An embarrassing feature of the financial crisis has been the lack of criminal prosecutions. Despite the extraordinary level of talent in the Justice Department, the Attorney General cannot muster a serious case. Promises of investigations and action have proven hollow.
Hitting Bottom?
This week we reached a new low in this dearth of prosecutions. A Wall Street analyst temporarily cheered the financial markets in his analysis of Goldman’s Sachs’ legal predicament:
Goldman Sachs Group Inc. (GS) won’t face criminal prosecution related to sales of mortgage-linked securities because such a move could threaten the U.S. financial system, according to Brad Hintz, an analyst at Sanford C. Bernstein & Co.
The U.S. Department of Justice, which is reviewing a Senate subcommittee report that alleged Goldman Sachs misled clients before the financial crisis, will avoid jeopardizing the fifth- largest U.S. bank by assets because it’s viewed as “too big to fail,” Hintz wrote in a note to clients today.
“If an alleged violation is identified during a Goldman investigation, we expect a reasoned response from the Justice Department,” Hintz wrote. “In a worst case environment, we would expect a ‘too big to fail’ bank such as Goldman to be offered a deferred-prosecution agreement, pay a significant fine and submit to a federal monitor in lieu of a criminal charge.” Goldman ‘Too Big’ to Face Prosecution Over Mortgage Securities, Hintz Says
Institutionalized Cynicism
Mr. Hintz’s analysis oozes Wall Street smugness. Too big to fail institutions can break the law with impunity with little threat of meaningful retribution? I would insist that “meaningful retribution” does not mean large fines; it means jail time for convicted executives and sanctions for criminal enterprises.
Let’s examine Mr. Hintz’ moral bankruptcy:
We are three years into this financial crisis. Even though it is patently absurd, Bernanke and Geithner have proclaimed themselves system saviors. To the contrary, we have spent $5.1 trillion dollars in deficit spending. We have rewarded reckless bank investments, and kept interest rates at zero. And yet an analyst has the temerity to assert that the indictment and conviction of Goldman Sachs would jeopardize the financial system? If this is true, then Geithner and Bernanke should be indicted as well.
Goldman Sachs has already entered into a $550m civil settlement with the SEC for misleading investors in mortgage-backed securities. It also agreed to reform its business practices. Clearly, Goldman does not fear the worst retribution, as it has misled or committed perjury in testifying before Sen. Levin’s subcommittee. Truthful testimony before a Congressional committee is fundamental to our democracy. Panels investigating Watergate, Washington corruption and organized crime elicited truthful testimony under the threat of perjury and jail time. How is the public served in letting a Wall Street firm and its executives expect but a wrist slap?
Equal justice under the law is fundamental to our democracy, and it is being undermined. Anger and cynicism is on the rise. Why not rob a bank if the worst penalty is that you will have to pay back only a fraction of the proceeds? Why continue to voluntarily pay your taxes? Underpay or refuse to pay and then negotiate. We cannot incarcerate enough juveniles from the ghetto nor throw enough drug dealers in prison. While these individuals may have committed reprehensible crimes, fraud and perjury are equally reprehensible.
A Glimmer of Hope?
Today the tide appears to be turning:
Goldman Sachs has received a subpoena from the office of the Manhattan District Attorney, which is investigating the investment bank’s role in the financial crisis, according to people with knowledge of the matter. Goldman Said to Get Subpoena Over Its Role in Crisis
The good news is that Cyrus Vance Jr. stepped into the prosecutorial vacuum and issued subpoenas. The bad news is the thunderous silence from the Justice Department and the New York state attorney general.
I attended a recent talk by Rabbi Adin Steinsaltz, a renowned biblical scholar. He noted that the genius of the Torah as a legal instrument is that judges were admonished to favor neither the rich nor the poor. America outside of Wall Street and Washington believes that the rich, “too big to fail” banks have been given a permanent get out of jail card. We could restore belief in equal justice under the law if we vigorously prosecuted and convicted rich wrongdoers the way we currently pursue poor ones.
Executive compensation is a “hot button” issue. Corporate executives argue the need for a free hand in setting compensation: we must attract and retain high performing executives. They further argue that correctly tailored compensation creates appropriate incentives to increase shareholder value. According to this thinking, this aligns management and shareholder interests.
Shareholder activist groups strenuously disagree. Management over compensates itself, and awards senior executives hundreds of times the average worker salary. Equity compensation (options, restricted stock grants) richly rewards management at the expense of diluted shareholders. Even more egregious are executive compensation increases even when the corporation has a bad year or underperforms its industry peers. Boards of Directors, who should be guardians of shareholder interests, are often too aligned with ineffective management. True confession: executive compensation issues comprised much of my career. Generally, I agree with keeping the government out of the executive compensation process. In my view, management knows its own business and knows the market for top talent. With Board of Directors’ review, advice and consent, let management set compensation and let the chips fall where they may. Internal safeguards and shareholder activist groups inevitably punish bad or greedy managements.
