The Fourteenth Banker Blog

September 30, 2010

More on Foreclosure Abuse

Filed under: Running Commentary — thefourteenthbanker @ 4:15 PM

To begin with, I agree with this quote by Mke Konczal on New Deal 2.0:

Before I tell you more about what I think about the Florida situation, I’ll tell you I was raised by a family in law enforcement, and as such, I tend to think people who are arrested are usually guilty.   And I think that the people who are ending up inside the Florida bankruptcy courts are usually going to be people that shouldn’t be in their homes.

It’s because of the fact that I and others usually believe this to be true that I think due process and trust in the process of our courts is so incredibly important. It’s necessary to force the parties at hand to marshal evidence that they swear is true, and to present it to an impartial judge to render judgment after full consideration. This is America, where everyone gets a chance before the court. If this system breaks, the weak and the innocent are the ones who suffer.

So it’s because of this background that I feel sick to my stomach learning of a random sampling of foreclosure cases conducted by the Florida Bar News has just found “that 20 percent or more of the cases set for summary judgment had some procedural or paperwork problems.”

That said, here is an update on developments in Ohio.

Per this press release, Ohio Secretary of State Jennifer Brunner has described how her office is currently fighting illegal foreclosures. In her state, she identified that notary’s were being falsely attached to foreclosure documents. Essentially at the directive and according to the policy of their employer, notarization was done in bulk on documents processed in bulk. The notarys affixed their signatures and stamps to the documents when they were aware that what was being sworn in the documents was false.  Specifically,

REFERRAL OF CHASE HOME MORTGAGE AND MORTGAGE ELECTRONIC REGISTRATION SYSTEMS, INC. TO FEDERAL PROSECUTOR: Secretary Brunner, in two letters dated Aug. 11, 2010 and Sept. 1, 2010, referred matters of alleged notary abuse in thousands of home mortgage foreclosures by Chase Home Mortgage and the Mortgage Electronic Registration Systems, Inc. to U.S. District Attorney Steven Dettelbach in Cleveland. Citing two depositions, (onetwo) of Chase employee Beth Cottrell, taken in Columbus in May of 2010, and a deposition of MERS Secretary and Treasurer, William Hultman taken in New Jersey in April of 2010.  These depositions contain sworn testimony that at Chase Home Mortgage, 18,000 documents per month are executed and notarized per month by eight people, with admissions that:

  1. it is the notary and not the document signer who gives an oath who fills in numbers in the affidavits used in court ordered foreclosures,
  2. no oath is administered for the signing of each document,
  3. notarized documents are not verified by the person signing and giving oath that they have personal knowledge of the contents of the documents, but rather, signers are relying on verification by others,
  4. documents are signed in bulk and notarized in bulk separately,
  5. notaries know this at the time they notarize documents in this process.

This is obviously a shortcut to deal with a large volume of foreclosures without incurring the cost to actually verify that what is being presented to the court is in fact a true and accurate rendition of the legal facts. In the Secretary’s words:

“Mortgage foreclosure documents must be notarized according to the law. Requiring this is not an afterthought or an exercise of form over substance—the law must be followed when taking away someone’s home, regardless of the circumstances.

For too long thousands of homes have been taken from consumers without proof that the foreclosing party actually has that right. Our courts must be cautious and require absolute adherence to the law. As the officer in Ohio who licenses notaries, I cannot stand idly by and watch financial institutions concoct a chain of title they never had by abusing the notary process.

It’s not fair to consumers or to the employees who by virtue of their jobs, are signing these documents. I urge the U.S. Department of Justice to take up this investigation with vigor and purpose to protect consumers and hold financial institutions to the standards of scrutiny and exactitude required by law, even if it means prosecuting some of our largest corporations. These apparent violations of state law point to schemes that merit federal investigation of large institution lending practices and use of the U.S. Postal Service.”

It may seem nit picky to refer notarizations to the Federal Prosecutor. I suspect that this is one way to raise an issue with the entire process and not just individual cases.

One question that should be asked of GMAC is why they are suspending foreclosure activity in only 23 states? The obvious answer is that these are judicial foreclosure states and there is greater legal burden to prove the foreclosures are in fact proper. However, the reason these improper documents are often submitted to the courts is to remedy issues where the servicer cannot prove that the supposed note holder is the party at interest. If this situation exists in 23 states, surely it exists in all states. These corporations are apparently not interested in making sure foreclosures are done properly in all 50 states, just in those where they have the most legal jeopardy. What are the representatives of the people and the legal system doing in the other 27 states to protect their citizens?

According to CNBC, these issues are very material to the financial system and the economy.

Worst case is that the current foreclosure problems turn out to be industry-wide and trigger a landslide of legal challenges that lock up foreclosures resolutions for a year or more,” says Guy Cecala, publisher of Inside Mortgage Finance.

That means all kinds of borrowers would sit in their homes free of charge, banks would be unable to get any return at all, and the housing market would still be facing the inevitable: “We may then see a [foreclosure] surge at some point in the future,” notes Treasury’s Maggiano.

We’ve talked an awful lot about artificial government stimulus skewing the housing recovery as it tries to help; that’s nothing compared to the potential for this latest scandal to wreak havoc on housing yet again.

I wonder what the position of the Fed is on this? They hold on their books some $1.1 Trillion of Mortgage Backed Securities. It appears the Fed may find itself at cross purposes with the rule of law. They have a supervisory responsibility for safety and soundness in the banking industry. They also have funded the banking system through purchases of MBS. I’m sure they will be very quiet on this but I wonder what the auditors think about the values these MBS are carried on the books?

Comments welcome.

