Wall Street's Fraud

Janet Tavakoli has launched another salvo related to the massive Fraud Street machine:

Wall Street gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securities (RMBS).  Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses.  But many RMBSs were backed by portfolios comprising risky fraud-riddled loans.  Most of the “AAA” investment was imperiled, and subordinated “investment grade” components were worthless.  Wall Street disguised these toxic “investments” with new value-destroying securitizations and derivatives.1

As I have repeatedly pointed out it is not possible for the value in a transaction to ever be higher than at the point of origination of a loan.  It is mathematically impossible for it to be otherwise as the cash flow from the debtors is a fixed quantity; you can divide it up and siphon part of it off, but you can’t manufacture that which does not exist.  Any claim that you can do so is fraud on its face.

Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in doomed securities.  New money allowed Wall Street to temporarily hide losses and pay enormous bonuses.  This is a classic Ponzi scheme.

Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities.  Underwriters are responsible for appropriate due diligence, an investigation into the risks.2   If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed.  If you fail to disclose material information, expect to be investigated for fraud. If you have a mortgage subsidiary, expect it to be investigated, too.

One question: When?

An IMF official asserted: “You can’t prove fraud” and insisted it was in the interest of risk managers not to let their institutions collapse.  (He was unable to attend my exposition based on Chs. 5-12 of Dear Mr. Buffett).   This IMF officer isn’t just soft on crime; he’s in denial.  Failure to recognize fraud led to statements like the one that opened Chapter 2 of the IMF’s April 2006 Global Financial Stability Report:

Actually, proving fraud is simple: All you need to do is prove that a financial institution marketed securities from some batch of debt that had as its total claimed return a number greater than the original deals that went into the package. 

This requires nothing more than a calculator.  The claimed returns are known from the marketing and the coupon on each asset that went into the package is also known.  2 + 2 still equals 4 and if the institution claimed to have “manufactured” wealth it committed fraud.

Likewise, the risk-adjusted return of each loan in the package is known (interest .vs. growth at the time of origination.)  If, at the time of origination, the risk-adjusted return of the “securities” was greater or equal (remember, nobody works for free!) than the components, once again, fraud was committed.

Yes, there were thousands (or tens of thousands) of loans in a package.  So what?  We have a thing called a “computer” nowdays that makes summing and dividing large quantities of numbers a trivial, sub-second enterprise. 

To demonstrate that fraud was the essence of these securities we need only show that a financial institution represented that it had invented perpetual motion in the financial sense.  As that is mathematically impossible any such claim is ipso facto fraudulent.

Troubled financial entities should be put into receivership and restructured.  Old shareholders will be wiped out.  Debt-holders will take a haircut (discount) along with a debt for new equity swap to recapitalize the entity.  But the job won’t be complete until we separate high risk activities from traditional banking in a return to a Glass-Steagall like structure with regulators that indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper. 

The laws already exist; it is illegal to promote perpetual-motion machines and take money from people for their promised delivery, irrespective of where and how you claim to have “invented them”, because such a machine, whether in the form of a physical engine or a financial product, cannot possibly exist.

Janet does a great job in this piece of exposing the web of interconnections between parties, including the fact that Tim Geithner headed the NY Fed when the “big burst” of this fraudulent activity took place and that as the NY Fed’s head at the time he was directly and personally responsible for the willful regulatory blindness to what was an obvious and “in your face” scam.

As Janet says, we have the tools to take care of these problems – we simply need to will to use them.