Felix Salmon

I love the way that the WSJ today covers the collapse of Ireland’s banking system, and with it the country’s fiscal leadership. There’s little if any actual news here, but that’s a feature, not a bug: it frees up the WSJ‘s writers and editors to present the big-picture narrative in as clear and compelling a manner as possible, without having to overemphasize some small factoid which they happen to be breaking.

The story reads like one of those epic lyric tragedies of old, where no one ever learns from their mistakes, and errors simply compound endlessly. First, the Irish government, convinced that the country’s banks were suffering from a liquidity crisis rather than a banking crisis, decided to solve that problem in the way that only a government can — with a blanket guarantee of substantially all of the banks’ liabilities.

But of course the banks were fundamentally insolvent, and so began a series of cash drains on the government, each one meant to be the last and final. First there was €1.5 billion for Anglo, and €2 billion each for Bank of Ireland and Allied Irish. Then there was another €7 billion for Allied Irish and Bank of Ireland. Then Anglo’s losses reached €20 billion, with another €48 billion “at risk” of default. And where are we now?

The total capital injected into banks by the government so far: €34 billion, with at least another €12 billion on the way. The bailouts mean Ireland will run a government deficit equal to 32% of its gross domestic product, the highest figure ever in any euro-zone country. Skeptics say a still-sinking property market will next sour residential mortgages, inflating the government tab even more.

Yes, this inconceivably enormous bailout tab—32% of GDP would correspond to an annual deficit of $4.7 trillion here in the U.S., or something over $40,000 per household—has been run up on commercial real-estate losses alone. If and when Ireland’s residential mortgages start defaulting, the country is surely toast.

Bankers, auditors, regulators, politicians—all of them made the same mistake, in Ireland, which was to believe the numbers they were being shown. Numbers are like that: once they’re printed and ratified, they become perceived as hard facts, in the way that merely verbal statements never are. If a politician says “our banks are solvent,” that’s a contentious statement; if PricewaterhouseCoopers comes out with a massively overoptimistic take on the strength of Anglo’s loan book, backing up an official-looking report with lots of numbers and institutional authority, people simply believe them implicitly.

One of the authors of the article, Charles Forelle, has a great accompanying blog entry in which he explains that Ireland’s crisis came out of the blue: it wasn’t a slow-moving train wreck like Portugal. And even with hindsight, it would have been incredibly hard for either the Irish government or the European Union to prevent the build-up of bad loans.

That blanket guarantee of banks’ liabilities, of course, was entirely preventable, and in hindsight a very bad idea. While the banks’ smaller depositors deserve to remain whole, their other lenders should have taken much larger haircuts by now. Instead, they’ve been bailed out by Irish taxpayers, which doesn’t seem fair at all. The Irish government is sovereign, of course: it could always unwind that guarantee if it wanted to. But at this point, it’s too late to do that, since unwinding the guarantee would immediately precipitate a massive run for the exits and a monster sovereign collapse.

One of the key lessons we’ve learned in this crisis is that any time a small country takes pride in its large and profitable international banks, everything is liable to end in tears. Big banks are too big to fail, which means their national governments have to bail them out—but when the banks are as big or bigger than the government in question, such a bailout becomes politically and economically disastrous. My feeling is that no government should ever allow its banks to become too big to bail out, because no government can credibly promise not to bail out such banks should they run into difficulties.

If you look down the Financial Stability Board’s list of the top 30 systemically-important financial institutions, there are definitely a few on there which look like they’re too big for a national bailout. The two big Swiss banks certainly are, and possibly the two big Spanish banks, too; then there’s six insurers as well. I have no idea what can be done about this: no one’s going to blunder in and force UBS and Credit Suisse to break themselves up just because they happen to be based in a small Alpine nation. But the lessons of Iceland and Ireland should wear heavily on any government with an oversized financial sector.

It’s hard to sell a circular house: over the past year, the palindrome-friendly realtors at Weichert have tried and failed to move 300 Farmington Road at $524,425; $499,994; and most recently $449,944. But it’s still on the market, and the banks are to blame. Mae Ngai and John New wanted the house, had the 20% down-payment ready, and were pre-qualified for a loan. But it wasn’t enough for the lenders:

Two mortgage companies turned us down. The first did so after its investors – big banks with household names – rejected our application. The second mortgage company’s internal underwriters also rejected us. Their reasons were the same: The home, a customized modular house of internationally acclaimed design, built in 1989, is . . . round.