September 28, 2010

Colossal Failures in Judgment

Filed under: Running Commentary — thefourteenthbanker @ 7:42 AM

Once again our largest banks have botched things up. Hat tips all around on this one. Everyone has been covering it but I will recognize specifically the Huffington Post, New York Times, Washington Post, Bloomberg, Naked Capitalism, and Representative Alan Grayson’s office. A few days ago I blogged on foreclosure fraud in Florida, so I won’t run through that background again. What has newly developed in the last several days are these facts:

The banking industry is still reeling and in denial on this one. This excerpt is from Yves Smith:

One of my colleagues had a long conversation with the CEO of a major subprime lender that was later acquired by a larger bank that was a major residential mortgage player. This buddy went through his explanation of why he thought mortgage trusts were in trouble if more people wised up to how they had messed up with making sure they got the note. The former CEO was initially resistant, arguing that they had gotten opinions from top law firms. My contact was very familiar with those opinions, and told him how qualified they were, and did not cover the little problem of not complying with the terms of the pooling and servicing agreement. He also rebutted other objections of the CEO. They guy then laughed nervously and said, “Well, if you’re right, we’re f****d. We never transferred the paper. No one in the industry transferred the paper.”

This creates a lot of problems. If the originator is bankrupt (New Century, IndyMac), the bankruptcy trustee is supposed to approve any assets leaving the BK’d estate. I’m told bankruptcy judges who have been asked were not happy to hear this sort of thing might be taking place, which strongly suggests this activity is going on without the requisite approvals. And who from the BK’d entity can endorse it over? It doesn’t have any more officers or employees. Similarly, a lot of the intermediary entities (the B and C in the A-B-C-D chain earlier) are long dead. How do you obtain their endorsements?

Now you understand why everyone is resorting to fabricated documents and bogus affidavits. There is no simple way to fix this mess. The cure for the mortgage documents puts the loan out of eligibility for the trust. In order to cure, on a current basis, they have to argue that the loan goes retroactively back into the trust. This is the cure that the banks have been unwilling to do, because it is a big problem for the MBS.

The former subprime lender CEO still refused this to consider this a problem: “Oh, Congress will pass a law.” My colleague pointed out that this was a state law matter, Congress had no authority, and even the Supreme Court was unlikely to intervene in well settled real estate law. The arguments from the CEO were distressingly familiar, bank industry incumbents seem to resort to the same script: any borrower friendly solution will wreck the economy, the banks will have to get another bailout to get themselves out of this mess.

So here we are back to 2007-8. If you and I make a serious mistake at our jobs, we get fired, and if we make a really serious error, our company could perish. But when bankers screw up, and leave a lot of collateral damage in their wake, they are confident that their sugar daddies in DC will clean up the mess for them.

The question must be asked, how does this happen again and again in the financial system? Lets face facts. This is the system we have. There will likely never be a good post-mortem on this. Many details will emerge, individual cases will be litigated, perhaps there will be hearings. But the root of the problem will not be discussed because exposing the rot is too problematic. The rot goes to the top. It is too pervasive not to go to the top.

These things do not happen in a vacuum. The old “rogue employee” line will be trotted out. “Errors in judgement” will be admitted. But it will not be admitted that errors in judgement are produced systematically. You see, the cost of such errors in judgment is less than the ill-gotten gains. Such costs are a “cost of doing business”. The profits that were generated by this activity dwarf the potential cost. Executives incentives are to produce gains today and they do not pay for the risks that are left for tomorrow. The decision to have individual employees sit and sign affidavits that are false was made consciously. Someone decided to save the expense of doing it right. Or someone figured out that the chain of title had already been broken and it is better to whistle past the graveyard and defraud a court, a debtor, an investor, or a shareholder, than it is to do the right thing. All of those someones will likely not be identified or will get a slap on the wrist. The shareholders will never really know what happened and how certain executives created the culture in which these decisions made sense. But the truth is that decisions to cut corners, commit fraud, abuse clients, or mislead investors are generally cognitively rational given the position in which the individual employee is put.

Do any executives get that? Let’s hear one Wall Street CEO stand up this week and say, “I created this. I was wrong. I will pay the price and I will change the system in my bank so that employees never feel they have to choose to commit fraud. I will root out the responsible managers. Until this is complete I will work without pay. When it is complete I will offer my resignation to the Board of Directors and ask that it be put to a vote of the shareholders at the next annual meeting.” Oops, I’m dreaming.

September 25, 2010

Misdiagnosing the Small Business Jobs and Credit Act

Filed under: Running Commentary — thefourteenthbanker @ 5:40 PM

The AP did a reductionist story on the Small Business Legislation just passed by the Congress. This has circulated widely and the I will reference a version included in a post by Mish Shedlock, who I follow and generally find informative. On this one he has missed the boat. The Act does have something meaningful to offer, but only to bold and creative financiers and their clients.

There is a refrain taken up by bankers immediately in the wake of the financial crash of 2007-2008. The refrain is this, “It is not our fault that small business lending plunged, there was no loan demand.”

That refrain is basically repeated in Mish’s piece. Only now, we are two years later and in fact there is reduced loan demand. But contrary to his point, that does not make such a program irrelevant and wasteful, it makes it all the more necessary.

You tell me, does this look like insightful economic analysis or political reactivity?

When government passes out the money normally people are lined up, in advance, with both hands out. When that does not happen, it’s because the offer smells like a rotten fish.

Please check out Obama’s latest rotten fish offering as described in Small businesses, community bankers may snub Obama’s $30 billion loan program.

So here we have the tone of the piece. Note the comment, “latest rotten fish offering”. I guess this follows on many previous rotten fish offerings.

From the AP:

President Barack Obama’s $30 billion small community business lending program faces one big challenge: many of the community banks and businesses it’s supposed to help don’t want it.

The lending program is part of a bill that passed the House of Representatives on Thursday and now awaits the president’s signature. The legislation contains a mix of tax cuts and credits aimed at helping small businesses. The centerpiece of the bill is an effort to make billions of dollars available to community banks for loans to small businesses.

Bank executives say their customers don’t want loans, even at low interest rates, because the sluggish economy has chilled expansion plans.