However, there is one industry where the government needs to take an active role in setting executive compensation.
Is Goldman Sachs Allowed To Fail?
Simon Johnson, former IMF chief economist, asks the question: if another financial crisis appears would Goldman Sachs be permitted to fail and follow the Lehman Brothers bankruptcy route? SeeCould Goldman Sachs Fail? Johnson polled leading experts who unambiguously stated that Goldman would be bailed out again. Goldman’s balance sheet at $900b would be just too big to permit bankruptcy. Dodd-Frank legislation which has resolution authority to handle a large bankruptcy would be ineffective because of the international scope of Goldman’s operations.
While Goldman is one case study, Mr. Johnson could ask the same question about JP Morgan, Citibank, Wells Fargo or a number of other large American financial institutions. I believe he would get the same answer: they are too big to fail. Thus, the experts agree that these institutions have a favored position in the market place: they borrow at below market costs, and benefit from the full faith and credit guarantee of the US government.
A Modest Proposal or a Proposal for Modesty
Mr. Johnson posits that the only solution is to “press hard for higher capital requirements for Goldman and all other big banks.” More capital would permit absorption of more losses in the event of a financial crisis. Allow me to propose an alternative.
Goldman and other large banks pay out nearly half their revenue in compensation: amazing that this practice has not received more government scrutiny. As we know from Untimely News That’s Unfit to Print, the government is afraid to prosecute these banks for their financial misdeeds. How about severely limiting executive compensation?
I can hear the howls from Wall Street now. How can we attract the best talent? This is antithetical to the principles of the free market! Our work would not be properly valued!
When a bank accepts bailouts from the government (TARP), when it enlists the government to make good on derivative bets (AIG and Goldman), when it is subsidized by American savers through a zero interest policy, and when it receives a full faith and credit guarantee of the US government, that bank is no longer a free market enterprise. That bank is a ward of the state. As such, its compensation should look more like the federal civil service pay scale.
Controlling and changing bank top management pay scales in this way would be hugely beneficial:
Banks would be able to retain more earnings, and immediately improve their capital base.
Shareholders would benefit as more cash would be available for dividend payments.
The productive economy could successfully compete for the best university graduates.
Wall Street firms would shrink.
Systemic risk of too big to fail institutions would diminish as would rent seeking behavior.
The real economy would flourish.
Perhaps we should start a new campaign: Government Service Levels (GS) for Goldman Sachs (GS). Put more simply: GS for GS.
In the The Very Late News, we examined the media’s late and lazy reporting on important stories related to the 2008 financial crisis. Today the New York Times does it again with Financial Crisis, No Prosecutions of Top Figures. The lead reporter, Gretchen Morgenson, has a weekly column in the Times. She is no neophyte on issues of financial fraud. Why has it taken the New York Times three years from the onset of the crisis to report the lack of prosecution of Wall Street criminal conduct?
A Lame Apology
Morgenson asks the hot question: why has there been no prosecution of high profile executives? But instead of hitting hard, she opines on the “complexities of pursuing legal cases in times of panic.” In a meeting between the Fed’s Tim Geithner and Andrew Cuomo, Geithner never suggested “any lack of diligence or a slowdown” in ongoing investigations. He did not have to. He was the perfect third base coach. All he needed to do was run through the signs: “bunt, take, hit – Do Not Prosecute.” Mr. Cuomo did not miss the “don’t prosecute” sign.
The remainder of the Times article explains why federal prosecutors chose not to bring an action. I recommend it in its entirety for a treatise on federal and state prosecutorial delay, obfuscation and denial. The article begins and ends with Andrew Cuomo, but where were the other government prosecutors?
“The report pulls back the curtain on shoddy, risky, deceptive practices on the part of a lot of major financial institutions” …“The overwhelming evidence is that those institutions deceived their clients and deceived the public, and they were aided and abetted by deferential regulators and credit ratings agencies who had conflicts of interest.” SeeNaming Culprits in the Financial Crisis
Will we be prosecuting these offensive deceptive practices?
Banks and Bonds
Ironically, today’s Times also reports that Barry Bonds was convicted of one count of obstruction of justice. The investigation of steroid use in baseball started in 2002. After nine years of investigation, huge prosecutorial resources and 25 government witnesses, the government could not prove that Mr. Bonds used steroids.
Too bad Mr. Bonds is a baseball player rather than a Wall Street bank. Perhaps if his name were Ernie Banks instead of Barry Bonds, he could have confused the prosecutors, who might have overlooked the offense. We don’t want to rattle or hurt the Banks.
Dual Standard of Justice
Bonds stole no money, yet the full force of Congress and federal prosecutors pursued him for years. Banks that stole billions and nearly destroyed the economy were deemed too fragile to prosecute. These “fragile” banks were back in business with near record bonuses in 2009 and 2010. We have a dual standard of justice that weakens all respect for law.
Some people criticize the injection of politics into economic discussions.