Being “unusual” or “unique,” it was deemed “not marketable.” Despite its evident worth and multiple independent appraisals, the lenders said they could not assign a value to the house because there were no comparable properties. And, with no “value,” there was insufficient collateral for a loan.

Ngai and New say, reasonably enough, that “there is a certain perversity about making a house unbuyable, even to two eager would-be purchasers, for fear of it being unsellable in the future”.

More generally, this shows a mortgage system broken in all manner of different ways.

For one thing, everybody is far too rule-bound, still. If a lender is worried about the difficulties involved in selling a round house, then it should be able to ask for a higher downpayment, or require a slightly higher mortgage rate, to make up for the extra risk. But no one seems set up to be able to do that.

What’s more, unique houses have an upside as well as a downside, from the point of view of a big lender: they’re less correlated to the market as a whole. If you’re trying to sell a standard suburban tract home which is to all intents and purposes identical to the 152 other suburban tract homes on the market, you’re in trouble. The nightmare for a mortgage lender is a property-market crash with prices plunging and far more properties coming onto the market than there are qualified buyers for them.

The other nightmare for mortgage lenders, of course, is the idea that homeowners might simply walk away from their underwater property, often because it makes perfect rational sense to do so when you can rent something identical or better for less money than you’re paying on your mortgage.

Unique homes, by contrast, are the kind of things which can prompt bidding wars in the midst of a property crunch — they’re not nearly as susceptible to the whims of the broader market. And when they’re sold, they’re nearly always sold to people who love them and have a strong emotional connection to them, which makes their owners less likely to walk away from their mortgage.

If I were a big bank with a large mortgage portfolio, then, I’d love to add a few unique houses to the mix: they would help a lot on the diversification front. But that would involve giving individual bankers more discretion, and trusting them to be good at their jobs. So instead the banks just say no. And the owners of 300 Farmington Road, I guess, are just going to have to wait for a cash buyer to come along. Or be willing to finance any purchase themselves.

Kevin Drawbaugh has obtained a letter from Spencer Bachus, the probable new chair of the Financial Services Committee, to Tim Geithner. And it turns out that Bachus is no fan of the Volcker Rule:

If the Volcker Rule’s prohibitions are expansively interpreted and rigidly implemented against U.S. institutions while other nations refuse to adopt them, the damage to U.S. competitiveness and job creation could be substantial…

I strongly recommend that your study of the Volcker Rule take account of how trading activities fit into the core business plan of global banks, as well as the consequences for U.S. banks and the banks’ clients of prohibiting those activities in the U.S. while they continue to be permitted everywhere else in the world.

This might well presage a significant weakening of the Volcker Rule, which curtails banks’ proprietary trading and tries to limit their growth, and was introduced into Dodd-Frank very late in the game, reportedly over the objections of the more technocratic members of the White House economic team, including Geithner himself. You might recall Geithner standing well off to the side, with a miserable expression on his face, the day that Barack Obama announced the rule.

You might also recall a letter that Geithner sent to Rep. Keith Ellison in January:

Finally, preserving the flexibility of the Federal Reserve and the other U.S. banking agencies to design and calibrate a leverage constraint for U.S. financial firms is essential to enable the agencies to successfully negotiate a robust international leverage ratio that works in all the major jurisdictions and does not leave U.S. firms at a competitive disadvantage to their foreign peers.

Clearly, Geithner is sympathetic to arguments which worry about putting US banks at “a competitive disadvantage” globally: he’s made them himself. And equally clearly, the Volcker Rule is little more than an expression of intent at this point: if Geithner and Bachus decide to render it toothless, they almost certainly can.

But of course the explicit thinking behind the Volcker Rule is that there are good and bad ways for a bank to become globally competitive. The bad ways involve taking unnecessary risks with taxpayer money. The point of the Fed’s discount window is to provide a funding source for banks to make loans into the broad economy, not to provide a near-zero cost of funds for proprietary bets. And no bank in the world will deliberately cross-subsidize its lending operations with its prop-trading profits.

