The Banks Lost the Notes: This is no Joke!

What kind of banker loses promissory notes? "A damn careless one," according to Law Professor Douglas Whaley, who spent 40 years teaching Commercial Paper at Ohio State University.

What kind of banker destroys promissory notes? A "really stupid" one, says Professor Whaley.

And yet, it is now clear that promissory notes underlying mortgage backed securities were lost or destroyed on a systematic basis, in what can only be termed yet another exhibition of the infinite recklessness (or corruption) of the bankers running the US economy. How bad was it?

The Florida Bankers Association told the Florida Supreme Court that banks routinely destroyed notes after e-recording the notes to "avoid confusion." The Florida bankers told the Supreme Court that this was the "industry standard." Professor Katherine Porter wrote a 2008 Texas Law Review article that looked at the loan documentation from 1700 bankruptcy cases. A stunning 41.1 % of the files reviewed lacked a promissory note to support the mortgage claim. Yves Smith, the high profile author and economics blogger, states that her sources indicate the notes were "never" transferred to the MBS trust. This certainly will prove to be a major problem, as demonstrated by the recent rescission claim being pressed by (among others) the New York Fed which claims that MBS were plagued by "shoddy paperwork."

On some levels losing the note is worse than blowing the mortgage (due to MERS Madness, for example). Because promissory notes are negotiable instruments generally only the original (and not any copy) is enforceable against the borrower. Under the UCC (a uniform commercial code in place in most all jurisdictions in one form or another), section 3-309, a lost note may not be fatal to recovery by the owner of the note. But the requirements of proof under this section are quite demanding; most notably, the section requires that possession and ownership of the promissory note be vested in the plaintiff at the time of loss. It appears that many MBS notes disappeared before transfer to the trust that now holds the note, which would defeat recovery under this section. Moreover, in order to enforce a lost note under the UCC, the court must assure that "the person required to pay the instrument is adequately protected against loss that might occur by reason of a claim by another person to enforce the instrument." That sounds like an indemnity bond to me (particularly given the transitory nature of the banks holding these notes, as I will show in my next post). And, that could prove costly. These are serious impediments to enforcement of lost promissory notes in this context.

Moreover, analysis of the ability to enforce lost notes is made more difficult by the fact that each state may have quirks in their version of the UCC. Some states have amended their UCC statutes like this version in Florida which is less demanding than most states. It could take years for the courts across the country to work out these issues.

Again, these issues are not technicalities. Instead, they are integral parts of a statutory scheme designed to balance commercial certainty and enforcement of contracts against protecting the borrower from multiple claims. The ultimate protection of the borrower is an original canceled note. Once a borrower pays a note obligation he is entitled to a canceled note. If the lender loses the note he has in a real sense deprived the borrower of this basic right. So courts are rightly suspect of efforts to enforce lost notes, and courts should take appropriate steps to give borrowers that same level of protection--i.e., an indemnity bond or better. Thus, courts have not hesitated to refuse to enforce lost notes despite efforts by claimants to avail themselves of 3-309, as illustrated in this case, and those cited therein.

Even if courts allow enforcement of missing and lost notes, therefore, this will require more proof and costly hearings, not to mention the cost of indemnity bonds. It is probably true that few have been wrongfully subject to foreclosure proceedings; on the other hand, it appears very likely that many, many homeowners were evicted through flawed proceedings where the bank failed to prove its entitlement to foreclosure properly. Figuring out how to manage these grim outcomes will also require extensive litigation--largely due to the ineptitude of the banks and their failure to follow the law. At best, from the point of view of the banks, this will slow down foreclosures, increase foreclosure costs, and further impair the value of MBS, leading to more bank losses.

So, here we go again. The banks failed to see to it that this reckless subprime lending entailed any semblance of basic and prudent documentation practices. I can think of no more powerful indicator of gross ineptitude than this: they lost and destroyed promissory notes. These are the bankers that we bailed out and left in control of a huge chunk of our financial sector.

SEC Smacks Angelo Mozilo with 67.5 Million Fine

Just four days before Angelo Mozilo’s securities fraud and insider trading trial was to begin in Los Angeles, the former CEO of now-defunct Countrywide, settled the SEC’s claims against him for 67.5 millions dollars, resulting in the first personal punishment for a prominent executive who engaged in reckless and grossly negligent behavior during the subprime mortgage boom and bust. Mozilo raked in hundreds of millions of dollars in ill-gotten gains during his company’s foray into the subprime mortgage markets.

