By Abigail Caplovitz Field | November 8, 2011
UPDATED: Amazingly, I forgot to include securitization fail and the failure to recognize losses on servicer-owned slices of securities. I’ve added those in now.
Somehow the banking industry has convinced much of the public and most of our political leaders that our housing and foreclosure crisis is the fault of irresponsible borrowers despite the overwhelming evidence that greedy bankers are to blame. Since good policy can’t happen unless people escape the bankers’ web of misinformation and spin, I thought it would be appropriate to synthesize what we’ve learned about the greed-driven decisions of bankers and Wall Street traders and what they reveal about how we got where we are now.
Chasing Illegal Profits in the Mortgage World: MERS
In the beginning, there were clear rules about how ownership of land, and the right to foreclose, were transferred and created. The rules were state specific, rooted in our history, from back when each state’s sovereignty rivaled the federal government’s. Although the rules varied in important details, one feature was constant across states: an accurate public record of property ownership. These records were created and maintained by local governments, and financed by recording fees.
In the 1990s, Fannie Mae, Freddie Mac, and the mortgage industry created MERS. MERS, they claimed, not only prevented the industry from publicly recording changes of ownership and servicing of mortgage loans, saving many millions of dollars by depriving counties of them, but it eliminated the need to even create records that ownership changed, saving even more in document creation, handling and storage costs.
Yes, MERS claimed that its private database would enable mortgage servicers to keep track of who owned what, but MERS did nothing to ensure the accuracy or completeness of the database. Indeed, the MERS database is frequently wrong, as Delaware Attorney General Beau Biden discovered. His complaint against MERS does a fabulous job of detailing what a deceptive sham MERS is.
Though AG Biden doesn’t put it in these terms, the picture he paints is of a legal fiction created for complying (in theory) with the letter of the law but violating the law’s policy intent so a big corporation can save a lot of money. In that way MERS is just like the tax shelter ‘products’ made by corporate law firms.
Frankly, MERS seems of relatively poor quality as these things go. For example, consider the profound legal uncertainty–and unquantifiable legal risks–MERS has created for its members. What if a state supreme court decided that a cash-starved county could pierce MERS’s corporate veil and reach into the big banks’ big pockets? Enough counties may sue, Dallas Texas style, to give a high court the chance.
Or consider MERS’s inability to legally foreclose in some states, despite marketing its ability to foreclose as a particularly attractive design feature. Consider how many times MERS has had to change its procedures (not that MERS has a clue if any member adopted, in practice, any changes). Consider how arrogant and reckless Fannie Mae, Freddie Mac, and the mortgage industry (including the big banks) had to be to put over half of American mortgages into the fundamentally flawed MERS machine.
I mean, any big law firm worth its billing should have known MERS was flawed and should have been able to convince its clients to redesign MERS so that it worked, or talked them out of doing it. Either the law firm and in-house counsel that blessed MERS was fundamentally incompetent, or the clients were so arrogant and reckless they just didn’t care.
(On client arrogance, note that several years ago Max Gardner litigated a case against Fannie Mae in which Fannie Mae claimed its servicing guidelines had the same authority and power as a government regulation. They don’t, and Fannie Mae lost on that issue. But just making that claim shows how arrogant it was.)
Whether from hubris, incompetence or both, the creation and widespread use of MERS maximized corporate profits and executives’ personal wealth at the expense of the rest of us. MERS has damaged our records of who owns which parcel of America, and the millions of dollars lost by counties across the country has resulted in less services and higher taxes.
Chasing Illegal Profits in the Mortgage World: Robosigning
MERS, unfortunately, is not the only personally enriching measure mortgage industry executives adopted at the expense of us 99%.
Robosigning is another. By fragmenting a very important legal process–the transfer of ownership of land or other rights in it–into discrete, meaningless steps that low skill workers could mechanically complete, over and over, banks saved tons of money but made a mockery of Due Process, the rules of evidence, and the entire concept that they had to follow the same laws everyone else did.
I mean, imagine if borrowers committed wholesale document fraud, filing false affidavits, forged documents and other worthless bits of paper with our courts. People would go to jail. I mean, robosigning notaries were forced to plead The Fifth, but I’ve heard nothing about investigating the executives that demanded the notaries’ practices. Indeed, the top bankers act as if their document fraud was meaningless.