Shuttering prop desks, writes Bachus, “will cause these firms to be less profitable”. Well, yes. That’s a feature, not a bug. We don’t want financial institutions to be profitable: they’re middlemen, and their job is to help capital flow to where it can best be put to work, rather than to retain as much of that capital as possible for themselves, in the form of profits and bonuses.

But I fear that Geithner is sympathetic to Bachus’s points. Could this be the beginning of the end of the Volcker Rule?

Remember Anacott Financial, the scam credit card website which would spit out a completely random number when you asked it for your credit score? It seems that Capital One has taken a leaf out of their book when it comes to offering car-loan rates. Go ahead and visit this page using various different browsers: I got rates as low as 2.3% in Firefox, 2.7% in Safari, and 3.1% in Safari for iPad. J-Walk has found minimum rates as high as 3.5% using Explorer, which corresponds with what Devin found — he was the guy originally shopping for a car loan, who wrote up his experiences at the Capital One website and sent them in to Consumerist.

It seems there are four possible permutations here — 2.3%, 2.7%, 3.1%, and 3.5% — which get served up randomly when you visit that page. I’m all in favor of A/B tests, but this is meant to be serving up a simple statement of fact, and when the public discovers these things it hardly increases our level of trust in financial institutions. Someone at Capital One clearly put quite a lot of effort into this ostensibly-simple web page; I’d love to be a fly on the wall when that person gets asked questions by the new Consumer Financial Protection Bureau.

Bloomberg not only should know better; it does know better. And it says as much, in paragraph 21 of its story. But that doesn’t stop it from leading the story with this:

The world’s biggest bank isn’t in the U.S., where regulators banned lenders from proprietary trading, nor in Switzerland, which is doubling capital requirements. BNP Paribas SA is in France, which is doing neither.

BNP Paribas’s assets rose 34 percent in the three years through June, reaching 2.24 trillion euros ($3.2 trillion), equal to the size of Bank of America Corp., the largest U.S. bank, and Morgan Stanley combined.

At the end of the piece, there’s even a league table of what Bloomberg calls “the world’s 15 biggest banks by assets”, with BNP Paribas in first place and BofA in 5th.

But here’s that 21st paragraph, which pretty much entirely negates the entire premise of the story:

European and U.S. banks use different accounting standards, making a direct comparison of their size difficult. In particular, U.S. generally accepted accounting principles net out the banks’ derivatives positions, unlike the international financial reporting standards used in Europe. This results in higher reported assets under IFRS. The comparison also excludes assets held by banks off their balance sheets.

And here’s a chart, via Alea, showing that Deutsche Bank’s assets, as of end-2008, were more than twice as high under European rules as they were under US rules:

Basically, it all comes down to those derivatives books: in the chart above, Deutsche Bank’s derivatives assets alone, at €1.2 billion trillion, are significantly larger than its total size under US GAAP.

I’m quite sure that if JP Morgan had to report its assets under IFRS, it would be significantly larger than BNP Paribas. And I’m pretty sure that if anybody at Bloomberg stopped to think about it, they would come to exactly the same conclusion. So why on earth are they running headlines saying that “BNP Paribas Grows to World’s No. 1 Bank”? Anybody?

I’m back! And I couldn’t be happier with the fantastic set of guest blogs from Justin and Barbara — wonderful stuff. If you haven’t read it, for instance, check out Barbara’s post on rules-based vs principles-based regulation, especially as it applies to the Volcker Rule. Volcker himself advocates a principles-based approach, contra Michael Lewis, who wants some very tough rules:

Here’s a simple, straightforward way… to construe the Dodd-Frank language, and it would reform Wall Street in a single stroke: to ban any sort of position-taking at the giant publicly owned banks.

Our crisis was not drastic enough to enable legislation that ambitious, but in theory I like this idea. Basically, it forces all broker-dealers to be private rather than public companies. That was the case before Bear Stearns went public in 1985, so it’s clearly entirely possible. And Lewis points to Citadel as a good example of a private broker-dealer dealing very successfully in the much larger and faster markets of today.

