Posted Wed, 04/02/2008 - 06:56
Max Gardner, a nationally renowned consumer bankruptcy attorney, has written an article on the mortgage mess--and it's impact on taxpayers thanks to Freddie Max and Fannie Mae.
The article says "Whether or not you agree with Ron Paul on most things you should agree with him with respect to his concerns about our liability for the operations of Fannie and Freddie." Max wrote it this way since he sent it to an association of consumer bankruptcy attorneys whose members are not too tolerant of Ron Paul or real liberty. (I am a member of this group and I used to have Ron Paul in my email signature and some of the members raised hell about my supoort for Ron Paul. One would expect lawyers to support the one candidate who gets the US Constitution, but liberal orthodoxy outweighed that old piece of paper.)
Max sent me his first draft of the paper and I sent him Ron Paul's speech from 10/27/2005 about GSEs. Max then added the part about Ron Paul.
You can find his website at:
Andy, Have You Met Fannie and Freddie?
O. Max Gardner III
Shelby, N.C. March 31, 2008
Times are tough. Suffice it to say, we are embroiled in considerable market, economic and outright personal turmoil. Gas and food prices are going up and up and home values are going down and down. Real wages are flat and as they say “a dollar ain’t what it used to be.” Since we stand to see trillions of dollars' worth of assets vaporize in the ensuing mess, we ought to take a long look back at history to see how we got into it, and how we might get out of, this god-awful mess. We also need to understand that Henry Paulson and Ben Bernanke, without an explicit vote by the Congress, have put virtually billions of dollars of taxpayer money at risk to save us from the risky and unregulated business practices of the investment bankers and hedge funds.
What has placed the entire American financial capitalism system in jeopardy of a complete collapse? How did we get to the point where the Government of last resort (the U.S. Treasury) is working with the lender of last resort (the Federal Reserve) to shore up housing and credit markets to avoid the Great Depression II? And, what caused a Republican administration to throw overboard the idea that the market can sort out this mess by itself? How did the fifth biggest investment bank in the world implode in approximately 24 hours? In order to understand the present, we must first understand the past.
Just ten years ago the markets and the economy were shocked when John Meriwether’s Long Term Capital Management fund imploded and lost some $4 billion dollars. The failure of LTCM helped foster a global financial crisis and triggered both a Wall Street-led bailout and congressional hearings on the dangers of hedge funds, the free-wheeling pools for wealthy investors and institutions that often trade heavily and rely on borrowed money to bolster returns.
Did we learn anything from this disaster and did Mr. Meriwether? Regrettably, the answer to both of these questions is no. Even today Mr. Meriwether’s biggest fund, JWM Partners LLC, has plunged 28% since the first of the year and some of his investors are trying to get their money out. The struggles of Mr. Meriwether and his new investment funds represent clear warning signals that we have learned nothing from the past and that the perils of the current crisis are far from over. In fact, one observer has noted that we are just in the first inning of an extra-inning game.
The Meriwether problem was not the only warning sign. Half a decade ago, the entire nation was shocked when award-winning "innovator" Enron and George Bush’s favorite son, Kenny-Boy Lay, turned out to be little more than high-end con artists in charge of what was then the largest cash-shredding pyramid scheme in the history of the world. The crucial failing for investors was Enron's use of opaque, "mark-it-to-model" accounting techniques.
The problem with this type of accounting is that it uses “computer or notional values” where there is no real market for the real-world valuation of assets. So, instead of using an objective market to benchmark the value, you mark your assets to the so-called model, which in many cases is completely divorced from the real world. This accounting magic is especially helpful when you are wrong about the real value of the assets, either because you made an error or because you based it on exceedingly generous assumptions. I don’t know about the rest of you but the theory of “notional asset values” has never really registered with me. Or, to put it another way, this is the type of deal that even Howie Mandel would call out “no deal.”
In the end, of course, we all learned that Enron's accounting was more or less a mark-to-fairy-tale model, with the company booking enormous gains from assumed future profits on schemes (like bandwidth trading) that sounded great, but had little chance of producing anything besides headlines. Enron actually securitized every receivable and contract it created and in some cases resecuritized the original deals two or three times over. Enron even securitized contracts where there was no real chance of any future income to fund the deal. Enron operated on the theory that if we show you the securitized bond and if you show us the money then we will eventually show you a big future profit.
