Felix Salmon

Bank stocks didn’t do so well this week, what with foreclosuregate coming to a boil. But they didn’t do all that badly, either, as a group: the XLF financial sector ETF ended the week down a pretty modest 2.45% from where it started.

You might remember the XLF fund from a famous column by Evan Newmark two years ago, a few weeks after Lehman Brothers declared bankruptcy and the global financial system threatened to implode into a mess of nationalization and mass insolvency:

Bear Stearns, gone. Lehman Brothers, gone. Merrill Lynch, gone. Washington Mutual, gone. Wachovia, gone. Fannie and Freddie, basically gone. AIG, almost gone.

Absolute carnage. The fastest restructuring of a banking system in economic history.

Will the U.S. financial-services industry survive? Plenty of folks think not. But if you believe yes, now is the time to buy financial stocks.

Which is why I have been buying the XLF, the financial sector exchange-traded fund…

The optimist will tell you that we have a crisis of confidence. That with the Treasury’s bailout program in place, bad assets will be speedily removed from balance sheets and credit will again flow. Throw in a Federal Reserve interest-rate cut and soon banks profits will follow.

Frankly, I don’t know who is right today. But I have a five- to 10-year time horizon, so I don’t have to know that.

All I have to do is believe that the US financial-services industry will survive…

For the XLF a break down of more than 20% from Friday’s close, would put it at less than $15.

This would probably indicate the total collapse of the U.S. financial system. And I just don’t buy that. I am buying the XLF instead.

In many ways, the column was prescient. The US financial system did survive. Treasury’s bailout program, along with Fed rate cuts, did indeed break the back of the financial crisis, and large bank profits have followed as a result.

Yet XLF has been trading between $13 and $15 since May — a level which, according to Newmark, “would probably indicate the total collapse of the U.S. financial system”. And looked at over the past three years, it’s pretty clear what happened to the XLF: it fell off a cliff and then recovered to settle happily at a new, low level. Here’s the chart; the vertical line marks the date that Newmark’s column appeared.

I think that this helps to provide, at least in part, an answer to Ezra’s question about why the markets don’t seem to care about the foreclosure crisis: they’ve known about it all along. (For instance, see this story from Reuters’s Patrick Rucker, dated July 27 2007.)

What’s happened over the past week or so is that the mortgage shoe has finally dropped, as it inevitably was going to do sooner or later. But since the markets were already pricing in that shoe-drop, they haven’t needed to overreact this week. They didn’t know when all this was going to happen, but they were relatively well prepared for this: it’s a slow trainwreck, not a sudden crisis. And the still-depressed level of financial stocks is testament to how none of this comes as much of a surprise.

Clayton isn’t the only company doing due diligence on mortgages: another company doing the same thing is Allonhill. Whose CEO, Sue Allon, has a blog post up today explaining that there’s nothing to get excited about here:

In the run-up to the crisis, there was no rule that issuers had to perform due diligence at all. They obtained diligence for their own purposes, and when they did, no rule dictated that the results be disclosed to rating agencies and investors.

Allon goes on to say that “nobody – not investors, nor the SEC nor the rating agencies” was demanding that the due diligence reports be made public.

But this doesn’t make sense to me: why wouldn’t investors want to see the reports, if they knew they were being conducted?

And then there’s this:

The fact remains that investors still don’t have access to due diligence reports.

Still? How is that even possible? Isn’t the whole point of Section 15E(s)(4)(A) of the Exchange Act — introduced recently as part of Dodd-Frank — to force underwriters to give investors access to due diligence reports?

And as for the SEC not caring about this, I’d point you to to a letter that Clayton sent to the Financial Crisis Inquiry Commission. The idea was to distance itself from its former employees’ testimony, but check out this admission, towards the end:

Clayton began to review prospectuses in the summer and fall of 2007 in response to specific questions from regulators about whether Clayton’s due diligence results were set forth in MBS prospectuses.

Clearly, regulators have known about this issue for three years now; they’ve certainly known about it for long enough to insert Section 15E(s)(4)(A) of the Exchange Act into the Dodd-Frank bill.

So while Allon is right that there might not have been a specific rule requiring disclosure of the diligence results, there were still general rules requiring that underwriters disclose all relevant information when they sold mortgage bonds — or any other kind of security — to investors. That’s where the huge potential liability lies.