Broker-dealers as a set might well get smaller if such a rule were enforced, but that’s a feature, not a bug. In fact, if broker-dealers don’t shrink at all, then the Volcker Rule has clearly achieved nothing at all.

More generally, I suspect that a lot of people who blame Gramm-Leach-Bliley (the repeal of Glass-Steagal) for the financial crisis should really be blaming the broker-dealers going public instead. After all, Bear Stearns and Lehman Brothers and Merrill Lynch were both entirely Glass-Steagal compliant, as, for that matter, were Fannie and Freddie and AIG. The problem wasn’t that they were merged with commercial banks; the problem was that they had far more leverage than any private partnership would ever be comfortable with.

The difference between the Volcker and the Lewis view of things is this: Volcker wants to stop banks making proprietary bets when they’re so big that the government will be forced to bail them out if they lose. Lewis wants to stop banks making proprietary bets with other people’s money, period, on the grounds that no one has ever treated external shareholders’ money as if it was their own.

Broker-dealers could still borrow, of course, and would still be active in the repo markets. But bond investors are by their nature much more cautious than stock investors, and so the level of risk that the banks could take would be ratcheted down a lot. And indeed if you look back at the crisis, no privately-owned broker-dealer got into trouble. That’s partly a function of the fact that very few of them exist, of course. But a system of small-enough-to-fail partnerships is in principle much more stable than having a handful of highly-regulated public megabanks.

It’s probably sad we’ll never get there.

People often talk (and write) about how commercialization is changing the nature of microfinance. Yet increasingly it looks like an even more fundamental shift is afoot. Microfinanciers are finally figuring out what their customers want.

The well-worn story of microfinance goes something like this. Lend a poor person in a poor country a little bit of money, and that person can invest in a business—by buying a sewing machine, say, or another cow. Over the long run, that person pulls himself out of poverty with the income generated by his endeavor.

One reason this story involves a loan is because in most countries it's a whole lot easier to lend money than it is to take deposits. (The latter requires a banking license, which the former doesn't.) But there's another reason loan-making is at the center of traditional microfinance: the people who started this work more than 30 years ago assumed that since mainstream banks didn't lend to poor people, there was a massive, untapped demand for borrowing.

The thing is, no one ever really asked poor people if business loans were the most important financial product they were missing. That's now starting to change, thanks in part to a recent wave of academic research. As it turns out, poor people lead complicated financial lives and they need money for all sorts of things.

Thursday I was at this conference, where Dean Karlan of Yale talked about research he's been doing with Jonathan Zinman of Dartmouth. In interviews with microfinance recipients in the Philippines, the pair discovered that some 46% of borrowers used a decent chunk of their business loan to pay down other debt and about 28% spent part of the money on a big household purchase—even though fewer than 4% of people in either category ever admitted this to their bank. (Disclosure: I was at this conference because I am now doing work for the Financial Access Initiative, which co-sponsored the event.)

This sort of finding—which quantifies what many practitioners have long suspected was the case—is having an impact on how microfinanciers go about their business. "We're an industry built on assumptions, and we've gotten to a point where we have to test those," said Carlos Danel, a co-founder of the Mexican microfinance behemoth Banco Compartamos. "Research is showing us that we actually don't know a lot about the customers we serve." That's why Compartamos is conducting a 4-year study with Karlan and other researchers to find out how customers use microfinance products, and how those products do—or don't—change their lives.

As Danel put it, microfinance is an industry that was born out of supply—one that came from people thinking about what organizations were capable of doing. Now, he said, the challenge is to figure out what poor people around the world actually need.

Nelson Schwartz links the big lawsuit against BofA/Countrywide directly to the mortgage bond scandal I’ve been banging on about:

The legal battle turns on the question of whether the banks properly represented the loans they put together into mortgage-backed securities when they sold them to investors. If the banks ignored evidence that the underlying mortgages did not conform to underwriting standards or they lacked the proper paperwork, the banks could be obligated to buy the troubled mortgages back.

Schwartz also reports that this legal trade is attractive enough that vultures are circling:

Hedge funds like York Capital and Moore Capital have been jumping into the game recently, buying up bad debt in the hopes it will eventually be bought back…

“Any hedge fund with a distressed desk is contemplating this trade,” said one analyst.