But economic historians tell us that economists used to understand and accept that economics is wholly interrelated with politics, and that politics affects our economy. They note that modern economists have artificially tried to somehow separate the two, like Descartes tried to separate the mind from the body.
Indeed, the father of modern economics – Adam Smith – talked a lot about politics in relation to economics. Washington’s Blog
Recognizing the inter-connectedness of politics and economics, the discipline was originally referred to as “political economy.” In fact Georgetown University has a political economy major.
The blog goes on to criticize the multi-trillion dollar expenditures on the Iraq and Afghanistan wars and the consequent deleterious effect on the economy. Moreover, for the last ten years we have undermined any semblance of a free market by living under a state of economic emergency. We have massively lost trust in government. With the financial crisis and lack of prosecutions the public has also lost trust in our financial institutions, the SEC and the Justice Department. But what is missing from this excellent analysis is the role of the Federal Reserve.
The Federal Reserve: Earnest Technocrats or Politicians in Disguise?
The Federal Reserve has a limited statutory mandate: maintain full employment and price stability. Under Ben Bernanke the Federal Reserve has gone far afield from that mandate:
We now have a fourth branch, the imperial Federal Reserve. Without our permission, this rogue branch is dictating economic policy for the United States. Mission creep is taking the Fed from its dual mandates of employment and stable prices to its own self-proclaimed mandate: economic stimulation (in direct contravention of the views of the newly elected Congress and the American public) and dollar devaluation. In QE2 it also has taken on the role of guardian of stock market prices. See Who Elected Ben Bernanke?
Bernanke has crossed into the realm of political decision making:
Ultra low short-term interest rates have fattened bank profits at the expense of retirees, pension funds and insurance companies.
QE2 money printing has set off a speculative binge in commodities hurting consumers.
QE2 has hurt the value of the dollar, favoring US exporters over foreign importers.
Higher import prices have hurt consumers since we have de-industrialized America. Consequently, we are dependent on cheap foreign-made goods.
QE2 has exported inflation to foreign countries. Revolutions in the governments of our allies, Egypt and Tunisia, are not a coincidence. Higher food prices in impoverished economies are a breeding ground for unrest. SeeA Perfect Storm in Egypt
QE2 has set off currency wars and raised global tensions with China, the EU countries, Brazil, and emerging economies.
QE2 permits the Federal Reserve to purchase a major portion of newly issued Treasury debt. This permits continuance of unprecedented federal budget deficits. Thus, Congress avoids making the necessary tough budget cutting decisions.
QE2 has also perversely raised the all important 10-year Treasury note yield by 1.25%, thus increasing mortgage rates and retarding any housing recovery.
Holding the Federal Reserve Accountable
The Federal Reserve cherishes its vaunted independence. This independence was predicated on adhering to a technocratic, apolitical agenda of controlling money supply to provide a background for economic growth. The Federal Reserve is now overtly operating in a political role: it determines winners and losers in the economy (banks favored over savers), the value of the dollar (exporters favored over importers and consumers), and financial speculators (the wealthy over the middle class and Wall Street over Main Street). It is also interfering in foreign policy, exporting inflation in key commodities to foreign countries (many of which are our allies) and triggering a potential currency war and protectionism. Finally, Dr. Bernanke recently lectured Congress about deficits: a topic far afield from the role of the Federal Reserve. SeeBernanke Makes Sure Fed Reminds Congress Deficits Bigger Than QE2
Let me repeat: Ben Bernanke was not elected and he is not a benign technocrat. Politics and economics are intertwined. He was wrong about the housing crisis, the financial crisis and QE1. Our politicians must rein him in and restore economic policy control to elected officials.
Some would argue that encroaching on Federal Reserve independence would undermine the institution hurting economic policy. The military is under the control of civilian political leadership and there is no uproar over “military independence.” If the military can be under political control then the Fed can be too. The real issue is accountability and the Federal Reserve has little, if any accountability. Conversely, it will also make our profligate elected officials equally accountable for economic policy.
It will not be easy or elegant, but it will begin to restore trust in our government and economy.
A critical advantage of our legal system is its inherent inefficiency. Domestic and international investors happily invest in the United States securities markets because of our financial transparency and adherence to laws. At the core of it all is a maxim: no one is immune to the law. Importantly, within this definition is the corollary that individuals have procedural safeguards and substantive legal rights.
The Rule of Law, however, has a price: expense, time consumption and inefficiency. In civil law, a complaint must be drafted, filed and served. A defendant is afforded time to research, draft, file and serve an answer to a complaint. Both parties appear before a judge who sets a discovery schedule so that each party may learn pertinent facts. Discovery may consist of written interrogatories, requests for production of documents and depositions. A judge then sets a briefing schedule for motions to limit introduction of evidence and for dispositive motions to summarily dismiss or resolve the matter in court. Barring resolution of the case on motion a trial is set. A trial is held with or without a jury, a verdict reached and a time set aside for post trial motions. After a final verdict the litigants may appeal to a higher court. Time from filing a complaint to trial can take as much as two years. An appeal can take several more years.