Yes, the sluggish economy has chilled expansion plans. For historical context, we should be aware the the sluggish economy is the result of mal-investment by our largest financial institutions, hedge funds, private equity, pension funds, government sponsored enterprises, and individuals. Everyone wanted a quick profit. Banks chose to change their product mix to feed assets into securitized pools from which derivatives, CDOs, CDSs, etc could be created. Generally, this meant pushing standardized consumer loan products. The focus of credit activity shifted massively towards centrally underwritten, scored, mathematically modeled mortgages, home equity loans, and credit card products. These could be made sufficiently uniform to lump them together and sell off the risk to suckers at a quick profit. Customized personal credit and small business lending were de-emphasized. Why? they just did not generate the quick profit and the risk could not be offloaded to an investor or government sponsored enterprise. The result? Massive over-investment in residential real estate and debt fueled personal consumption. And, massive under-investment in the productive capacity of our industries. The busting of the bubble then had the follow on effect of putting most of our financial institutions on the brink of insolvency. The largest banks were saved by the bailout. Some will deny that they were saved by the bailout, saying they did not need the TARP. But the truth is, without the bailout all their counter-parties, including AIG and many foreign banks, would have wiped out even the strongest of our domestic financial institutions. Everyone was bailed out. Today however, despite what you will read below, many banks are constrained for capital and must limit lending and reduce their overall risk weighted assets. Do not let political posturing or propaganda fool you. Recent unofficial problem bank lists indicate that there are well over 800 problem banks in this country. These banks cannot freely lend. Many other banks are suffering the same conditions even if they have not moved to the point of being “problem banks”. Lending is constrained. I have seen it in the market.

The AP characterizes the situation as unproblematic, relying on the testimony of one banker. (there are others, but the AP article does no serious analysis)

Bank executives say their customers don’t want loans, even at low interest rates, because the sluggish economy has chilled expansion plans. Some say the federal money isn’t worth it because they fear it will come with too much regulatory oversight.

“We have taken a strategic decision not to have our primary regulator, the government, also be a partner in our bank,” said William Chase Jr., CEO of Triumph Bank in Memphis.

Chase said the bank already has enough capital to meet the paltry demand for loans. “Our business customers are mired in uncertainty and are reluctant to invest in their businesses,” Chase said.

This particular banker’s politics are also easily discerned. He does not want government money. Perhaps his little bank does not need it or does not have the creativity to know what to do with it.

The crux of the lending program is this. The balance sheets of banks will be improved by increasing their capital positions with government purchases of preferred stock in banks with under $10 Billion in assets. Depending on their size, the banks can obtain this capital in amounts up to 5% of their assets. That is a huge amount of capital. In some cases it could increase capital ratios by up to 70% and fully support both the increase in loan portfolios and risk. The ask in return is moderate. The cost of capital is 5% at the baseline and can drop to as little as 1% if a bank increases its business loans by 10% or more from today’s lows. That is not hard for a bank with the ability to take on risk and a plan to do so. It is hard for a bank with no plan. But why would we want such to participate anyway?

The loans may be used for these purposes:


(A)   IN GENERAL The term ‘‘small business lending’’ means small business lending, as defined by and reported in an eligible institution’s quarterly call report, of the following types:

(i)   Commercial and industrial loans

(ii)  Owner-occupied nonfarm, nonresidential real estate loans

(iii) Loans to finance agricultural production and other loans to farmers.

(iv) Loans secured by farmland.

So these loans are for job creating activity and agriculture. A bank with a plan could seek to develop expertise in businesses related to clean efficient energy. No, a small bank cannot do massive wind farms. But they can support the myriad of small businesses, engineering firms, etc that support clean energy production. They could be used for businesses that promote the use of new technologies that provide for energy conservation. What would be required is actual expertise, not the mechanized mass-production, judgement free methods that have come to pervade the industry. A bank could also support the development of more healthy local fresh food production and the logistical apparatus to bring it to market. This would serve multi purposes of job creation, improving diet and health, reducing health care expenditures, and increasing quality of life. Such is the role finance used to play.

There may not be massive demand for small business loans now. But should we be ready when the demand comes back? We cannot depend solely on the community banks that remain robust. We cannot depend on the mega-banks with their mechanized processes and lack of local knowledge or support for the subjective analytical processes that allow innovation. We cannot depend on bubble money providers from hedge funds and custodians for the uber rich. So we should have a program to support the development of more capacity for financial innovators in the banking sector, those that can develop a plan, build the expertise, act with purpose and integrity to do what is necessary to support our communities and the job and income growth that is necessary for a return to economic security.

To quote Amar Bhidé: “The measure of a financial system ought to be the service it provides the economy as a whole, not the employment or bounties it bestows upon financiers.”

So do not be discouraged by the words of Mish and others like him, works like these:

So what does Congress do?

Why it sets up a convoluted $30 billion program, onerous on small banks, so those small banks (who don’t want the money) can offer loans to small businesses that do not want the money either!

That is simply defeatism and is neither forward looking or backwards aware. This is a nice simple program that will provide benefits if even 5% of financial institutions choose to participate. But do you know what? When they figure out how easy it is, plenty of financial institutions will draw this capital down and then employ it in ways that help get us out of this economic funk.

September 22, 2010

Foreclosure Fraud and Why We Need New Banks

Filed under: Running Commentary — thefourteenthbanker @ 1:44 PM

By now you have all read about the mortgage foreclosure fraud going on in Florida and in other places. There is clearly a big problem and there are clearly not many constructive solutions.

This article is the best that I have seen because it explains the broader situation. From Washington Post:

Some of the nation’s largest mortgage companies used a single document processor who said he signed off on foreclosures without having read the paperwork – an admission that may open the door for homeowners across the country to challenge foreclosure proceedings.

The legal predicament compelled Ally Financial, the nation’s fourth-largest home lender, to halt evictions of homeowners in 23 states this week. Now it appears hundreds of other companies, including mortgage giants Fannie Mae and Freddie Mac, may also be affected because they use Ally to service their loans.

As head of Ally’s foreclosure document processing team, 41-year-old Jeffrey Stephan was required to review cases to make sure the proceedings were legally justified and the information was accurate. He was also required to sign the documents in the presence of a notary.