There’s a whole bunch of different things going on here, but the key development is that bondholders have managed to get organized, and they’re taking the battle not only to otiose trustees, but also to loan servicers.

The key number here comes right at the top of the letter sent to BofA/Countrywide:

The undersigned are the Holders of not less than 25% of the Voting Rights in Certificates issued by the Trusts listed on the enclosed Exhibit A.

Once that 25% level is reached, bondholders have all manner of rights, which are now being put to good use. For one thing, they’re allowed to file exactly this letter: a notice of nonperformance, telling the servicer in pretty strong language to buck up and start doing its job, or face a massive legal action.

Isaac Gradman says there might be a problem here:

These efforts may well fail for an additional reason that was cited as a basis for Bank of New York’s refusal to comply with Patrick’s earlier request – the failure to provide evidence of a specific breach.

But I’ve also heard that the 25% number is crucial on this front, too. If you own 25% of a securitized issue, I’m told, you can force the custodian to hand over the underlying, individual loan documents — exactly the same documents that Clayton and other due diligence companies examined before the bonds were issued. At that point, it becomes a lot easier to find specific breaches and to make BofA’s life a legal nightmare.

The position of BofA here is hilariously complex and conflicted. BofA owns 34% of BlackRock, which is a lead plaintiff in this case. (BlackRock manages the mortgage bonds which the Federal Reserve inherited as part of the Bear Stearns bailout.) BlackRock, in turn, is suing Countrywide (owned by BofA), the loan servicer which has clearly not been doing its job:

Although there are tens of thousands of loans in the RMBS pools that secure the Certificates, the Trustee has advised the Holders that the Master Servicer has never notified it of the discovery of even one mortgage that violated applicable representations and warranties at the time it was purchased by the Trusts.

In other words, Countrywide has an obligation to tell the bond trustee whenever a loan turns out to be in violation of the bond’s representations and warranties. But Countrywide has never done that. Why? The answer is obvious: the minute that it did so, the trustee would force the servicer to put the loan in question back to the originator. And the originator is — you guessed it. Countrywide.

Essentially, BofA is suing BofA so that BofA can be forced to put bad mortgage loans back to BofA.

Yves Smith reckons that the winner here is likely to be BofA — that the lawsuits (which, remember, haven’t even been filed yet, and won’t be for at least 60 days) will probably be settled for a relatively modest sum. But I’m less sanguine.

For one thing, Smith says that the plaintiffs will only be able to collect on loans which have gone bad and where they can show damages. But the bondholders might want to force BofA to buy back even performing loans, if they got thrown into the pool without conforming to the relevant standards. Calculating BofA’s loss on such things won’t be easy: after all, if those loans continue to perform, then BofA would ultimately make a profit on them. But given the ongoing foreclosuregate mess, there’s a very real chance that even performing loans will end up in strategic default.

The big picture I think is that a lot of the risk embedded in mortgage bonds could shift from bondholders back to the investment banks which underwrote them. In a just world, the bond trustees would be leading this charge, but they’re not, so the cause has been taken up by the bondholders themselves, who are only now beginning to organize and to become familiar with all the legal avenues that the various players can explore.

It’s entirely possible, of course, that obstructionist lawyers for BofA and the trustees will manage to block these suits and keep all those toxic bonds in the hands of bondholders. But mortgage-bond owners are becoming increasingly aggressive and activist, and they’re comparing notes with bond insurers who are also in a very similar situation. The investment banks, BofA foremost among them, might win. But the fight is going to be long and hard and expensive, and is going to make them look very bad indeed. They might well find it more attractive, all things considered, to negotiate a settlement, write a ten-figure check, and move on.

Here’s a chart of what tail risk looks like, in the stock market:

The thick blue line is Bank of America stock, hitting a new 52-week low today after reporting losses of $7.3 billion in the third quarter. The thin blue line is financial stocks generally, which are doing much better than BofA. And the thin red line is the S&P 500, which is significantly higher than it was this time last year.

