Sunday, November 6, 2011

The Real Subprime and Predatory Fraud (Fannie and Freddie Acquitted Again and Again II)

Facts are stubborn things but ideologues are immune. Extreme right wing rhetoric concerning the role of Fannie and Freddie in the subprime debacle, is an example. As readers of this blog already know, nine out of 10 commissioners of the bi-partisan Financial Crisis Inquiry Commission rejected the thesis that Fannie Mae and Freddie Mac (the "GSEs") operated as the primary cause of the financial debacle. No matter the facts, the right twists some new tale about how the GSEs caused it all (as opposed to being essentially bit players or one of many causes).

Therefore, I anxiously await the response to the following: the real culprits have already fessed up to (or at least paid for) monumental frauds of unprecedented audacity and scale in the subprime market. And, Fannie and Freddie played zero role in this story. A massive number of real estate loans were made with the specific intent of default (i.e. the ultimate in predatory lending) so that Wall Street could make a killing (killing American capitalism for their enrichment) on undisclosed short positions on subprime assets they selected for portfolios that they then foisted on investors across the globe. THEY DEMANDED LOAN DEFAULTS! Wall Street literally loaded up mortgage backed securities (in the form of collateralized debt obligations or CDOs) with the riskiest loans possible so they could cash in on their secret short positions on the very securities they were selling to firm clients.

So, Goldman Sachs paid an all time record $550 million to settle charges that it marketed securities based upon subprime loans without disclosing that a hedge fund was short those very same securities and that the hedge fund played a role in selecting the underlying mortgages for inclusion in the portfolio. In Goldman's own words: "it was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors." This rare admission, betrays a brazen fraud and explains why so many senseless loans were made at the height of the subprime frenzy. In short, the great Wall Street derivatives machine demanded subprime loans that would default.

Citigroup also settled similar charges, on Oct. 19, 2011, with the SEC, for $285 million. Here, Citigroup held an undisclosed short position in the very securities they were selling to investors. Citigroup also allegedly exercised "significant influence" in selecting the underlying portfolio. According to the SEC complaint: "One experienced CDO trader characterized the . . . portfolio in an e-mail as 'dogsh!t' and 'possibly the best short EVER!' An experienced collateral manager commented that “the portfolio is horrible.'” Again, Citi sold securities that it wanted to default, and therefore demanded the riskiest loans possible. Perhaps this explains why private subprime loans failed at over twice the rate of even the riskiest Fannie loans as shown on the chart at right. Banks like Citi wanted loans that would default and default fast. In fact, the portfolio at issue in the SEC action closed in February of 2007, and defaulted by November, in synch with the subprime collapse. Citi made $160 million on this sordid deal.

JP Morgan Chase paid the SEC $153.6 million for its misconduct in subprime lending. According to an SEC official: “What J.P. Morgan failed to tell investors was that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection. With today’s settlement, harmed investors receive a full return of the losses they suffered.” The SEC also alleged that when the deal closed in May 2007, the hedge fund--called Magnetar--held a $600 million short position that dwarfed its $8.9 million long position in the portfolio. "In an internal e-mail, a J.P. Morgan employee noted, 'We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart.'" The SEC further found that Chase frantically sold interests in the portfolio because it knew how bad the portfolio and it knew the market was starting to come unglued.

The SEC continues this line of enforcement actions. Still, we probably will never know the full scale of these predatory frauds. The FCIC found that more than half of all CDOs generated in the second half of 2006 appeared infected with this so-called "Magnetar Trade." (FCIC Report, p. 192). Notably, all the deals underlying the SEC securities fraud actions hail from 2007. The three settlements above already total in excess of $1 billion. Thus, billions and billions worth of subprime mortgages resulted from this demand for loans that would default.