In a sworn deposition, he testified that he did neither.

The reason may be the sheer volume of the documents he had to hand-sign: 10,000 a month. Stephan had been at that job for five years.

How the nation’s foreclosure system became reliant on the tedious work of a few corporate bureaucrats is still a matter that mortgage lenders are trying to answer. While the lenders may have had legitimate cause to foreclose, the mishandling of the paperwork has given homeowners ammunition in their fight against foreclosure and has drawn the attention of state law enforcement officials.

Ally spokesman James Olecki called the problem with the documents “an important but technical defect.” He said the papers were “factually accurate” but conceded that “corrective action” may have to be taken in some cases and that others may “require court intervention.”

Olecki said the company services loans “from hundreds of different lenders,” but he declined to provide names.

Spokesmen for Fannie and Freddie confirmed Tuesday after inquiries from The Washington Post that they use Ally, formerly called GMAC, to oversee some mortgages. The companies have launched internal reviews to assess the scope of any potential issues.

Ally, Fannie and Freddie – all troubled mortgage companies that received extraordinary bailouts by the federal government during the financial crisis – declined to say how many loans might be affected.

Florida is a state with a huge foreclosure backlog and a lot of problems in the foreclosure process.  They have set up special courts to reduce the foreclosure backlog. Some of these courts are trampling on the law itself in order to clear the docket.

No one disputes that foreclosures dominate Florida’s dockets and that something needs to be done to streamline a complex and emotionally wrenching process. But lawyers representing troubled borrowers contend that many of the retired judges called in from the sidelines to oversee these matters are so focused on cutting the caseload that they are unfairly favoring financial institutions at the expense of homeowners.

Lawyers say judges are simply ignoring problematic or contradictory evidence and awarding the right to foreclose to institutions that have yet to prove they own the properties in question….

…Florida’s foreclosure mess is made murkier by what analysts and lawyers involved in the process say are questionable practices by some law firms that are representing banks. Such tactics, these people say, have drawn out the process significantly, making it extremely lucrative for the lawyers and more draining for troubled homeowners.

Doctored or dubious records presented in court as proof of a bank’s ownership have become such a problem that Bill McCollum, the Florida attorney general, announced last month that his office was investigating the state’s three largest foreclosure law firms representing lenders.

“Thousands of final judgments of foreclosure against Florida homeowners may have been the result of the allegedly improper actions of these law firms,” said Mr. McCollum in an interview. “We’ve had so many complaints that I am confident there is a great deal of fraud here.”

To be sure, adjudicating foreclosure cases is difficult, complicated by multiple transfers of mortgages and notes when a loan is sold, bewildering paperwork submitted by loan servicers and shoddy record-keeping by the many institutions that touched the mortgages during the byzantine securitization process that fueled the housing boom.

Nevertheless, Florida law requires that before a financial institution can foreclose on a borrower, it must prove to the court that it actually has the standing to do so. In other words, it has to show that it is truly the owner. And this is done by demonstrating ownership of the note underlying the mortgage.

This is where the Foreclosure Fraud comes in. Banks created this situation by developing toxic complex products and trading assets like baseball cards. To maximize value of these tradable products, they had to minimize servicing costs so the net cash flows to the investors would be maximized. So they cut corners. All information goes into electronic systems and it is those systems that buyers and sellers rely on. The documents themselves are just so much trouble. They have to be filed, shipped, imaged, tracked, stored, and so on. That costs money and is prone to human error. And, when you do this on a massive scale, there are a lot of errors. But no one really cares as long as you can foreclose anyway. Well, that monkey is no longer dancing.  Here are part of the findings of Judge Johnson of the Fourth Judicial Circuit Court in Duval County Florida:

Fraud on the Court. This is no small matter. After said finding and other similar findings, the chickens are coming home to roost.

What will solve this problem? It may be that many records will have to be sorted out, some of these swapping transactions re-documented, errors cured, new cases filed and litigated, tort cases defended, etc.

I have mixed feelings about this because slowing the clearing of the foreclosure backlog is not good for the general economy. Uncertainty will remain in the real estate markets about what the floor valuations are and buyers will not return to the markets even when they can afford to do so. But, the laws of nature cannot be reversed. Actions have consequences and those must play out.

This investment newsletter elaborates on what the consequences may be for banks. The actual dollar consequences are unknowable. But there will be consequences. The question is whether these ongoing uncertainties create what this author describes as “zombie banks” out of our largest institutions that handle something over 60% of total US bank deposits? I’m not sure we can wait to find out.

We need new banks with clean balance sheets, clear consciences, and new ways of operating.

Stirrings in the Third Estate

Filed under: Running Commentary — thefourteenthbanker @ 12:22 PM

Perhaps you are noticing that citizens are beginning to shed their old political attachments and are casting around for alternatives. The Tea Party smells to me like a transient happenstance, much like Ross Perot’s coalition. But it does speak of something among the electorate. What is it? Disappointment morphed to anger?  Fear?  Loss of confidence in the overextended empire?

George Washington refers to these as “Post-Partisan coalitions” in yesterday’s post.

Now, a new Gallup poll shows that the majority of Americans – 58% – say that both the Republicans and Democrats are doing such a poor job representing the people that a new, third party is needed.

And even the Washington Post writes:

Poll after poll shows that both national parties are deeply unpopular with an electorate looking for something new and different.

Pundits claim that the Republicans will gain quite a few Congressional seats in November. But even if they do, it doesn’t mean that Republicans are regaining popularity.

As the Post article notes:

[Pollster Glen Bolger said]: “This is the first time where there has ever been data like this – where the party poised to take control has not improved its image ….”

Indeed, the American people are acting like a guy standing on hot sand hopping back and forth from one foot to the other. He doesn’t like how the burning sand feels on either the left foot or the right foot.

He just knows he’s getting burned, and can’t wait to get wait to get somewhere cooler. The American people know they’re being burned by both parties, who are serving the big banks and military-industrial complex at the expense of the little guy.