To judge by the headlines, BofA ought to be doing pretty well. Its earnings report today beat expectations, and yesterday it announced that it was going to start foreclosing on properties again, long before anybody expected it would do so. On top of that, it’s the biggest bank in the U.S., with a deposit base of $900 billion—that’s 11.71% of the total U.S. deposit base, making BofA the clear leader on that front and the only bank now to break the 10% cap. With the Federal Reserve throwing free money at the entire U.S. financial system in an attempt to keep the recovery going, and the yield curve sloping upwards in the right direction for easy banking-sector profits, these ought to be good times indeed for BofA.

So why is BofA’s stock in the doldrums, relatively speaking? The answer is tail risk. Part of that risk is regulatory: BofA is too big to fail, and will therefore be subject to extra regulatory scrutiny and higher capital requirements than smaller banks. On top of that, huge swathes of the post-Dodd-Frank regulatory architecture remain to be written in detail, and the risks to big banks on that front are all to the downside, given how deregulated they were up until now.

But the much larger part is mortgage-related: JP Morgan came out yesterday and said that banks could be forced to buy back as much as $120 billion in mortgage bonds from investors. And BofA bears the lion’s share of that risk, incorporating as it does not only Merrill Lynch but also Countrywide.

The mortgage mess hasn’t gone away, and BofA is going to trade at a discount unless and until it’s resolved. That doesn’t mean that the market is pricing in some kind of mortgage-related disaster. It’s just pricing in a very uncertain probability distribution of possible outcomes, some of which are very bad indeed. And since investors hate that kind of uncertainty, the share price is underperforming, and is likely to stay low for as long as the uncertainty persists.

I’m going to be spending the next couple of weeks in South Africa, which means I’ll be off the grid (on a plane) for all of Monday, and less-than-fully online thereafter. I’ve invited the old team from the Curious Capitalist—Justin Fox and Barbara Kiviat—to help out with some guest-blogging, which I’m very excited about. But in the meantime, here’s a FAQ on the mortgage bond scandal to keep you tided over, since there seems to be a lot of confusion out there.

I’m hearing a lot about foreclosuregate, MERS, moratoriums, bad title, etc. What does this have to do with that?

Nothing. This is an entirely separate, parallel, scandal. The main area overlap is that it gives investors in mortgage bonds one more colorable reason why they should be able to put back their bonds to the banks who issued them—over and above the fact that they have the right to do that if the mortgages weren’t properly transferred.

So this isn’t about legal title to mortgages. What is it about?

Just like the Goldman Abacus case, it’s fundamentally about investment banks’ lies of omission when it came to the investors who were buying bonds from them.

In that case, Goldman neglected to tell investors that John Paulson, who had helped select the bonds in a CDO, was also short the CDO. In this case, what’s the information that the investment banks neglected to tell investors?

The results of the due diligence tests that companies like Clayton and Allonhill performed on the loan pools the investment banks were buying.

Hang on, back up a minute here. Without waving your arms around like a demented spider monkey, can you explain what you’re talking about?

I can try. A key part of the mortgage securitization process was the way in which mortgage originators like Countrywide—lenders which lent you the money to buy your house—would then get their money back by taking those loans and selling them, in bulk, to investment banks like Lehman Brothers or Merrill Lynch. They’d put a large number of loans into a pool, circulate a document detailing the characteristics of each of the loans in the pool, and then sell the pool to the highest bidder.

But banks didn’t simply pay whatever they bid. Instead, after they won the auction to buy the loan pool, they would hire someone like Clayton to do due diligence on the loan pool, to make sure that what they were buying was what they had been told they were buying. “At the core of our service,” says Clayton, “is the capability to compare electronic file data against data retrieved from source documentation made available to Clayton (i.e. loan files).”

Now, it’s easy to be shocked by what Clayton found when it did its due diligence: it turns out that in many of these loan pools, the loans simply didn’t conform to the lenders’ own underwriting guidelines. But whether you or I find such things shocking is actually pretty much beside the point. The point is that the banks found the findings shocking—or at least they pretended to when they then turned around to the originator and demanded a discount on the price they were paying for the loan pool.

So that’s why the Clayton findings count as material information, right? They were directly responsible for lowering the price of the loan pool.