The idea that our biggest, most powerful corporations don’t have to play by the same rules as everyone else is incredibly dangerous. Right now people are rejecting the government’s authority because our government and its law enforcers are losing legitimacy. And every time a powerful company or powerful banker gets at most a slap on the wrist for conduct that would get anyone else incarcerated, the government’s legitimacy shrinks further. At times of extreme economic stress and insecurity, an illegitimate state will lead to profound social disorder.
If we want to avoid riots and a big spike in crime, the government has to be seen as defending our basic values, such as ‘all men are created equal’ and ‘equality before the law’ and ‘blind justice’. Instead, our government and law enforcement seem cowed by the banks into dismissing as insignificant the willful rejection of the rule of law in the name of business convenience and increased profits that robosigning represents. That’s really dangerous; thank goodness Attorneys General Beau Biden (DE), Eric Schneiderman (NY), and Catherine Cortez Masto (NV) are setting a counter-example. All legitimacy is not yet lost.
Chasing Illegal Profits in the Mortgage World: Foreclosure Mills
Beyond MERS and robosigning, the mortgage industry saved itself tons of money by deploying fleets of foreclosure attorneys via the “network attorney” business model. Most lawyers wouldn’t recognize the activities these firms consider the practice of law. The clients respected these attorneys so little that they had intermediaries communicate with them purely by computer message–virtually no direct client-attorney contact–and graded them on speed, on quantity over quality. Mass foreclosure counsel were treated, essentially, as high level robosigners.
Not surprisingly, some (many?) network attorneys were robosigners, and committed other forms of document fraud. At least some practiced sewer service and other abusive, illegal tactics. These practices have further damaged our land records, harmed homeowners, and wasted a tremendous amount of legal system resources (i.e. tax dollars.)
So one thread of how we got to where we are now is the mortgage industry’s relentless drive to cut costs/maximize profits regardless of legal requirements or societal impacts. MERS, robosigning and foreclosure mills are a huge part of why foreclosure cases can’t be effectively processed or resolved by modification. And our government’s failure to confront the culprits–outside of a few stellar AGs–is destabilizing our nation.
Fraudulent Lending to Feed the Securitization Machine
So MERS, robosigning and ‘network attorneys’ are the mortgage industry’s early and major contribution to our present mortgage and foreclosure crisis. Another key contribution of the mortgage industry was knowingly making lousy loans.
People, fed the bankers’ spin, envision greedy borrowers deceiving innocent loan officers into making loans that couldn’t be repaid. But that’s just not true. Beyond the fact that loan underwriting should prevent all but the most sophisticated fraudulent borrowers from fooling lenders–and surely competent underwriting is a basic duty banks owe their shareholders–evidence is mounting of decisions to systematically to make bad loans.
For example, some Countrywide mortgage departments kept a special fax machine so they could send themselves “borrower” documentation that they’d faked, Michael Hudson reported. Or consider the casual demand to fake numbers made by a loan officer from JPMorgan Chase in an email. And if you’ve never done it, or not recently, listen to Planet Money expose the dynamics of race-to-the-bottom lending during the bubble.
Or consider the fact that in 2004 the FBI was warning about mortgage fraud, and by 2007 the FBI said that 80% of the fraud involved industry insiders such as loan officers, mortgage brokers, real estate agents, appraisers and lawyers. And the industry knew: see this 2006 fact sheet from the Mortgage Brokers Association for Responsible Lending that analyzed data from 2004 and 2005. By doing a quick check, the group found that 90 out of 100 liar’s loans exaggerated the applicant’s income, and 54 of those loans inflated it by more than 50%. For more, see the piece I wrote for DailyFinance nearly a year ago.
Why did all sorts of lender-driven fraud happen? Simple–you get what you pay for, and management paid for loan volume, not loan quality. Management was so committed to rewarding loan volume regardless of fraud–at least at Countrywide, though there’s no particular reason to imagine it was unique–that whistleblowers were punished and fired. Why did loan volume trump everything? Well, because the fees from selling loans into the securitization machine drove profits and bonuses.
All the lender-side mortgage fraud directly fed our current crisis, and not just because individual loans collapsed into foreclosure. Much worse, the lending (fueled by inflated appraisals demanded by the lenders) grossly inflated housing prices beyond all reason. When the housing market broke, those fake prices plummeted quickly, sending many homeowners underwater. Underwater loans are a big part of the housing crisis, because those homeowners can’t sell or refinance when they need to–because of job loss, divorce, medical crisis or other catastrophe–and thus send many into foreclosure who otherwise could’ve simply moved on. (Yes, short sales exist, but not meaningfully, and yes, the refi-program will help those underwater who least need help. But that’s nibbling at the margins of a huge and growing problem.)