Come 2012, the American voter might sprint off of the hot sand of big-money-parties-fleecing-the-little-guy altogether for more welcoming turf: a party which does more than just talk populism, but actually stands up to the powers-that-be.

What can we anticipate? I would guess that the quirkiness of the Tea Party candidates will lead to underwhelming results. Those who happen to win in a voter  paroxysm may quickly discredit themselves in a deliberative body.

It will be hard for a small philosophical minority to gain and hold power as a third-party. There are too many fractures in the party coalition itself. In order for the Third Estate to have  power, a variety of small parties must form coalitions. As the Tea Party splinters between 2010 and 2012, other parties need to form and galvanize enough support to take some legislative seats. There must also be a constitutional challenge against the arcane electoral rules that provide for 2 party dominance. So this process will take a lot of time and probably needs some catalysts along the way.

September 18, 2010

The Challenge Elizabeth Faces

Filed under: Running Commentary — thefourteenthbanker @ 11:23 AM

The appointment of Elizabeth Warren has raised the hopes of many and the ire of a some.  According to Simon Johnson, she is the perfect person for the job.

the president finally has an adviser who understands the financial sector and who has healthy skepticism about its intentions and actions.  As we documented at length in 13 Bankers, too many top policy people – both in this administration and all its recent predecessors – have been overly inclined to accommodate the interests of finance, particularly the big banks.  In this regard, putting Ms. Warren directly into the White House with the highest possible level of access is exactly the right thing to do – much better, for example, than making her purely a Treasury appointment.

So now the question is, what will she actually be doing? Some Senators don’t know.  A lot of folks though, seem to know how she will be doing it.

Warren herself also became enormously popular, thanks to her own directness, intellect, ability to communicate, and most of all because of her apparent passion for protecting consumers. People are hungry for that kind of voice,

So let’s move into the meat of this. Over the last 24 hours I perused the actual Dodd-Frank bill, skimming through 1300 pages, and found this helpful White Paper by Vincent Dilorenzo of St. John’s University School of Law, a mere 115 pages. I will return to that in a minute.

Dodd-Frank establishes that the purpose of the Bureau is to implement and enforce Federal consumer financial law to ensure that markets for consumer financial products are fair, transparent, and competitive. Which raises the question, if all it is to do is enforce existing law, what has been going on all this time? Dilorenzo addresses that in great depth. A lot of the problem is that the enforcement of the existing law was not a priority of the various regulators that are currently extant. Consumer protections were always secondary. In many cases, consumer protection was viewed as being in conflict with the primary legislative purposes. Two of those legislative purposes have been to keep financial institutions safe and sound and to make home ownership cheap and easy. To accomplish these purposes, a regulator may have determined that banks should have nice fat profits and that credit should be liberal and easily obtained. Well, for a long time the regulators accomplished both of those purposes. However, it was at great expense. Dilorenzo identifies in his paper what some of that expense was. It can be summed up as lasting harm to vulnerable populations who have had their wealth and credit ravaged, predatory profits by many unscrupulous lenders, and of course the damage to financial institution safety and soundness that required the bailout of the entire system, at great taxpayer expense. Then you can add to those the large numbers of unemployed and the damage to general business conditions and the security of all citizens.

So that should be easy to fix, no?

Well, the jury is still out on that. You see, there is a little complication written into the bill. From Dilorenzo:

As discussed in Part One of this article [Dilorenzo’s], Congress has embraced three goals for the mortgage markets: safety and soundness, access to credit, and fairness. In the past Congress consistently sought to harmonize these goals and allowed regulatory bodies discretion to act in a manner that served, as nearly as possible, all three of these goals. As consequence, when Congress debated the imposition of statutory protections for consumers in the past, costs and benefits of prohibiting particular practices that unfairly disadvantaged consumers were considered but decisions were not determined by the net societal benefits standard. As result, consumer protections were enacted even when they might impair access to credit or might adversely affect banking industry profits, as fairness was at times accepted as the paramount goal. Title 10 of the Dodd – Frank Act changes this legislative landscape. Congress has, for the first time in recent memory, subordinated the goal of fairness in consumer credit transactions to a new goal of economic efficiency. Congress has embraced what Arrow, Sunstein and others have cautioned against. As a result, if the Bureau does not enact a detailed rule prohibiting particular ‘unfair” conduct, the industry is faced only with a principles-based prohibition against “unfair” products and practices. The legislative signal that no product or practice is intended to be prohibited if it serves the goal of economic efficiency then serves as a further justification for the industry to continue such activity unrestrained by the legislative principle.

So let me explain that a bit more. In the past, Congress put consumer protection on an equal footing in the legislation. It was implementation of the legislation that allowed consumer protection to be secondary to safety and soundness and liberal credit. Now, the rule making powers of the Bureau are limited (prohibited) if the proposed rules conflict with the goal of economic efficiency. In other words, if the people in power determine that the consumer protections will restrict the flow of credit, jobs in construction, or whatever their priorities are, they may restrict the ability of the CFPB to make rules.

So there is an element of subjectivity. The door to political influence is wide open. In a Bush administration, there is little doubt that the error would be on the side of the banking lobby and the rules would be prohibited unless it could be proven that they will not interfere with economic efficiency. In an Obama administration, the subjective judgements will likely fall more to the protection of the individual consumer. This is why the qualities that Simon Johnson and Richard Eskew describe are so critical. The director must be articulate and persuasive in order to win these debates.

Now that is not to say there are no teeth in this bill. There is another section that provides greater power to the CFPB in the event an act or practice is considered “abusive”.  An act can be considered abusive if it takes “unreasonable advantage” of:

  1. Lack of understanding
  2. Inability of the consumer to protect their interest, or
  3. The reasonable reliance by the consumer on a covered person (employee) to act in the interests of the consumer.

Elizabeth needs to drive a truck through door number 3. Banks have taken an adversarial posture relative to their customers in many instances. Number 3 provides an opportunity to change that.