Right. The banks were willing to pay X for the loan pool based on the electronic file data supplied by the originators, but after having Clayton go in and test that electronic data against the original loan files, the banks were only willing to pay some sum less than X.

But isn’t Clayton’s research just like anybody else’s research—just an opinion about publicly-available information? Investment banks doing a secondary offering of shares don’t need to tell investors about other banks’ buy or sell ratings on those shares, even if those ratings affect the share price.

No, this is different. Because the loan files that Clayton had access to were not publicly available. And in any case, Clayton wasn’t being paid for its opinion. It was being paid to diligently go through a subset of the loan pool, one loan at a time, and check each loan against various underwriting standards. Clayton’s opinion didn’t matter to anyone. What mattered was the new information that Clayton dug up.

What do you expect, that the banks would put all the loan-level information into the bond prospectus? That would make it thousands of pages long! Didn’t John Hintze report back in May that, in the words of his headline, “The Loan Data Was There for All to See”? Anybody could have done the Clayton analysis, and in fact people like John Paulson and Michael Burry did do the Clayton analysis of loan-level data. They didn’t like what they saw, they shorted the bonds, and they made lots of money. So long as the information was public, there can’t be anything wrong here.

Yes, the investment banks, as well as companies like CoreLogic, did make some loan-level data available to investors. But that data, presented in easily-digestible spreadsheet form, was essentially the same as the electronic data that the banks were using to price the loan pool before they sent in Clayton. That data alone, it turns out, if looked at in the right way by someone like Paulson or Burry, was all you needed to short the bonds and make lots of money. But the original loan files which Clayton checked that data against? They were not publicly available, and for good reason: they included things like the borrowers’ names, salaries, social security numbers, and other private information.

Clayton’s report, then, was non-public information: it was the product of looking at private loan files, not semi-public spreadsheets. No one else—not Paulson, not Burry—could do what Clayton was doing, and so Clayton was adding a valuable layer of information to what was publicly known.

Now, it’s true that even when investors knew that Clayton had done these tests, they evinced precious little interest in seeing the results. All they really cared about was the credit rating. And even the ratings agencies weren’t interested in seeing Clayton’s results, which is scandalous in and of itself. But the securities laws don’t say that banks can withhold material non-public information if the investors don’t seem to care about it.

But even if the banks didn’t pass on Clayton’s reports to investors, couldn’t investors have got those reports from Clayton directly? If Clayton was running these tests for the banks, and if it was offering the same information to the ratings agencies, couldn’t anybody have simply bought the reports from Clayton? And if so, that hardly makes the information nonpublic, does it?

That’s a stretch. Investors weren’t even told that Clayton had done due diligence on the loan pool; they were barely informed that any kind of due diligence had been done at all. And even if they did somehow find out about the existence of the Clayton report, it’s not obvious that Clayton would or could have sold it to them. After all, it had been commissioned by the bank, which presumably therefore had control over who could see it and who could not.

And in any case, the investors in the Abacus deal ended up winning a lot of money from Goldman Sachs, even though they had exactly the same information about the contents of Abacus as John Paulson and Goldman Sachs did. What I’m talking about here looks as though it’s clearly worse than Abacus: the investors didn’t have the same information as Clayton and the investment banks had. The banks could have passed that information on, but they chose instead to keep it to themselves. Why? The obvious reason is that they feared that if they made the Clayton reports public, the investors might not pay as much for their bonds, or the ratings agencies might not give them the all-important triple-A rating.

Still, it seems that you’re seeking to punish banks for doing more work on these bonds than they needed to do. The banks were not required to do due diligence on these loan pools. If they didn’t want investors to know the results of the due diligence, they could have simply not done any due diligence at all, and then, according to you, there would have been no scandal. Instead, they spent their own money on hiring the likes of Clayton to double-check everything — and for that you want to punish them?

Yes. It’s great that the banks did the double-checking. But the whole point of double-checking is to make sure that nothing unexpected is lurking in the loan pool. When something unexpected did turn out to be lurking in the loan pool, the banks had an obligation to pass that information on to their buy-side customers. The banks put themselves in a situation where they found themselves in possession of material non-public information. That they did so voluntarily is beside the point; they still had an obligation to disclose it.