Update: Patrick Rucker of Reuters was all over this back in July 2007:

Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass much of the information to credit rating agencies or investors, Wall Street sources said…

“If all the information about these investments was properly disclosed, our client would have made different decisions…and, specifically, not bought these investments,” said Dale Ledbetter, a Florida attorney suing Credit Suisse.

If bankers are good at anything, surely it’s counting money. If there’s a cashflow, anywhere, bankers will surely be able to quantify it and report it. Or, not:

Mortgage-bond buyers are losing faith in the accuracy of remittance reports, and some say the apprehension could soon factor into their investment strategies.

Remittance reports, distributed monthly by securitization trustees, are supposed to provide routine snapshots of the cashflow-collection and distribution activities of servicers. However, investors say there has been a rash of recent instances in which the reported data differed considerably from what actually happened.

Loan servicers, it seems, are so spectacularly incompetent that they can’t even report to bondholders how much money they’re being paid. Especially when a loan has been modified, the servicers don’t seem to be able to report the new cashflows accurately.

Not that this is a bad time to reduce investors’ faith in the transparency and reliability of mortgage-backed securities, or anything.

Just how bad is the mortgage mess right now?

Mike Konczal finds an Andy Kroll piece from January which shows just how unregulated mortgage servicing has been: the OCC, for instance, has never taken action against mortgage servicers. And it’s far from clear that it’s inclined to now:

The OCC, which regulates the nation’s largest banks, has initiated “examinations” of foreclosure and loss-mitigation procedures at big banks, “to be conducted over the next several weeks to confirm compliance and that banks have remedied any identified issues,” an OCC spokesman said.

The point here is that the decision to go after banks and loan servicers is ultimately a political one, and there doesn’t seem to be a huge amount of appetite in Washington to have another huge fight with the banks, so soon after the last one. The OCC could, at any minute, get very tough on the servicers. But will it? That’s very uncertain.

Meanwhile, the incredibly low rate of existing home sales looks like it’s going to plunge still further:

New buyers have stepped back from the market for distressed property, which now accounts for more than 30% of new transactions, according to RealtyTrac. New owners are worried they don’t have a legal right to their homes. Title insurers are worried about their exposure to faulty documents and unwilling to stand behind new purchases. Since title insurance is required for most mortgages, the market is essentially at a standstill.

In other words, the housing market, which was broken before, is even more broken now.

What’s this all going to cost? Nelson Schwartz is throwing around numbers less than $10 billion, which is decidedly manageable, but that’s just the cost to banks, and crucially it assumes that the problem is merely one of paperwork. Hire a few new people, be a bit more diligent, and things will be able to sort themselves out.

If you start looking at the mortgage market, the potential cost gets much, much higher:

An alarming report on Bank of America, compiled by Branch Hill Capital, a San Francisco hedge fund, circulated widely on Wall Street on Thursday. Branch Hill suggested that the bank, the nation’s largest, could be facing more than $70 billion in losses from mortgage securities that it may have to repurchase from Fannie Mae and Freddie Mac, as well as private investors.

“We think this is a very important issue, and the liability will be substantial,” said Manal Mehta, a partner at Branch Hill. “There has been pervasive bad behavior throughout the system.”

The problem is hardly confined to Bank of America, of course. All investment banks did this, which means they all have enormous potential liabilities.

And then the costs to the broader housing market are higher still. The longer that market fails to properly clear, and the longer that the overhang of unsold houses continues to grow, the less it makes sense to talk about what any given house is “worth” — and the more it makes sense for homeowners to default on their mortgages. They’re very unlikely to get thrown out of their homes for at least a year and possibly much longer, and there’s a pretty good chance, if they’re underwater, that at the end of this mess they’ll be able to negotiate some kind of principal reduction.

So what are the mortgage originators and investors doing about this huge problem? It looks as though they’re sticking their heads in the sand:

The Executive Director of the American Securitization Forum, Tom Deutsch, released the following statement regarding misinformation circulating within the financial markets that transfers of residential mortgage loans to securitization trusts were not valid.

“In the last few days, concerns have been raised as to whether the standard industry methods of transferring ownership of residential mortgage loans to securitization trusts are sufficient and appropriate. These concerns are without merit and our membership is confident that these methods of transfer are sound and based on a well-established body of law governing a multi-trillion dollar secondary mortgage market.”