Wall Street’s Crucial Role
In the beginning, the mortgage securitization market was clean, not corrupt. All the rules for getting mortgage loans into securitization trusts were honored, AAA-rated meant what it’s supposed to mean, the securities’ salesmen accurately described the mortgages and the securities to their customers. All that changed.
Two critical drivers of the change were growing conflicts of interest and Wall Street’s capture of the ratings agencies. A conflict of interest example is Countrywide’s practice of making a lot of loans, selling them into the securitization process, but retaining the servicing rights, that is, servicing the loans for the investors’ trust. Why is that a problem?
Well, the servicer is the one handling the loans day to day, so missing or incomplete documentation, or any problem with loan quality, comes to the servicer’s attention first. And the servicer is supposed to alert the trustee of problem loans, to force the loan maker to buy back the bad loans. But when the servicer and the loan maker are one and the same, why would the servicer say anything? Uniting servicing and loan making in one corporation eliminates a key check against fraud.
Wall Street’s ability to essentially dictate AAA ratings to the ratings agencies was an even greater driver of fraudulent lending. Professor and former regulator William K. Black explains the raters’ willful blindness. Once Wall Street knew it could get its precious AAA ratings—the passkey to investment by main street, via pension funds and life insurance policies—they got positively reckless.
Consider the discovery-backed allegations in the Ambac suit against Bear Stearns and its current corporate parent JP Morgan Chase that’s currently pending in New York State Court:
“Bear Stearns had deliberately and secretly altered its policies and neglected its controls to increase the volume of mortgage loans available for its “securitizations” made in patent disregard for the borrowers’ ability to repay those loans. After the market collapse…JP Morgan executives assumed control over Bear Stearns and implemented an across-the-board strategy [to avoid] honoring its contractual promises to disclose and repurchase defective loans through a series of deceptive practices.
“In what amounts to accounting fraud, JP Morgan’s bad-faith strategy was designed to avoid and has avoided recognition of the vast off-balance sheet exposure relating to its contractual repurchase obligations – thereby enabling JPMorgan Chase & Co. to manipulate its accounting reserves and allowing its senior executives to continue to reap tens of millions of dollars in compensation…
“In full recognition that its due diligence protocols did not screen out defective loans and were merely a facade maintained for marketing purposes, Bear Stearns’ trading desk needed to quickly transfer the toxic loans from its inventory and into securitizations before the loans defaulted. So as early as 2005, Bear Stearns quietly revised its protocols to allow it to securitize loans before the expiration of the thirty- to ninety-day period following the acquisition of the loans … referred to as the “early payment default” or “EPD” period. Bear Stearns previously held loans in inventory during the EPD period because, as Bear, Stearns & Co.’s Managing Director Baron Silverstein acknowledged, loans that miss a payment shortly after the loan origination (i.e., within the EPD period) raise “red flags” that the loans never should have been issued in the first instance. …
“Not satisfied with the increased fees from the securitizations, Bear Stearns executed a scheme to double its recovery on the defective loans. Thus, when the defective loans it purchased and then sold into securitizations stopped performing during the EPD period, Bear Stearns confidentially (i) made claims against the suppliers from which it purchased the loans… (ii) settled the claims at deep discounts, (iii) pocketed the recoveries, and (iv) left the defective loans in the securitizations. Bear Stearns did not tell the originators of the loans that it did not own, but rather had securitized, the loans as to which it made the claims, and did not tell the securitization participants that it made and settled claims against the suppliers.”
Did you catch that? Ambac says Bear ‘double-dipped’ on lousy loans. Payment 1: Bear bought lousy loans and securitized them super quickly so there was no chance the loans would default before Bear sold them. Payment 2 on the same loan: after the loans defaulted within a month or two of being made, Bear went after the companies it bought the loans from to get compensated being sold a lousy loan.
Here’s JPMorgan Chase’s answer to Ambac. Check out the response to the double-dipping. Rather than deny it, Chase says the standards in each set of contracts were different. That is, the loans Bear double-dipped on were lousy enough that it had a right to get paid by the loan makers, but not so lousy that the investors had a claim against Bear. If that’s accurate, it’s quite a testament to Wall Street’s shrewdness.
