mortgage fraud non-bank lending securitization investors

Another call for the rule of law
risk model

The Singular Problem With Credit

It might be a case of calling for enforcement now that lack of enforcement has come back to bite investors, but upholding just law, for whatever motive, is the right thing to do. This 2009 article is from The Market Ticker of February 25.

by Karl Denninger

People in the mortgage industry claim "we can't go after all the fraud in the mortgage business -- get over it.”

But listen. Fully 2/3rds of credit provided in our economic system is non-bank lending. It is hedge funds, sovereign wealth funds, pension funds, insurance companies, and both foreign and domestic private investors. These are the buyers of securitized debt. This market is closed. Both ASF (American Securitization Forum) and Federal Reserve statistics say that there has been essentially no securitized debt issuance over the last six months.

That market is closed because of the fraud.

Arguing over whether the banks are responsible for not verifying information provided (they are), automated approvals are responsible (they are), ratings agencies are responsible for being essentially purchased rubber stamps (they are), or borrowers who fraudulently overstated income and understated debt (they are) misses the point. The point is that all of these factors are in fact elements of fraud.

All of these are willful and knowing misrepresentation of the risks and true credit profile of the collateral, borrower's character and capacity, market assumptions used in modeling or all of the above. The 2/3rds of the credit provided to securitization is not coming back until the misrepresentation ends.

For example, Asian investors won’t buy debt and mortgage-backed securities from Fannie Mae and Freddie Mac until they carry U.S. guarantees, similar to those given on bonds issued by Bank of America Corp. or Citigroup Inc. These investors in some cases lost on CDOs and similar 100%.

These events are not supposed to happen, according to risk modeling. And if the risk model actually had put into it the quality of underwriting (none), the verification of income and assets (none), a realistic model of credit growth and asset prices (ha!), and similar, it wouldn't have -- because there would have been no market for those securities at the prices asked.

But in the attempt to divert attention from one group or another -- and all of the guilty parties are engaged in it at this point, including Congress and our The Fed -- we forget that the private capital is still gone and until we guarantee that another assault will not happen that capital will not return.

While lawmakers and policymakers continue to blame "understaffing" (code in DC for "we want more money") and the lack of fully-formed plans, the fact remains that unless private capital can be convinced to return, we are headed for an economic depression worse than the 1930s.

How can we maintain our standard of living or economic output at anywhere near former levels with 2/3rds of credit capacity gone? How can we replace that 2/3rds of the former capacity via other means?

The credit universe for the United States is about a $50 trillion; 2/3rds of that is ~$30 trillion dollars. It is not possible for the government or Fed to replace this; even with the commitment of $9 trillion made thus far the economy is not responding. And trying to actually fund $9 trillion through T-bond sales would cause an immediate implosion in the Treasury market.

We have two choices, and if we do not pick #1 we will get #2:

Stop "the bezzle" and punish the fraudsters across the board and clamp down on all manner of fraud in the future with enforcement of the law being the primary driver of policy.

Accept that we will have an economic Depression worse than the 1930s, as the continued absence of private credit will contract GDP at least 30%. This will result in the bankruptcy of about 20% of the S&P 500, 25-30% unemployment, half of all private businesses in the United States going under.

Those are the choices folks, and if we do not adopt this policy within a very short time the economic contraction will continue and, once it reaches a critical point, the collapse in the equity and credit markets will accelerate and be impossible to stop until liquidation has run its course. We are very close to reaching that tipping point.

We can only convince private capital to return by guaranteeing that the rule of law will be upheld, that those who screwed them this time will be punished in accordance with the law and that anyone who attempts to screw them in the future will be immediately dealt with under the same provisions. The reaction in the markets is a direct consequence of the Obama administration's failure to follow through with concrete steps to restore trust, transparency, and the rule of law.

Also see:

Lose a home, suffer; lose billions, get a bailout

Eliot's Mess

1929 Redux: Heading for a Crash?

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