The yield from this system is immeasurable: fairness to all parties and an honest result.
Dynamic Tension: Foreclosures and the Rule of Law
Banks and their supporters have woven a public relations campaign to limit the damage from the mortgage foreclosure crisis. The current spin is that dead beat homeowners are seizing on minor paperwork problems and legal technicalities depriving banks of their right to speedily foreclose on homes. In her Naked Capitalism blog, Yves Smith exposes the Wall Street Journal’s attempt to disparage the consumer attorneys representing the homeowners:
The lead article in the Journal tonight, “Niche Lawyers Spawned Housing Fracas” telegraphs its bias in its headline: the foreclosure crisis is merely the creation of two bit lawyers who by implication don’t know what they are doing, and are pumping trivial issues up for their own enrichment, with the housing market as collateral damage.
Funny that anyone can think this spin is remotely true. The fact that solo practitioner lawyers could have such an impact on the system is not proof that they are miscreants, as the Journal implies. It is that the foundation of mortgage securitzations is rotten as a result of widespread abuses, first on the origination end, later in the foreclosure process. These small firm players are using the legal equivalent of toothpicks; the fact that their efforts have destablized the foundation of the residential mortgage backed securities market is tangible proof that they were imperiled to begin with. SeeThe Wall Street Journal Runs Inaccurate Piece on Antiforeclosure Lawyers
Ms. Smith goes on to point out that mortgage servicers (GMAC in the article) imposed hidden charges on homeowners, refused to process payments that would have made the homeowner current and other abuses. The homeowner’s attorney merely did what good attorneys should do, i.e., look carefully at the facts and the law and find abusive practices. Further, the attorney deposed a GMAC official (a “robo” signer) who admitted that they signed an inaccurate affidavit. Somehow the Wall Street Journal felt that depositions were part of the bag of legal tricks from the foreclosure attorneys. The Journal minimized the fact that a false affidavit is a criminal offense. Ms. Smith concludes that banks cannot have it both ways: they cannot proclaim the sanctity of law and contract and then abuse legal processes to speed through foreclosures. Servicers do not get to be judge, jury and executioner.
The Mills of the Gods Grind Slowly, but they Grind Exceedingly Fine
I have seen our lumbering justice system first hand. It is slow, expensive, time consuming, detailed, and frustrating. Sometimes judges can be dismissive, rude and unfair. On the other hand, corporations are all about efficiency. How quickly can we get something done? How little can we spend? I once sat in an industry forum and the chief attorney for a major computer corporation suggested that employers should lobby Congress to federalize all of employment law, which would divest states of any right to regulate the workplace. While an intriguing idea, it would have undone the US Constitution and severely undermined our federal system.
The Wall Street Journal should be embracing these safeguards, inefficient though they may be. Newspaper reporters were once arrested for treason and sedition for publishing anti-government articles. (See the Zenger case and the Alien and Sedition Acts). Would the Journal want to return to a society where politicians and bureaucrats were judge, jury and executioner? I don’t think so.
Years ago, when one of my labor cases ended particularly badly, I ranted about the unfair result and poor decision. My boss pulled me aside in an avuncular manner and reminded me that this is the price we pay to avoid labor anarchy. Due process and adherence to the rule of law is the price we willingly pay to avoid total anarchy.
Before the Obama Administration or Congress makes another run at overriding state real estate law, they should think long and hard about the long term and fundamental damage their actions could cause. Inefficiency in support of the Rule of Law is good.
The last blog outlined features of the impending mortgage foreclosure crisis. Some additional thoughts:
No easy fixes: banks fervently hope for a cure all, omnibus federal law that results in a quick resumption of foreclosures. Why this won’t happen:
- Federalism – We are a federal republic with distinct areas of sovereign rights divided between the federal and state governments. Most people do not give this principle a lot of thought, but it is critical. Real estate is the province of state and local government. Recording of deeds and liens on real property, filing fees, notarization of documents, certifications and state transfer fees are all state processes. Sweeping away several hundred years of real property law through federal override legislation will create enormous constitutional issues.
- State Investigations – The forty state joint attorney general investigations have already asserted state primacy in resolving this matter. Note – As of this afternoon, all fifty state attorney generals have joined the investigation. Attorneys General Launch Mortgage Probe
- The Plaintiffs’ Bar – Plaintiffs’ trial lawyers form their own constituency on this issue. The pro-plaintiff American Association for Justice (formerly the American Trial Lawyers Association) is a formidable lobbying force and a major contributor to the Democratic Party. Numerous class actions have been launched against the banks and title companies and we should expect more. These suits will not disappear without a fight.
- Other Constitutional Issues –
o Retroactive legislation raises its own constitutional issues, especially trying to divest a party of a long- held, established right.
o The impact on due process rights – Substantive due process, a little used Supreme Court doctrine, prevents the federal government in the economic realm from trampling on individual property rights.