Finally, there are additional enforcement measures that if they are used can change the cost benefit scenarios the banks and other firms operate under. Often in the past the downside to an aggressive interpretation of the rules by a business was that their hands would be slapped and they would be required to cease predatory practices. In the meantime they may have made huge amounts of profit and the employees and executives may have personally banked big incentives. Dodd-Frank does provide new forms of relief including disgorgement (the giving back) of compensation for unjust enrichment, public notifications of violations, banning persons from the functions they abused, and civil money penalties. The imposition of such remedies will require a strong hand. The prosecutor, so to speak, will need to ask for a tough sentence.

So welcome, Elizabeth, and godspeed.

September 15, 2010

Elizabeth Warren In!

Filed under: Running Commentary — thefourteenthbanker @ 9:41 PM

Sources disclosed to the AP that Elizabeth Warren will be named the Acting Director of the Consumer Protection Bureauby the President. This is welcome news. The politics have been contentious. Simon Johnson made the case a few days ago that the President should go this route and explains the rationale in this piece.

Elizabeth Warren’s credentials are impeccable – she came up with the original idea for the CFPB, she pushed effectively for it to become legislation, and she has proved most effective in her oversight role as chair of the Congressional Oversight Panel (COP) for the Troubled Asset Relief Program.  And her manifesto for the CFPB is sensible and actually pro-business – although she naturally opposes the specific ways in which big banks mistreat people.

No doubt Republicans in the Senate would try to derail her nomination to head the CFPB as they have done with numerous other nominations over the past year and a half.  Their motivation would not be her views or expertise – she has earned serious Republican respect as a result of her COP role – just part of their electoral strategy to block the president’s agenda and to undermine an agency they have consistently opposed.

The Treasury Secretary is explicitly authorized by an Act of Congress to pick an interim head for the new agency – with a view to getting it up and running immediately (in fact, what has he been waiting for?)  Presumably the Senate (and the House) passed this specific measure expressly to expedite the CFPB’s work.

Professor Warren has strong political support and would get the new agency off to a great start.  She would represent the Obama administration’s serious attempt to rein in financial misbehavior – at the same time as keeping the economic recovery on track.  Anyone who thinks she would be bad for American families has not been paying close attention.  And best of all, she is very good at explaining what she is doing and why that makes sense.

There is a lot of hard work in front of Warren. Working on the rules is a big job. Changing the culture is a bigger one. There are almost always ways around rules and new products, schemes, and half-truths backed by a legion of lawyers can keep profiteers a step in front of regulators. So Warren needs to attack the heart of the problem, the attitudes and incentives that make this a game in which winning pays big and losing is just a small temporary setback. Banks will play that game all day long.

September 12, 2010

Cleaning up Corporate Fraud

Filed under: Running Commentary — thefourteenthbanker @ 6:54 PM

It has been widely commented that there have been virtually no prosecutions under criminal statutes related to the financial crisis. Yet, so many reported transactions and episodes have that slimy feel. They feel like a crime was committed. People feel like they were victimized by a crime.

Some want to justify slimy episodes and transactions on the basis of economic philosophy. George Washington posted this week on the matter under the headline that A Free Market Is Not Possible Without Strong Laws Against Fraud.

Well, as I’ve repeatedly pointed out, the economy cannot recover until trust and the rule of law are restored (and see this).

Imposing accurate accounting standards, stopping high-frequency trading, quote-stuffing and front-running, and prosecuting fraud to the fullest extent of the law are prerequisitesto restoring trust in our economy.

America has a long tradition of using fraud, antitrust, conspiracy and racketeering laws to rein in the worst economic abuses. These laws are an important part of American history, and our recent abandonment of them must be reversed.

George is absolutely correct about this and recent revelations continue to point out the shame of our captured regulators. It was a shocking headline a couple of months ago when the Comptroller of Citicorp was given a virtually free pass on proven and egregious misrepresentations to his own shareholders. His penalty?  A civil fine of $100,000. His compensation in the year he made the misrepresentations? $19.4 million.

This week the SEC was defending its actions in that case.

The Securities and Exchange Commission made its case in a filing Wednesday to a federal judge, who said last month she was “baffled” by the proposed settlement and wasn’t ready to approve it without more information. The SEC said the $75 million penalty is “fair, adequate, reasonable and in the public interest.”

The SEC announced the settlement of unintentional civil fraud charges in late July. The agency had accused the third-largest U.S. bank of repeatedly making misleading statements in calls with analysts and regulatory filings about the extent of its holdings tied to high-risk mortgages. Citigroup had said the exposure was $13 billion or less; the SEC said it exceeded $50 billion.

While Crittenden paid $100,000, Citicorp paid a fine of $75 million. The undisclosed risks ultimately lead to losses of billions of dollars and contributed to a stock price drop from approximately $55 per share to under $1.00 per share at the low. How many investors and citizens lost money in that debacle? How much? What about the taxpayers? $45 billion bailout.

The SEC found unintentional civil fraud. Well excuse me, but that is baloney. The non disclosures were intentional. People who are paid $20 million per year are not unaware of risks involving an extra $37 billion in assets.

Who else knew? CEO Chuck Prince and the disgraced Robert Rubin.

But perhaps the government is learning something. While I do not know enough about Hydraulic Fracking of gas wells to make any claims about whether it contaminates drinking water or not, the EPA request for information this week had a little glimmer of light. It actually asks for individual accountability.

The agency seems to be taking names with this latest request. The letter calls for a corporate officer to certify that the information provided is, to the best of his or her knowledge, “true, accurate and complete,” and it requires the company to specify the source of each piece of information by name, position and title. These two requirements could be important, should the information provided prove to be insufficient or inaccurate.

I had to read several media versions of this story before this little jewel showed up. Requiring an individual to sign a certification will increase the likelihood of complete disclosure, with this caveat. If the SEC and other agencies slap the wrists of those who lie to shareholders, regulators, and the public, then some corporate officials will decide the best bet is to lie, because the upside of the deception exceeds the downside of the penalty.