Apparently the Forum is going to release a white paper “over the course of the next two weeks” designed to put our minds to rest. Needless to say, it won’t. Even if the narrow question of the transfer of ownership to the securitization trust is cleared up, there are still numerous enormous concerns surrounding mortgage bonds, including whether the banks misled investors, whether investors might be able to force the banks to buy the bonds back, and whether the bonds themselves are going to plunge in value as house prices fall, defaults rise, and the ability to foreclose on notes in default slowly evaporates.

And what happens if and when the homeowners who have already been foreclosed upon start filing class action suits against various parts of the financial-services industry, saying that the banks had no right to do that? If the verdicts of kangaroo courts start being overturned, things could start getting really messy.

What’s desperately needed here — and what isn’t going to happen — is someone to come in and take ownership of the whole mess, and cobble together a roadmap for getting out of it. But that would take more political will than seems to exist in the White House. So this is going to drag on, painfully, state by state, quite possibly for years. And while it’s doing so, the chances of any kind of robust economic recovery — at least outside the world of high-priced legal firms — seem slim indeed.

John Cassidy on the blogonomics of Gawker — TNY

Microfinance institutions are now kidnapping minor children?! — India Microfinance

Justice, as expected, is appealing the DADT ruling — Reuters

I took the subway downtown from work today, since it was raining rather heavily, and saw an ad for something called Chase Commuter Cash. The idea is that you enroll your Chase debit card in the scheme, use that debit card to pay for your Metrocards and then get $10 back from the bank for every $150 you spend.

Now Metrocard vending machines are, by their nature, a huge security hole when it comes to credit cards. They’re completely anonymous, you don’t need to sign anything, you don’t need to show ID: all you need to do is swipe and maybe punch in your Zip code. Which isn’t much of a security check:

When paying by credit card it may ask you for a zip code. I just use the New York Zip code 10007. It has always worked for me so far.

As such, you’d think that Chase would be urging all its customers to use the much more secure PIN code when they pay with debit cards. But you’d think wrong. In order to get the cash back from Chase, only ” transactions made without using your PIN” qualify.

The reason, of course, is that Chase gets higher interchange fees if you press the “credit” button on the machine and don’t put in your PIN, even though you’re using a debit card. Why are the interchange fees higher for credit than for debit? To make up for all the extra fraud, of course. But clearly Chase doesn’t seem to be worried about that.

All of this is prima facie evidence, of course, that the interchange fees for signature debit are far too high. But it’s also a way of getting the public into the habit of hitting the “credit” button whenever they use their debit card — something which will ultimately only serve to increase the amount of fraud in the system.

Signature debit is an abomination which ought never to have existed in the first place and which really ought to be abolished rather than encouraged by the very banks who will ultimately suffer ever-greater losses as a result of its use. But the banks, desperate for fee income, are ignoring the obvious fact that what they’re doing simply is not sustainable.

I’m reminded of airlines’ bag-check fees:

Here’s an indisputable truth: The more baggage fees that the big airlines pile on their customers, the faster their overall revenue is collapsing. In fact, the only carriers that escaped a double-digit revenue decline in the second quarter were the two that still allow all passengers to check at least one bag for free…

“Baggage fees are the kind of shortsighted things that are killing us,” the top U.S. executive of a European airline told me recently. “The accountants we have are great at tracking the ‘ancillary’ revenue we generate whenever we invent something like a baggage charge. But they have absolutely no way to match that against our potential overall revenue exposure if travelers book away from us. And no one holds them accountable for their one-way accounting. It’s a scandal.”

For “baggage fees” read “signature debit” and I suspect that we’re seeing exactly the same thing with the commercial banks. No good can come of this, over the medium term. Which only goes to prove that bankers are no better at building long-term value than they ever were.

My review of Michael Perino’s new book about Ferdinand Pecora, The Hellhound of Wall Street, is up now chez B&N. I liked the book a lot, and learned a lot from it, and ultimately came away saddened that history can’t and won’t repeat itself this time round. In 1933, Pecora was the hero of the financial crisis: the man who brought the banksters to book. Today, there’s no such hero. And while Dodd-Frank and Basel III are all well and good, they’re not remotely as far-reaching and revolutionary as the Securities Act, and the Exchange Act, and the creation of entities like the SEC and the FDIC.