Politics and Greed
- TARP – Banks have been saved through TARP, the AIG bailout and numerous federal guarantee programs.
- HR 3808 – To remedy problematic notarizations (only part of the problem), bank lobbyists tried to force passage of the seemingly innocuous HR 3808, “The Interstate Recognition of Notarizations Act of 2010.” This measure passed both chambers by unanimous voice votes. A firestorm of protest arose, and the President took the extraordinary step of a “pocket veto” and, to leave no doubt, a formal veto. Imagine the reaction to a more comprehensive piece of legislation to save the banks. SeeHR3808 Now ACTUALLY Vetoed
- Federalism – I have lobbied on broad pieces of industry-favorable legislation. Congress has real sensitivity to preempting states rights, making sweeping corrective legislation very unlikely.
Other aggrieved parties will not be silent:
- Mortgage Investors – If the securitization problem was fraudulent, investors in mortgage backed securities have rights under the securities laws to seek redress. Since these mortgages were sliced, diced and sold internationally this becomes a global issue.
- Pension Funds – Many of the mortgage investors were pension funds. There is a fiduciary question whether these were appropriate investments. Is there a corollary pension fund obligation to seek redress?
- Fannie Mae and Freddie Mac – These two government agencies may have been defrauded into purchasing mortgages from the Wall Street banks. These agencies have started subpoenaing files from the banks in order to “put back” the mortgages to the banks. Since the taxpayer is the ultimate guarantor of these two entities, there will be political pressure to force the losses on the banks.
Faulty Transmission Mechanisms
This has become quite a mess and there is no easy way out. One of my savvy financial friends argues that the banks are the transmission mechanism for the economy and must be saved at all costs. The mortgage crisis demonstrates we have a very faulty transmission mechanism.
I would argue that the recently enacted Dodd-Frank financial reform bill has a mechanism for dealing with these failed behemoths. It will not be fast or pretty, but our system of laws requires it. Shortstopping the legal processes and again bailing out the banks will have immeasurably worse political consequences.
Unfortunately, this is not a broken transmission mechanism that you can take for a quick fix to your local AAMCO dealer – “The World’s Leading Transmission Expert.”
This magic moment, so different and so new,
Was like any other, until I met you.
And then it happened, it took me by surprise…
I knew that you felt it too, I could see by the look in your eyes… This Magic Moment – Lou Reed
Wise investing is difficult. Constant spin and deception in the mainstream media only make it harder. A sudden event that changes everything is, in parlance, a magic moment. Previously, I discussed how one bank, HSBC, took a $10b write off in 2007. This was our initial warning, the “magic moment,” that predicted a major financial crisis. SeeWatershed Event in the Financial Crisis. In that case, the smoke-and-mirror financial atmosphere at the time prevented most of us from seeing what was happening.
To make things more frustrating, an old saying on Wall Street goes: “no one rings a bell at the top.” That means, no one is ever going to alert us to the market’s magic moments. We have to be smart enough to peer through the smoke, push aside the mirrors, and see clearly what may be right in front of us. And we can never count on the same set of circumstances to happen twice. The lack of that bell leads us to an epiphany: things are never going to be the same again.
We are again approaching a magic moment – “Foreclosuregate”. JP Morgan, Ally and Bank of America are imposing moratoriums on foreclosures and 40 state attorneys general are on the verge of announcing a joint investigation into the practices of the mortgage servicing industry. 40 States Expected to Investigate Foreclosures. Two major title companies, Old Republic and Stewart, have ordered their agents to stop writing title policies on foreclosed homes. Stewart Title Clamps Down on Foreclosure Sales. The Wall Street Journal and the New York Times have tried to downplay the issue; they so far dismiss the problem as one of technical defects and paperwork errors. Why does this remind us of Ben Bernanke”s 2007 assertions that the subprime crisis was “well contained?” Fed’s Bernanke: Subprime Mortgage Problems Contained
Elements of “Foreclosuregate”
First, a disclaimer: although I am an attorney, I worked on only two real estate closings in 35 years of law practice. I did learn, however, that real estate transactions are document intensive, detailed and precise. Disclosures must be crystal clear. All legal formalities must be observed, such as notarizations, fees, stamps, seals, etc. Documents must be promptly and correctly recorded to protect the buyer and the mortgage holder. Any shortcuts could harm one’s client, law license and malpractice premium.
Apparently, in the frenzy of mortgage backed securities, banks and lenders took many such shortcuts. It is beyond the scope of this blog to detail every bit of malfeasance and poor legal practice during the Roaring 2000’s in the housing market. But here are some of the pitiful truths fueling the developing crisis:
Poor underwriting standards – Individuals who clearly did not qualify received loans. Stories are legion of low wage workers taking out loans of several hundred thousand dollars. Interest only and teaser rate loans were used to generate fees for the mortgage broker. The broker was hoping that the borrower would return in a couple of years, refinance the home based on an inflating house price and generate more fees.