Are the Citigroup guys “rogue employees”? No. This is our culture, and will be until we change it.

September 9, 2010

Another Quality Post

Filed under: Running Commentary — thefourteenthbanker @ 7:00 AM

Here is a rather lengthly post that compliments the one from yesterday.  Believe it or not, this is a short segment of the post by a UW professor with a rather interesting background.  Jerry will appreciate the take on energy. I recommend the whole post as it discusses markets at length.

It turns out that as long as buyers are generally making more income over time (or believing they will in the future) and there are ever more buyers entering the markets over time, the economic measure of the market (not its intrinsic aggregate value) can rise without seeming to cause too much of a problem. These conditions are met as long as the economic system in which the particular market is embedded is growing. The housing market in the US and earlier in Japan are examples. And that condition had been met as long as energy flow was increasing throughout much of history. But starting around the early 1970s things started to change. Energy flow was still growing but at a slower pace each period. It had entered the top part of an ‘S’-shaped curve. This is the point beyond which the marginal return on energy (and money) invested in getting more gross energy out of the ground went into serious decline*. And as economists are fond of reminding us, such conditions cause a decline in period to period profit growth.

When the rate of marginal energy return started to diminish the real work that needed to be done to support the production of real (actual physical) wealth began to diminish as well. Almost nobody noticed because nobody paid attention to net energy and its role in production. The energy inputs to production are relatively small for any one firm, so the marginally rising costs of those inputs could be easily ignored. Nor were they paying attention to the declining growth rate of real assets. Instead financial wizards had started to push financial ‘instruments’ and ‘products’ onto the financial markets. Ordinary people started thinking of their homes as investment that paid dividends. Everyone was fooled into believing the economy was still growing over the last several decades The sales of these products and consumer goods based on money borrowed from supposedly appreciating asset values fluffed up the GDP. Indeed the demand for services in the artificially buoyed economy led to the creation of many jobs. All of which led economists to declare the economy healthy.

In reality it was moribund. Real wealth was being produced at declining rates. What was being called real wealth, trinkets and toys made in China, further enhanced the illusion that our material wealth was expanding. Behind the scenes, as is now painfully obvious, governments ignored important infrastructure investment letting entropy work its will on bridges and power grids were not upgraded to deal with the growing demand. We let slide the deep basis of society and the economy for superficial and illusory marks of a healthy economy. We, in the west, shipped manufacturing and other jobs off to Asia because it was expedient and supported maintaining the bottom line. Of course a few companies that could not sweep their cost structures under the Asian rug were stuck looking for another way out through creative bookkeeping. Companies did what they had to to keep the illusion of America and the other OECD countries as economic engines producing wealth, when in fact it was producing hot air to pump into the bubbles.

Without real growth in the real asset base, especially when there is growth in population, you will find that markets will crash and fail at the slightest provocation — call it the trigger effect. One little hitch and a bubble or two will bust and bring the whole edifice down with it. That is what we are witnessing now.

And further in his conclusion that these conditions are necessary for the proper functioning of markets. I do not have quite the same confidence in regulation as it currently operates but do believe it can be made more effective and at the same time not overly disruptive.

To summarize, markets work when:

  • Buyers have adequate information
  • Sellers are restricted to reasonable profit margins
  • Competition among buyers is regulated to assure best uses
  • Competition among sellers is regulated to assure non-overuse of resources
  • Not expected to provide coordination over larger scales (smaller is better)
  • The system as a whole is either in steady-state or growing

September 8, 2010

Witless Patsies?

Filed under: Running Commentary — thefourteenthbanker @ 7:08 AM

Before his untimely demise, Lee Harvey Oswald made the claim that he was a patsy, framed by conspirators.

Interestingly, Oswald was a self proclaimed Marxist. Since this financial crisis I have wondered more than once about whether Karl Marx was right, whether capitalism would fall of its own internal tensions. So this interesting piece hooked my attention. David Harvey is a Distinguished Professor at City University New York. He teaches a full course on reading Karl Marx, but prepared this paper for presentation to the American Sociological Meetings in Atlanta a few weeks ago.

Given the financial crisis, Harvey wanted to revisit material he has taught for a long time. Some of the material is highlighted here and is chilling in its applicability. Which raises the question of financiers, are they unwitting patsies for the wearing down of a plundered economic system? I would submit, and those who have followed my blog know well, that while at some date in the future such financiers may claim “Patsy” status, it is by many individual actions that such outcomes come to be collectively accepted. Individuals are responsible, despite the camouflage provided by massive corporations.

So here are some highlights of the selected paper.

Continuous financial innovation has been crucial to the survival of capitalism. But finance and money capitalists also demand their cut of the surplus value produced. Excessive power within the financial system can itself then become a problem, generating a conflict between finance and production capital. Financial institutions, furthermore, have always integrated with the state apparatus to form what I call a “state-finance nexus.”5 This usually stays in the background except in a crisis, as happened in the United States in the wake of the Lehman collapse: the Secretary of the Treasury (Henry Paulson) and the Chair of the Federal Reserve (Ben Bernanke) were making all the key decisions (President Bush was rarely seen).

Two key points to note here. First, the conflict between Finance and Production Capital. For Marx, Production Capital was that segment of the economy that combined capital with labor to produce goods and services for profit. Perhaps it is stating the obvious to note that Finance has now come into conflict with the goods producing sectors. It is oft noted that Finance has grown to an outsized portion of public company profit and market capitalization. It is also commonly noted that the function of the allocation of capital has been heavily distorted by the self-serving nature of Finance at this stage in our history. Be it the profanity laced cynicism of internal Goldman memos, the prevalence of front running on the trading platforms, the complicity in the hiding of public finances in Greece, the privatizing of profit and socializing of risk, or the nonchalant acceptance of a financial crisis every 5 to 7 years, Finance no longer even maintains an illusion of serving the economy. Unemployment and under employment render grim testimony to decades of profiteering with callous disregard to the welfare of the greater populace in the home country or abroad. Second, the state-finance nexus, or what I have referred to as the first and second estates, work in tandem, particularly evident in crisis. To say that the government did not sell out to Wall Street is to deny reality.