Of course, it’s thanks largely to Pecora that we don’t need anything so far-reaching and revolutionary. It’s great that Perino has rescued Pecora from the dusty reaches of history, and is showing what an aggressive prosecutorial lawyer can do, given subpoena power and the moral high ground. I’d love to see one of those in the Senate today, or even in an AG’s office somewhere, or at the SEC. But ever since Eliot Spitzer became governor of New York, that job has seemed to be vacant. It looks very much as though there will be precious few prosecutions coming out of this crisis. Unless, of course, I’m right about the degree to which the mortgage scandal could explode.

Update: Thanks to Economics of Contempt. This turns out not to be the cut-and-dried breaking of the law that it looks like. Because it turns out that Section 15E(s)(4)(A) of the Exchange Act is very new: it was only inserted into the Act by Dodd-Frank (page 1,376, if you’re following along at home). So it wasn’t in force when these bonds were issued. You couldn’t do this kind of thing any more — it would be illegal. But Section 15E(s)(4)(A) isn’t enforceable retroactively.

After my post yesterday on the mortgage bond scandal, a lot of commenters said that it looked like a violation of Rule 10b5-1 of the Exchange Act — the bit that prohibits trading on material nonpublic information. Well, it may or may not be a violation of 10b5-1. But that might be beside the point, because this looks like an absolutely textbook violation of Section 15E(s)(4)(A).

This rule is not dense legalese at all. In fact Section 15E(s)(4)(A) is written in very plain English. Here it is in full (see page 231 of the PDF):

The issuer or underwriter of any asset-backed security shall make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

I can’t for the life of me work out how every single mortgage bond that Clayton taste-tested didn’t violate this rule.

And in fact, the SEC has now proposed its own additional rule, which would mandate this kind of due diligence, and would also mandate that the issuer disclose the nature, findings and conclusions of any such taste test.

Up until now, underwriters have not been obliged to do this kind of due diligence. But the fact is that they did it, and that Clayton, in particular, made good money from performing such due diligence for just about every major investment bank in the world. As far as I know, not a single one of those banks disclosed Clayton’s results when they sold their bonds. And that looks to me like a blatant violation of Section 15E(s)(4)(A).

Or is there something I’m missing here? (Obviously, yes, there was.)

Update 2: If Section 15E(s)(4)(A) doesn’t do the job, what are we left with? Well, there’s still 10b5-1, of course. That prohibits the sale of any security on the basis of material nonpublic information. And there’s also Section 17 of the Securities Act:

It shall be unlawful for any person in the offer or sale of any securities… to obtain money… by means of any untrue statement of a material fact or any omission to state a material fact.

Which still does the job, I think.

I’ve been getting a lot of good feedback about my post yesterday on the way in which just about every major investment bank in the world might have huge legal risk surrounding the way that they built their mortgage bonds. The stock market in general might be relatively sanguine about the mortgage mess, but bank stocks are falling, and I suspect that the worst is yet to come. Certainly the tail risk to the banking industry as a whole is as high as it’s been since TARP was first unveiled.

In any case, if the post was a bit tl;dnr for your tastes, here’s a jerky video version, complete with libel-conscious bleepage. You’ve heard of the foreclosure mess. Here’s a mortgage-bond mess to layer on top:

Cullen Roche today revisits his advice from a year ago, which was published in New York Magazine, on how to buy toxic assets. He says that he “received a pretty substantial backlash from the article”, which is true: I wrote about it under the headline “Awful investing advice of the day, distressed-mortgages edition”. But now he’s defending himself:

First of all, I wasn’t making, nor do I ever make recommendations for anyone. That should be ABUNDANTLY clear to any and all readers of everything I write. I was simply brainstorming about the ways that small investors could gain access to toxic assets because it’s a relatively closed space to the small investor if you don’t have certain connections…

Even though these ideas were generated well after the market bottom the one year results prove that we were indeed in the midst of a once in a lifetime opportunity…

Unfortunately, the once in a lifetime opportunity is likely gone as the risk/reward environment has altered dramatically… In fact, distressed debt looks more crowded by the minute.

So does that mean, pace Joe Weisenthal, that I’ve been proven wrong?

No.

