Posted by Karl Denninger
Is this just words? A glimmer of light flickers on in the dark halls of 535 fools….
Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm and which included riveting detail on the firm’s accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis.
Exactly. I’ve been writing about this for three years; indeed, it was recognition of fraud in large financial firms that led me to begin writing The Market Ticker.
Lehman structured its repo agreements so that the collateral was worth 105 percent of the cash it received – hence, the name “Repo 105.” As explained by the New York Times’ DealBook, “That meant that for a few days – and by the fourth quarter of 2007 that meant end-of-quarter – Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.”
It was a little more than that. Lehman accounted for these transactions as a sale, when in fact they were a loan. There’s a hell of a difference between the two – in one case you remove an asset from your balance sheet and replace it with cash (and that change is permanent) and in the other you exchange an asset for a liability, and the net impact on your balance sheet is in fact negative, not positive (since you must pay interest on a loan.)
First, we must undo the damage done by decades of deregulation. That damage includes financial institutions that are “too big to manage and too big to regulate” (as former FDIC Chairman Bill Isaac has called them), a “wild west” attitude on Wall Street, and colossal failures by accountants and lawyers who misunderstand or disregard their role as gatekeepers. The rule of law depends in part on manageably-sized institutions, participants interested in following the law, and gatekeepers motivated by more than a paycheck from their clients.
Second, we must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street. We must treat financial crimes with the same gravity as other crimes, because the price of inaction and a failure to deter future misconduct is enormous.
Third, we must help regulators and other gatekeepers not only by demanding transparency but also by providing clear, enforceable “rules of the road” wherever possible. That includes studying conduct that may not be illegal now, but that we should nonetheless consider banning or curtailing because it provides too ready a cover for financial wrongdoing.
Everything that went on leading up to the crisis, and most of what went on in “managing” it, was unlawful under already-established black-letter laws. Some examples should make this clear:
AIG sold credit-default swaps (a form of insurance, even though we don’t call it that) with no capital behind them – that is, no ability to pay. Entering into a contract with full knowledge that you have no ability to perform is a fraudulent act – you are representing to someone that you have capacity to pay under the loss scenario, when you do not.
Purchasing “protection” of this sort at below the market rate of risk as determined by the spread is an uneconomic act. That is, the essential purpose of such a purchase is not to buy protection against the adverse event, but rather to intentionally misrepresent to regulators that your assets are “covered” and thus of better quality than they are, for the explicit purpose of not having to hold reserves against them. I argue that this is an act of fraud. The essential point is that nobody works for free – it is therefore impossible to buy a Bond that has a risk spread over Treasuries (of equivalent duration) of 3% plus a credit-default swap to cover it for less than the same spread. A seller of protection who does not charge at least the risk-adjusted spread will not have sufficient capital to pay, and a seller who does charge at least the risk-adjusted spread (and thus can pay) leaves you with a trade, in total, that yields less than the Treasury! If you desire a risk-free trade it makes no sense to purchase the more-risky bond and credit-default swap, as your total return will be lower than just buying the Treasuries!
- Mortgage origination and rating was rife with fraud up and down the line. The breaches of representations and warranties are not accidents or oversights – they are frauds. The most-carefully-negotiated set of terms in any offering document (for anything) is always the reps and warranties; as a seller of a business in the past I can tell you with absolute certainty that this is the case, because it is the section by which you can be hung if you make false statements. The Securitizers represented to the buyers of these mortgage-backed securities that the credit quality was of a certain caliber in the loans that were made, when in fact post 2004 it was known that the majority of “ALT-A” loans contained some element of misrepresentation.
- Carrying second lien loans on the books of a bank that are behind a 60+ delinquent first that is underwater at any material value is, in my opinion, a fraudulent act. By black-letter law these second-position liens are entitled to exactly nothing until the first mortgage is fully paid. In the case where such a loan is underwater and not performing they have no economic value whatsoever. Current statistics are that virtually all 60+ delinquent mortgages will ultimately foreclose or sell short. 80% of the dollar value of HELOCs are in the four bubble states (Nevada, Arizona, California and Florida) and the majority of these lines are behind an underwater first. ALL of the big banks are currently holding a massive number of these loans (tens of billions individually and hundreds of billions in aggregate) on their balance sheets at or near par value, that is, 100 cents on the dollar. I can come up with no reasonable argument for these claimed valuations, and yet they are allowed to persist. Packages of these loans currently trade on the second market for literal pennies on the dollar.
Why is this allowed to continue? I have, for the last three years, asked repeatedly “Where are the cops?”
I have also asked a more-serious question, and one with unpleasant implications for our society as a whole: Is the government a felon itself?
I believe these questions are fair. You speak in your letter of FERA, The Fraud Enforcement and Recovery Act. Well, if we’re supposed to be enforcing the law against fraud, where are the cops sir? All I’ve seen FERA do thus far is fatten the officers at the local donut shop.
As I said more than a year ago: “At the end of the day, this is a test of whether we have one justice system in this country or two. If we don’t treat a Wall Street firm that defrauded investors of millions of dollars the same way we treat someone who stole 500 dollars from a cash register, then how can we expect our citizens to have faith in the rule of law? For our economy to work for all Americans, investors must have confidence in the honest and open functioning of our financial markets. Our markets can only flourish when Americans again trust that they are fair, transparent, and accountable to the laws.”
The American people deserve no less.
We may deserve no less, but so far we the people have received zilch, all in the name of “not disturbing the so-called recovery.”
But in point of fact we’ve not only refused to prosecute, we’ve allowed these financial institutions to try to cover the holes blown in their own balance sheets as a consequence of this fraudulent activity with fees and interest charges assessed on the people!
This is akin to not only looking the other way when the robbers show up and commit their heist, but then in addition assessing the victims a tax to pay for the robber’s getaway car!