This newfangled source of predatory lending adds to the predatory loans generated for fees, or to grab collateral, or other old-fashioned predatory lending. Thus, Illinois Attorney General Lisa Madigan (Loyola University Chicago, Law Alum) spearheaded a multistate predatory lending action against Countrywide leading to an $8.7 billion dollar settlement (affecting over 400,000 homeowners nationwide) and currently is again suing Countrywide as well as Wells Fargo for steering racial minorities into high-cost, subprime loans. And, even the Fed took action against Wells Fargo for predatory lending and steering involving 10,000 home mortgages, as noted on this blog, by dre cummings. The bottom line is that massive predatory lending occurred, by any measure, and formed a core cause of the subprime debacle. According to the Wall Street Journal, 61% of all subprime loans in 2006 went to prime borrowers. An LA Times expose' found that 32 former Ameriquest employees "across the country say they witnessed or participated in improper practices, mostly in 2003 and 2004. This behavior was said to have included deceiving borrowers about the terms of their loans, forging documents, falsifying appraisals and fabricating borrowers' income to qualify them for loans they couldn't afford."

So, my question to the right is simply this: given the indisputable evidence of massive predatory lending, how can you ignore this as one (of many) cause? Do you really want to continue to maintain that it was all the GSEs in the face of overwhelming evidence of this massive predatory lending and fraud?

Professor Steven A. Ramirez
Loyola University Chicago


  1. Damning evidence. If i am reading you correctly, the subprime loan market in 2006 was driven primarily by Wall Street banks so that they could manufacture create and market junk mortgage backed securities and CDOs that they could in turn short for massive profit. If true, and it appears to be, this is downright damnable, unconscionable behavior!

  2. Thanks so much for this post and for bringing to light the evidence of the hedge fund profits. In many ways, the investment banks have tried to portray themselves as victims in this mess. The argument is that they bought up bad loans that they didn't oringinate and because they were at the top of the ladder, the banks took the blame. However, this argument can't be true. These banks go after the most highly educated people to run their businesses. They go after critical thinkers. How can they expect us to believe that these critical thinkers were oblivious to all of this. They should have been the first ones to recognize the bad loans and to warn their stakeholders of the potential damage that this would do to the economy. Instead, the banks turned a blind eye. I never understood why, but the potential for profit makes absolute sense.

  3. "I anxiously await the response to the following: the real culprits have already fessed up to (or at least paid for) monumental frauds of unprecedented audacity and scale in the subprime market. And, Fannie and Freddie played zero role in this story." -- Steven Ramirez

    Facts are stubborn things, which is why you do your best to ignore or twist them. Goldman structured and sold the securities in question at the request of a clients wanting to bet against what they believed was the extreme excess in the market for CDOs. And while Goldman and its clients may have selected these particular loans based on their risk related characteristics, they did not originate them.

    The clients on the other side of this transaction, most of whom were money managers and professional investors, had a responsibility to do their own due diligence. By your own admission, "experienced CDO traders" were referring to these securities as "dogsh!t" . The fact that the buyers failed in their fiduciary obligation and that their clients suffered a loss does not constitute fraud. If anyone was defrauded it was the clients who counted on these professionals to scrutinize and to understand what they were investing in on their behalf.

  4. This was not a "newfangled source of predatory lending" it was a response to the incredible degree of excess in the mortgage markets, an excess driven in large part by government policy which had resulted in the lowering of mortgage standards across the board in order to satisfy the lefts desires for an engineered outcome in home ownership.

    As for disclosing the motives of the parties involved, this is never done when trading and these firms were under no obligation to do so. Do you really believe that every time someone shorts a security or derivative that the party on the other side of that trade is informed of the identity of the counterparty and their motives? This is basic stuff, and if you do not understand that you have no business commenting on the financial markets.

  5. Facts show Fannie, Freddie led mortgage market to the collapse‏, Washington Times

    Yes, the federal government has the resources to extract a settlement out of even the largest firms, regardless of the evidence. This does not, however, mean that these firms have broken any laws. It only means that settling the suit is the most cost effective way to make the government go away.

  6. I thought that you were anxiously awaiting the response, is that why you took down my comment?

  7. anonymous (11.16.11, 1:52 p.m.):

    only offensive or disrespectful comments are edited or removed.

    apparently, google blogspot limits comments that contain words over a certain number and are posted as "anonymous." please always double check to ensure that your comments make it to posting. if not, please try cutting down the word count, or posting in multiple comment boxes.