The settlement consists of 45 million to disgorge ill-gotten profits and 22.5 million as a penalty. Despite the hefty sound of the fine, the total settlement represents a drop in the bucket of what some have deemed obscene profits earned by Mozilo during 2000 to 2008. Countrywide’s bread and butter during the subprime boom was the incredibly risky zero-down, negative amortization, adjustable rate mortgages. Mozilo earned 500 million during this 8 year period. Amazingly, of the 67.5 million penalty, Mozilo will only be responsible for paying the 22.5 million in ill-gotten profits. Insurance and Bank of America (successor to Countrywide) will pay the remaining 45 million, based on various indemnification agreements. So, at bottom, Mozilo received more than $500 million in compensation and bonuses while driving Countrywide into the ground and defrauding shareholders, yet will only be forced to disgorge 22.5 million of his personal fortune, and agreeing to a ban from ever serving again as a corporate executive. A small price to pay for recklessly leading Countrywide into bankruptcy.

The record-setting default rates for these terrible mortgage products caused not only the demise of Countrywide, but contributed significantly to the near collapse of U.S. financial markets. Mozilo himself described these loan products as, “poison” and “toxic” in emails to other Countrywide execs in 2006, signaling that he could readily foresee the collapse of the company that he was leading, but Mozilo chose to continue to enrich himself by defrauding investors and shareholders recklessly.

Bank of America eventually acquired Countrywide in 2008 in a fire sale.

The Federal Reserve We Need

Professor Timothy Canova has recently published “The Federal Reserve We Need” in The American Prospect. Therein, Professor Canova details, painstakingly, the path that The Federal Reserve has taken from a governmental agency charged with safeguarding the American economy through sound monetary policy to an organization that has simply adopted the private banking interests and agenda as its own. Professor Canova highlights the groundbreaking work of former Fed Chair Marriner Eccles during and after the Great Depressions and juxtaposes the role that Eccles played in assisting the American economy with that of Alan Greenspan and Ben Bernanke and argues that Greenspan and Bernanke have co-opted the private interests of banks rather than safeguarding the best interests of the American economy. Read his excellent article here: The Federal Reserve We Need

Additionally, Reuters has just published an investigative report, entitled “Cozying Up to Big Investors at Club Fed,” that details the many conflicts of interest that continue to exist at the Federal Reserve, including what amounts to very nearly insider trading engaged in by members of the Federal Reserve and the clients that subscribe to a specific member’s consulting services. The full article can be read here: Club Fed

Is A Mortgage Bond Meltdown Imminent?

The above charts show that our mega-banks suffer from higher perceived risk of default, as the market prices of credit protection have soared--in response to the threat to bank capital from MERS Madness and the Robo-signing fraud. Many commentators, however, believe that these scandals pale in comparison to a fast-approaching meltdown in the entire private label mortgage bond market. Essentially, we appear to be on the brink of a flood of claims that the mega-banks simply did not package and sell loans in accordance with their representations and warranties at the time of sale and withheld material information.

Today, the New York Fed announced that they and other major investors are seeking $47 billion from Bank of America for precisely this kind of claim and credit default protection on BOA bonds has now soared to 15 month highs. Chase analysts estimate that the mortgage bond buybacks could cost the banks $120 billion.

But so far, the claims seem to me to be the tip of the iceberg. For example, here is the gist of the claim brought by the FHLB of San Francisco:

In its amended complaints, the Bank is seeking to rescind its purchases of 136 securities in 116 securitization trusts, for which the Bank originally paid more than $19.5 billion.

The amended complaints reflect the Bank's further investigation of specific loans in the 116 trusts. The amended complaints allege, on a trust-by-trust basis, that the defendant dealers made untrue or misleading statements about the loan-to-value ratios of the mortgage loans in the trusts, the percentage of those loans that were secured by the primary residence of the borrower, and the extent to which the originators of those loans departed from their disclosed underwriting standards in making the loans.

Similar suits have been brought by the FHLB of Seattle, the FHLB of Chicago and no doubt many others will emerge. But perhaps the biggest suits will be those arguing that when you sell mortgage-backed securities you need to include mortgages--enforceable mortgages, no less. In other words, the MERS Madness also rears its ugly head here, in the form of yet another basis for investors to pursue claims against the mega-banks. Given that MERS infects 60 percent of all mortgages and that there over two trillion dollars of private label securitizations outstanding it is really hard to imagine that this is only a $120 billion problem. Similarly, the lawyer at ground zero of this particular fiasco states that 50% of all loans tested did not meet the representations and warranties made by the issuer. So the Chase estimate reminds me of the false confidence displayed in the early stages of the last crisis. Perhaps global capitalism will survive, but more than $120 billion in losses will hit bank capital as a result of this meltdown; indeed, BOA may take a $74 billion hit alone.

Now some pundits claim that the US Government will come to the rescue. And, I do not want to underestimate the power of money in politics. But if the Democrats lose control of either House we are facing deep gridlock. There will be no rescue.

Dodd-Frank does authorize Fed and FDIC bailouts. It also authorizes a reasonable Orderly Liquidation Authority. Nevertheless, the bankers defanged the OLA, and the Fed and the FDIC may actually lack the firepower to pull off another bailout without a sentient Congress. This will be a forthcoming blog topic.

MERS Madness!

What is MERS?