A low profit-margin regime arose in almost all lines of conventional production in the 1980s even as real wages stagnated. With the dismantling of capital controls over international movement, uneven geographical development and inter-territorial competition became key features in capitalist development, further undermining the fiscal autonomy of nation states. This also marked the beginnings of a shift of power towards East Asia. But it also led capital to invest more and more in control over assets – capturing rents and capital gains – rather than in production. The speculative asset bubbles that formed from the 1980s onwards were the price that was paid for unleashing the coercive laws of competition world-wide as a disciplinary force over the powers of labor and over the previously autonomous powers of the nation state with respect to fiscal and social policies.

Deregulating and empowering the most fluid and highly mobile form of capital – money capital – to reallocate capital resources globally (eventually through electronic markets and a “shadow” unregulated banking system) facilitated the deindustrialization in traditional core regions. Capital then accelerated its reliance on a series of “spatial fixes” to absorb overaccumulating capital….

…Two corollaries then followed. One was to enhance the profitability of financial corporations relative to industrial capital and to find new ways to globalize and supposedly absorb risks through the creation of fictitious capital markets (the leveraging ratio of banks in the US rose from around three to thirty). Non-financial corporations (such as auto companies) often made more money from financial manipulations than from making things.

Harvey loses me a bit at this point as he implies a deliberate class power grab with specific and intentional dispossessing of populations prone to exploitation historically (overseas) as well as the bankrupting of the middle class here in America. But I am forced to realize that my repugnance for the language is based on my presumptions. I instinctively want to cut the elites some slack here. But the only slack I can muster is to suggest that they have acted in individual capacities rather than as conspirators. Or is that being to generous?

The other impact was heightened reliance on “accumulation by dispossession” as a means to augment capitalist class power. The new rounds of primitive accumulation against indigenous and peasant populations (particularly in Asia and Latin America) were augmented by asset losses of the lower classes in the core economies, as witnessed by losses of pension and welfare rights as well as, eventually, huge asset losses in the sub-prime housing market in the US. Intensifying global competition translated into lower non-financial corporate profits.

There is much more in the paper but I think you get the drift. I return from time to time to the idea that a new banking model may be possible and that new capital is needed in the business. Perhaps some recall the older “ownership conundrum” posts. I still stand by the hope that a new kind of owner will create a possibility of a new kind of institution. Just two days ago a more famous blogger made just that point. John Hempton was linked to Naked Capitalism and he says the following:

I mention this because of my perverse view that re-regulation – opposed by most bankers – might be surprisingly good for banks over the long run.

The real winners and losers of deregulation

Competition – I argue – removed any real benefit of deregulation for bank shareholders.  (The benefits for bank management created by the sudden need to cope with this brave-new-world however were obvious.  They saw the opportunity and need to grow to maintain ROEs – and they lent with gay-abandon – taking all sorts of fees, commissions and bonuses along the way…)

The benefit for borrowers of competition however were dissipated in higher home prices and hence larger mortgages.  The real winners were people selling homes – not people buying them.  Even quite modest houses became valuable – and the elderly (the classic group moving to less expensive homes) did quite well.  I haven’t heard the expression “old and poor” quite as much as I used to.  More generally you can see the relatively affluence of the elderly in the sell-the-home and go cruising set.  Carnival Cruises was – for a very long time – a better stock than you might ever have imagined.

The other supposed beneficiary was suffering an illusion.  Plenty of people – especially in their children’s teenage years – had an-in-the-end-illusory wealth effect – where they thought their home was worth much more than it was – and felt confidence in spending some of that money – or in saving less for their retirement – because after all they could downsize and they might inherit part of Grandma’s (housing) fortune.

Net-net the losers out of excessive bank leverage were (a) the shareholders because they got lower spreads and took more risk, (b) taxpayers because they partly bore the risk and (c) younger home buyers because they got royally-rogered by the elderly people they bought from.

I am waiting for some bank management – particularly a stronger incumbent – to see it that way and advocate sweeping bank re-regulation which will (a) reduce taxpayer risk (b) increase spreads and (c) reduce leverage.  This will allow the strong incumbent to earn a good ROE at little risk on a lot more capital and will make the bank’s shares a surprisingly good investment.

So with John I will wait to see if any banking leader wakes up to these realities and puts aside the mantle of “Patsy” to Karl Marx’ prophesy.

September 3, 2010

Trending: Too Big To Fail

Filed under: Running Commentary — thefourteenthbanker @ 1:29 AM

As this post points out, the trend of the regulatory regime has been to nudge or auction weak institutions to bigger, purportedly stronger institutions.  Wachovia to Wells Fargo, Merrill and Countrywide to Bank of America, Bear Stearns and Washington Mutual to JP Morgan.  As FDIC points out, more banks are becoming troubled. As Naked Capitalism points out, surviving banks with share prices possibly bolstered by weak accounting rules will roll into consolidations with larger banks, continuing the concentrations of deposits, clients, and risk into fewer hands. No wonder Bernanke says it will be hard to shrink the Megabanks.  We are going backwards.

From Naked Capitalism:

The “lax” [regulation] is clearly a tad inflammatory, but tweaks in Basel III rules to allow dubious quality items like mortgage servicing rights as Tier I capital speak volumes. In addition, the various noises from policy makers makes clear that they aren’t willing to make banks raise capital level by much due to fears of the impact of lower loan availability on economic growth (more equity behind lending means higher lending costs, since equity is more expensive than debt). And with that not-very-strong starting point, the banks have pushed for even weaker rules.

Should this come to pass, Credit Suisse, via a Wall Street Journal story, is already predicting the outcome: more bank mergers.

So to echo my recent refrain, we need new banks that are capable of adding market forces to shrink TBTF institutions that will not be forced smaller by regulation.

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