Firstly, of course Roche was making investment recommendations — he was citing specific ticker symbols, ferchrissakes, and the first line of the piece (headlined “The Beginner’s Guide to Toxic Assets”) was this:

So how can you consider joining Michael Osinski and invest in toxic assets?

The entire piece, in other words, was presented as a way to give those “beginners” a “guide” for how to “invest in toxic assets”. You can reiterate until you’re blue in the face that you’re not giving investment recommendations, but a guide like this — especially if it comes with ticker symbols — is exactly that.

Secondly, the one year results are not particularly convincing. Roche’s own numbers say that his recommendations went up by 21% on average, compared to a rise of 11.45 percent in the S&P 500. But the 21 percent return figure doesn’t include transaction costs, and it certainly doesn’t make any attempt to account for the the fact that these stocks are inherently riskier than a big index of the largest companies in America.

Does the excess 955bp of return make up for that risk? Maybe it does — but it would be nice if Roche had told us in advance what kind of outperformance would constitute proof that his “once in a lifetime opportunity” thesis was true. Personally, I would expect that a once-in-a-lifetime opportunity would generate rather more than 955bp in excess returns, but maybe that’s just me.

Finally, and most importantly, the initial story didn’t give any kind of exit strategy. I’ll give Roche some small credit for posting exit advice on his blog today. But 99% of the people who read his original article on nymag.com will never see that blog post. And so if you took his advice a year ago, right now you’re just sitting on paper profits. And there’s no indication at all, in his original article, that you should sell after one year, or sell when the portfolio has risen by 20 percent, or even sell at all, really.

Every article saying that now’s a good time to buy X should be ignored automatically if it doesn’t say when you’re meant to exit that trade. (“Never” is a reasonable answer to that question, but if you’re giving buy-and-hold-forever advice, be explicit about that.) Given that NY Mag is unlikely to run a piece saying “hey, those stocks we recommended, now would be a good time to sell them”, it should never have run the article saying that it was a good time to buy them a year ago.

But hey, if someone at NY Mag is reading this, maybe a little blog entry might be in order. It can’t hurt, and it might save a few readers from following these stocks down after riding them up.

Bloomberg TV host: “Are you buying? Adding more gold to the collection?” Mr T: “The highest weight I carry is 45lbs” — YouTube

When asked if their food was not biodegradable, McDonald’s said: ‘This is an outlandish claim and is completely false.’ — Daily Mail

States probe mortgage industry practices — Reuters

“I know Arianna doesn’t like it,” Obama said lightly. “But I like taupe.” — NYT

Remember the WSJ front-page headline saying “SEC Blasted on Goldman“? It was based on a few comments from the SEC inspector general, David Kotz, who has now released his official report on Goldman. And there ain’t no blasting here:

The OIG investigation did not find that the SEC’s investigation of, or its action against, Goldman was intended to influence, or was influenced by, financial regulatory reform legislation. The OIG found that the investigation’s procedural path and timing was governed primarily by decisions relating to the case itself, as well as concern about facts about the investigation’s subject matter being publicized prior to the SEC filing an action and concerns about press coverage and maintaining a relationship with the NY AG.

The OIG also did not find that the settlement between the SEC and Goldman was intended to influence, or was influenced by, financial regulatory reform legislation. The settlement’s timing was driven primarily by factors relating to the civil action against Goldman and Goldman’s quarterly earnings release.

The OIG did not find that anyone at the SEC shared information about its Goldman investigation with any journalists or members of the media prior to the filing of its action against Goldman on April 16, 2010.

In fact, pretty much the only negative thing that the OIG did find was that the SEC, according to its own rules, should have given Goldman a heads-up before announcing the suit. As a result, the OIG recommends that the SEC… take another look at those rules.

The report isn’t wholly believable. Of course the New York Times had a heads-up about the case: you can’t read a complaint, write a long, detailed story about it and publish that story, all within five minutes of the SEC press release going out. But then again, the OIG somehow wasn’t able to get his hands on that story:

The New York Times Company represented that it was unable to retrieve the version of its article about the SEC’s action against Goldman as it was first published at 10:38 a.m. As a result, the level of detail concerning the SEC’s action contained in this first iteration of the article could not be reviewed by the OIG.

Well, you can see the final version of the story here; it doesn’t differ substantially from the story as first published and it’s over 1,700 words long. It clearly wasn’t written in five minutes.