According to Professor Christopher Peterson, over 60 percent of all American mortgages are recorded in the name of MERS, even though they do not own the mortgages or underlying notes. This was apparently done to avoid paying recording fees when mortgages were transferred. Here is what MERS does, from the MERS website:

MERS was created by the mortgage banking industry to streamline the mortgage process by using electronic commerce to eliminate paper. Our mission is to register every mortgage loan in the United States on the MERS® System.

Beneficiaries of MERS include mortgage originators, servicers, warehouse lenders, wholesale lenders, retail lenders, document custodians, settlement agents, title companies, insurers, investors, county recorders and consumers.

MERS acts as nominee in the county land records for the lender and servicer. Any loan registered on the MERS® System is inoculated against future assignments because MERS remains the nominal mortgagee no matter how many times servicing is traded. MERS as original mortgagee (MOM) is approved by Fannie Mae, Freddie Mac, Ginnie Mae, FHA and VA, California and Utah Housing Finance Agencies, as well as all of the major Wall Street rating agencies.

Mortgages are held by MERS as "nominee" no matter who actually holds the beneficial interest? As Professor Peterson shows in his outstanding work on this issue, there are serious problems with this means of managing mortgages. First, the mortgage (as well as any assignment) must be recorded with public recorders of deeds to maintain priority over subsequent transferees of any interest in the underlying real estate. (pp. 3, 13). Second, under the statute of frauds the name of the owner of the mortgage must be listed on the face of the mortgage. (pp. 16-19). Third, mortgages cannot be split, transferred or assigned away from the underlying note and MERS does not retain any beneficial interest in the notes. (pp. 5-7). Fourth, only the owner of the mortgage may enforce the mortgage. (p. 5). Finally, it is "extremely unclear" that a mortgage can be held in the name of an agent or nominee. (p. 5). All of this means that there may be very serious flaws in millions of mortgages across the nation, that likely renders many such (perhaps millions) mortgages unenforceable. MERS has thus met skepticism in the courts to say the least. (pp. 8-11). Recent cases fully support the upshot of this analysis.

Professor Peterson suggests that these flaws render the mortgage debt unsecured debt. This would naturally greatly erode the value of all mortgage backed securities infected with the MERS flaws. Peterson also suggests that perhaps courts could impose equitable mortgages in place of legal mortgages; but in equity the mortgages would be unlikely to retain some of their more predatory features. Moreover, equitable mortgages can be discharged in bankruptcy and the ability of lenders to pursue deficiency judgments may well be reduced. In short, this is a costly and uncertain road, and lenders would be well advised to negotiate and reduce their principal than to litigate endlessly in hope of equitable relief. (pp. 20-22).

Obviously, this MERS madness could have serious adverse effects on the continued solvency of our financial sector. But, it is worth noting that these time-honored rules are not technicalities. They exist to assure that a borrower does not have to pay, again and again. By requiring that the mortgage and note stay together in the same person, the borrower can only be sued once on the same debt. In fact, there is already much evidence that some debt has led to exactly this problem with MERS. So requiring the plaintiff in a foreclosure action to show up with the original signed note and mortgage (or to account for same), is a basic protection of homeowner rights.

Professor Peterson highlights other policy ramifications from this fiasco. "For the first time in the nation's history, there is no longer an authoritative, public record of who owns land in each county." (p. 4). Because MERS did not in fact have any claim to the mortgages, its mortgage recordings were false documents. "Using false documents to avoid paying fees to the government sounds a lot like tax fraud." (p. 25). But perhaps most importantly, "the lives and fortunes of generation after generation [of] America's middle class turn more on their ownership of land than any other asset." (p. 18). The massive destabilization of middle class property rights (the rich can hire teams of lawyers) implicit in this MERS madness will impose costs and uncertainty at the heart of the American economy for years to come. Once a mortgage goes into the MERS black hole, there is no tracing the actual owner of the mortgage for purposes of negotiations, payment certainty, or history of the loan. If MERS holds the mortgage there is literally no way to know for sure whom should be paid. Ten years from now these problems will be even worse.

Frankly, this is outrageous. Doing this right is simple: the original lender is named on both the mortgage and the mortgage note; these documents are recorded at the recorder of deeds office; when these interests are pooled (into a trust or some other entity) for purposes of securitization, then the mortgages and notes are assigned to the securitization vehicle; and, the assignment is recorded to preserve priority. This is simple and time tested. It conforms to law. Yes, it could cost a bit more, but these guys sucked the economy dry with their blasted bonuses, and recording costs about 40 bucks. Our system of property rights is looking like some Banana Republic for a few pieces of silver.

One more time: the apex of our economy is dominated by the most inept, if not corrupt, financial elites in the history of financial elites. Its as if the entire Wall Street culture decided the world was going to end in just a few weeks. It is (way past) time to fragment these banks into 10,000 pieces and terminate all of the senior managers of these unbelievably reckless entities.

The MERS madness shows that these people really think they above the law.

