Posted by Karl Denninger
An amazing set of written testimony was given to the panel on Lehman’s collapse that you all need to read has been filed by Bill Black.
Lehman’s principal source of (fictional) income and real losses was making (and selling) what the trade accurately called “liar’s loans” through its subsidiary, Aurora. (The bland euphemism for liar’s loans was “Alt-A.”) Liar’s loans are “criminogenic” (they create epidemics of mortgage fraud) because they create strong incentives to provide false information on loan applications. The FBI began warning publicly about the epidemic of mortgage fraud in 2004 (CNN). Liar’s loans also produce intense “adverse selection” – even the borrowers who are not fraudulent will tend to be the least creditworthy. The combination of these two perverse incentives means that liar’s loans, in economics jargon, have a deeply “negative expected value” to the lender. In English, that means that the average dollar lent on a liar’s loan creates a loss ranging from 50 – 85 cents.
The value of Lehman’s Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.1
Gambling against the casino creates a negative expected value, but making liar’s loans creates inevitable, catastrophic losses.
Is it over? Oh hell no.
That loss, however, may not be recognized for many years – particularly if the liar’s loans become so large that they help hyper-inflate a financial bubble. In the near-term, making massive amounts of liar’s losses loans creates a mathematical guarantee of producing record (albeit fictional) accounting income. (As long as the bubble inflates, the liar’s loans can be refinanced – creating additional fictional income and delaying (but increasing) the eventual loss.
And what are we doing right now with our still existing banks?
We have issued official guidance that they do not need to mark their commercial real estate exposures to the market so long as they are receiving income from them, even if the lies (valuation) are known.
This is EXACTLY IDENTICAL to making liar’s loans to buy houses “which are perfectly ok so long as the people can make the (initial) payments”!
It gets better:
It was a painful, as a former regulator, to read the Valukas report’s discussion of the FRBNY staff’s open disdain for working cooperatively with the SEC to protect the public. The Valukas report exposes the sick relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The FRBNY, led by President Geithner, had a clear statutory mission — promote the safety and soundness of the banking system and compliance with the law – stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine” (p. 1470).
And what are we doing right now with so-called “disclosure”? Mark to fantasy accounting for commercial real estate loans and HELOCs, hundreds of billions of dollars of off-balance sheet “vehicles” that are being carried by all major financial institutions without any capital behind them at all since they are not counted in the firm’s “capital ratios” and explicit direction by the FDIC to examiners to not require banks to hold more capital against underwater real estate loans so long as rents are being paid?
Meanwhile we continue to see disclosures from the ratings agencies and others that CMBS (commercial mortgage backed security) delinquency/default rates continue to rise, with FITCH now saying that defaults will exceed 11% of all outstanding securitizations in their rated deals by the end of the year.
Yet the banks are being explicitly allowed to fail to reserve against these predictable and expected losses by both current policy and explicit direction from the so-called “risk managers” in the FDIC (that is, bank examiners) and others in the regulatory apparatus.
Translation: The FRBNY knew that Lehman was engaged in fraud designed to overstate its liquidity and, therefore, was unwilling to loan as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of the fraud. The Fed official doesn’t even make a pretense that the Fed believes it is supposed to protect the public. The FRBNY remained willing to lend to a fraudulent systemically dangerous institution (SDI). This is an egregious violation of the public trust, and the regulatory perpetrators must be held accountable. The Fed wanted to maintain a fiction that toxic mortgage product were simply misunderstood assets, so it allowed Lehman to keep dealing the three card monte scam.
Far worse than what happened with Lehman in this regard it is still the ongoing policy of all of these agencies to do the same damn thing with the still-existing banks and bank-holding companies!
Or, in plain English, the Fed didn’t want Lehman and other SDIs to sell their toxic assets because the sales prices would reveal that the values Lehman (and all the other SDIs) placed on their toxic assets (the “marks”) were inflated with worthless hot air.
AND STILL IS – the entire point of “extend and pretend”, that is, a formal and written policy crammed down FASB’s throat at literal gunpoint by the US Congress and implemented by current FDIC examiners with regard to both underwater commercial real estate loans and HELOCs behind underwater, delinquent first mortgages is to prevent the liquidation of these products into the market, thereby preserving the ability to make willfully and intentionally fraudulent claims of value that does not exist.
The FRBNY has vastly greater leverage than the FHLBSF ever had and in the context of the Lehman crisis it had the leverage to force any change it believed was necessary, including an immediate conversion of Lehman to a bank holding company and a commercial bank.
Of course it did. The entire point of the scam was to prevent the recognition of the true value of any of these assets, lest they force a mark-to-market by all other system participants. That would have been catastrophic (and still will be) but the market cannot clear until it happens.
Fifth, the Fed is addicted to opaqueness and its senior ranks believe the bankers when they claim that the people must never be allowed to learn the truth about asset losses. One of the conflicts of interest that a banking regulator must never succumb to is the temptation to encourage or allow the regulated entity to lie about its financial condition for the purported purpose of preventing a run on the bank.
Like, for example, claiming that the big banks all passed “stress tests” that were orchestrated to be impossible-to-fail because they were predicated on forcing FASB to allow these same institutions to carry underwater and unrecoverable paper at par?
What Bill Black has documented is not only how and why Lehman blew sky high, but that nothing has, in fact, changed – other than the fact that we have now effectively backstopped this activity among the current survivors by sweeping the truth under the rug!
If we do not stop it now the system will blow sky-high – again – and this time there won’t be enough money or credit available to the United States Government (or any other government) to stop it.