Poor Documentation – Mortgages consist of the mortgage itself and an accompanying promissory note. These documents are usually promptly filed at the county level to perfect a lien on the property. It appears that this step may have been handled incorrectly or bypassed (See MERS).
MERS (Mortgage Electronic Registration System) – MERS is a bank creation to enable financial firms to securitize (create mortgage backed bonds – MBOs) quickly and to avoid county filing procedures and attendant filing fees. Let’s take a quick look at how and why the banks did this:
In the mid-1990s mortgage bankers decided they did not want to pay recording fees for assigning mortgages anymore. This decision was driven by securitization—a process of pooling many mortgages into a trust and selling income from the trust to investors on Wall Street. Securitization, also sometimes called structured finance, usually required several successive mortgage assignments to different companies. To avoid paying county recording fees, mortgage bankers formed a plan to create one shell company that would pretend to own all the mortgages in the country—that way, the mortgage bankers would never have to record assignments since the same company would always “own” all the mortgages.
They incorporated the shell company in Delaware and called it Mortgage Electronic Registration Systems, Inc.
Even though not a single state legislature or appellate court had authorized this change in the real property recording, investors interested in subprime and exotic mortgage backed securities were still willing to buy mortgages recorded through this new proxy system. The MERS Edifice Quavers
Poor Foreclosure Processes – To foreclose on a property, one needs proof of ownership of the note, supporting affidavits and notarizations. An affidavit requires personal knowledge of the bank official seeking to foreclose, who then swears that he has reviewed all documents and that they are true. MERS has thousands of assistant secretaries, who are not employees of the firm, but employees of the bank, seeking to foreclose on their behalf. Some courts have ruled that MERS has no legal standing to foreclose. Moreover, many of these assistant secretaries sign thousands of these foreclosure documents each month, and have no personal knowledge of the documents or file. These individuals have been called “robo signers” and are arguably acting in violation of court rules. In addition, it appears that original documents do not exist and have been recreated, raising the issue of forged documents.
Poor Securitization Processes - Real Estate Mortgage Investment Conduits (REMIC) are investment vehicles designed to hold commercial and residential mortgages in trust and issue mortgage backed securities representing an undivided interest in the mortgages. Under IRS regulations and NY Trust law, the mortgages must be contributed on the startup day. A problem arises if MERS claims to have title to the mortgage:
… all rights to a mortgage loan must be deposited into the trust for it to achieve tax exempt status under federal REMIC law—which does not contemplate the use of a proxy mortgagee. Yet, despite claiming sole ownership of mortgages sold to investors, in documents regularly recorded with county officials these same institutions maintain that MERS is the sole owner of the mortgage. The chain of financial institutions linking originators to securitization depositors collectively want to have their lien and sell it too. The MERS Edifice Quavers
These are just some of the myriad problems arising from the mortgage mess.
Implications
This is not a problem that is going to be resolved quickly. Banks are vulnerable on a number of fronts:
- At best, the banks will have a delayed right of foreclosure thereby reducing the value of the mortgage note.
- Banks could be charged with fraud or required to take back the mortgages from MBS purchasers who were misled as to the value of mortgages and the shoddy securitization practices now imperiling their investment.
- The banks could owe tax penalties for failing to have the mortgages and notes conveyed to the REMICs on startup date.
- Plaintiffs’ lawyers have already brought a number of class actions against the banks seeking damages and a stay of foreclosures.
- State attorneys general will be seeking recording fees, foreclosure stays and other penalties for these practices.
- Title companies will be forced to pay out policies and seek redress from the banks. .
- Courts may impose sanctions against the banks and their attorneys and may delay or dismiss foreclosure proceedings.
Mistakenly, the press has focused only on the issue of residential foreclosures. There are two more issues to be concerned about: securitized commercial mortgages and MERS procedures were used in that part of the market as well. Second, failure to follow procedures may affect homeowners not in foreclosure. When an owner has paid off his mortgage and the mortgage and note has been resold and assigned numerous times, how does he know he has a legally binding accord and satisfaction of his mortgage? The chain of title may have been compromised on a national level. In fact recently a website encouraging homeowners to demand proof that one’s servicer is holding one’s mortgage note has gone online , Where’s the Note?
The market continues to rally much as it did after the HSBC subprime confession and write down in 2007. Another financial aphorism goes: economic facts don’t matter, until they matter. See It Doesn’t Matter Until It Matters. Disturbing facts are just entering the public consciousness. In this volatile, thinly traded market dominated by computer traders, I would rather exit two months early and sell my bank stocks, rather than be five minutes late and thousands of dollars poorer.
Disclaimer: The Prophet does not have a position in any banks, title insurance companies or other financial institutions and this is not a recommendation to buy or sell any security. Consult your own financial advisor.