I’m also unsure how much of this to take at face value:

Chairman Schapiro testified that she was “quite surprised” at how much media coverage the Goldman action received… Cohen testified that he and others at the SEC were surprised at the attention given to the Goldman case once it was announced… Many other witnesses in this investigation testified that they were surprised or “shocked” at the extent of the media attention given to the Goldman action.

Certainly there was a lot of press coverage given to the case and Goldman’s share price went down more than I think anybody at the SEC or even Goldman would have expected. In hindsight, it’s easy to see why the case got so much attention, but at the same time I can maybe believe that the SEC didn’t anticipate the full extent of the media firestorm. (Here’s one datapoint: it’s the only occasion I’ve been asked to write an op-ed for the Washington Post.)

But all those are quibbles. The OIG report is clear and it’s a full exoneration of the SEC both in terms of whether the case was political from the start and even in terms of whether its timing was political. Kotz concludes in both cases that it wasn’t. I’ll be fascinated to see how much prominence the WSJ gives this story.

Foreign aid is a much cheaper way of conducting a country’s foreign policy than the military — and in many cases it can be much more effective, too. The Obama administration is very keen on this: a recent roundtable discussion on its new Global Development Policy, for instance, featured not only secretary of state Hillary Clinton but defense secretary Bob Gates and treasury secretary Tim Geithner as well.

At one point in the discussion, Clinton explained that the U.S. was running into an unexpected problem:

We have to fight to get the U.S. Government’s label on our material because a lot of our aid workers and our NGO partners are afraid to have association with the U.S. Government, whereas China, Japan, everybody else, emblazoned across all that they do, “Gift from the people of China,” that – “From the generosity of the people of Japan,” or you name it. So the American taxpayer is looking at this and saying, “We want to help those people. That’s a terrible disaster. But they don’t even want to admit that it’s coming from us?”

Philanthropy is a very public thing in the U.S.: if you give a lot of money to a certain cause, you can often demand your name emblazoned across it somehow. The problem is that when the US makes similar demands, it puts lives at risk. Here’s Rob Crilly:

if you were, say, a Western aid worker you might a few reservations about delivering goods with a nice red, white and blue logo with a row of stars and stripes on it…

Anyway this is what the good people at USAID are insisting on. Inevitably, charities tried to avoid displaying it too prominently – and maybe US officials were prepared to turn a blind eye – but that was until Richard Holbrooke visited and expressed his concern that the US was not getting sufficient credit for the hundreds of millions of dollars in aid being poured into Pakistan…

Such is the strong feeling among aid agencies that some – including, I understand, Oxfam – are prepared to give up millions of dollars in funding rather than risk more lives…

It is not a question of courage. The aid workers I know are aware of the risks they face. Many here in Pakistan here now knew Linda Norgrove, who was kidnapped and killed in Afghanistan. It is a question of knowing the limits of acceptable risks. Using a stars and stripes logo lies on the wrong side of stupid.

It’s one thing to espouse a generous foreign-aid policy on the grounds that you will ultimately do well by it in terms of domestic security. But it’s something else entirely to try to squeeze every last ounce of PR value out of that foreign aid, even if doing so puts the lives of aid workers at risk. (Many of them won’t even display their own logos in places like Afghanistan, let alone the stars and stripes of USAID.)

Let’s hope that Clinton and Holbrooke back down on their hard line here, especially since the value of the U.S. branding is so anecdotal and fluffy, while the cost is clear and harsh. It might not be particularly American, but sometimes the most noble kind of aid is the aid you’re not always rushing to take credit for.

Politico has the transcript of Tim Geithner’s appearance on Charlie Rose last night:

I think it’s important to recognize, Charlie, that if you — a national moratorium would be very damaging to exactly the kind of people we’re trying to protect, because the consequence of that would be in neighborhoods that have been most affected by the foreclosure crisis, where you see lots of houses on the block empty, unoccupied, what it means is those communities will be living longer with houses unoccupied, with more pressure on their house price with the people still in their houses. That would be very damaging.

I don’t follow this logic at all. Geithner is absolutely right that empty houses are a Bad Thing. But he seems to think that a foreclosure moratorium would cause empty houses. Isn’t it foreclosures which cause empty houses?

