. To be sure, apart from being unhinged ideologues who say one thing and do another, the Republican party's real goal is to keep the market collapse going so they can pin it on President Obama in November (so much for "America First"). Still, in the final analysis what we have is a leadership - both national and global - who cling to the tenets of a dying ideology like the monarchs of Europe clinged a decadent and dying feudal system.

Apart from the fact that Krugman has gotten so many things right over the years, I'm inclinded to agree with Krugman's assessment because of the evolving characteristics of our economic situation. The biggest issue for me is how we continue to believe that if we appease the same corrupt market gods who got us into this mess that they'll act good and respond with appropriate investment strategies, just like the textbook says it should happen. This expectation is simply naive.

From the tricks behind high frequency trading, to the astronomical bets made in derivative markets few understand, to the lack of transparency surrounding toxic assets, to the use of unicorn math (mark-to-market accounting) and a genuine depence on government favors (both bailouts and legislation), we are witnessing the wholesale destruction of market capitalism around the world. The focus is no longer on wealth creation, but wealth extraction. Adam Smith is turning in his grave.

That policymakers believe fiscal authority, without serious real financial reform, will save the day in this environment says much about our failure to learn the lessons of history. A third depression, indeed.

- Mark

WHAT DO YOU KNOW ... YOU CAN TURN A PINTO INTO A MUSTANG

Some of you might recall that back in October of 2009 I wrote "You Can't Turn a Pinto Into a Mustang." At the time I was using Ford cars to explain how - in the real world - you can't take a piece of crap car (Pinto) and suddenly revalue it and get classic car (Mustang) prices. That is, of course, unless you're one of the financial institutions that can take advantage of a Jan. 1, 2009 government ruling which says "Go ahead, revalue the toxic crap you own ... we don't mind."

In my October post I explained (by using Ford cars as a metaphor) how the Financial Accounting Standards Board's (FASB) 2009 ruling effectively allows America's financial institutions to ...

Level I: Price their financial instruments according to everyday market prices, known as the "mark-to-market" method.

Level II: Price their financial instruments according to what similar assets might sell for if more of them were around and/or sold. On this, think assessed value on hard to value antiques or one of a kind goods.

Level III: Ignore Level I and Level II pricing methods and simply make shit up ... known in the accounting world as the "mark-to-make-believe" method. 

All too often, it appears that America's financial institutions are using Level III mark-to-make-believe methods to make up their prices. What I didn't explain at the time are the details behind the game. Here's how it's happening ...

It turns out that when FASB implemented "Statement 157" on January 1, 2009 - in addition to directing financial firms on how to assess "fair value" for their goods (Levels I, II, or III) - it also left a loophole wide enough for William "The Refrigerator" Perry to walk through.

More specifically, FASB rules allow America's financial institutions to ask for a pricing waiver on financial instruments if they don't like the numbers from Level I or Level II methods. This is akin to a homeowner who hopes to secure a loan on their house being able to say, "I don't like the value my house was assessed from the Level I or Level II methods. I want a waiver so I can apply mark-to-make-believe (Level III) methods ... yeah, I want to let Peter Rabbit assess the value of my house."

Put another way, you get another shot at reassessing the value of your house at a price that has nothing to do with what it's really worth. Making matters worse, other financial institutions, the American taxpayer Federal government, and other unsuspecting market players have to play along with the charade and accept the price too.

To be sure, the financial firms have to fill out some extra paper work to gain access to the mark-to-make-believe (Level III) pricing method. The FASB does have it's standards (wink, wink). But what's a few more fairy tales penned in an economy that already has an Alice in Wonderland character to it? Once you're down the rabbit hole does it really matter if you burrow deeper?

Gaining access to mark-to-make-believe (Level III) method is the result of a loophole that says if your financial asset is exposed to "forced liquidation or distress sale" conditions you can apply for a waiver. As you might guess, given the market conditions of the past year, virtually any toxic financial instrument created on Wall Street could qualify for a Level III categorization, as long as the financial firm is willing to do the paper work.

And just like that, a toxic CDO or an SIV (which are akin to financial toilets), can be revalued to some made up number that makes Wall Street's financial mandarins feel better about themselves. More importantly, because of Tim Geithner's hare-brained scheme - which allows financial firms to use their toxic crap as collateral for new money - financial firms can dump their repriced assets on the American taxpayer Federal Reserve for new loans, credit, and profits.

To be sure, the market value of the product may still be in the toilet. But who cares? As long as the book value of the instrument hasn't collapsed we can all make believe that our banks are doing just fine. Thank you FASB.

In the end, it's because of FASB (which is under the SEC) that Wall Street's biggest players (1) have been able to maintain the illusion that their assets and their financial institutions are worth more than they really are, and (2) can go to Uncle Sam for more loans and credit guarantees, using collateral that's toxic and/or has tanked in value.

So, yes, if you work in Wall Street's Alice in Wonderland world, it appears you can turn a Pinto into a Mustang.

-  Mark