Does any of this sound familiar? It should because all of this was engineered by Enron’s original golden boy, Andy Fastow. If you want a little hint about why things at Enron went so far south, then you need to know that before he signed on with Enron Andy was one of those tall-building mortgage bankers. Andy really only applied to the questionable Enron receivables and other opaque “assets” the bizarre securitization models and structures that he had worked with on a daily basis in the mortgage banking business. In light of the current market meltdown, I suppose that Andy must be having severe second thoughts about his guilty plea. Kenny-Boy Lay, on the other hand, is well past the second thought process.
Andy Fastow, meet Freddie and Fannie
You might think we'd learned our lessons about fantasy accounting after John Meriwether and Enron, but you would be wrong. Things actually got worse. And I mean much worse. Meriwether and Enron were like the “head start” problems for high school seniors. The Enronization infection moved to the comfy-sounding "homeownership" market. Against a star-spangled, feel-good backdrop of George Bush touting the "American Dream" and increasing homeownership, our recent mark-to-model mania tripped up a lot more than one big company.
The problem is that this infection quickly swept through the entire banking world. Bear Stearns is not the first to choke on the lousy, poorly modeled mortgage-backed securities, and it will not be the last. I would even suggest that the late author Hunter Thompson would find the “collateral debt obligations” and “credit default swaps” to be just plain weird stuff! What did Hunter say, when things turn weird the weird turn pro? Well, we have had our share of pros in this game, that’s for sure. Tony Mozillo, the butcher’s son, is one name that hits the top of this list.
But more dangerous yet was the way this mania also infected our own almost scared Government Sponsored Entities. The fact of the matter is that the most widespread mark-to-model fantasies were actually committed not by some easy-to-blame Wall Street guru like Mozillo, but by Freddie Mac and Fannie Mae, our two most favored GSEs.
One of my dear friends refers to the two GSEs as Fanron and Freddie Kruger. And, her fears as expressed by her naming rights may not be so far-fetched. Mr. Paulson and the Federal Reserve Board just allowed Fannie and Freddie to increase their leverage so that they can buy about $200 billion more in bad mortgage-backed securities. So, Fannie and Freddie will get even bigger but at what price? They accounted for 76% of the new mortgage market share for the fourth quarter of last year, up from 46% in the second quarter. And even though they are not part of the Government, everyone knows that if either Fannie or Freddie stumbles, the taxpayers will get stuck with the tab. Whether or not you agree with Ron Paul on most things you should agree with him with respect to his concerns about our liability for the operations of Fannie and Freddie. We should cut off the implicit government guarantees for their operations and let them take their losses like the rest of the losers.
It was flawed models (and the habit of booking earnings on these models) that enabled financial companies to concoct the elaborate securities that funded the bubble. And now, to save us from disaster the Federal Reserve has agreed for the first time in history to make direct loans to these same investment banks. As a non-lawyer asked me last week, “Is this legal?” The answer is I don’t know but it does not pass the “smell” test. In the first three days of this new era, securities firms borrowed an average of $31.3 billion per day from the Federal Reserve System. These are big numbers any way you do the math. And yes, these are the same investment banks whose CEOs paid themselves handsome bonuses ahead of the current financial tsunami.
These guys don’t deserve a bailout with our money. What they deserve is a public flogging and then about 20 years of hard-labor at GitMo.
But the fat-cat CEOs weren't the only ones making out like bandits. While Wall Street was booking fantasy profits on bad assumptions about real estate mortgages, Freddie and Fannie were securitizing anything that looked like a mortgage, whether the broker-completed application form was based on real numbers or just plain fabricated numbers and made-to-order appraisals. So the thought of using Freddie and Fannie, no matter how you dress them up, to save us from financial ruin seems like another Alice-in-Wonderland story from the dark side. This is akin to selecting Tony Soprano to serve as Director of the Federal Bureau of Investigation. Does this really make you feel safer about the security of our money? I don’t think so.
But, What Were They Really Thinking?