I feel I’m missing something obvious here — but as I understand it, when a bank forecloses on a house and sells that house, it evicts the previous owners as part of that process. One the old owners are evicted, the house is empty — until the bank manages to sell it. If the foreclosure doesn’t happen, the eviction doesn’t happen, and the house isn’t empty.

Is Geithner implying that banks will continue to evict homeowners even without foreclosing on those properties? Is that even possible?

Update: Treasury responds, via email.

First, at least 40 % of all homes in foreclosure are vacant.  Delaying conveyance of title and resale has devastating impacts on neighborhood values
and increases demand for municipal services.

Also, a blanket moratorium equally impacts the banks that are acting in accordance with the law increasing costs for servicers and investors.
This threatens the safety and soundness of smaller community banks that are not part of the document problem and ultimately limits market
liquidity preventing low and moderate income borrowers from refinancing or buying a house as investors are ever more hesitant to lend to all
but the most pristine credit borrowers.

You thought the foreclosure mess was bad? You’re right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren’t properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it’s looking very much as though none of the notes were properly transferred.

But that’s not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there’s a pretty strong case that they lied to the investors in many if not most of these deals.

I mentioned this back in September, and I’ve been doing a bit more digging since then. And I’m increasingly convinced that the risk to investment banks isn’t only one of dodgy paperwork; there’s also a serious risk of massive lawsuits from the SEC or other prosecutors, as well as suits from individual mortgage investors.

The key firm here is Clayton Holdings, a company which was hired by various investment banks — Goldman Sachs, Bear Stearns, Citigroup, Merrill Lynch, Lehman Brothers, Morgan Stanley, Deutsche Bank, everyone — to taste-test the mortgage pools they were buying from originators.

Here’s how it would work:

First, the bank would put in a winning bid for the pool of mortgages, with the intention of slicing it up into mortgage bonds and selling those bonds off to investors at a profit.

After submitting the winning bid, the bank would commission Clayton to take a closer look at a representative sample of loans in the pool. Clayton controlled as much as 70% of the market for this service, which is known as third-party due diligence. But Clayton’s not at fault here, and the problem is likely to apply no matter who performed this service.

The size of the representative sample would vary according to the size of the loan pool; it could be anywhere between 5% and 35% of the loans in the pool. Essentially, Clayton would go back to the loans, one by one, and re-underwrite them after the fact, checking that the originator’s underwriting standards were in fact being upheld.

Clayton would either accept or reject the loans it was looking at, according to whether or not they met underwriting standards. Here’s the results of what it found for one bank, Citigroup; the chart comes from this document filed with the Financial Crisis Inquiry Commission. I’m just using Citi as an example, here; all banks behaved in basically exactly the same way.

Look at the first line. Clayton reviewed 1,280 loans on behalf of Citigroup in the first quarter of 2006. Of those, it accepted 554 outright: they lived up to the originator’s underwriting standards. It also waived another 144, on the grounds that there were mitigating factors (a large downpayment, say). And it rejected 582 for a rejection rate of 45%.

This kind of information was valuable to Citigroup: it showed them that the quality of the loan pool was much lower than you’d think just by looking at the ostensible underwriting standards.

Armed with this information, Citigroup would do two things. First of all, it would take those 582 rejects and put most of them back to the underwriter. Essentially, they said, the loans weren’t as advertised, and they didn’t want them. But Citi would still keep some of them in the pool.

But remember that Clayton had tested only a small portion of the loans in the pool. So Citi knew that if there were a bunch of bad loans among the loans that Clayton tested, there were bound to be even more bad loans among the loans that Clayton had not tested. And those loans it couldn’t put back to the originator, because Citi didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of Clayton’s test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there’s language about how the underwriter had done an “underwriting guideline review”, although there’s nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator’s standards.

In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That’s a lie of omission, and if I was one of the investors in one of these pools, I’d be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can’t imagine they’ll like what they find.

The bank I talked to didn’t even attempt to excuse its behavior. It just said that Clayton’s taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That’s the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn’t have that crucial information.

This whole scandal has nothing to do with the foreclosure mess, but it certainly complicates matters. It’s going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.

Update: KidDynamite asks a good question in the comments: were the bond investors able to do their own due diligence on the loan pool? The answer is no, they weren’t — the prospectus did not include the kind of loan-level information which would enable them to do that.