Another part of Chase’s answer of note is at the end, in its “Affirmative Defenses.” Affirmative defenses, by definition, don’t deny that what the Plaintiff says happened, happened. Instead, affirmative defenses say, ‘so what if that happened. You don’t have any right to get paid by me, because…” Chase offers the judge 33 of these ways to decide that even if Ambac’s right on the facts, Chase is right on the law.
Here’s just a sampling of what Chase says, mostly paraphrased:
#3: Ambac can’t get paid because it knew the loans and our practices were lousy, and moreover “Ambac engaged in the same conduct as alleged against [Chase & subsidiaries], i.e., that Ambac lowered its own underwriting, due diligence, and risk assessment standards so as to increase its structured finance revenues and share of the mortgage securitization market.”
#7: Ambac’s reading the contracts wrong; and
#8 & #9: If Ambac’s not reading the contracts wrong, the contracts don’t say what we intended them to say so don’t hold us to them.
Why would Bear Stearns (or any other Wall Street firm in the mortgage securitization market) do the things Ambac claims? Here’s Ambac’s answer:
“73. Bear Stearns’ top executives adopted and succumbed to a compensation structure that created perverse incentives for Bear Stearns to purchase and securitize loans regardless of their quality in order to secure obscene payouts. Indeed, based on publicly available information, CEO James Cayne, Executive Committee Chairman Greenberg, Co-Presidents Alan Schwartz and Warren Spector earned an aggregate total of over $1 billion in total salary, bonus and stock benefits during the years preceding Bear Stearns’ collapse in 2008. Even after accounting for the drop in stock value resulting from Bear Stearns’ colossal failure, these individuals made an aggregate net payoff exceeding $650 million. Meanwhile, the firm disintegrated, its shareholders’ investments evaporated, and the loans it funded and securitized – and the mortgage-backed securities and other financial products linked to them – have wreaked unprecedented harm on borrowers, investors, and the economy as a whole.” (emphasis in the original.)
Net payoff of $650 million for four guys who wrecked their company? Nice.
Securitization Fail: The Mother of All Wall Street Greed Driven Screw Ups
How blinded by greed and careless did Wall Street get? So careless it ignored virtually every key provision of its securitization contracts. Seriously. As the Ambac suit (and many others) detail, the loans in the securities weren’t close to the promised quality. But other provisions that governed the most critical feature of securitizations, namely, actually giving the trust ownership of the loans, and thus investors the right to collect payments from the loans, appear to have been violated either routinely, or, at least often enough to cause massive problems.
These contract provisions described how the loan documents critical to every homeowner, namely, their promise to pay (the note) and the right to seize their home if they didn’t (the mortgage), would be handled and transferred to the trust. These provisions had very important goals: 1) give the trust ownership of the loans; 2) transfer ownership in a specific window of time to get investors favorable tax treatment; and 3) make the loans “bankruptcy remote” so investors wouldn’t have to weigh the credit worthiness of the securities’ seller when deciding whether or not to buy them.
By violating these contract provisions, those involved in these deals (the big banks, the Wall Street firms, and their lawyers) a) broke the chain of title for affected properties, with all attendant consequences on the right to foreclose; b) exposed investors to large potential tax liability (not that the IRS has shown an inclination to investigate much less take enforcement action); c) made big bank balance sheets even more fictional because loans that should be back on their books–triggering reserve requirements the banks can’t honor–aren’t being recognized.
So how widespread is the securitization fail problem? Well, testimony and documents suggest it’s a huge problem for BofA/Countrywide, and given AG Masto’s inclusion of the issue in her suit against BofA, we may find out just how big a problem it is for that bank.
But it’s not just a BofA issue. Not only is it easy to find court documents involving other lenders that lack evidence the notes and assignments of mortgage were properly handled, Deutsche Bank itself told a court that missing and incomplete documentation (read securitization fail or possible securitization fail) is a widespread issue.
Moreover, the famous Ibanez case by the Massachusetts Supreme Court suggests that many Massachusetts loans may never have been securitized. That’s because, under longstanding Massachusetts law, ownership of a mortgage can’t be transferred “in blank” the way a negotiable note can, but in the typical securitization deal, apparently, the assignments of mortgage were all done “in blank.” How many other loans were not securitized in other states because the typical deal didn’t follow the local law?