In their pyramid schemes (excuse me I mean in their computer models), house prices always go up. In their models, you can pay any price for a home, so long as you can make the monthlies with a teaser-rate ARM, never mind the upcoming adjustments that will take the APR up to 14% and then double the monthly payments. In their models, it’s OK to take out a Payment Option ARM where you elect to make no monthly payments at all, thereby increasing the total debt owed each month (this is what the accountants call negative amortization). In their models, you avoid all of these problems via a refinance down the line with an equity cash-out to boot. In their models, it's OK to buy on a less-than-forthcoming, Alt-A so-called "liar loans," because there's no real punishment for lying on a mortgage application -- particularly if everyone's doing it. With these models, it makes sense to buy three other homes, in order to flip them later. And it makes sense to extract HELOC cash from the home, based on fantasies about continually increasing "equity."
What goes up never goes down, right? The law of gravity has no application to residential real estate!
The sad truth of the matter is that all of this is not so different from what brother Meriwether and Enron were doing. Freddie and Fannie were marking up the value of their assets (the bonds) to a model (their belief that real estate prices always go up). They were allowing the consumers who were taking out the underlying mortgages to spend their new-found "income" immediately, on iPods, Hummers, $250 designer jeans, and fancy vacations to Maui and Mexico. What was the saying—here today and gone to Maui? This happened all over the country, and millions of people behaved the same way. In fact, the American Fantasy of owning a home (for no money down) that would provide a fully leveraged, 10% annual returns for a decade, is precisely what enabled those Wall Street suits to do what they did. It takes two to tango, folks. And this was the biggest dance party in economic history.
Last year's model got ugly.
Alas, the music stopped and the dance is over. And when the music stopped we all found out that there were not enough chairs for all of us to sit down. It is bye-bye Miss American Pie, we all went to the bank but all the banks were dry. And, finally, we all realize that this dream's "income" wasn't actually matched by real cash flows, just fuzzy math and bizarre computer models -- precisely the problem at Enron. The "income" was all hot air. And now that the "income" from home appreciation has turned negative, it must be supported by cash mortgage payments. But many people can't pay those bills, the mortgages are defaulting in huge numbers, and now, we are all paying a huge price, even those of us who didn't throw our money into a flimsy, overpriced McMansion.
Almost 18 months ago the “industry” lambasted the Center for Responsible Lending when it predicted that foreclosure rates on subprime mortgage loans could hit a outstanding and unbelievable rate of 19%. Well, the most recent figures from December of 2007 reveal that the current rates are 25.2%! As they say on the Verizon commercials, can you hear me now? And just last week Fitch predicted that almost 50% of these mortgages would eventually end up in foreclosure. I think that is 1 out of every 2, regardless of how you do the math or the model.
We all know that the Bear Stearns stockholders were wiped out for either $2.00 or $10.00 per share, take your pick. Hell, their office building in New York is worth more than Morgan has offered for all of the stock. Many other stocks have been creamed. The losses at those companies most directly victimized by their own housing-bubble ineptitude – Citigroup, HSBC, USB and Wachovia -- are easy to understand. But, of course, the losses have extended much further than that. Even mighty Apple has dropped like a rock, as investors wonder how many iPods can be sold in Foreclosureville, U.S.A. And if they can't afford their beloved iPods, what will they buy? That's the thinking that has crushed everything from trendy togs-sellers like Zumiez to mom and pop carmakers like good old GM and Ford.
Consumers are spending less, and the Federal Reserve is printing money like the banks used to print credit cards. We are in a serious recession and appear to be headed directly into stagflation-a combination of recession and inflation. And the real concern at the kitchen table is that no one appears to be in charge or on top of the problem. The average American does not care what Reverend Wright said, but whether or not they can buy food and fuel next week.
It’s Ugly Out There
By now, it ought to be clear that I have been, and remain, very negative on the state of the American economy. But, I am certain that this systemic failure has steered us into a terrifying and possible direct crash right into the proverbial ditch. And, make no mistake about it, this ditch is deep and nasty and the extraction process will be long and difficult. As the lost safari leader once said, “Folks, there just ain’t no easy way out.”
The real tragedy is that all of these problems were spawned by greed gone amok on Wall Street and by the lack of any meaningful oversight from Washington and the Federal Reserved Board. I am not sure if we will have another Great Depression but it is possible and more of us realize it every day. If it happens, and if the worst case scenario turns into a real American tragedy, then the road to recovery will be long and winding with many bumps and detours along the way. It all makes me think that Andy Fastow must be sitting back in his cell at Club-Fed with a little smile on his face. If so, the Andy is the only one laughing now! The only one.
O. Max Gardner III