  8. Zach H - Memphis LawNovember 17, 2011 at 8:40 PM

    Anonymous, buyers are required to do their due diligence, but traders are also required not to make material misrepresentations about the securities they are trading. That is fraud.

    As for your link, the only proof it offers to support its claim is that 1) Fanny and Freddie were the dominant loan securitizer in the market and had their goals lowered in '92 by Congress 2) Countrywide originated a large amount of subprime loans 3) Countrywide securitized a large percentage of their loans with GSEs. So, where's the beef? It makes no mention of the percentage of subprime loans that made up the GSEs portfolio, nor does it address what percentage of the total subprime loan market GSEs securitized.

    This article does offer some of those insights.

    According to those sources, the majority of the subprime market was actually held privately. These private players had absolutely no obligation to meet the federal standards set out in '92, and yet they did so anyway. How is that the government's fault?

  9. "As readers of this blog already know, nine out of 10 commissioners of the bi-partisan Financial Crisis Inquiry Commission rejected the thesis that Fannie Mae and Freddie Mac (the "GSEs") operated as the primary cause of the financial debacle." -- Steven Ramirez

    The Financial Crisis Inquiry Commission was a sham run by long time Democrat Party hack, Phil Angelides. Investors Business Daily makes short work of his qualifications for the commission chairmanship:

    "Angelides ran a dirty investigation. He fixed it so trial lawyers who donated more than $225,000 to his political campaigns in California could leverage banks for class-action settlements for union pension funds that invested in bad subprime securities.

    As IBD first reported, Robbins Geller Rudman & Dowd — the country's dominant plaintiffs law firm for class-action securities lawsuits — ran the crisis inquiry through chief investigator Chris Seefer (a Robbins Geller partner) and FCIC commissioner Byron Georgiou (a Robbins Geller counselor).

    Last September, months before the FCIC had closed its "investigation," Georgiou and Angelides spoke at a conference in Laguna Beach, Calif., hosted by Robbins Geller. Congressional investigators are probing whether the two violated ethics rules when they talked about their ongoing commission work.

    Talk about unfair advantage: The commission essentially provided a massive discovery operation and service for trial lawyers at public expense.

    Angelides dumped millions of pages of subpoenaed confidential bank documents on the FCIC website so his trial lawyer pals could get a multibillion-dollar payday ...

    Through this vaunted, blue-ribbon, bipartisan commission supposedly set up to get to the bottom of the worst financial calamity since the Great Depression, banks were set up — not just by Democratic politicians looking to cover their "affordable housing" rears, but by sleazy trial lawyers and their cronies looking to line their own pockets with their own profiteering.

    We include Angelides in that club. As we also recently revealed, Angelides has been a partner in an offshore hedge fund — Canyon Value Realization Fund (Cayman), Ltd. — that shorted more than $1 billion in subprime mortgage securities before the crisis.

    All this explains the commission's anti-bank agenda, and why it went gunning for banks from the opening gavel. That agenda included using government subpoenas — not to mention $10 million in taxpayer funding — to dig up dirt on banks — including documents and testimony that trial lawyers are now citing in their class-action lawsuits to strengthen their cases against those very same banks.

    A spokeswoman for House Oversight and Government Reform Committee chair Darrell Issa tells us that the panel is actively investigating the Angelides Commission and its fraudulent investigation. Hearings may start late this summer."

  10. "According to those sources, the majority of the subprime market was actually held privately. These private players had absolutely no obligation to meet the federal standards set out in '92, and yet they did so anyway. How is that the government's fault?" -- Zach

    At the onset of the financial crisis in 2008, there were about 27 million subprime or otherwise low quality (Alt-A, or so-called "liar" loans, no down payment, etc.) loans a little over 19 million of these loans, or about 70 percent, were held or guaranteed by Fannie and Freddie, other government agencies, or banks under the CRA.

    "Contrary to Paul Krugman’s assertions, Fannie and Freddie did not “fade away” or “pull back sharply” between 2004 and 2006." In 2004, Fannie and Freddie purchased 44% of all subprime MBS. In 2005, 35.3%. And in 2006, they purchased 25.2% of the record $272.81 billion in subprime MBS.