So far, the markets have had an apparently mixed reaction to the foreclosure crisis, but the cost of credit default insurance against major banks is climbing higher. Perhaps the hope is that these legal problems can somehow be resolved over time. If these problems persist I doubt the market will not suffer.

ADDENDUM: Here is the best case for MERS, as stated by their spokesperson.

Ruminations on Robo-signing and Our Corrupt Financial Elite

Every American should be outraged by the subversion of middle class property rights now underway in courthouses across America where massive fraudulent foreclosures appear to be occurring. The video above provides an overview of the problem. As Paul Krugman puts it: "the mortgage mess is making nonsense of claims that we have effective contract enforcement -- in fact, the question is whether our economy is governed by any kind of rule of law."

So far, Wells Fargo, JP Morgan Chase, Ally (GMAC), Citi, PNC, Bank of America and Goldman Sachs among others have each been caught up in the robo-signing fraud. Apparently our major banks decided to kick-out homeowners through the cheapest and fastest means they could get away with regardless of illegality. Basically, according to one attorney who has deposed 150 "robo-signers," this was "an industry wide scheme designed to defraud homeowners."

This started to unravel when Attorney Thomas Cox discovered that GMAC hired a "limited signing agent" to execute 10,000 affidavits a month in support of foreclosures--a veritable dispossession machine. Obviously, such a pace makes it impossible to testify based upon personal knowledge and to assure that the bank actually has the right to foreclose. Now attorneys have admissions from agents of major banks that they had no personal knowledge of the facts they swore to, they did not understand the affidavits they signed, and they had not searched for basic documents like notes and mortgages that would prove the right to foreclosure. A paralegal at one foreclosure mill testified that signatures were forged, documents backdated, and social security numbers swapped to support faster foreclosure actions.

Maryland now appears poised to conduct a massive audit of foreclosure actions in its courts. The SEC is investigating publicly held firms involved in this entire sordid affair, and the DOJ, FDIC and OCC are also conducting their own inquiries. These actions have been announced since I posted my first blog on this topic which was triggered by the coast-to-coast investigation of our 50 state attorney generals. Class action attorneys will no doubt file massive claims. This fraud in foreclosures amounts to a massive assault on the judicial process and the rule of law in America and should lead to convictions, judicial sanctions and the imposition of massive legal liabilities.

According to one bank analyst the litigation losses to the banks from this pattern of fraud could mount to $80 billion. Another analysis suggests a $6-10 billion loss from the delay in foreclosure recoveries. For now, at least, it appears that the value of MBS has not suffered much. So, standing alone, these losses ought not to lead to another Lehman meltdown. But, the mortgage bond meltdown (which I will cover in more detail soon) may lead to even larger losses. In a fundamentally weak economy, the combined problems in the mortgage market could easily trigger another financial crisis, complete with federal bailouts of our banks, again.

I became a lawyer in 1986, shortly after graduating from Saint Louis University School of Law. Since then I worked for large corporate firms, small firms, the SEC, the FDIC and as a teacher at two different law schools in Chicago and Topeka, Kansas. Nothing in my experience prepared me to understand the robo-signing scandal now gripping the banking sector. In my opinion the systematic submission of fraudulent documentation to support residential foreclosures was impossible. Lawyers cannot participate in fraud and owe a duty of candor to courts. CEOs and directors would never approve such a brazen method of generating revenues now while exposing their firms to massive legal liabilities down the road. Under Model Rule 1.13 any in-house attorney as well as outside counsel would be duty bound to alert corporate authorities to the fraud and would even confront the possibility of reporting wrongdoing within publicly held banks to the SEC. Fraud ought not to pay, and the system really does punish fraudfeasors (other than securities fraudfeasors which benefit from special legal protection).

Nevertheless, I was clearly wrong. We are seeing the most massive legal fraud in US history, right before our very eyes, right now. This all makes a mockery of the rule of law in America, which already was suffering from excessive elite subversion, as I argue in my forthcoming book Reimaging Capitalism.

We should have expected this. When we bailed out the banks we permitted the reckless bankers to remain in control, even though they had proven themselves inept, at best, and corrupt at worst. According to Professor Emma Jordan Coleman, 92% of the senior bank managers who caused the crisis remain in control of their firms. They sunk global capitalism in the name of short term profits. Now they are so anxious to generate revenue from foreclosures they seem to be utterly unconcerned about committing fraud on the courts, fraud on homeowners, and fraud on buyers of tainted properties. It is now past time to oust the managers of these "zombie" banks that do not lend and instead "suck the lifeblood out of our economy." That is why I argued here, here, here, and here that any bailout should require dismissal of the senior managers who recklessly crashed the economy.

Otherwise, the managers will simply be emboldened by their ability to foil legal accountability to pursue even worse misconduct--like judicial fraud.

Trouble with Foreclosures Intensifies: "Where Were all The Lawyers?"