I’ve been watching the financial crisis since it began in 2007. Every so often it is good to step back and consider some of the anomalies. Thus, some disconnected thoughts:
- The time between crises gets shorter. It was seven years from the dot.com to the sub-prime crash. It has taken us only one year from TARP and other alphabet soup US-based federal bailout programs to the European Commission trillion dollar bailout. With the Euro plunging after the bailout, how long will it be to the next crisis?
- If everything is really improving why have short-term US interest rates not risen? I am amazed that for over 2-years of regular Treasury auctions, 3 month bill rates have ranged between .1 – .2%. Why does the Federal Reserve keep stating in its guidance that it intends to keep rates at zero for an extended period of time?
- Why would anyone invest in the US equity markets? The most active stocks each day are severely troubled, probably insolvent companies: Citicorp, Fannie Mae, AIG, and Bank of America. More than sixty percent of every day’s volume is non-human, computerized, automated trading. And what is worse, computers doing this trading are shaving cents off each transaction to the detriment of institutions and retail investors. No one believes in long term investment value any more. Respected analysts believe the market is severely overvalued and should probably trade at the 850 S&P level.
- How do Goldman Sachs and JP Morgan have perfect trading performance, that is, making money every day of the first quarter? Karl Denninger has calculated the odds of achieving this feat at one in many trillions. Have the SEC and other government regulators taken an extended holiday during the financial crisis? It sure seems that way.
- The 1987 version of the SEC portrayed in the movie Wall Street was able to detect illegal activity in the fictional Blue Star Airlines and arrest the hapless Bud Fox. Mary Schapiro and the current SEC staff can’t seem to find water with two hands if they fell out of a rowboat in the middle of the Atlantic.
- Why do things keep getting more complicated and less clear? Yes, we live in a complex world. But I have a deep suspicion that complexity is being used as a subterfuge to mask true intent. Why do we need multi-thousand page financial and health reform legislation, customized credit default swap instruments and impenetrable corporate proxy statements? The answer: complexity is designed to disguise the essence of each issue.
- Why is the Federal Reserve afraid of a full-fledged audit? As taxpayers, we are the ultimate financiers for the various government bailout programs. What happened to sunshine as the best disinfectant in public matters? This is an economic, not a national security matter. Or in the minds of the government, has everything become a national security matter, even the Fed’s purchase of the Red Roof Inn?
- Why is Senator Chris Dodd, himself compromised with a Countrywide below market loan, allowed to lead financial reform?
- With a Justice Department of 100,000 employees, why haven’t we indicted a major financial institution?
We live in dangerous times. Perhaps some of our leaders should be thinking about some of these questions and issues.
Tuesday’s Senate hearings on Goldman raised as many issues as they answered. Today’s thoughts on the status of Goldman Sachs’ current folly and the US financial industry:
- Goldman executives have no idea how angry the average American is at Wall Street in general and Goldman in particular.
- Nobody likes Ivy-league trained, arrogant, wise-cracking executives, least of all those who wear great suits and have great haircuts.
- In a work-related email, lack of discretion and caution can really return to haunt the writer. Thus, characterizing a deal as “shitty,” calling the securities “monstrosities,” doubting the sale of your product to “widows and orphans,” and not understanding the complexities of these products guarantees later problems to both writer and firm.
- When pressed on the use of the word “shitty” in the email, the correct response is not that it was an unfortunate use of words. Rather, explain whether or not it was a good or bad deal for the investors.
- To the average American, trying to justify a $9 million cash compensation package as “modest” will never work.
- If indeed the customer comes first at Goldman, it is impossible to duck questions on fiduciary duty to your customer.
- “I did nothing legally wrong” will only antagonize the SEC and other prosecutors. The court will decide what is lawful.
- As a corollary point, isn’t Goldman smart enough to stop its ongoing public relations releases attacking the SEC and proclaiming innocence? Nobody believes them.
I have made much of Wall Street’s casino atmosphere. The Senate should now focus on the following:
Why are these types of securities even legal?
What societal or economic good do they promote?
How did Goldman and other firms prosper through the short-selling of their competitors’ securities (e.g. AIG, Bear Stearns, Lehman)
Even if a security is marginally legal, is it ethical to sell it to customers without detailed and comprehensive disclosures?
Since Goldman does not write mortgages, commercial loans or engage in other aspects of retail banking, why should it have a national bank charter?
Since it is really a disguised hedge fund, why should it be able to borrow at the Federal Reserve’s discount window at zero percent interest?
What is Goldman’s current level of leverage compared to leverage employed just prior to the financial crisis?
How could overuse of leverage cause a second more serious financial crisis?
Does Goldman (or any other firm) expect to be bailed out again if the crisis reappears?
What has Goldman done or approved to assure the public of no more tainted securities and no second bailout? Personnel changes, managements controls, ethical standards, external oversight?
The press has given much coverage to these hearings. It is now time for some thoughtful reflection on Wall Street’s behavior: Is there excessive leverage? Favoring of certain financial institutions? Are we investing or gambling? Have we learned any lessons? Where are the regulators?
