The historical echoes of the mortgage bond scandal

By Felix Salmon
October 17, 2010
reviewed here, reminds us.

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What did Wall Street used to be like, before the Securities Act of 1933? Michael Perino’s new book on Ferdiand Pecora, which I reviewed here, reminds us. For instance, there was National City Bank’s Peru deal.

National City’s South American experts had reported that the government’s finances were “positively distressing”, with the treasury “flat on its back and gasping for breath” and the president surrounded by “rascals”. Yet, inevitably, National City decided to underwrite a series of bonds from Peru. Nowhere in the prospectus was there any indication of National City’s view on the country; meanwhile, National City’s ads stated that “when you buy a bond recommended by The National City Company, you may be sure that all the essential facts which justify the Company’s own confidence in that investment are readily available to you”.

Perino continues:

National City kept right on offering Peruvian bonds in 1927 and 1928, even though one of its own South American experts continued to conclude that he had “no great faith in any material betterment of Peru’s economic condition in the near future”. The political situation, he wrote, was “equally uncertain,” with “revolution” a distinct possibility. Would the public have purchased these bonds, Pecora asked, if that information had been included in the prospectus? “I doubt if they would,” Baker replied.

Pecora did something similar with a bond offering for the Brazilian state of Minas Gerais. National City used much of the proceeds to pay off a loan due to itself, without telling telling investors that it was using their money to exit the very credit they were buying into. And that’s not all:

How Minas Gerais would use the proceeds of the bond offering was not the only misrepresentation in the prospectus. Pecora put George Train, the man who originally urged National City to underwrite these bonds, on the stand. Train, it seemed, was willing to play fast and loose with other crucial facts in order to get the deal done. In 1927, analyzing Minas Gerais’s history of bond offerings in Europe, Train was amazed at the shoddy way the government had handled its obligations. The “laxness of the State authorities,” he wrote in an internal company memorandum, “borders on the fantastic”. His review of Minas Gerais’s history “showws the complete ignorance, carelessness and negligence of the former State officials in respect to external long-term borrowing.” It would, he wrote, “be hard to find anywhere a sadder confession of inefficiency and ineptitude than that displayed by various State officials.” Despite those conclusions, Train wrote in the prospectuses for the bond offerings, “Prudent and careful management of the State’s finances has been characteristic of successive administrations in Minas Gerais.”

I’m quoting Perino at length, here, because I’m getting a lot of pushback from various commenters to my assertion that pretty much every major investment bank in the world withheld material nonpublic information when they failed to pass on to investors the results of the due diligence tests that Clayton did on mortgage loan pools.

Kid Dynamite says that we’re not talking about material nonpublic information here. But of course we are: it’s information, it’s nonpublic, and it’s certainly material, since it resulted in the investment banks negotiating down the price of the loan pool in question.

The Securities Act came into law largely in reaction to exactly the kind of behavior that Pecora uncovered with the Peru and Minas Gerais bonds. The banks knew bad stuff about the bonds they were selling, but they didn’t pass on that information to investors. And so the Securities Act was written to put an end to such shenanigans.

The Clayton reports were much more than mere opinion, like the ratings agencies pretend to be. (And in any case, credit ratings are public information.) Clayton did detailed empirical research on the loan pools, and when the banks didn’t like what they saw, they used that information to their own advantage — by asking for a discount on the loans from the originator.

The whole point of the Securities Act was to ensure that information like that was passed on to investors. That’s why bond prospectuses are so long: they include every conceivable piece of information, and every conceivable risk factor, that might possibly be relevant to the price of the bond.

Yet the MBS prospectuses for the loan pools that Clayton examined didn’t include the fact that Clayton had done due diligence on them, didn’t say what Clayton’s results were, and certainly didn’t disclose that those results had allowed the underwriter to buy the loans from the originator at a discount.

If Ferdinand Pecora were alive today, he would recognize all this behavior — and be shaking his head at the way in which banks simply ignored the spirit of the laws which FDR put into place in the wake of the Pecora Commission.

Did the banks behavior violate the letter of the law? I think there’s a good case that they did; they certainly broke the law as it exists today. But let’s find out! Come on, prosecutors — file some suits, here, and see what happens. This crisis has yet to reach the stage at which people start going to jail. And we need to pass through that stage before it’s all over. So let’s get to it.


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