Material non-public information, eh? So you’re saying that banks violated Rule 10b5-1 of the Exchange Act?

Yes, but that’s not all. There’s also Section 17 of the Securities Act, which says that banks can’t withhold material facts when they offer securities to the public. And of course Section 15E(s)(4)(A) of the Exchange Act was specifically written to close any possible loophole and ensure that banks will never attempt such behavior again.

So we can expect a bunch of lawsuits around this issue?

From investors, certainly. And possibly from regulators and/or prosecutors too. They’ve been looking at the issue for a long time and so far haven’t taken any action, but times change. The public—left and right—is furious at the banks for seemingly being the sole sector of the economy to emerged unscathed from the crisis they caused. Regulators and prosecutors ultimately represent the public. And a lot of the detail surrounding Clayton’s reports only emerged quite recently, with the FCIC hearings in Sacramento on September 23. It’s possible there won’t be any prosecutions. But it’s equally possible that there will be.

Joseph Tauke has a monster 5,600-word excoriation of the mortgage industry. It’s a great read, and it includes a lot of information you probably won’t know unless you’re a regular reader of Naked Capitalism and 4closureFraud. But the most important thing about the story is nowhere to be found in the story itself; rather, it’s the fact that it was published by the Daily Caller, Tucker Carlson’s right-wing website.

The Tea Party wing of the Republican party has never been a big fan of Wall Street, of course. But at the same time, it has also tended to oppose any Democratic attempts to bring Wall Street into line. And it hasn’t made bank-bashing a central part of its platform at all. (TARP-bashing, yes. But TARP was a government program.)

TARP was a bipartisan deal to save the banks, and its outcome is now regarded as desperately unfair: the rich bankers are now back to making multi-million-dollar bonuses, even as most of the country continues to suffer from a weak economy and high unemployment.

So if the Daily Caller’s story is any indication, there might just be a consensus in Congress to gang up on the banks and dole out a bit of punishment for their fraudulent behavior with respect to respectable homeowners.

The big question mark with regard to foreclosure fraud has always been the willingness, rather than the ability, of authorities to prosecute the banks involved. If the political winds change so that regulators have every incentive to sue, you can be sure that they will do so. Given that any indication of friendliness towards banks constitutes political suicide right now, I’d guess that the banks’ litigation risk is higher than it has ever been.

Which is maybe why JP Morgan Chase set aside $1.3 billion in additional litigation reserves last quarter. At this rate, they might well need all of that — and more.

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.

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.

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.

I can’t help but think that UBS’s widely-publicized tax issues are hurting its U.S. brokerage:

UBS AG executives are trying to squeeze more production out of several hundred brokers in the U.S. who received bonuses to join the company but haven’t brought in enough clients or other revenue to become profitable for the Swiss bank. UBS has about 6,700 brokers in the U.S.

Senior managers in the division such as its chief executive, Robert McCann, have been pushing some new brokers for about six months to “win back” their old clients.

Broker-poaching is commonplace in the brokerage industry and is universally predictated on the idea that clients are much more loyal to their broker than they are to their broker’s firm. So if a broker moves from Morgan Stanley, say, to UBS, then that broker’s clients are expected to move with her.

Except, this doesn’t seem to be happening at UBS, which lured away brokers with the promise of large bonuses and then saw those brokers’ former clients stay put, refusing to follow their broker to the now-notorious Swiss bank.

This could also be related to the move from active to passive investing. Stockbrokers are by their nature active investors, picking stocks and looking after your investments. Maybe the departure of your broker from one shop to another is as good a time as any to ask whether you need a broker at all or whether you should just put all your money in ETFs. Especially if your broker turned out to give bad advice during the crisis, buying just before the market crashed and selling near the bottom.

The human touch is valuable, of course, but it’s not worth nearly as much as most brokers earn or as most of their clients end up paying. Hire an independent financial adviser, if you must, to help you out with asset-allocation decisions and to hold your hand in times of market turmoil. But just like picking stocks or picking fund managers or even picking a stockbroker, picking a good financial adviser is hard. Go for one with a minimalist approach: in general, less is more. If they tell you they’re smarter than everybody else, run away.