For some time, there have been signs of trouble with real estate foreclosures because issuers of securitizations apparently failed to assure that loans could be foreclosed upon in the event of default on the underlying mortgage debt. So, for example, in Cleveland, in 2007, a judge dismissed a number of foreclosure actions brought by Duetsche Bank because the bank's ownership of the mortgage documents had vaporized and could not be proved in court.

I am frankly amazed that these problems have emerged because it seems to me that the lawyers representing the issuers of these securitizations owed professional obligations to undertake due diligence. This due diligence would require, at a minimum, to see to it that the notes and mortgages being pooled were valid under state law; that the mortgage was perfected, recorded and could be enforced through foreclosure in the event of default; and, that the foreclosure proceedings would not entail excessive cost. These mortgage interests in real estate then must have been transferred to investment vehicles in writing, in accordance with the Statute of Frauds, and through a recorded transfer that would preserve priority against subsequent transferees. A lawyer cannot be willfully blind to a client's reckless misrepresentations and must exercise due diligence to avoid participating in a fraud. Thus, a mortgage securitization must include enforceable mortgages. This entire process would then be preserved through the retention of appropriate documentation.

So, in 2007, when these issues first appeared, I was certain that they must be the result of isolated aberrations. In fact, the recklessness (or worse) of the private label securitizers now appears to be systemic and has triggered a coast-to-coast investigation of foreclosures by all 50 state attorney generals. There are three major problems.

First, there is certainly a procedural problem spawned by so-called robo-signers who were used to short-cut court procedures by signing affidavits in support of foreclosure actions without any factual basis or investigation. Some robo-signers executed 6000 affidavits in support of foreclosure per week. This systemic effort for cheap foreclosures simply reiterates the fundamental recklessness of the financial sector. This is fundamentally fraudulent. By raising the costs of foreclosure, here it appears that the state attorney generals seek massive loan write-downs, meaning massive loan losses to banks.

Second, many key loan and mortgage documents were not recorded in a proper way and instead used a nominee of dubious legal standing--in particular an outfit called MERS. This means of tracking mortgages seems to be a colossal failure because the courts are increasingly refusing to enforce mortgages held in nominee names. Consequently, there is some chance that a significant portion of the 64 million mortgages held in the name of MERS will be unenforceable leading to massive financial losses. Professor Chris Peterson suggests that MERS grew from hubris that exalted short tern profits over long term legal risks.

Third, it appears that many mortgage documents simply cannot be located. This one really baffles me. According to Professor Katherine Porter this is very common. Basically it appears that investors were induced to buy mortgage pools without enforceable mortgages. This will spawn years of litigation and accompanying losses for the financial sector. And, it is likely to require massive loan write-downs as banks renegotiate loans in the shadow of missing documents.

One financial expert calls this "the biggest fraud in the history of capital markets." According to Professor Georgette Phillips of the Wharton School of Finance: "This entire debacle is a symptom of the Wild West, shoot first and ask questions later, attitude of the securitization industry." My friend Christian Johnson puts it more succinctly: "This is all unbelievably bad."

Where does this all lead? Undeniably, this will mean a major loss of bank capital in a context where both the banking sector and the economy generally are already vulnerable, as Nouriel Roubini (48 minute mark) and Chris Whalen (1:07) make clear in this video. Moreover, this will hardly help the residential real estate market recover. So this will likely extend our economic problems, at best, and has the potential to trigger a major financial crisis, at worst.

The magnitude of the problem is betrayed by the banks' resort to congressional fixes. President Obama just vetoed legislation that would have eased many of the banks' documentation problems. The banks would not have sought such legislation unless they needed it to resolve a serious problem. Only the banks know the magnitude of this problem with certainty, but there is simply no doubt that is is now a major economic problem.

For me, however, the question is: where were all the lawyers when these securitization deals came down?

Revisiting Citizens United

When the United States Supreme Court decided Citizens United v. Federal Election Commission earlier this year, many commentators, including several on the Corporate Justice Blog, predicted that the decision would have a nefarious impact on future elections. Recall, that Citizens United essentially held that United States corporations are entitled to free speech rights in electioneering contributions and that Congressional prohibitions that restricted the ability of corporations to finance particular candidates in contested partisan elections were unconstitutional. The Supreme Court essentially freed corporations and unions to make unfettered election contributions to specific candidates in American elections. Now that the 2010 mid-term Congressional election period is in full swing, has Citizens United had the predicted nefarious impact? The answer to that question lies in one's perspective. Without question, corporate campaign contributions have increased in 2010 to levels never before seen.

Recent empirical analysis confirms what many feared: Citizens United has “liberated” corporations from most of the campaign finance restrictions imposed by the McCain-Feingold law which were struck down as unconstitutional. While 2008 was a record-breaking election year in terms of donations, now in 2010, due in large part to Citizens United, corporate political spending has increased by 10-15%, and this despite a relentlessly depressed economy. Compared to the last mid-term election in 2006, campaign contributions in 2010 are predicted to increase by more than 35%. “Super PAC’s” are taking in money like never before, including huge corporate contributions into and large negative advertising buys by Karl Rove’s American Crossroads group. More than anything else, Citizens United will likely increase exponentially the money spent on negative election advertising.