    But the governments role in the mortgage crisis didn't stop there:

    "By steering banks' leverage into mortgage-backed securities, Basel I, the Recourse Rule, and Basel II encouraged banks to overinvest in housing at a time when an unprecedented nationwide housing bubble was getting underway, due in part to the Recourse Rule itself — which took effect on January 1, 2002: not coincidentally, just at the start of the housing boom. The Rule created a huge artificial demand for mortgage-backed bonds, each of which required thousands of mortgages as collateral. Commercial banks duly met this demand by lowering their lending standards. When many of the same banks traded their mortgages for mortgage-backed bonds to gain "capital relief," they thought they were offloading the riskiest mortgages by buying only triple-A-rated slices of the resulting mortgage pools. The bankers appear to have been ignorant of yet another obscure regulation: a 1975 amendment to the SEC's Net Capital Rule, which turned the three existing rating companies — S&P, Moody's, and Fitch — into a legally protected oligopoly ... they trusted S&P, Moody's, and Fitch ... Moody's did not update its model of the residential mortgage market after 2002, when the boom was barely underway. And Moody's model, like those of its "competitors," determined how large they could make the AA and AAA slices of mortgage-backed securities." -- CATO

    So, government regulation was, in large part, responsible for driving demand for low quality mortgage backed securities.

    As for having no obligation to meet the federal standards set out in '92, this 2000 City Journal article The Trillion-Dollar Bank Shakedown That Bodes Ill for Cities explains how a change made by the Clinton administration to the Treasury Department's 1995 regulations was used to force compliance with the new CRA interpretation through extortion.

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  12. So, the response is: "predatory lending did not happen?!?"

    Or is it: "pay no attention to all that predatory lending?!?"

    So we should just ignore it?

  13. I believe what "Anonymous" is getting at is not necessary that predatory lending did not occur. Anonymous is simply trying to point out that predatory lending was enabled, if not encouraged, by the federal government. I know this is a highly unpopular idea, especially on this blog, but without any of the 90's Federal legislation and "regulation" this entire situation might have been avoided or at least really lessened. More regulation simply creates more avenues for intelligent individuals to exploit the system.

  14. @Josh as opposed to a system without regulation in which less intelligent people can freely reek havoc on the stability of the economy? Anonymous raises a good point that fannie and freddie were not entirely innocent in the trade of these CDO's however I think admitting that Fredie and Fannie participated in wrong doing is not an effective argument against the enforcement of regulations that are supposed to preclude lenders from participating in this sort of predatory lending. Freddie and Fannie were supposed to have a public mission to make home ownership accessible to Americans that wouldn't have access to funding otherwise. If they cannot achieve this goal without engaging in illegal activity they are obviously not serving the public good. However, if private banking institutions such as Citigroup and Goldman Sachs can't be profitable without engaging in this type of lending and securities trading then they have no place in the market as they are currently composed either.

  15. Let me clarify some key points:

    1) Fannie and Freddie as currently structured suck. They are in need of radical reform;

    2) Even beyond their structure they were as politically corrupt as any Wall Street bank;

    3) Far from being blameless, they opened the subprime market, they opened securitization and they did in fact purchase massive amounts of non-conforming mortgages, particularly before 2006 (see chart above).

    But, their portfolios were simply too safe to cause this massive crisis. I have seen no evidence they were ever involved in predatory loans of the type driving this crisis. Further, the regulatory changes that required their push into affordable housing were bi-partisan. Both Democrats and the GOP pushed affordable housing.

    And that is the difference between my position and the ideologues. Many times on this blog I have challenged the extremists to fess up to the involvement of the GOP--and, in general, they only wish to blame the Democrats.

    This was a bi-partisan crisis. And the GSEs played a role. But follow the money!

    98% of this crisis lies on Wall Street (and their government cronies), not government programs designed to help the middle and lower middle class. All Americans got screwed from this crisis--except for a handful of Wall Street billionaires.

    Plus who holds power in America? Does anyone really think the lower 60% or even 70% run this country? We all know the system is rigged in favor of the most economically powerful, not in favor of the most dis-empowered.

    So when considering causation two simple rules apply: 1) follow the money and 2) blame the most powerful not the powerless.