For a public with a short attention span and a Senate looking for quick financial reform, it is handy to target Goldman. Unfortunately, flogging their executives is merely peeling back one layer of the very large, smelly onion that Wall Street has become.
By and large compliance with the law is voluntary. Every crime cannot be prosecuted. In an ethical business culture companies and individuals believe compliance is the right thing to do. For those who lack a moral compass, the fear factor of imprisonment, fines and social obloquy do the trick. But now companies display a disturbing cynicism toward legal compliance.
The notion of “Too Big to Fail” is no longer new. Unfortunately, we are creating a new concept: “Too Big to Jail.”
Pfizer
CNN reports in Feds Find Pfizer too Big to Nail that Pfizer illegally marketed Bextra, a painkiller. The FBI conducted a criminal investigation and with much fanfare announced the appropriateness of a Pfizer indictment; i.e., fully prosecuting Pfizer would send a clear directive for tough law enforcement. But the government did not try Pfizer, and instead settled. The company agreed to pay a large fine, $1.2 billion dollars, and entered into a special reporting and compliance program. The government did not seek the ultimate penalty of prohibiting (debarring) Pfizer from participating in Medicare and Medicaid programs. Prosecutors reasoned:
that excluding Pfizer would most likely lead to Pfizer’s collapse, with collateral consequences: disrupting the flow of Pfizer products to Medicare and Medicaid recipients, causing the loss of jobs including those of Pfizer employees who were not involved in the fraud, and causing significant losses for Pfizer shareholders.
Thus, to avoid debarment, an agreement was reached between a shell subsidiary of Pfizer, which was created for the sole purpose of paying fines and the government. One federal prosecutor questioned whether even a $1.2b penalty was enough to punish Pfizer.
JP Morgan Chase
To finance a sewer upgrade project Jefferson County (Birmingham), Alabama, entered into a series of financial transactions with a division of JP Morgan Chase. JP Morgan advised the county to move from a fixed rate mortgage to a variable rate mortgage. JPMC then created complex synthetic derivative rate swaps to match cash flows between payments to bondholders and payments it was to receive from the bank for the interest rate swaps. In 2008, these deals blew up. The county was then required to pay a major part of the project in 4 years instead of 40 years, and a $647m one time penalty fee. The county’s annual payments jumped from $53m to $636m.
In addition to the poor financial advice which has nearly bankrupted the county, federal bribery convictions were obtained against twenty officials and businessmen. However, so far, JP Morgan Chase has not been indicted. Rather, it has faced an SEC action and been required to forgo collecting the $647m one time penalty. See Mike Taibbi’s excellent article and chronology Looting Main Street.
As with Pfizer, JPMC avoided indictment for reasons that are clearly expedient rather than ethical. Karl Denninger on Market Ticker explains:
JP Morgan is the firm that handles the Federal Government’s food stamp program – by creating debit accounts so that there is no “stigma” associated with public assistance. They issue what look like generic debit cards and of course collect a fee when they’re used, as well as a maintenance charge….
JP Morgan would have a hell of a time justifying the retention of their lucrative food stamp business were they to be charged and convicted of criminal fraud in the Jefferson County case. SeeGreenspan’s Delusions Deepen
Reeling in the Small Fish
The government seems to be allergic to indicting and fully prosecuting the worst perpetrators of financial fraud. For over two years Angelo Mozilo of Countrywide, the ground zero of shoddy mortgage practices, has been investigated without an indictment.
Instead we have been treated to insider trading cases involving Martha Stewart and Samuel Waksal in the Imclone insider trading case and Robert Moffat, an ex-IBM executive who fed inside information to the Galleon Group hedge fund. Bernie Madoff was convicted only because he confessed to the crimes. The SEC ignored evidence of his criminal fraud and indeed has been embarrassed by the revelations brought to light in the case.
The Unbalanced Criminal Justice System
A standard not written into the law is the preservation of a corporation deemed systemically important to the society as a whole. As a result, the criminal justice system has treated the large corporate offender with kid gloves. However, we now know that fraud was part and parcel of the current financial crisis. And as Karl Denninger has opined, the system will not recover until we clear it of corporate corruption. So, how to approach this ethical Catch 22 that may keep us in crisis for the foreseeable future?
President Obama is an attorney who is well aware of the disproportionate sentences meted out to accused and convicted minorities. He was also a constitutional law professor who understood the need for equality under the law. Yet more than two years into the financial crisis we have yet to indict, try and convict any “too big to jail” institutions. Continuing this inequity will only convince Americans that there are two sets of laws, one for favored institutions and individuals and another for the rest of us.
For more than 32 years, I worked as an attorney. In addition to a clerkship and law firm experience, I worked for some of America’s biggest corporations. I have an academic background in both law and economics. Unfortunately, when one works for any big corporation or bureaucracy, one often has to self-censor one’s more provocative thoughts. But…it’s a living. More