The GOP's Pledge to America: Extending the Bushonomics Misery

Remember those horrific last days of the Bush Administration when in September and October of 2008 global capitalism collapsed and the Bushies rushed to Congress to get an $850 billion rescue for the big banks? Well, the GOP now pledges to bring that hellish nightmare back if you elect them. That's right, in a desperate effort to escape responsibility for being the party of "NO" during the worst economic crisis of our time, the GOP now pledges to bring back policies that simply cannot be distinguished from the Bushonomics that caused the entire economic maelstrom in the first instance.

For example, today we are all familiar with the efforts of the Bush Administration to render government incompetent and ineffective. This effort allowed New Orleans to be destroyed, Bernie Madoff to engage in an unprecedented Ponzi scheme and the banks to run wild. "Around the world the Bush name is synonymous with arrogance, ignorance, reckless insouciance, torture, violence and ineptitude." The Bush approach proved the costliest episode of near criminal negligence in our history. So now, The GOP plans to freeze federal hiring so that the new financial reform bill will lack any regulators to enforce the new reforms. In other words, they want to let the banks go wild again. Basically, having lost the effort to defeat Dodd-Frank democratically, in Congress, the GOP intends to jam unregulated banks down our throats by refusing to hire regulators to regulate the banks. Defanging Dodd-Frank has been a hard right goal since even before it was signed.

They also pledge to increase unemployment by slashing government spending in the face of an economy that teeters on the brink of deflation, which even conservative voices recognize failed to work in 1937. They pledge to crash the real estate market by ending federal efforts to use Fannie and Freddie to provide the only life support between us and total housing collapse. And of course, they pledge to increase the budget deficit and impose billions in debt upon our grandchildren and great grandchildren by slashing taxes even more than Bush, including for all those making more than $250,000, at a cost of $700 billion.

The ultimate irony here is that they make these upside down proposals just as powerful new evidence has emerged that President Obama's stimulus efforts certainly helped save us from a depression--for now, at least.

Basically, the GOP offers Bush II. So, if you enjoyed the first economic collapse, prepare for Economic Collapse II. The GOP Pledges it.

More on Fannie and Freddie

As detailed on this blog, last week the Federal Housing Finance Agency (“FHFA”) released the first of what will be quarterly status reports of the financial health and condition of the mortgage giants Fannie Mae and Freddie Mac. The report provides a revealing snapshot of the companies, and its conclusions challenge many commonly-held assumptions about the reasons the quasi-governmental agencies nearly failed.

A handful of economists, hundreds of politicians, and thousands of citizens place entire blame for the financial crisis on the two mortgage giants, in particular for creating and later bursting the housing bubble that nearly collapsed the global economy. Wrong. The Report shows that Fannie and Freddie’s market share plunged in 2003 and at the peak of the dangerous subprime mortgage and mortgage backed securities markets, Fannie and Freddie’s combined total share was only 1/3 of the mortgage market. Fannie and Freddie are not blameless, in that they clearly dipped their toes in the subprime market mania most notably in 2005 and 2006. Still, the report makes clear that private investment banks drove the appetite for subprime mortgages, the mortgage backed securities market and the collapse.

"Fannie and Freddie Acquitted"

Case closed.

Oh yes, there are the so-called GSE investments. Problem there is that they lost a relatively measly $20 billion. Hardly enough of an investment to stoke a massive bubble. Quoting from the GSE Conservator report:

"The Investments and Capital Markets segment accounts for $21 billion, or 9 percent, of capital reduction from the end of 2007 through the second quarter of 2010. Losses in the Investments and Capital Markets segment stemmed from impairments of private-label securities, fair-value losses on securities, and fair-value losses on derivatives (used for hedging interest rate risk)."

Of course, as I have long noted on this blog Fannie and Freddie actually leaned against the bubble by essentially exiting the market just when it reached bubble proportions:

These are damning facts for those claiming that Fannie and Freddie caused the meltdown. Basically, their subprime investments were a drop in the bucket and they had little or nothing to do with the worst of the lending.

The bottom line is this: in a desperate effort to save face, laissez-faire ideologues strove mightily to impugn government efforts to facilitate home ownership rather than massive financial deregulation as the primary cause of the meltdown of 2008. They lacked facts and they ignored history--after all, Freddie and Fannie have been around for decades before the housing bubble whereas massive deregulation immediately preceded the fiasco. The Conservator's Report will not stop their delusions.

Students of history and economics know that laissez-faire does not work--it did not work in 1929 (before Fannie, Freddie, the SEC, the FDIC, etc.) and did not work in 1995-2008. It has not worked anywhere. Laissez-faire may be an attractive political philosophy in theory but it is an economic dead end. The subprime fiasco is just the latest laissez-faire disaster.