Why weren’t the notes and assignments of mortgage handled properly in every case? Well, endorsing the notes as required takes time, and millions of loans were changing hands. Doing note endorsing properly for all the deals being done at the time would keep a fleet of robosigners busy 24/7, and, unlike the documents generally given to robosigners, the original notes–the ones needing all the signatures–are intrinsically valuable and are stored with “Document Custodians” to keep them safe. So doing the deals right would cost a lot in labor and in document tracking because of the original notes’ involvement.
Unfortunately, it’s impossible for anyone lacking subpoena power to get a real grasp on how big the securitization fail problem is, because contrary to court rules, foreclosing banks often use scans of the notes involved instead of getting the originals from the vault, and it’s possible the scans are obsolete. That is, it’s possible the scans lack endorsements the originals have.
Cooking the Books Still?
In a must-listen podcast, Martin Andelman interviews Talcott Franklin, the lawyer for a majority of securitization investors. Among many other topics, Tal discusses how mortgage servicers aren’t always recognizing the losses the securities are incurring, which means that the owners of the riskier slices of the securities are getting paid money that should be saved to pay the top, AAA-rated tier. As a result, Tal says, the AAA investors–main street, via pension funds and life insurance policies–are going to take much bigger losses than they should. And it means that the servicers–who often own these riskier slices–are making their balance sheets look better than they are.
Gambling with Other People’s Money
An even more important economy-wrecker, beyond executive compensation-driven stuffing of securities full of crappy loans and failing to even do that properly, are the bets Wall Street traders made on those securities. Those bets were particularly damaging because of “leverage.” Leverage meaning money borrowed from other people to increase the size of the bets, magnifying both wins and losses. A Wall Street trader’s use of “leverage” is functionally the same as a casino gambler maxing out his credit card cash advances to make his “sure thing” pay off big.
This paper from the Philadelphia Federal Reserve outlines the market dynamics that make leverage particularly destructive in a financial crisis. Importantly, it cues up the discussion by asking: “Why did rising defaults in a relatively small portion of the U.S. housing market cause a financial crisis?”
See, everyone who has paid close attention to what happened understands that borrowers’ failure to pay off their loans didn’t cause the crisis. All the defaulting loans, totaled up, were nowhere near the size of the holes in the bank balance sheets that opened up when the defaults started happening. Homeowners’ failure to pay didn’t wreck our economy; wild Wall Street gambling (atop a teetering pile of mortgage industry greed and fraud) did.
Read that again:
Homeowners’ failure to pay didn’t wreck our economy; wild Wall Street gambling (atop a teetering pile of mortgage industry greed and fraud) did.
And Wall Street’s recklessness is still hurting us all. Because the securitization market for most mortgages no longer functions—investors are refusing to be chumps again, the fraud was too broad and too deep—wannabe homeowners can’t get loans, so housing demand has collapsed, which drives prices down, wiping out equity and trapping borrowers with homes they can’t sell and, because of unemployment, health crises, divorce, or other life catastrophe that destroys household economics, they can no longer afford. That fuels more foreclosures, more housing price collapse, more joblessness…
The people whose lives are being wrecked by the housing crisis are no longer the small slice of the housing market that shouldn’t have been given loans in the first place, but were because of bank executives’ greed. The people suffering now are responsible people who did everything right. And increasingly, the people being hurt aren’t homeowners in trouble; it’s everybody: foreclosures are destroying our tax base. That means higher taxes and less services for everyone. We’re not getting out of this mess until people—most important, policy makers—stop being paralyzed by the idea that reducing homeowners’ debt load is rewarding irresponsible borrowers.
We got into our today’s nightmare because the mortgage industry adopted practices that were most profitable for it, regardless of legality; banks committed mortgage fraud on a huge scale to line their executives’ pockets; bank executives structured their business to reward massive mortgage fraud because Wall Street wanted loans, regardless of how lousy; Wall Street wanted the lousy loans to line its executives pockets, and juiced its riches by borrowing lots of money to magnify its bets; Wall Street could sell its lousy loans because the ratings agencies did what Wall Street told it to; and investors, once awakened to how lousy the loans were, refused to invest good money after bad. On top of all that, our government helped banks but not homeowners.
So please, please, policy makers: blame the banks and Wall Street, not the homeowners, and more important, implement policy that helps homeowners and forces the banks and Wall Street to take a well-deserved hit.