BASEL III: FINANCIAL ELITES WIN AGAIN

The Basel III accords released this weekend may seem like financial and accounting minutia, but it actually goes to the very heart of the ongoing financial crisis. In order to pump up profits bank managers used leverage--debt--to enhance the profitability of their risky bank activities. When bank assets fell their thin capital cushions vaporized and the government rode to the rescue with trillions in morally repugnant and economically damaging bailouts. Because of ongoing capital problems we have a deeply dysfunctional financial sector at the foundation of a deeply dysfunctional economy. As such, the failure of Basel III (combined with a similar failure of Dodd-Frank) to impose meaningful regulatory discipline upon the financial sector can only be termed yet another missed opportunity to avert a future meltdown. I see two huge problems:

First, the new capital standards do not take full effect until 2019--and by then we could well experience multiple financial crises. Moreover, because banks have been hoarding capital they all comply with the new standards already, as shown in the chart above. So, while it appears that higher capital standards are on the way this regulatory requirement is illusory. This why bank analysts call the new regime "surprisingly accommodative." The new regime changes nothing in any meaningful time frame.

Second, the new capital rules have no impact on accounting standards that allow banks to hide losses (like the now infamous practice of extend and pretend) underlying those capital standards. This means that banks still face severe capital challenges that Basel III fails to address. At best banks have taken only 2/3 of total write-downs. Just because losses are buried, however, does not mean they disappear; instead, they fester and create more problems in the future, including an enhanced risk of future meltdowns. Lack of an accord on accounting standards effectively "will scuttle Basel III before it’s even implemented." The new regime allows this basic accounting scheme to continue.

Basel III will not prevent a future meltdown--indeed Lehman's 31 to 1 leverage ratio complies with the new regime--and therefore fails to address the gaping holes I previously decried in Dodd-Frank. Its getting more difficult to see a positive ending to this misshapen reform effort.

We Need More Money

I enjoyed reading Prof. Ramirez's previous post and think the analysis is spot on. I slightly disagree, however, with his policy prescription. I believe he is absolutely correct in that "instead of trickle down bailouts the Obama Administration needs to pursue bottom up bailouts." I also agree that a massive stimulus would help the economy. But, learning the lessons of the previous stimulus we know that there are certain practical limitations on how quickly the government can spend money. For this reason, many economists believe that monetary policy is the best way to stimulate a recovery.

Probably the bast way to explain why this is is to start with why recessions happen in the first place. It's not because people make bad business decisions or because people desire to work less, but because of poor policy decisions made by those who handle monetary policy, the Federal Reserve. Paul Krugman explains in a piece he wrote in 1998 (for explanation why structural reasons are an unlikely cause of this recession I'd suggest reading the whole piece):

"A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?"

What Krugman is saying here is that we have lots of people who want jobs and lots of work for them to do, but people value money more than they value what is produced. There is excess labor and capacity, but not enough demand. Why does this matter? In an excellent post, which contains some colorful language , Karl Smith explains:

This is not a big deal like the GOP doesn’t appreciate public goods. Or, Democrats don’t understand incentives. Or some other such second order debate that could reasonably concern us in different times.

This is a failure of our basic institutions of production. The job of the market is to bring together willing buyers with willing sellers in order to produce value. This is not happening and as a result literally trillions of dollars in value are not being produced.

Let me say that again because I think it fails to sink in – literally trillions of dollars in value are not being produced. Not misallocated. Not spent on programs you don’t approve of or distributed in tax cuts you don’t like. Trillions of dollars in value are not produced at all. Gone from the world entirely. Never to be had, by anyone, anywhere, at any time. Pure unadulterated loss.

Time and time again I see people speak about recessions as if they are a bad harvest – an unfortunate event wherein we have to figure out how to go with less. Some say we should all sacrifice – some say the sacrifice should be based on X or Y. Some say each family should take their lumps as they come.

However, they are all getting the basic idea wrong. This is not a bad harvest. The problem isn’t that there is less to go around. The problem is that we are creating less, building less, making less.

We have people who would be working but are instead watching Judge Judy. We have machines that could be spinning but are literally rusting for lack of use. This is a coordination disaster.

So what is the right policy to solve this problem? Certainly stimulus helps, it puts people to work and creates demand in the economy because these jobs put money in their pocket, something the economy craves. A better approach, however, is to favor inflation (or rather a NGDP target). Without explaining the intricacies of inflation, this would make the debts that people currently have worth less and make them easier to pay off, reducing the incentive to save and the demand for money. This policy would also not only provide debtor relief, but does not require the consent of Congress who is clearly clueless as to how this recession happened and the policies that are necessary to fix it. In the end, it doesn't matter how the economy gets the excess demand that it requires, whether through stimulus or an inflation target, but that our institutions are strong enough to solve the policy errors that got us into this mess. On that count I'm quite worried.

Obama's Latest Stimulus: A Drop in the Liquidity Trap Bucket?

President Obama announced a brand new $50 billion (over six years) infrastructure bill today which is infinitely more than any GOP proposal to fix the economy but still is woefully inadequate. To get a sense of the scale of the problem consider our so-called banks. As is evident from the above, banks are still hoarding unbelievable amounts of capital and continue to starve the economy of credit. The above chart shows that for two solid years now reserves have soared to unprecedented levels, no doubt because the banks still do not trust their balance sheets which are still bloated with toxic assets. And that is literally the tip of the iceberg: corporations are now hoarding capital rather than risking the hazards of a credit strapped economy ($500 billion more than before the meltdown); investors of all stripes have crowded into Treasury bonds causing yields to plunge across all maturities; and, finally, consumers are paying down debt and cutting back on expenditures at a record pace. So at a time when Apple Computer alone sits a top a $50 billion cash hoard, the President kicks-off the midterm election season by announcing a $50 billion infrastructure plan over 6 years--about $8 billion per year. The smallness of the plan boggles the mind, particularly in light of the scale of the problem.

Amazingly, the US real economy seems to absorb blow after blow from the financial sector without falling off the cliff. Although the latest jobs report saw unemployment measures increase and the all-important employment ratio continue to stagnate, the markets actually rallied because they expected worse. Nevertheless, most experts, especially those that have proven right again and again, are not optimistic going forward, largely because the government seems politically paralyzed and unable to muster the political will for decisive action.

The economy and the Obama administration now sit at the edge of an abyss. The economy seems likely to either tip into a double dip recession or stagnate for years to come. Team Obama faces a historic electoral drubbing in November.

Why would Obama go so small under these circumstances?

For reasons that are difficult to comprehend Obama is wedded to the Rubinites--Larry Summers and Timothy Geithner. Rubin opposes any new stimulus. He will only support more tax cuts, which I have long argued will lead only to debt repayments in a deleveraging economy and thus more money for the banks. The 2008 tax cuts for example, initiated to forestall the catastrophe we now face, failed to demonstrably reignite spending and consumption. Instead most of the money went to payoff debt. Notably, President Obama seems poised to announce new tax cuts for businesses--to the tune of $200 billion.

The solution could not be more clear. Instead of trickle down bailouts the Obama Administration needs to pursue bottom up bailouts.

In December of 2008, I called for a massive recapitalization of the middle class, stating: "Trickle-down bailouts are poisonous. . . .Instead of [the] failed trickle down approach, the government must now immediately throw a lifeline to the 99% of Americans who have so far seen only pennies of the trillions the government has expended in its rescue efforts. We need immediate direct stimulus from the government on a scale more massive than ever before."

Later in 2009, in my Dayton Law Review article entitled Subprime Bailouts and the Predator State I argued that empirical evidence from the world of economic science demonstrated that you must terminate bank managers and extend generous debtor relief in order to avert extended economic misery.

What we needed and what we still need today is debt relief in the form of massive loan modifications as advocated by bond expert Bill Gross; a massive jobs bill on the scale of the CCC as advocated by economist Robert Shiller; and massive investment in our economy so that we have the world's best physical and human infrastructure as Paul Krugman has long advocated.

The Administration's first stimulus package probably created or saved 3 million jobs based upon the best economic studies to date. But it will expire before the economic gloom and pain. It is a shame that the Administration has given up on its own success and caved-in once again to the Robert Rubin dominated economic team.

Krugman on Economic Stimulus

Paul Krugman, winner of the Nobel Prize in economics, provided some interesting insights in the New York Times this week on the 2008 economic stimulus, including why it has not worked as hoped, and suggests ways to appropriately stimulate the economy in coming months. A few of the more salient points from Krugman include:

"The actual lessons of 2009-2010, then, are that scare stories about stimulus are wrong, and that stimulus works when it is applied. But it wasn’t applied on a sufficient scale. And we need another round."

Krugman argues that the 2008 stimulus was too cautious, too minimalist and that a bolder, more profound stimulus would have better served the American people and the U.S. economy. He argues that a new round of stimulus is necessary and sound economic policy, but a second round of stimulus must be much bolder than the first.

Responding to critics of the 2008 stimulus as too much and those politicians suddenly concerned with Washington spending (where were they when tax cuts and defense spending drove the deficit into record territory?), Krugman rejoinders:

"And if, as expected, the G.O.P. wins big in November, this will be widely regarded as a vindication of the anti-stimulus position. Mr. Obama, we’ll be told, moved too far to the left, and his Keynesian economic doctrine was proved wrong.

But politics determines who has the power, not who has the truth. The economic theory behind the Obama stimulus has passed the test of recent events with flying colors; unfortunately, Mr. Obama, for whatever reason — yes, I’m aware that there were political constraints — initially offered a plan that was much too cautious given the scale of the economy’s problems."

Krugman urges President Obama to go bold next week and in coming months, in connection with stimulating the economy. Krugman's N.Y. Times Op-Ed can be accessed here.